Who is winning in the current environment ?

Call me a recession-skeptic, consider me blind or oblivious to the bleeding obvious… but just as long as so many parties are clearly benefiting from the current economic situation, I refuse to believe that things are as bad as those same parties tell. Especially since those are often the thought leaders of the general opinion.

However, let me begin with the obvious: those are difficult times for a lot of people. Many people are laid off, many people (including myself) have lost considerable portions of their wealth on the stock markets, many companies will disappear and many fresh and promising initiatives are born dead because of lack of funding.

Despite all this, let us not be blind to the fact that those are very promising, even joyful times for many as well.

1. The International Monetary Fund (IMF)

The IMF is clearly winning from the current crisis. Since the vanished glory of the ‘90s, the IMF was undergoing a fundamental identity crisis. Its reputation was seriously damaged by the deep and long-lasting misery its prescriptions engendered, to a point even where developing countries looked at each-other to fund their development plans.














As shown by the amount of outstanding loans coming from the IMF’s Annual Report, the IMF didn’t have much new activities at hand in recent times, in fact it was mostly chewing on the loans it has granted in the 90’s.

How different the world is now for the IMF! A 75.6 M$ ‘exogenous shock facility’ grant to Senegal, 100 M$ to the Kyrgyz Republic, 77.1 M$ to Malawi, a 1.7 B$ ‘stand-by’ arrangement with Latvia… this is just an excerpt of the IMF activities in December !

Not to forget the 2.1 B$ loan to save Iceland in October. The least one could conclude is that the IMF is back in action, which probably explains its rosy projections on future income and funding:














2. European Governments

Those are joyful times for government leaders, at least for those that show to be good crisis managers. Where did Sarkozy , Brown, Merkel stand last year in the opinion polls ? where do they stand now ?

- Sarkozy: up 6% in October vs September, 43% approval rate;
- Brown: up 5% in November, 52% of the surveyed people think he’s the right man for the job;
- Merkel: 70% approval rate in September…

Clearly, some country leaders have all the incentives to keep the sphere of crisis running for a bit longer than needed…

Furthermore, some of them will be glad to be untightened from the stringent Euro-criteria (Maastricht norms), especially France and Italy will feel relieved for not being summoned any longer about their lack of compliance with the budget deficit restraints.

But less obviously, governments have found an easy way to find fresh money, or did you think the ‘deposit guarantees’ that governments granted their banks, came for free? This is money they don’t have to spend –most of them don’t even have such amount of money- and still they perceive up to 8% of the guaranteed amounts as compensation… ‘Free money’, reinvented…

3. Companies and industries

Many companies also have good reasons to rejoice, although summing them up might sound like I’m being cynical about it, which I’m not:

- Government money to sustain the economic activity will certainly –albeit partially- go directly in companies’ wallets… the car and finance industry being the most obvious -but not the only- examples;

- The current crisis gives a very good reason for many industries to perform a big clean-up, as it obvious that the hugely inflated market expectations won’t materialize in the short term. However, this is a ‘chicken & egg’ story: do industries have to clean up because the slowdown, or is their a slowdown because of industries rationalizing their production ? A bit of both perhaps ?















- As recent crises have shown (see one of my next blogs), the current slowdown constitutes a good opportunity for many companies to gain market shares, solidify their outlooks, increase their margins, etc. Many are still growing, some even above expectations. The financial crisis and the tighter lending criteria associated with it, will hit smaller companies most. Bigger companies will feel less urge to renew and innovate in order to compete with those smaller competitors.














In conclusion

Sure, this world is experiencing a serious crisis, and this crisis emerges in a new world with plenty of unique circumstances never experienced in the past. As those uncertainties (see previous blog) make it hard to predict anything, let us not forget that most big companies are still very healthy –even, or especially, as they prepare for difficult times ahead, and let us not forget that some parties have enough reasons to inflate the climate of crisis.

Let us look at the current problems in a rational way, solve them one-by-one, in a scope that will ensure a more stable global environment for generations to come. It has been done in the past, it is feasible in the present.

Economic Sentiment Indicator as an early sign of Recovery?

My single most favorit economic indicator is the monthly Economic Sentiment Indicator (ESI) of the European countries, provided by Eurostat.

Of course, this indicator has its flaws. It’s survey-based, first of all, which makes it vulnerable to ‘opinion’ and ‘trends’. Secondly, the one that I’m using most (from Eurostat) is being challenged by a multitude of other business and consumer confidence surveys, so why favor that one ?

Well, the major reason is that it’s telling quite an interesting story.

Let’s start with an example for Europe (EU 27):

(Source: Eurostat December ’08)

In those charts, I compare the monthly Economic Sentiment (at quarter end) with the Nominal GDP change for that quarter (q/q change).

Why take the Nominal GDP instead of Real GDP or GDP by Volume ?

