The Four Horsemen of the Economic Apocalypse

The position FDs face as they set out to draw up budgets and business plans this year is unique. Not in the working lives of FDs has so much bad news come all at once. Yes, there have been economic downturns and market slumps. Yes, there have been consumer booms. Yes, there have been international crises and the threat of war. But never have all come together in such a potent cocktail.

Moreover, some pundits are beginning to wonder whether the economic paradigms which we have relied on in the past to make predictions are starting to fracture. Are we, for example, seeing a long-term asset shift from shares to housing? Have we really moved into a new era when the dragon of inflation has been conquered? Are interest rates set to remain in a low range for the foreseeable future? Finding answers to questions such as these is the essential precursor of making sound business decisions.

David Smith, chief economist at stockbrokers Williams de Broe, is one who believes there may be more of these “deterministic breaks” which suggest historical relationships are breaking down. “I am getting less philosophically confident that you can project anything anyway,” he says.

It could be that the current economic and political stresses will fracture more of these traditional relationships and create new ones. In this situation, forecasting is not impossible but it becomes more difficult. And it could explain why there is more disagreement than usual among economists about what the future holds.

But none of this much helps the FD who wants to know what is most likely to happen during the next budgeting period. Since the collapse of the dotcom boom, the world economy has remained in a fragile condition. The hoof beats of the four horsemen of an economic apocalypse – war, recession, deflation and asset price collapse – have sounded in the distance at various times. Could they hurry nearer in the year ahead?

Iraq war: The factor which causes most uncertainty is the first horseman – the possibility of war in Iraq. Like Roosevelt’s “fear of fear”, uncertainty about uncertainty is already depressing economic activity.

In an interesting new paper, Graeme Leach, chief economist at the Institute of Directors, sketches out six possible scenarios, each with their own economic outcomes. The two key questions for Leach are what the war will do to the US economy – the main engine of world growth – and to the oil price, which has a wide-ranging impact on industrial costs and inflation.

At one end of his scenario spectrum, Leach sees a stand-off in which, because of international pressure, the US and Britain don’t act until the inspectors have found the elusive “smoking gun”. Leach rates this outcome low-to-medium and sees US GDP growth of 2.2% and the oil price hovering around $30 a barrel for the rest of 2003.

Leach’s most likely scenario, which he rates as high, is Iraqi capitulation and regime change after a short war. This would include a return to production in the Iraqi oil fields within three months. This actually produces the best economic outcome because it removes uncertainty. US growth rises to 2.9% and the oil price falls below $20 a barrel by the end of the year. (Iraqi capitulation without regime change puts US growth at 2.5%.)

There are three escalation scenarios of varying degrees of horror in which the war is not concluded speedily either because the US cannot control Baghdad or other Iraqi cities, or because the US loses Middle East bases for conducting the conflict and OPEC countries cut oil production as a punitive measure. In the worst of these scenarios, which Leach rates very low, US GDP collapses by 2% and the oil price climbs above $80 a barrel.

Whichever scenario plays out, Leach says: ‘The international risk factor associated with Iraq is huge.” David Smith worries that Iraq will become the first installment of a programme of regime change for the Bush administration – with Iran and Saudi Arabia next on the agenda. If this happens, the world could be in for an extended period of uncertainty that depresses economic growth.

Recession: Which introduces the second horseman – recession. Only in Leach’s escalation scenarios does the US – and by inference most of the rest of the world – slip into recession. But there are uncertainties about how much growth the UK should expect this year.

The latest projection from the National Institute of Economic and Social Research says that Britain can expect only a “sluggish recovery this year” of 2.2% GDP growth. Rebecca Riley, senior research officer at the NIESR, points out that this represents a downgrading of the October 2002 growth target of 2.5%.

The NIESR sees consumer spending and the public sector being the main growth drivers during the year rather than business investment. But it does believe that investment, which fell 9.4% last year, will stabilise in 2003. Domestic demand will grow 3.3%, but a continuing trade deficit will curb growth in GDP by 1.2%.

Recession is not on the agenda for the world as a whole – NIESR predicts global GDP growth of 3.3% – but that doesn’t mean that some countries won’t have problems. Both Japan and Germany, the world’s second and third largest economies, are likely to have very low overall growth which will mean that parts of their economy are in technical recession.

Overall, it looks as though the world economy will recover less rapidly than optimists were expecting last year. Riley argues that to a large measure this is because world trade is likely to grow more slowly. The NIESR has revised its estimate of 2003 trade growth down from 7.4% to 5.1%. The net effect of the fall in the dollar against the euro and the very marginal rise in the yen reduces growth in the OECD. “A more sluggish recovery in investment will also dampen growth prospects over the next two years,” adds Riley.

