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Can the World Survive the US Downturn?

Goldman Sachs. 1. Can the World Survive the US Downturn?. Gavyn Davies Chief International Economist. Enron Advisory Council Houston 11th April 2001. Models to estimate the statistical probability of recession.

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Can the World Survive the US Downturn?

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  1. Goldman Sachs 1 Can the World Survive the US Downturn? Gavyn Davies Chief International Economist Enron Advisory Council Houston 11th April 2001

  2. Models to estimate the statistical probability of recession. The economic cycle and financial market risk premia - the importance of leading indicators. Goldman Sachs “main case” forecast for GDP. Downside risks - ICT spending; US domestic demand; oil. The downside case for economic activity. Interest rates for currencies. 2 Main Topics

  3. 3 Probability of Recession Model February Indicator Observation Coefficient T-Statistic Rank1 Univ. of Michigan Consumer Sentiment - 16.70 - 0.0610 - 2.79 2 Consumer Price Index - Energy 12.88 0.027 1.59 7 Inventory / Shipment Ratio - Mfg. 0.07 4.037 2.56 3 Ratio of Unsold to Sold Homes 0.34 8.266 5.46 6 10-Year / Fed Funds Spread - 0.39 - 0.869 - 5.65 1 Real M2 1.30 0.264 2.17 4 Corporate Yield Spread 0.77 0.83 2.13 5 1 Importance in recent rise in probability of recession. Source: Our Calculations.

  4. 1.2 1.0 0.8 0.6 0.4 0.2 0.0 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 4 US: Probability of Recession Probability of recession* Probability of recession starting within the following 12 months based upon a probit model using 7 real and financial indicators.

  5. 1.2 1.0 0.8 0.6 0.4 0.2 0.0 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 *Probability of a recession occurring within the following 12 months. Shaded regions indicate actual periods of recession. 5 Probability of Recession: OECD ex. USA*

  6. 92 93 94 95 96 97 98 99 00 01 Euroland GDP Growth Probabilities One Year Ahead 6 110 % 100 90 80 <2% 70 60 50 40 30 <0% 20 10 0

  7. 100 90 80 70 60 50 40 30 20 10 0 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 7 Japan: Probability of Recession* % * Probability of the economy entering a recession over the next 12 months.

  8. 90 % 80 Economy In Recession 70 60 50 40 30 20 10 0 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 8 UK: Probability of Recession* *Probability of negative annual GDP growth in one year's time.

  9. 40 12 % yoy % yoy 10 30 OECD Leading 8 Indicator 20 6 10 4 0 2 0 -10 -2 -20 -4 -30 World Equity Returns -6 minus Bond Returns in US$ -40 -8 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 9 Relative Performance of World Equities vs Bonds & OECD Leading Indicator

  10. 10 0 % yoy %, 3m Mov. Av 8 0.5 OECD LI 6 1 4 1.5 2 2 0 2.5 World ERP -2 3 (inverted) -4 3.5 -6 4 90 91 92 93 94 95 96 97 98 99 00 01 02 10 OECD Leading Indicator and WorldEquity Risk Premium

  11. 12 0 %, 3m % yoy Mov. Av. 10 0.5 US Baa Corporate 8 Bond Spread 1 (inverted) 6 1.5 4 2 2 2.5 0 3 -2 3.5 OECD LI -4 4 -6 4.5 -8 5 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 11 OECD Leading Indicator and US Corporate Bond Spread

  12. 80 12 % yoy % yoy Emerging Market minus 10 60 World Equity Returns in US$ 8 40 6 20 4 0 2 0 -20 -2 -40 OECD Leading -4 Indicator -60 -6 -80 -8 86 88 90 92 94 96 98 00 02 12 Relative Performance of Emerging Market vs World Equities & OECD Leading Indicator

  13. Turning Point in OECD LI Lead in months over... TYPE Date OECD Emg. Mkt. US Corp. World Equity Ind. Prodn Bond Sprd. Spread Risk Premium Peak Jan-00 4 8 1 1 Trough Oct-98 6 - 2 1 0 Peak Sep-97 4 0 - 4 8 Trough Jun-96 - 2 - 14 - 5 - 7 Peak Jan-95 7 - 12 0 - 3 Trough Oct-92 9 4 6 2 Peak Jan-89 3 — 3 — Average 4.4 - 2.7 0.3 0.2 13 Lead/lag of OECD Leading Indicators at Turning Points

