Complex Made Simple

Is the global economy really that bad?

The markets have been acting like another recession is around the corner in recent weeks. Stocks have tumbled, dragging oil with them and safe havens have reached record highs as investors' nervousness reaches fever pitch.

By Kathleen Brooks, Research Director

But is all of this justified? It was only a few months ago that stocks were cracking fresh highs and the global outlook was considered to be rosy.

However, a spate of weak economic data reports and the markets have swung the other way. There is no denying that the growth outlook has deteriorated. The UK, US and Germany could only muster dismal growth rates in the second quarter of the year. Germany’s slowdown has been particularly severe – it’s rate of growth slowed to just 0.1%, down from 1.3% in the first quarter of the year.

This is a sharp slowdown, but it is not entirely unexpected. Germany is working hard to cut public spending and reduce its fiscal deficit, which is having a dampening effect on growth. The debt burdens in the US and UK are much worse than in Germany so the cuts will be sharper and the impact on the economy even greater. However, the cutting phase is a bit like shock therapy.

It will hurt growth for the next couple of quarters after which things should start to pick up. There is also a valid argument to make that when bloated public sectors start to shrink it opens the way for the private sector to grow. Since the private sector tends to have a faster rate of growth than the public sector this could end up being a positive for the West’s most overly indebted economies.

Looking at the current situation from this angle suggests that the current slow patch in growth may be temporary and a recession may not be forthcoming. There are already some positive signs from the US in the manufacturing sector, and orders for long-lasting goods like cars and aircraft surged by 4% in July. These are all positive steps. An airline won’t order more aircraft if they think there will be a prolonged downturn. Likewise, if new cars are being ordered then someone must be confident that consumers will buy them in the coming months.

Although the growth outlook isn’t fantastic, it may not be as bad as some fear. The current downturn isn’t driven purely by economic factors – politics is also denting global business sentiment. The near shut-down of the US government over raising the debt ceiling last month combined with Europe’s political impasse on how to solve the sovereign debt crisis is also damaging sentiment.

Politics can cause excess volatility, and right now politics are fuelling investor behavior – selling risky assets and buying the safe havens. If the politicians sort out their respective crises then that may cause a reversal in risk appetite.

Politics and economic uncertainty are driving the markets right now, but central bankers are doing their part too. Since the financial crisis they have helped to keep western economies afloat. There is also pressure on them from some to provide more stimuli to get us over the current slow patch. Stimulus provided by the Federal Reserve, the US central bank, helped to suppress the rise of the dollar causing stocks and commodities to rise. However, eventually central banks won’t be able to patch over the deep structural change that these economies need to make. So another round of stimulus might be less effective than previous rounds and will delay the inevitable belt-tightening.

So although growth may have dipped, and could dip even further more stimuli is not necessarily the answer. If Western economies attack their structural deficiencies then the growth rates in the West should rise. It may be cloudy today, but the future should be bright.