The precipitous drop in the Fed Funds rate this year challenges even the law of gravity. From January to October 2, the Fed has cut this key rate from 6.50 percent to 2.50 percent. The latest round of rate cuts did provide psychological support to a market rattled by the vicious September terrorist attacks against the US. We think another round of cuts is possible, perhaps 25 basis points, by the December 11 FOMC meeting. The Fed Funds futures are currently trading at 2.20 percent, which imply at least a 25 basis points drop.
Based on the 2.4 percent drop in retail sales in September, it is likely that the recession started "officially" in the third quarter of this year. One of the casualties of the September 11 attacks has been consumer confidence. The University of Michigan consumer sentiment index showed a drop from 91.5 August to 81.8 in September, but recent indicators point to a modest pickup in October. We think it will take a while for consumers to overcome the fear and anxiety over terrorist attacks. It is likely that more attacks will be attempted. For this reason, we think the recession will be longer than most analysts predict. Our preliminary assessment shows US GDP growth of only 1.0 percent this year, based on year average figures, followed by a decline of 0.2 percent in 2002. This forecast is based on the assumption of a moderate recession. In view of the fragility of consumer sentiment the risks are that the recession could be more painful.
On a positive note, the fundamentals of the US economy were robust going into this recession. This just-ended expansion period was characterized by a strong growth in productivity. The banking system has been more cautious in its lending, thus minimizing the risk of systemic weakness. The Fed’s aggressive interest rate cuts since January of this year should first, help to counteract the decline in economic activity, and second, provide stimulus to spending once the economy hits bottom. The government’s fiscal support package, the tax rebate passed earlier this year, and then the $100 billion plus in additional stimulus, should contribute to greater spending. At the same time, the fast buildup of military activity, spending on security measures, and the rebuilding of the damage to New York City will add more demand stimulus to the economy. Fortunately, the US enters the recession with a significant Federal budget surplus, which will facilitate the spending appropriations. The fact that businesses had been paring down inventory levels since the end of last year could also attenuate the magnitude of future cutbacks in production.
Several areas of the economy have been more vulnerable in this recession. First, the industrial sector has been declining for more than a year. The industrial production index posted a cumulative 12 month drop of 5.0 percent through August of this year. The September 11 attacks further aggravated the downturn in this sector. The serious setbacks suffered by the transportation and tourism industries since September 11, have compounded the economy’s woes. While it is too early to assess the damage, the slowdown in transportation could have significant repercussions on industrial activity, particularly in those industries that rely on just-in-time production processes.
We are still concerned about the risk of higher inflation. The CPI is currently running at an annualized rate of about 3.1 percent, and we expect a moderately higher rate next year. The increase in production costs associated with the terrorist attacks against the US could add to inflationary pressures in the next several months. Unit labor costs were rising at a fast clip during the second quarter of this year, up 6.4 percent for manufacturing and 5.0 percent for non-farm businesses, this is significantly higher than the 2.1 and 2.6 percent rates recorded at the end of last year. On the other hand, a recession will tend to reduce inflationary pressures as businesses reduce margins in order to sell their products. For instance, oil prices have fallen noticeably during the past month and could end the year in the low 20's.
Recent developments have clouded the outlook for the fiscal surplus. Even prior to September 11, the Congressional Budget Office (CBO) had cut the projected surplus dramatically. As we have said in the past, public displays of 10 year budget forecasts can be embarrassing. Congress should focus on the budget forecast for the next two to three years, and not on forecasts that go ten years into the future. The longer-term forecasts should be limited for internal CBO planning purposes. Taxpayers will lose confidence in fiscal management when they are presented with ten year projections that change with the will-of-the-wisp. In January of this year, the CBO projected a cumulative on-budget surplus for 2002-2011 of $2.139 trillion. This figure represents the present value in 2001 of the projected future surpluses after applying a discount rate of 6.00 percent. The on-budget surplus excludes the Social Security trust funds and the cash flow of the Postal Service. We think this is the appropriate definition of the surplus, which is also used by many other countries. The discounting is necessary, since future values cannot be added up across the years. We do not understand why the budget surpluses presented by CBO are added up without discounting. In August, the CBO cut its projected 2002-2011surplus dramatically to a present value of $520 billion! This projection assumed GDP would grow 3.2 percent every year; in other words, the US would not have a recession for at least 20 years. Nor was any sensitivity analysis performed to evaluate the potential impact of a recession on the budget projections. After the events of September 11, we think the projected budget surplus has disappeared, and now the question is what will be the size of the expected deficit.