  14. -2 0 +6 0.50 0.47 0.05 0.15 0.26 0.10 0.21 0.24 -0.05 0.12 0.17 0.16 -7 -6 -3 0.854 0.854 0.811 — 0.809 0.749 -2 -1 +2 0.893 0.891 0.855 14 Correlation between OECD Leading Indicators & Other Variables Correlation with Leading Indicators x months ahead* Variable -6 -4 +2 +4 Months US Corp. Spread 0.45 0.48 0.35 0.20 Emg. Mkt. Bond Spread -0.09 0.04 0.25 0.17 World Equity Risk Premium 0.04 0.13 0.19 0.07 US Equity Risk Premium -0.03 0.04 0.18 0.16 -9 -8 -5 -4 Months OECD Ind. Prod. 0.838 0.847 0.849 0.835 OECD GDP 0.726 — — — -4 -3 0 +1 Months GS LI 0.888 0.891 0.887 0.873 * Month of highest correlation in bold.

  15. Turning Point Lead of “OECD” LLI in months over... OECD LI OECD IP TYPE “OECD” LLI Trough Dec-00 Peak Jun-99 7 11 Trough May-98 5 11 Peak Feb-97 7 11 Trough Dec-95 6 4 Peak Oct-94 3 10 Trough Oct-92 0 9 Peak Aug-87 17 20 Average 6.4 10.9 15 Turning Points in “OECD” Longer Leading Indicator and Other Indicators .

  16. 1.15 Ratio to trend "Longer" Leading 1.10 Indicator ("OECD" LLI)* f'cst values 1.05 1.00 OECD's Leading 0.95 Indicator *Constructed from the components of the OECD's indicator that have historically had a long lead on economic activity at turning points. 0.90 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 16 Leading Indicators of OECD Economic Activity

  17. 1.15 1.10 1.05 1.00 0.95 0.90 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 17 Leading Indicators of OECD Economic Activity Ratio to trend OECD's Leading Indicator GS Leading Indicator (GS LI)* f'cst *Based on an econometric model to predict values changes in the OECD's indicator.

  18. 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 18 Main Six Economies 12 16 % yoy % yoy 11 10 12 9 Leading Indicator 8 8 7 6 4 5 4 3 0 2 1 -4 0 -1 -8 -2 Industrial Production -3 -4 -12

  19. 19 Global GDP Forecasts % Change on Year Earlier 1999 2000 2001 2002 (f) (f) USA 4.2 5.0 1.4 2.5 Euroland 2.5 3.4 2.4 2.7 Japan 0.8 1.7 1.5 1.4 OECD Total 3.0 3.7 1.8 2.5 Non Japan Asia 6.5 7.2 5.1 5.8 Latin America 0.0 4.2 3.4 4.3 Emerging C. Europe 3.1 4.0 3.7 4.2 Emerging World 4.2 6.1 4.6 5.3 World 3.5 4.6 2.7 3.4

  20. 80 82 84 86 88 90 92 94 96 98 00 02 20 Estimates of G6 Output Gap 3 % yoy 2 Goldman Sachs 1 0 -1 -2 OECD IMF -3 -4 -5

  21. 3.0 % yoy 2.5 Headline CPI 2.0 Core CPI 1.5 1.0 96 97 98 99 00 01 02 03 21 OECD Headline & Core Inflation

  22. 50 % yoy 40 Orders, 3mma 30 Investment Spending 20 10 0 -10 80 82 84 86 88 90 92 94 96 98 00 02 US Hardware & Communications Equipment Spending 22

  23. ICT Spending Projections1 23 ICT Spending Hit to GDP2 (% Growth) (% pts) 1999 2000F 2001F 2001F US 15.4 22.9 - 2.4 - 1.0 Japan 5.1 20.1 10.6 - 0.5 Germany 6.4 9.6 4.3 - 0.1 France 16.2 24.1 10.8 - 0.4 UK 4.0 6.0 2.7 - 0.1 G5 11.6 19.6 2.3 - 0.7 1Assuming level of orders remains unchanged at average level between Dec '00 and Jan '01 throughout 2001. 2Direct impact on nominal spending. Total impact on real GDP will be higher.

  24. 86 35 US$/bl (Million Barrels) 84 WTI 30 82 25 80 Global 78 20 demand 76 15 74 Forecast Global supply 72 10 99 00 01 02 24 Oil Price Forecast

  25. Terms-of-trade or balance of payments loss* % of GDP 1978-80 1989-91 1998-01 1973-74 US 1.0 2.5 0.6 0.6 Euroland 2.6 3.7 0.9 0.8 Japan 3.0 3.8 0.8 1.0 OECD 1.9 3.2 0.7 0.7 25 Impact of Oil Price Change on Terms-of-Trade * Negative figure indicates a terms-of-trade gain. The terms-of-trade loss is calculated by multiplying the percentage increase in the dollar price of oil by the share of oil and gas imports in GDP. We assume the price of brent oil rises from $13.1bbl in 1998 to $26.5bbl in 2001.