The investment issue is part of a bigger problem – Britain’s two-speed economy with consumer spending racing along while industrial investment falters. It is the central dilemma which the Bank of England’s Monetary Policy Committee faces every month. The decision in February to cut interest rates by a quarter of one per cent took many commentators by surprise although both the Confederation of British Industry, the IoD and other industry organisations had been calling for a cut. The market reacted perversely with the FTSE-100 falling 2% on the day as traders suspected the worst – that the MPC had some bad news they didn’t.

But it seems likely that the cut will provide only a small measure of encouragement to business investment. Doug Godden, head of economic analysis at the CBI, says: “I think there is scope for interest rates to come down further.” There is considerable excess capacity in the US economy, although less in the UK economy. But any excess capacity is a drag on new investment.

The Shadow Monetary Policy Committee run by the Institute of Economic Affairs noted that corporate profitability had weakened and liquidity stagnated. The coming rise in national insurance contributions will hit corporate liquidity further. “Consumers are the only borrowers in town,” the IEA noted.

Can consumers keep the UK economy moving? During 2002, consumers borrowed record sums of money, much of it in equity withdrawal secured against fast-rising house prices. There are mixed messages about whether they can do so in 2003. The British Retail Consortium reported that pre-Christmas sales were “disheartening”. But at the end of January, the monthly retail confidence indicator compiled by Oxford’s Templeton College had risen infinitesimally from 38.3% to 38.6%.

Systemic deflation: Part of retailers’ gloom stems from the fact that prices for some goods fell during 2002 and may continue to slide in 2003.

Does this mean that the UK faces the danger of systemic deflation in the economy as a whole – the third horseman? Japan has suffered systemic deflation during periods of the past decade and Germany is now threatened.

The IEA’s shadow MPC suggests the risk needs to be taken seriously. One problem is that inflation indices distort upwards the real level of inflation in the economy. Under-shooting an inflation measure which is an under-estimate could move the real economy into the deflation danger zone. Kent Matthews, the Sir Julian Hodge professor of banking and finance at Cardiff University, says: “I think the deflation danger is becoming increasingly realistic.”

One problem is that monetary policy becomes less effective as an instrument of economic management when interest rates are low. Japan provides the warning of how lowering interest rates eventually becomes self-defeating if other factors are preventing investment. When interest rates reach an effective zero per cent – as they have in Japan – there’s nowhere else to run.

Asset price collapse: Systemic deflation is also linked with the fourth horseman – the asset price collapse. The FTSE-100 index peaked at the end of 1999 at 6,930.2. Since then it has lost nearly half its value.

New research suggest that optimists who see the FTSE scaling the heights again in a couple of years could be disappointed.

A new analysis by three professors at the London Business School, suggests that the FTSE might not reach the 6,900 level again for 15 years. In their latest research, they analysed data from 16 stock markets over the past 103 years. They discovered that the present bear market is the third worst on record. They found no evidence to suggest that a rally must immediately follow a collapse.

“The chances of a down year are about the same after a down year as after an up year or a sideways year,” says the report co-author Elroy Dimson. “The market has no memory.”

A comparison of the 1973 and 2000 bear markets by Brunel University’s E Philip Davis in the latest National Institute Economic Review, points out that it took until 1993 for US share prices to reach their 1972 inflation-adjusted level. But Davis argues that “the current bear market largely reflects a correction of an over-valuation in the context of a far more integrated global market, whereas the 1970s saw a marked deterioration of the fundamentals.” So perhaps the inflation-adjusted recovery might not take 20 years this time. In both the US and the UK a robust housing market has partially countered the asset collapse in shares. But in the UK, there are now worrying signs that the housing market is coming off the boil with falls in London house prices. The NIESR predicts that national house prices will rise by only 4% by Q4 2003. But Riley warns there is a downside risk of house prices falling. If prices fell by 20% during the year, GDP growth would drop from 2.2% to 1.9%, with some sectors of the economy feeling the pinch harder than others. Although the prospects for 2003 are far from bright, FDs should plan on the basis that only one of the four horsemen – war – will gallop by this year. But, plainly, most companies will want to plan cautiously. It would be imprudent to assume growth significantly greater than 2002 unless there are compelling special circumstances for doing so. *War and the World Economy, by Graeme Leach. IoD Economic Paper.