Another area for concern is the external accounts, which have become a structural problem. As of July of this year, the trade deficit was running at an annual rate of $450 billion; while moderately lower than the April figure of $458 billion, the deficit is still unsustainable and could result in additional downward pressures against the dollar. Between July and September, the dollar depreciated in value against the Euro at an annualized rate of 30 percent.
The combination of higher inflation, a projected budget surplus turned to deficit, a falling dollar, and greater future economic uncertainties associated with terrorism, will keep long-term interest rates at historically high levels. For example, based on an inflation rate of 3.2 percent and real interest rates of 3.5 percent, the 10 year bond could reach 6.5 to 7.0 percent within the next year.
Latin American Economies
StratInfo Assessment of the Impact of a US Recession on Latin America
The U.S. recession that we had been anticipating for the end of this year of the beginning of 2002, is already a reality. In view of its impact on the global economy, we have prepared a brief analysis on the implications for Latin America.
As a result of a US recession, Latin American economies will experience a sharp slowdown in GDP growth, with a consequent drop in imports and travel abroad. We expect GDP growth in the region to average 1.3 percent this year, followed by 0.7 percent in 2002.
The region is not a monolith; some economies will manage to do better.
Argentina will likely devalue its currency and negotiate a debt rescheduling. However, a post-devaluation economy will be in very good position to take advantage of a global recovery in 2003.
Brazil's economic outlook is dependent on the outcome of next year's presidential elections. This government has maintained an excellent track record in terms of economic management, and thus the economy's fundamentals were stronger prior to current downturn.
Chile's recovery, which began last year is now fizzling out. Falling copper prices have hurt export earnings, but strong economic fundamentals bode well for the outlook.
Colombia's internal strife will continue to worsen. Presidential elections next year could lead to a new government that takes a more hard-line position regarding the guerrillas.
Ecuador's dollarization was a temporary respite from the country's economic woes. However, the economy's competitive position is fast eroding due to increasing costs. High oil prices have so far kept the economy from dipping into another recession.
Mexico has already felt the impact of slower growth in the US. The pronounced decline in US manufacturing has had a notable impact on the assembly exports, one of the major components of the external economy. On a positive note, the quality of economic management by the government is a plus for the outlook.
With the scandals and election controversies behind, Peru should weather the global downturn relatively well. A weak economy raises some concerns about the health of the financial sector; but the government has kept a close watch on the banking system and has promoted greater consolidation among the stronger banks.
Venezuela's outlook is largely dependent on the fate of oil prices. President Chavez's populist policies could derail the economy. So far high oil prices have prevented a major devaluation of the currency.
The Central American and Caribbean economies are particularly vulnerable to a downturn in the US economy due to their dependence on tourism and assembly exports to the US.
Current Events
As expected, the mid-term elections in Argentina, resulted in a crushing defeat for the governing coalition. The opposition Partido Justicialista obtained control of both Houses of Congress, which means that president Fernando de la Rua will need the Peronistas support to govern for the rest of his mandate. However, the most notable feature in these elections has been the protest vote. About one third of total votes were blank or purposely damaged, to express the voters’ deep dissatisfaction with political institutions. This is a cause of concern, because it shows that the Argentine social fabric is getting dangerously frayed.
