Business survey and economic indicators have consistently improved since the beginning of the summer, suggesting that the worst of the recession is now behind us. The most positive signs have appeared in Asia, where industrial production bounced back by an impressive 40% in the second quarter. Since then, Korean, Taiwanese, and Chinese exports have been rising markedly on the back of buoyant domestic demand in the region. What’s more, stronger growth is now spilling over to North America and western Europe: business surveys and high frequency indicators, such as the Global Purchasing Managers surveys, point to a return to positive growth in the second half of 2009.
In Standard & Poor’s opinion, however, the sharp rebound in output growth over the remainder of the year is likely to be quickly followed by slower, sub-trend growth in 2010, with the main risks still toward the downside. From our perspective, the message to corporate treasurers and financial officers is clear: the economic outlook is going to improve from here on, but difficulties remain, particularly on the financing side as banks continue to maintain their tight lending criteria. In addition, the situation in a number of central European economies remains preoccupying as well and the risk of a currency crisis in that region have not gone away.
A Sharp Rebound in the Second Half of this Year
The rebound in economic growth, if it is confirmed for the third quarter, will signal the end of the most severe downturn in the past 50 years. From the peak of the economic cycle in the fourth quarter of 2007 and the trough in the second quarter of 2009, gross domestic product (GDP) declined 7% in Germany, 5% in the eurozone as a whole, and 5.7% in the UK.
The foundation of the forth-coming recovery was, in our view, laid by the vigorous policy responses across the industrialised world. The fiscal and monetary stimulus injected into most economies during the current downturn is a major difference compared with the Great Depression of 1929. During the Depression, money supply collapsed, while the weighted average fiscal deficits for the 24 largest economies remained below 4% of GDP. Lessons have been learned since then: on the monetary side, the balance sheet of the European Central Bank (ECB) jumped to 23% of GDP in March 2009, from 16% in June 2008. Meanwhile, the size of the US Federal Reserve balance sheet surged to US$2.4 trillion from US$900bn. Ultra-low interest rates have also eased pressure on indebted households, preventing a collapse in consumer demand. On the fiscal side, reflationary measures, such as the highly successful schemes to subsidise car sales introduced in a majority of countries, have also helped to limit the retrenchment in domestic demand. In addition, the sharp drop in oil and commodity prices since the second half of 2007 triggered a fall in retail price inflation – another factor of support for consumers.
The resilience of consumer demand in the first half of 2009 has led companies to end their inventory adjustment. Stock normalisation (i.e. a restocking boom) is a key factor behind the sharp rebound that we anticipate in the coming months. The surge in global trade initiated in Asia, resilient consumer demand, and inventory normalisation should, in our view, deliver above-trend growth across the globe for the remainder of 2009. Even so, this V-shaped recovery – a dramatic fall in output followed by a strong recovery – is likely to be short-lived. In our opinion, several factors are likely to weigh on economic activity, causing some disappointment in the performance of European economies next year.
Tight Bank Lending and its Implications for the Bond Markets
The recent ECB bank lending survey in July reveals continuing tight credit conditions in the single currency zone. Regarding loans to companies, 21% of surveyed banks tightened lending conditions while 79% left credit standards unchanged, with no bank reporting any easing in lending standards. Evidence of the banks’ reluctance to accelerate their lending can be found in the latest ECB refinancing operation on 24 June 2009, when €442bn was lent to financial institutions in the eurozone. A month later, about €192bn had been re-deposited by the banks at the central bank, while a good proportion of the remaining funds had been used in balance sheet repair operations via the purchase of government bonds. This is why the sharp increase in the central banks’ balance sheets, as mentioned above, has not translated into higher money supply growth – rather, the additional liquidities have remained within the financial sector.
Some fear that those liquidities could suddenly flood the economy as economic conditions improve, setting the stage for a return of inflation. In our opinion, that risk is small, for two reasons: first, financial institutions are likely to maintain a highly cautious stance in their lending practices to avoid a repeat of the pre-2007 excesses; and second, the pick-up in economic growth is likely to leave a lot of slack in terms of capacity utilisation. In the case of the UK, for instance, we do not anticipate GDP returning to its 2007 level before 2012.
Meanwhile, tight credit conditions will have a number of important implications. First, they indicate no near-term recovery in asset prices, which, in our view, is negative news for companies and consumers (because housing markets won’t recover anytime soon). We believe this is also going to slow overall debt restructuring, a process likely to contribute to a slow recovery in growth. Second, limited availability of loan funding implies greater reliability on bond markets. Corporate bond sales have already surged to an all time high of US$1.1trillion in Europe in the first half of 2009. By contrast, companies have raised US$109.6 billion in Europe this year by selling stock, including rights offers, a figure 25% lower than that raised in the same period in 2008, according to data compiled by Bloomberg. At the same time, syndicated loan volumes fell to US$188.4bn, down from US$713.3bn in the same period in 2008. Companies have been willing to pay higher spread premiums on the bond markets to raise their liquidity buffers and to replace bank loans.
