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Green shoots or weeds? Robert Gardner, Head of Macroeconomics What to expect in the next 30 mins: an RBS double-act Robert: A simple framework for thinking about the future An evaluation of the options Our view.... Peter: A closer look at the Nordic region Q&A Slide 2 A simple analytical framework..... High Policy Traction Higher Capacity, Higher Trend Growth Lower Capacity, Lower Trend Growth Low Policy Traction Slide 3 Four potential scenarios...... High Policy Traction Goldilocks Returns Return of Macro Instability Higher Capacity, Higher Trend Growth Lower Capacity, Lower Trend Growth Slow Grind Higher Deflation Low Policy Traction Slide 4 The worst outcome....... High Policy Traction Higher Capacity, Higher Trend Growth Lower Capacity, Lower Trend Growth "Deflation" • Very deep downturn then stagnation • Deflation • No scope for policy normalisation • De-leveraging: frustrated Low Policy Traction Slide 5 Disaster Avoided? Slide 6 Not exactly..... Peak to Trough Decline in GDP (Percentage Points) Ire Jap Ger It Fin UK Den Fr Nor Swe 0 -1 -2 -3 -4 -5 -6 United States Eurozone Average -7 -8 -9 -10 Slide 7 Source: Datastream Deflation fears appear to be receding...... 3.00 Inflation Expectations (10Y TIPS - 10 Y Tresuries) 2.50 2.00 1.50 1.00 Deflation Scares 0.50 0.00 2003 Source: Datastream 2004 2005 2006 2007 2008 2009 Slide 8 Unprecedented policy action stopped the rot Change in Interest Rates (2007-2009, bps) 0 -50 -100 -150 -200 -250 -300 -350 -400 S/Term Rates -450 L/Term Rates (10Y Yields) -500 Source: Datastream UK US Ger Fra India China Japan Slide 9 Key asset markets may have found a bottom.... 250 230 House Prices (Index, 2000=100) UK 210 190 US 170 150 130 110 Source: Datastream Stabilisation? 90 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Slide 10 Real activity also appears to be stabilising 65 Global Purchasing Managers Indicators (Index, >50 = expansion) 60 UK 55 World EZ 50 US 45 Contraction 40 35 2006 Source: Datastream 2007 2008 2009 Slide 11 Goldilocks Returns? Slide 12 Straight from despair to elation? High Policy Traction "Goldilocks Returns" • • • • • Quick recovery, robust growth Plenty of slack Low inflation Steady Policy Normalisation De-leveraging: quick and smooth Lower Capacity, Lower Trend Growth "Deflation" • Very deep downturn then stagnation • Deflation • No scope for policy normalisation • De-leveraging: frustrated Low Policy Traction Slide 13 Investors seem more convinced of the durability of the upturn 115 Equity Market Performance (Index 2007 = 100) 105 95 85 Swe 75 US Nor EZ 65 Key indices up by 40% to 65% 55 45 Source: Datastream Jul 09 May 09 Mar 09 Jan 09 Nov 08 Sep 08 Jul 08 May 08 Mar 08 Jan 08 Nov 07 Sep 07 Jul 07 May 07 Mar 07 Jan 07 35 Slide 14 Who said economists weren’t an optimistic bunch? US Economic Data and Outlook (y/y %, Period Average) 4.00 2004-2006 2011-2013 3.00 2.00 1.00 0.00 Source: Datastream Growth CPI Slide 15 Unfinished Business Slide 16 Our best guess..... High Policy Traction "Goldilocks Returns" Lower Capacity, Lower Trend Growth • • • • • Quick recovery, robust growth, Plenty of slack Low inflation Steady Policy Normalisation De-leveraging: quick and smooth Higher Capacity, Higher Trend Growth "Slow Grind Higher" • • • • Deep downturn, slow recovery Low inflation Gradual policy normalisation De-leveraging: slow and painful "Deflation" • Very deep downturn (-10%) then stagnation • Deflation • No scope for policy normalisation • De-leveraging: frustrated Low Policy Traction Slide 17 Inventory liquidation brutal, but final demand still lacking 1.6 US Inventory to Sales Ratio - Still Bloated.... 1.5 1.4 1.3 1.2 1992 1994 1996 1998 2000 2002 2004 2006 2008 Source: Datastream Slide 18 Repairing household balance sheets will take some time 10% US Household Balance Sheets (% change between Q2 2007 peak and Q1 2009) 5% +234bn 0% -5% -10% -15% -20% Source: Datastream -9,643bn Financial -4,206bn Housing -13,640bn Total -13,874bn Debt Net Worth Slide 19 Mechanisms for balance sheet adjustment Asset price growth – difficult for policy to gain traction Inflation – erode the real burden of debt, return of macro instability Widespread default to eliminate debt overhang – financial devastation Debt rescheduling - debt for equity swaps, partial mortgage debt forgiveness Income growth/debt repayment – slow and painful Slide 20 Surplus economies also have to make adjustments 12 Current Account Balances (% of GDP) 10 China 8 6 Germany 