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An Uneven Global Recovery - Lingering Effects of the Credit Crisis

Bill Hester, CFA
March 2011
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What is the state of the almost two-year old global economic recovery? Do the characteristics of this recovery so far match the characteristics of the typical post-war recovery? Or are they more comparable to the periods that followed prior credit crises? How large a role are the economic backdrops of individual country's playing in stock market valuations?

There aren't short, simple answers to any of these questions. But they capture some of the issues that investors are currently confronting in their attempt to appropriately price global stock markets. A closer look at recent global economic performance can hopefully provide some data for the discussion.

The next few weeks may turn out to be a crossroads for global economies and stock markets. Over the past two years policy makers around the world mostly agreed on the medicine the global economy needed: add more liquidity in response to any sign of faltering stock prices or credit stress. Soon, economic prescriptions will begin to vary. The ECB will likely begin to boost short-term rates in early April as Euro-area inflation rates have climbed above the bank's goal of about 2 percent. The Bank of England will likely respond in similar fashion later this year, although it finds itself in a tighter spot with higher levels of inflation than the Euro region, but also with output growing more slowly.

Meanwhile Fed Chairman Bernanke has made it clear that he will not be swayed by the trends in the volatile segments of inflation, like food and energy. He has suggested that the Fed will wait until the core rate of inflation pushes higher or inflation expectations rise to a greater extent before becoming concerned.

Continuing negotiations by Euro area leaders about the size and reach of the European Financial Stability Facility (EFSF) the rescue fund created last year to help backstop sovereign debt - also provide fertile ground for disagreement. The market is sending signals that the current fixes in place may not be sufficient. Three-year government notes in Greece are now yielding 18 percent, up from less than 13 percent in January. Portugal borrowed money this week at 5.99 percent, up from a yield of 4.08 percent on bonds with the same maturity sold in September.

This recent market action forced European leaders into an emergency summit on Friday. From that meeting came important changes to the rescue fund. The EFSF will now be able to loan the full amount allotted to the fund, it will be allowed to buy sovereign bonds on the primary market, and the interest rate on loans to Greece was cut by a percentage point while the maturities of the loans were extended.

But the summit also highlighted the continuing divergences in opinions on fiscal strategies in the area, including ways to increase competitiveness, equalize retirement ages for pensioners, and appropriate tax policies. Ireland's request for lower loan rates was denied by the group because the Irish refused to consider an increase in corporate income tax rates.

These growing disagreements in monetary and fiscal policies will likely create further divergences in economic recoveries. The health of the global economic recovery depends on which country you view it from. Some countries are performing much better than is typical for a period following a global credit crisis. Some are performing in line or worse - than is typical for these periods.

To help gauge the recovery on a country by country level, we'll lean on the body of work by Carmen Reinhart. In a paper published last year titled After the Fall , Carmen and Vincent Reinhart updated the research on the economic characteristics that follow credit crises. Where the book she co-authored with Ken Rogoff, This Time Is Different, looked at the immediate effects of global recessions that followed credit binges, last year's paper extends the window of the analysis to include economic performance during the subsequent decade. Their conclusion was that economies tend to grow more slowly following credit crises, have higher levels of unemployment, and emerge with higher debt loads in relation to GDP. This period of below-average growth will often last as long as the credit surge that preceded it.

The Reinhart's paper looked at the 21-year periods surrounding credit crises, comparing the decade following each credit crisis with the 10-year period that preceded it. To capture this style of analysis, the tables below attempt to provide a mid-recovery check-up. The tables compare the most recent data for each country to the average of that data during the decade that preceded the peak. The first table highlights changes in real GDP. For reference, the Reinhart's found that the median growth rate of GDP following prior credit crises was about 1 percent less than the decade that preceded it.

In the table above, the average recent growth rate is about 1 percent below each country's output growth prior to the peak. Of course, a large part of that average subpar GDP growth is due to the contraction in output in Greece. Without Greece, the average difference in growth rates is -.35%. But it's also clear that a majority of economies are still growing at rates below levels attained prior to the peak. This is sobering considering the tremendous amounts of liquidity introduced into global economies during the past 18 months. Of the countries in the table, two-thirds of them currently have growth rates below longer-term averages, despite economic slack that would normally allow them to grow at much higher than average rates.

The Reinhart's also found that high unemployment rates were sticky in developed countries following credit-related recessions. The median unemployment rate in developed countries was about 5 percentage points higher following these periods. The table below lists recent unemployment rates versus prior averages. The average difference among the countries is about 2 percentage points. As with GDP growth, there are large divergences. Peripheral Europe is enduring high rates of unemployment, with Ireland, Spain, Portugal, and Greece having unemployment rates that are averaging 6 percentage points above pre-crisis levels. More than 75 percent of the countries still have unemployment rates higher than the pre-crisis average.