I’ve built those charts using the 3 GDP figures, and the Nominal GDP is the only one where a clear correlation could be found. Thinking of it, this is logical. Nominal GDP doesn’t factor in the inflation, which would have a delayed and somewhat confused impact on the ‘real’ economy anyhow (consumer spending typically is slow to respond to high inflation).

Comparing the economic sentiment with nominal GDP tells the story of how people and companies feel their current wallet content will cope with how they perceive their near-term future. Probably some anticipation of future inflation is factored in -especially in disruptive times as we’re currently experiencing. But then, this is embedded in how people and companies perceive their future, which in turn is translated in the Economic Sentiment…

What can we learn from this chart ?

The most striking conclusion is that there seems to be a strong correlation between the Economic Sentiment and the Nominal GDP quarterly change: they seem to follow the same flow.

But which one leads to the other ?

Take a close look at the chart, the pattern that you’ll see emerge is that the feeling of the economic players (as expressed by the Economic Sentiment) is lagging just a little bit whenever the economy is declining, and leading just a tiny bit whenever economic tides are turning positive again.

This somehow makes sense if you take into account that the Economic Sentiment Indicator is a mixture of feedback from companies and consumers: companies will see their order books declining with some delay when times get rough, and consumers will be oblivious to economic downturns for a little while when those downturns occur.

On the other hand, after a rough ride, the economic sentiment is likely to turn positive at the first –even slightest- signs of recovery.

In short: economic players are slow in getting pessimistic, but are eagerly awaiting any sign of positiveness.

A closer look at the ESI of major Western European countries

(all figures are in Quarters except for last 2 data points which are in months)

(Source: Eurostat data December ’08)

For all those countries, we saw a sharp decline of Economic Sentiment starting just one year ago. At first sight, it looks like the economic actors surveyed were getting overly pessimistic in comparison to the Nominal GDP growth, but the declining ESI coincides strongly with the Inflation which was getting out of hand in the same period (and, hence, with the Real GDP slowdown).

Seen that way, whenever inflation is getting out of control, it has a clear negative impact on the overall economic sentiment. Of course, other factors didn’t help, like the financial crisis which was lingering but really broke through this year, or, in case of the UK, the housing crisis. Regardless of inflation or Nominal GDP, those type of evolutions are likely to impact the Economic Sentiment as well.

Long-term evolution of the Economic Sentiment

(Source: Eurostat data December ’08)

The current drop in Economic Sentiment is only comparable to the one from 1987-93, but back then the countries moved with different pace, while they are now declining in concert…

What can we take from all this ?

1. If the Economic Sentiment Indicator is indeed a leading Indicator for how the Nominal GDP moves, the worst is yet to come;
2. However, compared to historic movements, the economic actors surveyed for the ESI seem to be overly pessimistic;
3. The longest decline of the ESI in recent times lasted 5 quarters (1995-96 and 2000-02). We are currently in the middle of the 5th quarter of declining ESI;
4. From a longer perspective, the European countries are heading to a historic low;
5. An reverse of negative ESI trend is likely to prelude an upward trend in economic activity.

I know the world is much more complex than the picture that is being drawn here, but my major point was to highlight the relevancy of tracking the Economic Sentiment as provided by Eurostat.

Frederic

Hard time for economists...

Ever since I started to closely track the economic environment in Europe –about a year ago- I never believed the global economy was heading to a recession, at least not a heavy, long-lasting one, and certainly not in Europe.

Untill September, the order books of German Manufacturers (which can be considered the motor of the European economy) were still strong, the European Industrial Production showed monthly ups and downs -at least as many ups as downs-, the inflation was mainly due to factors that end-customers could ultimately control, and the financial crisis I thought was a good opportunity to get rid of certain excesses that characterized the Financial sector for quite a while.

I was not blind to the effect the Financial crisis could have on the 'real economy': tighter lending criteria would ultimately affect non-financial companies as well. But looking at the official figures from the European Central Bank (ECB) on the total amount of loans outstanding, both by corporations and citizens, one could only conclude that there was no effect at all, in other words: that there was no ‘Credit Crunch’ at all in Europe and that the financial crisis had only a limited effect on the ‘real economy’.














Well, given the latest figures released this month, I must admit I was wrong !














The figures in this table show the growth in terms of GDP Volume, basically measuring what has been produced and consumed, rather than the value of it.

Still, this table shows a 2 quarter consecutive decline of economic activity for a number of European countries: Germany, Italy and Sweden. Other countries don’t look in good shape neither.

So what happened ?
Starting in October, we started to see a huge amount of negative news from non-financial companies, as if they all waited for the same moment to bring negative news out. Substantial lay-offs, (temporary) factory closures, profit warnings, they all made the news headlines since then.

As often, this mechanism is self-feeding: if you look at the company financials as stated in their last Financial reports, one can see that most of them remain in solid financial health. The actions undertook by most of those companies are pre-emptive, preparing for a future that appears to be gloomy, because everybody is preparing for such a gloomy future.

For sure, there are some concrete negative trends affecting specific companies and industries at large. Consumer spending is declining, which has an effect on most Retail Companies; Industrial production is put on hold, which in turn has an impact on the order books of Machinery Manufacturers; etc.

