Tim Drayson, Economist, LGIM 

Recorded: September 2009

The consensus view from the industry seems to be that the recovery has started – would you agree with that view?

Many economic commentators have expressed the view that recovery has begun.  We would tend to agree.  I think the recession is clearly over now.  Many of the confidence surveys, both consumer confidence and business confidence, have shown a marked improvement in recent months, and now we are getting confirmation in the official data, to things like manufacturing production and retail sales, the housing market statistics, all suggesting that the worst is behind us.  We are now entering a period of reasonable growth at least in the next couple of quarters or so.  But this is something that we have been expecting, but we felt back in March that the pessimism had become overdone.  People were beginning to think the recession was going to last for a prolonged period of time, but they failed to take into account that the faster you go down the greater the scope for some kind of catch up and snap back to more normal levels of activity, and that is really what we are seeing now. 
We expect this trend to continue for the next few months, but as we go into next year, I think there is scope for a disappointment.  Particularly, people get over excited about the strength of the recovery.  I think the household sector is still suffering some pressure from the earlier declines in wealth; they have seen their house prices go down, they have seen their stock portfolios drop in value.  There is some pressure there for the household sector to save a bit more, and that is going to mean the recovery is ultimately slightly disappointing.

So where do you differ from consensus?

I think there are two main areas that we differ from consensus.  Firstly, in the strength of the recovery in the second part of this year, we feel that companies cut back production excessively, during the down turn, and now we are seeing enormous scope for catch up, and that should lead to a very strong growth rate over the next couple of quarters.  Secondly, as we go into 2010, the crucial determinants of growth will be consumer spending and business investments, and while we are not envisaging a so called ‘double dip’ recession, where growth turns negative again, we do think that both of these components of demand remain slightly subdued, and particularly if you look at the consumer, this stuff had quite a shock to their wealth, both with declining house prices and declining equity portfolios, and there is need there for a rebuild of saving.  At the same time, income growth is still fairly weak, and that is going to put a brake on the rate at which consumers can spend.

What is the likely trigger for a disappointment?

I think we need to look at the world in two parts; you have the emerging world, where I think growth will probably be quite robust next year; their banking system is nothing like as impaired as in the west.  They haven’t suffered from the credit crunch; there hasn’t really been a consumer credit culture, so the lower interest rates that we have seen across emerging markets, is really helping to support domestic demand.  We’re quite upbeat about growth prospects across that part of the world.  In contrast, in the west, the banks are still struggling.  They are attempting to re-capitalise.  This is going to take time.  I think lending conditions remain fairly tough, right through next year.  At the same time, you have got a household sector which borrowed too heavily in the boom years, and are now in the process of paying down some of their debt, and rebuilding their savings.  So, they’re becoming much more dependant upon income growth to fuel their spending.  If you look at the US in particular, the labour market is very weak; unemployment is likely to remain around about 10%, probably through most of next year.  At the same time, wage growth has been slowing, so it is very hard to see a strong sustained pick up in consumer spending.  If businesses see the consumer not really out there shopping, given the huge amount of slack in the economy right now, there is no real incentive for them to go out and invest aggressively, and if they are not investing, then they are not going to be employing quite so many people so there is a feedback loop back into sluggish income growth.

I think probably the US is very likely to see the biggest disappointment.  It is only relative to consensus, where the growth expectations have been rising over recent months and could well overshoot as we get this strong industrial data through the course of this year.  In Europe and the UK, those consensus expectations have lagged a bit behind, so I think there is further scope for consensus to revise up their growth numbers.  On average across Europe, the US, Japan, UK, we are probably looking at around about 2% growth for next year, which is okay, but given the scale of the downturn, it is a bit disappointing.

What would make you more positive about the US?

I think the US housing market is one of the key areas to analyse.  It was the epicentre of the crisis; we have seen 3 years of declining home sales, declining prices, the collapse in residential investment.  We are now seeing some more positive signs that maybe the market is going to clear, house prices bottoming out; home sales have ticked higher in recent months, aided by a tax credit from the Obama Government.  Also, housing investments, in terms of new housing stocks, are also beginning to edge a little bit higher.  At this stage, we are really talking about the drag from housing ending.  I don’t see it as a huge engine of growth.  There are still a lot properties out there to be sold, so you have got all of these properties overhanging the market.  That means it is going to be more like an L shape, so it’s a flat line along the bottom for a period of time.  House prices are broadly flat, but at least it is no longer subtracting from the economy, so we can see returns; there is still a 2% growth rate in the US.

Are there any positive signs for the UK?

If we look more specifically at the UK, I think households have benefited tremendously from reduction in interest rates.  A lot of people have mortgages which are either directly linked to the base rate, or a two year fix, which many are in the process of re-setting.  That has given a nice boost to household cash flow, as they are paying less in mortgage interest repayments.  On the more negative side, the labour market is still fairly weak.  We are seeing very limited wage growth, so there is not an awful lot of income growth there to drive consumer spending over the next year.  From the Bank of England’s perspective, if you don’t see any wage pressures, I can’t see where inflation is going to come from, and that means they can keep interest rates very low for some period to come.  In addition, whoever wins the next election is going to be faced with a very tricky public finance position, they may well have to either raise taxes or cut public spending.  That is further going to dampen growth and remove any pressure on the Bank of England to raise rates.  Our best view at this stage is that rates are probably on hold right through next year.

In summary, what’s the bottom line?

If we were to summarise our views, I would say we’re quite upbeat about prospects for the next few months.  I think business surveys will continue to show an improvement in confidence; gross domestic product figures should show a return to pretty healthy rates of growth really across the globe.  As we go into next year, attention will turn to the strength and durability of the recovery, and here we still have some doubts, particularly when we look at the consumer across the western world, and they took on too much debt in the boom years.  They are still in a process of paying down that debt, and this is a multi-year process.  It is not going to take just a few months. 

At the same time, labour markets are still fairly weak, income growth is soft, so it is going to be quite hard for consumers to go out and spend aggressively.  For the world as a whole, we see growth around about normal rates, which in an ordinary year would be perfectly acceptable, but given we have just suffered one of the most devastating losses of output, it is somewhat disappointing.