It seemed that as 2009 began, everywhere you looked there was risk. Output was plummeting. World financial markets were in disarray. Confidence was shattered. References to the Great Depression became fashionable. Markets were jolted into sobriety with the stark realization that risk appetite had for a long time been out of step with reality. Earnest recalibration of risk was underway.
Suddenly, capital was hard to come by. Consumers tightened immediately – even spendthrift US consumers raised savings rates from under 1% to almost 6% by mid-year. Financial institutions, stung by losses on toxic assets and weakened confidence in the financial system, tightened lending significantly. Bond spreads in the world’s riskier markets entered 2009 almost 500 basis points higher than just one year earlier. From being awash in liquidity, global capital markets were arid in a flash.
Policymakers acted fast to fill the vacuum, and by January, radical measures were already in place. Monetary easing was dramatic, and special government tax and spending plans were increasing by the hundreds of billions – and the world anxiously awaited the outcome. Stimulus plans are still taking time to implement, but the effect on confidence and the provision of liquidity has been obvious.
Halfway through the year, the outlook began to improve. Stock markets had rallied, if only partially. GDP was no longer in freefall, and grew modestly in some cases. Big banks were posting profits. Inflation concerns even resurfaced. The general mood shifted from alarm to relief. Indicators have generally improved in the second half of the year, and the word ‘recovery’ is being used liberally.
The increased feel-good factor is spreading further afield. A good deal of the risk recalibration seen at the beginning of the year has melted away. On average, emerging market bond spreads have fallen 400 basis points since early April, and are much closer to the historical lows seen in the 2006-07 period. In certain regions, spreads are even lower than 2006-07 levels. What is more, actual yields are now lower than they were. This is a staggering development, given that recovery still eludes us: overall activity is still well below previous peak levels, consumers and businesses are still deleveraging, and growth outlooks for 2010 are well shy of the pace normally seen in a recovery year.
Making sense of the situation is a challenge. We know that torrid global growth in the 2004-07 period gave rise to liquidity that increasingly scanned the globe in search of yield, a process that whittled down yields on riskier investments. Much of that liquidity dried up, but was replaced by huge policy-induced injections of cash into the economic system. But with financial institutions reluctant to lend, and consumers in the Western world reluctant to spend, the cash again seems to be making its way into these investments – and into other stores of value like commodities and selected currencies.
Is this sustainable? If it persists until full-blown recovery sets in, maybe. But that is still a year away, and in the mean time, the current retreat of risk is unsettling. Events like Dubai World and musings about Western economy ratings downgrades suggest that underlying sentiment is still twitchy.
The bottom line? 2009 is ending on a nervous note, but economic indicators are improving, giving hope for a better 2010. Happy Holidays! The Weekly Commentary will return on January 6.