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Morgan Stanley equity strategist Adam S. Parker reports that investors are asking 4 big questions, to which he provides his thoughts.

1) Is this just a temporary soft patch? While US GDP will likely recover in the second half of 2011, the correlation between GDP and the S&P 500 is negative year-to-date and very low historically. Moreover, auto stocks are not responding to the prospect of a 2H production recovery, with F and GM now at multi-month lows. In our view, even a mid-cycle correction (the current bull case) is likely to last longer than just a few weeks. We are not buyers of the retreat, at least until forward profit margin expectations get reset, as market sentiment has shifted –it’s now guilty until proven innocent.

2) What about energy stocks? While Brent has now strengthened back to within just 5.4% of its 2011 high, the stocks have nonetheless declined 5% month-to-date.    We remain neutral on energy stocks, preferring low beta exposure until evidence that strengthening demand resurfaces.

3) Are banks cheap enough? The correlation of the net income between banks and retailers is high, and pair-trading banks against retailers is now likely prudent giving the compelling attractiveness of banks’ beta. We remain market-weight financials, however, due to concerns about demand for loans and regulatory risk.

4) Where’s the attractive beta? Technology and industrials have been highly correlated in recent weeks, with AAPL, GOOG, MSFT, CAT, GE, DE, and UPS, among others, at or near multi-month lows. Technology has never been cheaper on price-to-forward earnings relative to industrials, and we remain overweight technology and underweight industrials.


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The UK can be seen as a kind of test case for the proposition that contractionary fiscal policy can induce an economic expansion, a proposition forwarded by most recently Alesina and Ardana (2010) [wp version] (following up earlier work by Alesina and Perroti). So far, admittedly early in the process, the evidence is not consistent with the view of expansionary contraction. Here’s Gavyn Davies’ view:

…The statistics were expected to show a significant slowdown in output growth, but nothing like the drop of 0.5% in real GDP (-2 per cent quarter-on-quarter annualised) which was actually announced this morning. …

Davies provides a caveat:

…these figures seem much too bad to be true, and not just because of the weather. The underlying growth rate of private sector GDP probably remains at around +2 per cent on an annualised basis, and it would not be at all surprising to see a sharp rebound in recorded growth in the current quarter. Nevertheless, the recovery in the UK economy, while still intact, continues to run at a less impressive pace than we are seeing elsewhere in the developed world.

The UK Recovery (and Relapse?) in Perspective

Davies provides graph of UK and G7 output trends (normalized) provides some context. The graph provides the ONS’s estimate of output abstracting from the severe weather in December.


Figure 1: G7 and UK GDP normalized to 100 at 2007Q4. Source: G. Davies (2010).

This is a preliminary release, akin to the “advance” release for US GDP statistics, so one should be particularly cautious about overinterpreting. Nonetheless, best estimates are for zero growth in 2010Q4. Where does the fiscal retrenchment fit in? In line with the plan to cut government overall expenditures (spending as well as transfers), the contribution of government consumption to overall GDP growth is negative.


Figure 2: Contributions to UK GDP growth (q/q) in 2010Q3 and 2010Q4. Source: Office of National Statistics, 2010Q4 preliminary GDP release.

Note, that the -0.5% q/q growth rate is equivalent to approximately -2.0 q/q annualized growth. The -0.02 ppt q/q contribution of government spending is a substantial decrease from the approximately 0.16 ppts contribution in 2010Q3. Presumably, going forward, this will shift to an even bigger negative contribution.

Looking forward, most economists appear gloomy. From The Guardian Alan Clarke, UK economist at BNP Paribas observes:

…as the year progresses we expect the implementation of the government’s austerity measures to bite, reinforcing the headwinds to growth. More generally, the biggest question for 2011 growth is whether or not consumer spending will grow – especially with inflation running well in excess of income growth. We expect pedestrian consumer spending growth at best, which given it accounts for around two-thirds of GDP by expenditure, will set the tone for a sluggish overall growth rate.

Overall, a terrible headline reading, probably exacerbated by the weather. Nonetheless, weak even without the weather and likely to reinforce our below-consensus growth forecast for this year.

Alasdair Reisner, Civil Engineering Contractors Association predicts:

Sadly there seems to be little in the way of confidence that there will be a turnaround in the industry’s prospects in 2011, and with the full effect of public sector cuts yet to feed through, there may very well be further bad news to come in future quarters.

Mark Bolsom, Head of the UK trading desk at Travelex Global Business Payments concludeses:

We knew that snow had seriously impacted retail sales in December but this will come as a massive shock; nobody expected contraction.

It’s a real disaster, given that January’s VAT hike will drain even more money out of the system. And whilst there had been talk of an interest rate hike, this is surely now off the agenda. Quantitative easing is now back on the cards.

Economic contraction is a really bad way to go into a period of heavy fiscal tightening and is not what the government would have wanted at all. The chancellor may find himself having to defend his economic plans over the coming days.

The UK as a Small Open Economy

Fortunately for the UK, it has a floating exchange rate, which serves as a buffer in times of economic weakness.


Figure 3: Log real broad trade weighted value of the British pound. Gray shaded area denotes UK GDP peak to trough. Source: BIS.

The graph highlights the fact that the UK economy has already experienced a currency depreciation that has provided some relief.

Will the UK Avoid a Contraction? (i.e., is 2010Q4 a blip?)