That trend will resume after the summer lull, and it is likely to result in important long-term changes in terms of disintermediation in Europe. In the US, the overall portion of bank loans is slightly below 40% of companies’ overall debt. For the eurozone, the corresponding figures at the end of 2008 amounted to €0.7 trillion in corporate bonds and €8.2 trillion in corporate loans; in other words, a loan portion of more than 90%.
Yet such a loan-to-bond conversion raises several issues. For instance, European bond markets have traditionally attracted only large cap companies mostly at the investment-grade level (that is, with long-term corporate credit ratings of BBB- or above). We observe that only a few mid-cap companies are assigned credit ratings, and most are not yet prepared to obtain funding via the capital markets. Until such a change starts to occur, tight credit conditions will penalise small and midsize companies the most and weigh on their ability to increase their capital spending, therefore limiting the scope for a strong and long-lasting economic recovery. Another risk factor concerns the substantial increase in sovereign issuance as a result of higher public deficits. This presents the risk of a crowding-out effect, where private sector debt spreads starts to increase substantially, causing a market crash and discouraging new corporate bond issuance. Such a scenario still carries a low probability, in our opinion, yet it cannot be completely ruled out.
In all cases, the transition toward greater reliance on bond market funding by European companies, while structural, will in our opinion take time – especially for midsize companies. Until such a move is complete, overall funding will remain tighter and more expensive than in the 2004-2007 period.
Risks Remain High in the East
Developments in central and eastern European (CEE) economies will, in our view, also curtail upside potential growth over the medium term. Specifically, we believe that the outlook for CEE economies, with their strong financial and trade links to western Europe, will dampen the strength of the recovery in the West. Among emerging markets, CEE economies have been experiencing the steepest rollercoaster ride in terms of growth. After exceeding global growth averages for the past decade, CEE regional growth has plummeted this year and will likely underperform both emerging Asia and Latin America. A combination of falling exports and slowing capital inflows lies behind this bleak picture.
Before the global slowdown, the abundant financing that was available through the large contingent of foreign banks in the region, coupled with the prospects of further convergence with the more mature economies of the EU, made the CEE economies look particularly attractive places to invest. Since mid-2007, however, countries with the largest current account deficits – especially Estonia, Lithuania, Romania, and Bulgaria – have been the most exposed to sharp corrections. Estonia and Latvia are already in the midst of sharp recessions; Hungary and Latvia turned to the International Monetary Fund (IMF) at the end of 2008 to avert a currency crisis. Furthermore, the strong foreign banking presence, previously a major supportive factor for economic growth, is now a real weakness. This is because the parent companies of those foreign banks are feeling the pressure from the ongoing credit crunch and have to reprioritise their lending choices, a development that could negatively affect their subsidiaries in Eastern Europe. Meanwhile, the high level of foreign debt to GDP in most countries – 103% in Bulgaria, 115% in Estonia, and 93% in Hungary – puts additional pressure on each country’s exchange rate, therefore limiting the local central bank’s margin for manoeuvre in terms of interest rates.
Not all CEE economies are in the same boat. The Czech Republic, which has a low foreign debt to GDP ratio (40% in the fourth quarter of 2008) and resilient consumer demand, has been weathering the downturn better than most of its neighbours. Poland is another bright spot: as eastern Europe’s biggest economy, Poland has a larger domestic market, making it relatively less dependent on exports to ailing western Europe. Furthermore, the country’s flexible exchange rate and record-low interest rates have helped cushion the slowdown. What’s more, Poland proactively distinguished itself from others in the CEE region and boosted investor confidence in May of this year by securing a US$20.5bn flexible credit line from the IMF – a special facility reserved for emerging markets with strong fundamentals. But while Poland’s economy has weathered the global turmoil better than most of its regional peers, we feel that a rapid recovery is unlikely and that the outlook is not without risks. In particular, Poland’s fiscal situation is deteriorating, which will likely push back the country’s planned adoption of the euro in 2012.
The Long and Winding Road to Recovery
In our opinion, the worst is likely behind us in terms of output declines and the next six months should see a fairly sharp rebound on the back of restocking activity, but European economies are likely to return to sub-trend growth quite quickly. This is mainly because, in our view, financing will continue to be tight, especially for small and midsize companies whose access to the capital markets remains limited. Also, the near-term prospects for western Europe’s closest export markets in the CEE remain highly uncertain, with the risk of foreign exchange turbulence triggered by current account crises still a distinct possibility.
What, then, are the implications for corporate treasurers? In our view, the focus on managing margins will remain critical, as the potential for strong sales growth will likely be limited in most sectors. Debt restructuring, continuous cost control, and hedging of financial risks come to mind as imperatives.