29/10/2007

Recession risks and fiscal policy

Last summer’s credit market turmoil could be the final straw that causes a recession in the US in 2008, and a major slowdown in other economies, with serious implications for public sector finances, according to research published today by leading investment house, Standard Life Investments.

In the latest edition of Global Insight, its monthly investment view, Standard Life Investments examines the implications for fiscal policy and investor choices as economists downgrade global growth expectations for 2008 amid the possibility of a recession in the US.

Andrew Milligan, Head of Global Strategy for Standard Life Investments, said:

“Monetary policy has rather dominated the discussion amongst market participants over the summer months. Central banks have been forced to change tack, whether by cutting interest rates, injecting liquidity into money markets through various channels, or acting as overseer of the financial system, such as helping with bank restructuring. So far, fiscal policy has rather taken a back seat. However, there are some key questions: are public sector finances in a good position to offset some of the economic headwinds, not only in the US but other major economies? As budget deficits expand for the first time in several years, what are the implications for bond markets and hence investor choices?

“The US, Germany and much of Europe has improved its finances. The US budget deficit at 1.2% of GDP in fiscal year 2007 is the lowest since 2001, while the Eurozone deficit has halved since 2003 to about 1.6% of GDP last year. However, other countries are in a more difficult situation, noticeably the UK and France where deficits are higher and governments face the distinct possibility of breaking their financial rules.

“Although there has been a broad improvement in public sector finances in recent years, we forecast larger deficits into 2008. The main danger is that tighter credit conditions lead to a steeper, more prolonged economic downturn than currently envisaged by most investors. This comes against a backdrop when many countries can be criticised, as they have been by the IMF, for not taking hard decisions over taxes or spending. At this phase in the business cycle, economies would normally be expected to see a public sector surplus. There is more limited scope than in the past for offsetting economic headwinds. This means that while there is some room for manoeuvre, most of the policy shift will have to come from the monetary route.

“What are the market implications of such an increase in bond supply? Academic studies show that, all else being equal, a higher supply of bonds can lead to lower prices and higher yields. The key issue will be the extent of demand from investors. In the short term, bonds will certainly be more determined by cyclical issues, the economic, inflation and interest rate outlook. Further ahead though, investors need to monitor structural demand for bonds, from pension funds in the UK and Europe, and from overseas investors for US assets. European demand looks strong, reflecting the reaction to accounting regulations and pension fund reform. However, the combination of a rise in US bond issuance in coming years, at the same time that sovereign wealth funds decide to move from defensive into riskier assets, could have adverse implications.”