If historical evidence is any guide, one should not expect a tremendous short run boom in response the the fiscal contraction. The last IMF World Economic Outlook (Chapter 3) assessed this issue in a systematic fashion, using a Romer and Romer (2010) narrative/action-based criterion to determine consolidation episodes, as opposed to examining changes in the cyclically adjusted primary budget balance (CAPB), used in Alesina and Ardagna (2010).

  • Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand—consumption and investment—falls by about 1 percent.
  • Reductions in interest rates usually support output during episodes of fiscal consolidation. Central banks offset some of the contractionary pressures by cutting policy interest rates, and longer-term rates also typically decline, cushioning the impact on consumption and investment. For each 1 percent of GDP of fiscal consolidation, interest rates usually fall by about 20 basis points after two years. The model simulations also imply that, if interest rates are near zero, the effects of fiscal consolidation are more costly in terms of lost output.
  • A decline in the real value of the domestic currency typically plays an important cushioning role by spurring net exports and is usually due to nominal depreciation or currency devaluation. For each 1 percent of GDP of fiscal consolidation, the value of the currency usually falls by about 1.1 percent, and the contribution of net exports to GDP rises by about 0.5 percentage point. Because not all countries can increase net exports at the same time, this finding implies that fiscal contraction is likely to be more painful when many countries adjust at the same time.
  • Fiscal contraction that relies on spending cuts tends to have smaller contractionary effects than tax-based adjustments. This is partly because central banks usually provide substantially more stimulus following a spending-based contraction than following a tax-based contraction. Monetary stimulus is particularly weak following indirect tax hikes (such as the value-added tax, VAT) that raise prices.
  • Fiscal retrenchment in countries that face a higher perceived sovereign default risk tends to be less contractionary. However, even among such high-risk countries, expansionary effects are unusual.
  • Model simulations suggest that over the long term, reducing debt is likely to be beneficial. In particular, the GIMF simulations considered here suggest that lower government debt levels reduce real interest rates, which stimulates private investment. Also, the lower burden of interest payments creates fiscal room for cutting distortionary taxes. Both of these effects raise output in the long term. Overall, the simulations imply that for every 10 percentage point fall in the debt-to-GDP ratio, output rises by about 1.4 percent in the long term.

Figure 3.2 from the IMF WEO shows the impact on GDP and unemployment.


Source: From Chapter 3 of IMF WEO, October 2010.

Note that the IMF estimates include the cushioning effects of exchange rate depreciation and net export increase (as well as offsetting stimulative monetary policy, something which is circumscribed for economies already at zero interest rates).

The Specifics of the UK Fiscal Plan

Returning to the UK experience, we shouldn’t be surprised, I think, to see a further negative readings in growth. Figure 2 from Mason and Walia (2010) shows the amount of planned fiscal consolidation.


Figure 2, Total Fiscal Consolidation (% of GDP), Her Majesty’s Treasury, OBR, RGE, from James Mason and Parul Walia, “More Than One Way to Skin a Cat: A Review of UK Fiscal Plans,” RGE Monitor (Jan 20, 2011).

They write of the government’s plan (“Plan A”):

Our main criticism of Plan A is that it is unnecessarily front-loaded in terms of cash impact, as opposed to policy approval. It is inevitable that hastily cobbled together measures to cut costs quickly will have a more detrimental impact on the economy (i.e. a higher fiscal multiplier) than more considered measures aimed at reducing long-term spending. Likewise, the severe cuts to capital expenditure and government investment will have a higher fiscal multiplier than reforms to long-term health provision or pension costs.

The Impact of Fiscal Austerity on Economic Growth

Based on a review of the literature described briefly below, we assumed a fiscal multiplier of 0.5 to estimate the impact on GDP growth from the fiscal consolidation (see Figure 4). That effectively assumes that the private sector picks up half of the slack left by the government pulling back.

RGE Monitor predicts output to be 0.3 percentage points of GDP lower in 2010-11, and 1 percentage point in 2011-12.

Simulations by the IMF using GIMF find that for a small open economy like Canada, fiscal contraction at a time when the rest-of-the-world is undertaking similar fiscal austerity measures roughly doubles the output loss (relative to an already increased loss when the zero interest constraint binds). The RGE Monitor estimates are based on the multipliers cited by Ethan Ilzetzki, Enrique G. Mendoza and Carlos A. Vegh [pdf] which do not account for the zero interest bound, so there is reason to believe they are understating the negative output impacts in the short run.

Concluding thought

In any case, regressions based on samples heavy on small open economies are unlikely to lead to conclusions terribly relevant to large, relatively closed economies like the US. A front loaded fiscal contraction in a much more closed economy such as the US would likely benefit much less from offsetting export-supported growth.

Postscript 1: An interesting methodological question, with a big impact on the end-results, is highlighted in Tables 3.4 and 3.5 in the WEO Chapter 3. One finds that the action-based criterion leads to many fewer episodes, particularly in small open economies (which have the luxury of greater depreciation to induce countervailing net export growth) than found using the Alesina and Ardagna (2010) approach.

Postscript 2: The IMF analysis spends some time on the discussing the differential impact of tax increases versus spending cuts. They posit this differential effect might be due to the monetary authorities reacting differently to each type of fiscal measure. To the extent that the interest rates are stuck at zero, the differential effects should be muted for the period that ZIRP holds.

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