But again, looking at financial statements of companies in each industry, you see a very mixed view, with some companies clearly suffering from the downturn, others being able to sustain or even grow substantially. With the exception of certain industries like Car Manufacturers or –obviously- the Financial Industry, there doesn’t seem to be an industry-wide trend affecting all the companies in it.

Where is this all heading ?
To put it quite bluntly: I don't think anybody knows.

Looking at all the predictions from bright economists from the IMF, the OECD, Eurostat, EIU (Economist Intelligence Unit) of the last year, going from a mild, short-lived recession that wouldn’t impact Europe or the Emerging Markets, to a ‘double dip’ scenario for the US, none of the scenario’s has materialized.

Back in March, everybody was certain that the US were going through a serious recession in Q2 –at least all the leading indicators pointed to that direction. In June, when the actual figures were released, the US economy appeared to have grown twice as fast as the European economy. And now, economists are telling us that the US is in a recession since Q4 last year !

My personal feeling is that we are dealing with a number of key uncertainties in the current environment. Each of these uncertainties is complicating any forecasting model in its own way, but the combination of these key uncertainties –and the way each of them has moved in recent months- has put the level of complexity and doubt to an unprecedented level –one that no econometric model can currently cope with.

To highlight just a couple of those key uncertainties:

1. If it happens, this would be the first truly global recession ever.

While this would certainly not be the first serious recession ever, the one that everybody is announcing now might become the first ever global recession. As shown on the long term GDP trend from IMF, in the past the major countries have shown some different growth patterns.

Take the ’93 recession as an example. You will see from the chart that, while the biggest European Countries –and Western Europe as a whole- dipped at the same time, the UK was recovering strongly from a serious recession in ’91, and the Worldwide economy was at the verge of an exponential growth that would last until ’97 !
















Compare this with the projected situation of 2009, you will see that all the economies are expected to experience the same dip, at the same scale, and the same length.

We can model what might happen in such a scenario, but we cannot know for sure due to a lack of experience with it.


2. Where is the bottom of the Financial Crisis ?

Here again, nobody really knows. True, governments all over the world are maximizing their efforts to save(mostly their own country’s) financial institutions from a ‘worst case scenario’. But the effectiveness of those actions still needs to be proved.

By injecting cash on the balance sheets of banks, or by guaranteeing the deposits as well as their new lending, governments are certainly taking the right actions, but will it pay-off ?

In modern banking –and this is where the crisis began- trust is the real currency that matters. Banks all over the world used to lend –sometimes overnight- huge amounts of money to each other, without really knowing what that money was used for –normally this money is crucial for sustaining the core activities of a bank, but in recent times it was also used to invest in risky equities.

With the balance sheets of banks starting to look faulty, that trust –and the money it bought- quickly evaporated. So the Million Dollar question now is: will the government money on the balance sheets be sufficient to restore trust ?

My guess: it won’t, just as long as there is no worldwide regulation limiting the use of ‘interbanking’ loans, or at least an obligation to tell where that money will be used for.

3. Will Keynes work in the current world ?

Hard to imagine, but John Maynard Keynes is back in business. 62 years after his death, he’s headlining newspapers and magazines. All for good reasons, his medicine for recession was successful in the past, and is currently implemented by most major countries: invest in public infrastructure, job-creation, low-skill industries… all to make sure a maximum amount of people keep on working… and spending…

This worked well in the past, but it’s not quite certain whether it will work in the current world, for two major reasons:

First, in the globalized world each industry is internationally fragmented, there is no such thing as a ‘national champion industry’ to protect or save by injecting money into anymore. Even the traditional activities that are subject to the Keynes medicine, like construction or infrastructure projects, are dependent on the worldwide markets. So any money the governments poor into such an industry, will ultimately benefit the economies of other countries as well –though it’s very hard to tell to what extend it will.

Secondly, the European governments are drawing quite some different conclusions from the Keynes doctrine. By lacking to understand the global scope of their industries and their challenges, and by engineering plans that lack coherence throughout the European countries, national governments might be poring money into an endless hole.


What to take from all this ?
My stance here is to show that in the current environment no prediction holds the ultimate truth. Despite all the alarming news and dramatic statements, the situation might as well turn favorably quite soon. Never forget that a lot of economic constituents are benefiting from chaos and panic…

Since the beginning of the financial crisis –almost a year ago- I had the feeling that this would be a period to which, in a year or two from now, we’ll look back and ask ourselves ‘what was all this fuzz about’. But then, we all know that people (including myself) have short memories.

And then again, this is just one likely scenario.

The key message is: no panic ! This is NOT a complete meltdown of the economy, this is NOT a return to the dark ages, this is NOT a situation comparable to the big crisis of the '30ies of last century. This IS a crisis, for sure, but it is a crisis like we've been trough in the past, and though the impact of certain factors are unknown, we do have the knowledge and the tools to cope with the current situation.