  26. 100 99.5 99 Tighter 98.5 98 97.5 97 96.5 96 Easier 95.5 95 94 95 96 97 98 99 00 01 02 26 US Real Financial Conditions Index

  27. 14 4.0 Ratio, % Net Worth/Disposable inverted 12 Income Ratio 4.5 10 8 5.0 Q1 estimate 6 Household 5.5 4 Saving Rate 2 6.0 0 -2 6.5 80 82 84 86 88 90 92 94 96 98 00 02 27 US Saving Rate at Record Low

  28. US Personal Saving Rate (% of Disposable Income) 28 Change, Predicted Change, Predicted Change, Predicted Change, Actual (wealth stays flat) (wealth rises 5%) (wealth rises 10%) 00Q1 - 1.3 - 1.1 - 1.1 - 1.1 00Q2 + 0.1 - 0.8 - 0.8 - 0.8 00Q3 - 0.5 + 0.5 + 0.5 + 0.5 00Q4 - 0.6 + 0.1 + 0.1 + 0.1 01Q1 + 0.9 + 0.9 + 0.9 01Q2 + 0.9 + 0.7 + 0.5 01Q3 + 0.8 + 0.5 + 0.1 01Q4 + 0.9 + 0.5 + 0.1 Source: Department of Commerce. Our Calculations.

  29. 8 13 12 6 11 10 4 9 8 2 7 6 Assuming 1990-99 Growth* Assuming No Growth** 0 5 90 91 92 99 94 95 96 97 98 99 00 01 US: A Stable Capital Stock Share = Collapse in ICT Investment 29 % of % of GDP GDP ICT Capital Stock ICT Business Fixed Investment

  30. 83 85 87 89 91 93 95 97 99 01 03 30 US - Financial Balances 8 % of GDP 7 6 5 Private Sector 4 Balance 3 Fiscal Balance 2 1 0 Current Account -1 -2 -3 -4 -5 -6 -7 -8

  31. US - 2.0 0.5 - 0.8 - 2.3 Japan - 0.2 0.7 - 0.5 0.0 Euroland - 0.1 0.6 - 0.2 0.2 31 Impact on GDP of Possible Global Shocks in 2001 Impact on GDP Direct Hit From US Gain from Collapse in Recession Collapse in Tech Total GDP % of GDP Via Exports1 Oil Prices2 Spending3 Effect Main OECD Countries - 0.8 0.5 - 0.5 - 0.8 1 This column shows the direct trade hit from a decline of 6% in exports to the US. This would likely happen if US domestic demand dropped by 3% in 2001 (relative to our main case forecast). The drop in US GDP would be around 2%. 2 This assumes average oil prices in 2001 drop by $10/barrel compared with our main case assumption of $22/barrel. 3 This assumes a drop in ICT investment in line with recent orders data. US tech spending decelerates from 22% growth in 2000 to 1% in 2001.

  32. 10 % YoY Simulations 8 GS Leading Indicator 6 4 Industrial 2 Production (YoY Chg) 0 -2 97 98 99 00 01 02 32 Euroland: Industrial Production

  33. 12 % of GDP 10 Private Sector 8 Balance 6 Current Account 4 2 0 -2 -4 Fiscal Balance -6 -8 -10 83 85 87 89 91 93 95 97 99 01 03 33 Japan - Financial Balances

  34. OECD 1.8 0.6 1.6 0.9 Outlook for 2001: Central Case & Downside Scenario 34 GDP - annual average CPI - yoy, end-year % Change Downside Downside Central Case Scenario Central Case Scenario US 1.4 -0.6 2.4 1.1 Japan 1.5 0.8 -0.1 -0.2 Euroland 2.4 1.7 1.4 1.0 UK 2.2 1.6 1.5 1.2 OECD ex US 2.1 1.5 1.0 0.7

  35. 35 G7: GSWIRE Scenarios % GS Forecasts Actual/Forwards Baseline Boom Bust

  36. 36 Euro / US$ EXCEL LINKED +1 Standard Error Spot GSDEER -1 Standard Error 02

  37. US: BAA Corporate Bond Spread* 37 % GS-Spread** Projections Actual *Moody’s Baa-30 year Treasury **Out of Sample

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