Balance sheets drove growth - now growth might drive balance sheets.

By Mike Lenhoff 09:12 10- Aug -2009

Sentiment on the prospects for the global economy has been transformed in the short space of a few months. It’s as if the issue is no longer one of recovery - the evidence points to one developing in the US this quarter - but whether a recovery will prove sturdy enough for a fully fledged expansion. I’ll return to this.  

I think two features have been influencing investors’ expectations recently but I also feel a third could have a profound influence. One is the lead provided by China in helping the rest of Asia, including Japan, to pull out of recession. There may be plenty of scepticism about the veracity of Chinese data but forecasts for growth throughout Asia are being revised up - not only for China - and have been for several months. Also, Japan’s trade with China now exceeds its trade with the US and its trade with Europe. The rebound in Japanese export growth in recent months is no figment of anyone’s imagination.

Second, the message coming out of the quarterly reporting season in the US, which is nearing completion, is that the corporate sector is leaving behind the worst of its recession. Admittedly, top line growth is a little mixed. But the bottom line has been stronger than expected and, while this is partly a result of the restructuring and cost cutting exercise under way to improve productivity and profit margins, recoveries have started this way.   

There is a third feature - highlighted in the chart - that could dramatically influence sentiment. I’m referring to the US housing market and the stability that looks to be returning to it. It’s worth conjecturing on where this might lead in the context of an improving outlook for the global economy.          

US consumer spending accounts for over 70 cents of every dollar’s worth of GDP. Thus, if we’re talking about the prospects for the American economy, which we always are, then we’re talking as much about the economic well-being of the US consumer as about anything else. On the view that consumers’ assessment of their financial well being is partially influenced by their balance sheets as well as by whether or not they have a job, then we’re also talking as much about the state of the US housing market as about anything else.

Stability in the US housing market is good news for balance sheets - and not just for households. It’s good news for banks and insurance companies. Falling house prices and mortgage delinquencies, which undermined mortgage backed securities and then any and all asset backed securities, wrecked balance sheets. Lenders couldn’t or wouldn’t lend and borrowers couldn’t borrow. In a way, balance sheets drove the economy and, in a way, rendered inoperable the transmission mechanism through which monetary policy operated.

However, stability in the housing market could help reverse this - slowly ... very slowly. For households, a steadier housing market will help their balance sheets which, in turn, should help consumer confidence improve. It might also remove some of the pressure on the household sector to de-leverage, which may not be a good thing, but still, if house prices stabilize, then the personal sector could be more disposed to spending and, indeed, more disposed to borrowing. Of course the downside for households is rising rates of unemployment and its influence on confidence, but not everyone is out of a job and not everyone is so highly leveraged.  

Aside from the housing market, a hopeful outlook for the global economy, the expectations for which are driving asset prices, also helps strengthen balance sheets. Indeed, the credit markets have gone a long way now in re-pricing risk. As the chart below shows, the spreads have narrowed considerably. This must have had an appreciably positive impact on balance sheets already.  

So, looking at it now, the causality could run the other way. That is, with the outlook improving for economic growth and with balance sheets all round on the mend, lenders are likely to be happier to lend and borrowers more inclined to borrow.

Which brings me to the issue: will the recovery prove sturdy enough to lay the ground for a fully fledged expansion? There are two points here. First, the major central banks, the Federal Reserve especially, are not prepared to take risks. The message is that the policy setting will remain as is until a recovery looks sustainable.

Second, a virtuous circle could come into play whereby more confidence in the prospects for the economy and stability in the housing market drive balance sheets. From here, better balance sheets facilitate borrowing and lending, not only generating more economic growth but more upgrading of expectations for growth and corporate earnings. The reduction is risk premiums that follows helps asset values and balance sheets even more, all of which induce still more growth and so on.

I think equity markets are plugging into the forthcoming cycle of upgrading in expectations for GDP growth and corporate earnings and, on this view, I would expect the broad upward trend in equity markets from their March lows to be sustained. However, after a 13 percent plus rebound in equity markets from their July lows, it is also not unreasonable to expect some consolidation, perhaps even a 5 to 10 percent correction (Equities look overbought but the trend is still your friend, 3 August 2009). The main point is though that the overall sweep of the news flow is improving and, against this backdrop, a major sell-off that takes the indices to new lows, seems unlikely.