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Global market overview – October 2009

This month we examine the impact of the financial crisis on Europe’s ability to compete internationally. We also look at the US dollar’s attractiveness as a funding currency and discuss the potential for accelerated economic growth on the back of global stimulus measures.

Europe is losing competitiveness

The relative inflexibility of European labour markets is proving to be a bonus for economic performance during the present crisis. Although unemployment has increased, employees have in fact benefited from rising real wages. This is due to the fact that many wage contracts were settled before the crisis and featured comparatively higher wages. Falling inflation has pushed the real wage increase even higher. Coupled with government incentives to spend (eg lower taxes and car scrappage schemes), this has prevented a strong decline in consumption, limiting the economic contraction.

The other side of the coin is less positive. Corporate Europe is becoming less competitive compared with the US. US firms have historically been more successful in lowering ‘unit wage costs’, that is to say, wage costs per dollar of production. In addition, some US product markets are more competitive than European product markets, forcing companies to be more productive with a stronger focus on costs. Furthermore, it is easier to adapt the workforce to changing circumstances in the US, whereas European labour laws are generally more restrictive. During this crisis, US firms were, on average, quicker to reduce their workforce and wage levels, whereas European firms have continued to face higher real wage costs.

Chart 1: Europe’s competitiveness has declined as companies have been unable to reduce labour cost quickly
Chart 1: Europe’s competitiveness has declined as companies have been unable to reduce labour cost quickly

Source: OECD/ECR

Initially, a weaker EUR/USD came to the rescue for European firms. However, EUR/USD is rising again and some economists believe that it is heading for 1.60, back to historic highs. We are not of this opinion however and expect that the increase in EUR/USD will prove to be self limiting. Equilibrium levels for EUR/USD are, according to calculations, between 1.10 and 1.20. Anything above this range means a heavier burden for European-based exporting companies. Therefore, a further rise in EUR/USD is likely to stifle any increase in European exports, limiting the recovery and forcing the authorities to maintain easy fiscal and monetary policies for a longer period. In turn, this would limit the upward potential for EUR/USD. We therefore expect the EUR/USD to decrease in the coming quarters.

US dollar as prime funding currency

The US dollar is quickly gaining popularity as a funding currency for investments in higher yielding assets or non-yielding assets such as gold (so called carry trades). The rationale behind this seems straightforward:

  • The short-term interest rates on USD loans are among the lowest of the main global currencies, and the Fed has repeatedly indicated that interest rates will not be raised in the foreseeable future.

  • The US dollar is a ‘deficit currency’ (the US has a current account deficit). This means that there will be continuous downward pressure on the dollar if the US does not attract sufficient investment flows.

In other words, borrowing in US dollars is cheap and could be repaid with a cheaper dollar over time, (sentiment indicators show an extreme bearish reading towards the dollar, meaning the majority expect the dollar to weaken). As a result, the dollar has overtaken the yen as the preferred funding currency. Over the last months, dollar carry trades have weakened the dollar considerably, as the process essentially ‘creates’ more dollars which are partially offered on the currency markets.

The attractiveness of dollar carry trades will diminish when US interest rates start to rise or higher yielding asset prices decline. We do not expect the former for the foreseeable future. However, we do expect asset prices to correct in the coming months to quarters, as we think the real economy can not fulfil the bullish expectations the stockmarket currently is discounting.

As soon as asset prices start to decline, it is possible that the dollar could recover rather quickly. Leveraged investors would then be forced to sell their assets, and repay their dollar loans, thus creating a higher demand for dollars, on top of more dollar demand stemming from safe haven flows towards US assets and repatriation of foreign investments by US money managers.

Accelerating growth?

Some economists believe that the risk of accelerating growth is being underestimated. They fear the effects of the unprecedented fiscal and monetary stimulus measures worldwide, following the credit crisis. The problem with easy monetary policy is controlling where the measures lead. Likewise, it is unclear where the extra liquidity created by these stimulus packages will go to, but it will go somewhere. If not into the real economy, then into the asset markets. The million dollar question is ‘where exactly’? If into the real economy, it will cause higher inflation and if into the asset markets it will result in rising asset prices.

Logically, one would expect the extra liquidity to push up asset prices instead of consumer prices. Rising unemployment and record low capacity utilisation will prevent higher inflation in the near future. On the other hand, stock and commodity prices have already been pushed up by expansionary policy. At the time of writing, financial markets showed classic signs of monetary reflation by the Fed (and other central banks); rising prices for stocks, gold and other commodities, while the dollar was being sold off.

Chart 2: Extra liquidity is flowing to the financial markets
Chart 2: Extra liquidity is flowing to the financial markets

Source: Reuters EcoWin/ECR

However, a successful reflation is not necessarily followed by accelerating growth. For this to happen, consumers and companies have to respond to rising asset prices by investing and consuming more. This causes us to expect no acceleration in growth in the coming months, although we do expect the authorities to stay ‘accommodative’, in terms of an expansionary fiscal and monetary policy.

Consumers spend more if they earn more or if they feel richer. In past recessions, the recovery was initiated by higher consumer spending (before unemployment started to decline), as easy monetary policy pushed up property and stock prices. Consumers therefore felt richer, took out a car loan or a second mortgage and then spent more.

Over time, this initiated a self-propelling growth mechanism, as higher consumption is followed by higher employment, rising wages and more consumption. This process essentially transformed the US consumer into the engine for world growth.

Today, stock prices have increased but house prices are still at depressed levels and banks are much more reluctant to lend again with assets as collateral. Furthermore, US consumers already have huge debt levels to service, while job security is low. This is no environment in which to spend freely. Therefore, unless house prices recover, we do not expect the consumer to pull the economy out of this recession.

Given weak demand and high excess capacity, investment spending will also remain sluggish. This leaves growth mostly dependent on higher government expenditure. However, this will not result in accelerating growth.

As soon as growth picks up, governments will either withdraw some stimulus or rising interest rates will force them to do so. Moreover, because the US is still the biggest economy by far, sluggish growth in the US will mean sluggish growth in the rest of the world. We do not think that Chinese growth is either sustainable or substantial enough to ignite a recovery in the US or Europe.