Germany is an example of a healthy economic recovery. Germany's unemployment rate is currently at nearly a two-decade low. These first two tables highlight the large extent to which the Euro area is relying on Germany's recovery.

Looking at the labor data in this context also highlights how weak employment growth has been in the US. The US unemployment rate sits 4 percentage points above the pre-crisis level. In this light, the US job recovery's best comparison is with peripheral Europe.

The data on changes in the rate of inflation that followed credit crises showed less agreement in the Reinhart's work than did output growth and unemployment trends. Highlighting the two credit crises that were global in scale 1929 and 1973 - deflation followed the former and very high rates of inflation followed the latter. Currently, divergences in global inflation rates are rising. Greece and the UK are experiencing high rates of inflation, versus generally accepted target levels. Ireland is experiencing low rates of inflation, as real estate prices continue to founder.

The table also highlights why the monetary policy trends among the major central banks will likely continue to diverge this year. While the UK confronts inflation rates at twice their longer-term average, the US inflation rate is still about one percent below its average prior to the crisis.

Real Interest Rates

Forward looking measures of growth are suggesting that sub-par economic growth will likely continue. As John Hussman recently noted , high real interest rates can signal opportunities for productive investment and future economic growth. During the technology boom of the 1990's, real rates in the U.S. stayed persistently high, and were followed by strong GDP growth. These same trends can be seen globally. The graph below plots real rates (the 10-year yield minus consumer inflation) in Britain, along with GDP growth a year later.

Current global real interest rates are uninspiring. The table below compares the recent real rate for each country in our sample to the pre-crisis average. It's important to highlight the countries with high real rates: Ireland, Greece, Portugal, Spain, and Italy. That's also a list of countries where investors are unsure they'll be paid back par on their bonds, so the high rates reflect significant default premiums. Outside of that group, all of the other countries currently have lower real rates relative to their pre-crisis average rate, either because of low interest rates or rising levels of inflation, suggesting potentially sluggish global growth going forward.

Debt and Economic Recovery

The tables above show that there's been variation in how developed countries have recovered from the depths of the global recession. Why has this variation occurred? One reason is different levels of public debt. Countries that entered into the crisis with near-balanced budgets and didn't need to issue debt to prop up their banking systems now have more flexibility and are generally experiencing healthier recoveries. In these countries output is growing more quickly, unemployment rates are falling, and inflation levels are staying low.

The graph below compares the growth in output for each country in our sample from June 2009 through the end of last year (where fourth-quarter data is available). That recent growth is compared to each country's public debt to GDP ratio.

The graph below compares the changes in unemployment rates since June 2009 relative to debt to GDP ratios. Again, generally less indebted countries have seen their unemployment rates fall, or rise modestly, while more highly indebted countries has experienced rising jobless rates.

Finally, the graph below compares the changes in the level of inflation since June 2009 to each country's debt to GDP ratios. Higher indebted countries have seen inflation rates rise more quickly relative to countries with healthier balance sheets.

Something to keep in mind when looking at these charts is that many of these countries will move outward on the horizontal axis as their debt loads in relation to GDP grow, especially when age-related liabilities are included in the analysis. Recent research from the BIS suggests that debt to GDP ratios will rise significantly over the next decade, growing to 300% in Japan, 200% in Britain, and 150% in Belgium, France, Ireland, Greece, Italy, and the United States. These increases would represent ratios of debt-to-GDP that are 60% higher than current levels, on average. (Japan was left out of our analysis only because its debt to GDP ratio is already so high that it visually distorts the trends of other developed countries.)

That means that a greater share of countries may take on the qualities of those economies currently saddled with high debt loads: slower economic growth, stubborn unemployment, and inflation rates above standard comfort levels. And these macro-economic risks correlate directly to stock market risk. The graph below displays the change in stock-market multiples (using MSCI price indexes and fundamental data) since June 2009 and the ratio of debt to GDP. The graph shows that investors continue to be sensitive to economic and default risks, containing the stock market multiples of the highly indebted countries, versus those with lower debt loads.

The health of the global recovery depends on which country it is viewed from. When compared to the decade ending in 2007, a majority of developed countries are currently growing more slowly, have higher rates of unemployment, and have higher levels of inflation. Some like the countries of peripheral Europe - are deeply mired in standard post-credit crises characteristics. There are exceptions. Notably, Germany is growing at twice its long-term average, with very low relative levels of unemployment. Stock market investors are showing growing sensitivity to differences in macro-economic risks. These differences may soon be further aggravated by monetary policies from the major central banks that are about to diverge noticeably.


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