The position of economic czar Domingo Cavallo is in jeopardy, since the vote also reflects a rejection of his policies. The dilemma for president de la Rua is to find a substitute for Mr. Cavallo. Whoever takes the helm of the economy will be constrained by the government’s iron-clad insistence on maintaining parity with the dollar. Under those circumstances, austerity is the only option, as demonstrated by Mr. Cavallo himself, who like his predecessors, has been merely tightening the belt. For these reasons we think a devaluation is inevitable.
Argentina’s authorities are now engaged in another exercise to restructure government’s debt, by exchanging short-term and high interest rates instruments for longer maturity bonds at lower interest. The arm-twisting is already on in Argentina, to force Argentine banks and institutional investors to comply, as was done before this year. This time, the authorities plan to take their road show to the international community. In a dramatic change of stance, Standard & Poor now agrees with our long-held position that this would constitute a technical default. The widely respected S & P is threatening with a dire bond classification of D if Argentina proceeds with this scheme.
Any hope for improvement of the Bolivian economy has been dashed by the U.S. recession. President Quiroga can only count on multilateral sponsored programs to provide some relief.
The Brazilian economy seems to be skidding toward a recession. GDP growth in the second quarter was a paltry 0.8 percent, which brings growth in the first half of the year to 2.5 percent. We must recall that GDP expanded at a strong pace of 4.3 percent in the first quarter, which makes the second quarter results even more dramatic. Our pessimistic outlook on the Brazilian economy is based on the observation that external demand was the only factor injecting dynamism to economic activity, since domestic demand was in a slump. The sharp global slowdown, triggered by the U.S. recession, will have a very negative impact on Brazilian exports.
Economic activity in Chile continues to decelerate, although it remains on a more solid ground than in other Latin American countries. The monthly indicator of economic activity known as Imacec shows an expansion of 3.4 percent up to July.
Costa Rica, already pounded by difficulties in the high-tech sector, will get another heavy blow in tourism. Since September 11, 14.4 percent of workers in the tourism sector have been laid-off.
Dominican Republic is already feeling the impact of sagging U.S. demand. First half GDP growth screeched to a halt, with just 0.1 percent. Construction fell by 8.0 percent and commerce by 4.4 percent. The most dynamic sector was that of telecommunications with outstanding growth of 21.1 percent, while the free zones still retained some energy with growth of 3.2 percent.
Another political controversy ended in defeat for Ecuador’s president Noboa. Mr. Noboa attempted to bypass Congressional rejection of an IVA increase from the current 12 percent to 14 percent, but the Constitutional Tribunal regarded his move as unconstitutional.
Family remittances to El Salvador have been dwindling in the weeks following the September 11 terrorist attack on New York. Sagging U.S. demand has caused the closing of a number of maquila plants, while others are working at half capacity.
Guatemala’s economy is encountering difficulties in the sectors of agriculture, agro-industry and maquilas. This year, 38 maquila plants have already closed. It is estimated that about 15,000 workers have lost their jobs, as a result of these and other plant closings in Guatemala. Honduras and Nicaragua are absorbed by the electoral process. Daniel Ortega maintains a lead in the opinion polls in Nicaragua.There is preoccupation in Jamaica about the U.S. recession. In addition to its impact on tourism, the transportation industry crisis could cause a decline in demand for bauxite and aluminum.
The outlook on Mexico has turned more pessimistic, in view of the U.S. recession. The Mexican government is projecting growth of about 0.1 percent for this year, followed by just 1.7 percent in 2002.
The pervading economic malaise in Panama is having a most detrimental impact on those industries that constitute the main source of employment, such as agriculture, industry, commerce and tourism.
The slowdown in Brazil is having a detrimental impact on Paraguay’s tourism and commerce sectors.
Peru’s recovery will be delayed by the unfavorable global economic environment.
Weaker oil prices should put the brakes on Venezuela’s economic expansion. For that reason, president Chavez has turned into one of the stauncher advocates for higher oil prices within the OPEC.