4 Japan 2 0 -2 Source: Datastream 2008 2007 2006 2005 2004 2003 2002 2001 2000 -4 Slide 21 Economic growth – where does it come from? 3.0 UK Economic Growth 0.7 2.0 1.0 Labour force growth Productivity growth 2.1 0.0 Long term GDP growth = 2.8% Slide 22 There are lots of headwinds: Labour force growth: • Demographic trends will be a drag • Pressures to limit immigration won’t help either Productivity growth • Lack of investment impacts capital stock • Cost of capital across the economy will be higher • Fixing public sector balance sheets: crowding out • Moving resources across sectors is likely to be costly Slide 23 Blast from the past? High Policy Traction "Return of Macro Instability" • • • • Quick return to growth, No slack, volatile inflation, interest rates Return to “boom-bust” cycle De-leveraging: disorderly "Goldilocks Returns" • • • • • Quick recovery, robust growth, Plenty of slack Low inflation Steady Policy Normalisation De-leveraging: quick and smooth Higher Capacity, Higher Trend Growth Lower Capacity, Lower Trend Growth "Slow Grind Higher" • • • • Deep downturn, slow recovery Low inflation Gradual policy normalisation De-leveraging: slow and painful "Deflation" • Very deep downturn (-10%) then stagnation • Deflation • No scope for policy normalisation • De-leveraging: frustrated Low Policy Traction Slide 24 The return of macro instability? 250 Economic Volatility (10 Year Rolling Coefficiant of Variation of Real GDP Growth) 200 Return of Macro-Instability? 150 The "Great Moderation" UK 100 50 US Source: Datastream Slide 25 2008 2006 2004 2001 1999 1997 1995 1992 1990 1988 1986 1983 1981 1979 1977 1974 1972 1970 1968 1965 0 Key messages/implications The worst is over, but we’re not out of the woods yet – Balance sheets have to be repaired – no quick fix – Sluggish growth for a protracted period – Policy stimulus likely to remain in place for some time The post crisis world will be different – Trend rates of growth will probably be lower – Taxes will be higher/public spending will be lower – Trade imbalances need to unwind too – Deficit countries – lower consumption, saving higher, higher net exports – Surplus countries – higher consumption, lower saving, lower net exports A tougher environment, but a more sustainable one Slide 26 Questions Slide 27 Cost of Capital is going to be higher.... Corporate Bond Spreads (£, 1-5Yr vs UK Gilt, Bps) 1400 BBB 1200 1000 800 600 400 1998-2008 average spreads 200 AA Source: Datastream 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 0 Slide 28 Fiscal policy also provided a vital lift... Change in Budget Balance (% of GDP, percentage points, 2007-2009) US UK Japan China Fra India Ger 0.0 2.0 4.0 6.0 8.0 10.0 12.0 Source: Datastream Slide 29 Return to “normality”? 90 VIX Implied Volatility Index 80 70 60 50 40 Volatile Conditions 30 20 Normal Conditions 10 0 Source: Datastream 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 Slide 30 Legal disclaimer This material is published by The Royal Bank of Scotland plc (“RBS”) which is authorised and regulated by the Financial Services Authority for the conduct of regulated activities in the UK. It has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments, other financial instruments or related derivatives (“Securities”). It should not be reproduced or disclosed to any other person, without our prior consent. This material is not intended for distribution in any jurisdiction in which its distribution would be prohibited. Whilst this information is believed to be reliable, it has not been independently verified by RBS and RBS makes no representation, express or implied, nor does it accept any responsibility or liability of any kind, with regard to the accuracy or completeness of this information. Unless otherwise stated, any views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the RBS Group’s Group Economics Department, as of the date of publication of this material and are subject to change without notice. Recipients of this material should make their own independent evaluation of this information and make such other investigations as they consider necessary (including obtaining independent financial advice), before acting in reliance on this information. This material should not be regarded as providing any specific advice. RBS accepts no obligation to provide any advice or recommendations in respect of the information contained in this material and accepts no fiduciary duties to the recipient in relation to this information. Slide 31