We reiterate our rate forecast. Although we have outlined the factors behind our call over the past six months, investors are demanding and deserve more explanation. The purpose of this note is to elaborate on the framework and factors driving our call. In a nutshell, we think real rates are well below long-term norms. Over the next 12 months, unprecedented net saving shortfalls, a revival in investment, a less accommodative Fed, uncertainty about inflation and concerns about the sustainability of US fiscal policy will likely boost real rates significantly above those norms. Here we focus on the role of saving and investment.
Long-term real risk-free rates tend to fluctuate around 3%. The framework for determining real rates varies with the time horizon, as different horizons change the emphasis on the factors involved. In the long run, and on average through the cycle, real rates should reflect returns on capital and potential real growth. Those who believe that returns on investment, productivity and potential growth have declined in recent years would argue that there should be a corresponding decline in real rates. We do not buy that story; productivity and potential growth are certainly lower than they were in the 1960s and in the late 1990s, but at about 2% and 2.5%, respectively, they are in line with the average of the last 60 years. Returns on capital declined as corporate overinvestment in the technology boom boosted capital-output ratios, and returns have declined cyclically in the recession. But to maintain profitability, Corporate America has slashed capital spending and boosted productivity; witness the 3.8% increase in labor productivity over the year ended in 3Q.
Meanwhile, investors need compensation for taking on duration risk (e.g., the risk of holding a ten-year security as opposed to rolling over ten one-year instruments). Our colleague Jim Caron thinks that this ‘term premium' for risk in normal times should be at least half a percentage point or 50bp. Adding that to the 2.5% potential growth rate yields a 3% norm for real, risk-free yields. Thus, we think real, risk-free, long-term rates may fluctuate around that 3% norm, well above today's levels.
But supply and demand can prevail in the short term. In the short-to-medium term, other factors can persistently drive real rates away from those long-term norms. In our view, the spectrum of real yields over a medium-term timeframe is determined by supplies of saving and demands for investment, or their financial counterparts, the supply and demand for credit. Of course, saving always equals investment ex post; the ex ante question is always at what price - what interest rate - will the market clear?
Explaining today's rate levels is simple as pie. We find it easy to explain why real rates are exceptionally low despite record-low net national saving. First, the deepest recession since the Great Depression has clobbered investment across the board - in housing, corporate capital and inventories - and it is the excess of saving over investment that has driven rates down. In the corporate arena, the non-financial corporate financing gap (the difference between internally generated cash flows and corporate fixed and inventory investment) fell to a record low of -2.8% of non-financial corporate GDP in 3Q. Correspondingly, the demand for credit has plummeted to record lows.
Second, on the supply side, the Fed designed its Large-Scale Asset Purchase programs (LSAPs) to take massive amounts of duration and convexity risk out of the fixed income markets. The LSAPs thus keep rates lower than they would otherwise be, inducing investors through portfolio balance effects to take on more risk. In our view, when investment rebounds, even modestly, the supply/demand balance driving real interest rates will change dramatically. Moreover, as the Fed ends the LSAPs early in 2010, duration and convexity will return to the fixed income markets, and portfolio balance effects will begin working in reverse to tighten the supply of credit.
In the very short run, technical factors may be the primary catalyst for higher yields. For example, our colleague Jim Caron believes that sellers of high-strike interest rate insurance may have to sell bonds as rates go up - in a move akin to convexity hedging by mortgage investors and servicers (see 2010 Global Interest Rate Outlook: The World Is Uneven, November 30, 2009; and Asymmetric Risks Point To Higher Yields, Steeper Curve, December 10, 2009). Jim and team believe that those technical factors could push 10-year yields up quickly to 4.5%.
In what follows, we present a review of the coming changes in saving-investment (im)balances that point to higher real yields. The end of quantitative easing and rising term premiums will further add to the pressure on yields.
Slight rise in saving would still leave it close to record lows. Net national saving in relation to the size of the economy is a critical building block in our analysis. Fueled by rising wealth and easy credit, national saving has trended lower over the past 35 years - with the exception of the mid-1990s. Over the past year, while personal saving has risen significantly in response to the plunge in household net worth, ultra-aggressive fiscal stimulus and declines in national income relative to output took net national saving to a record-low -2.6% of GDP by 3Q09.
Our analysis of the four sources of saving - personal, corporate, government and saving from abroad - indicates that net national saving will increase somewhat over the next year, but will only get back into positive territory in 2011.
For the consumer, we believe that caution and modest wealth gains will push personal saving gradually higher. In our view, that will not result in consumer retrenchment; on the contrary, we think income will be growing rapidly enough to provide wherewithal for spending growth of roughly 2% in real terms, and to boost the saving rate by about a percentage point over the next year from 4.5% to 5.5% (representing about a US$120 billion increment to saving). That is consistent with employment gains of about 1%, a half-hour increase in the workweek, a rebound in property income (such as dividends), and further significant growth in unemployment insurance benefits, Cobra assistance and the second installment of the Making Work Pay tax credit.
Corporate America will also contribute modestly to private saving, as stronger revenue gains will boost the top line and higher profit margins will boost the bottom line. In turn, companies are able to expand margins and exploit the operating leverage in their businesses because they have slashed capacity. For example, recent gains in production have lifted operating rates by some 250bp from their lows. We expect that much of the profit gain henceforth will be paid out in dividends rather than retained; dividends have plunged by a record 21% over the past two years. As a result, undistributed profits (the net corporate contribution to national saving) likely will decline as a share of GDP in 2010.
Government dissaving is likely to decline somewhat through 2010, and inflows of saving from abroad probably will increase as the current account deficit widens. With regard to the US budget deficit, however, we would stress two points that represent a one-two punch for interest rates: First, Federal red ink will remain well above all past records for at least five years, and neither the Administration nor Congressional leaders have so far put forth any credible plan to reduce future deficits. Second, as discussed below, Treasury debt managers are making dramatic changes to the maturity of debt issuance, which will change the balance between supply and demand out the curve.
We expect the Federal budget deficit to be about US$1.3 trillion in F2010 - a shade below the US$1.4 trillion gap seen in F2009. The slippage reflects a modest pick-up in tax revenue as the economy begins to grow and a pullback in outlays aimed at supporting the financial sector, which should more than offset an acceleration in stimulus spending tied to the American Recovery and Reinvestment Act that was enacted last February and other new measures (such as the expanded homebuyer tax credit and bonus depreciation changes). As a result, total government dissaving may decline slightly in the year ahead.
But the real story in Treasury issuance is that the composition is shifting dramatically towards coupon securities as debt managers attempt to gradually boost the average maturity of the Treasury debt outstanding from its current level of about 4 years up to a range of 6-7 years. Gross coupon issuance - the best gauge of the supply burden confronting the market - likely will top US$2.5 trillion in the current fiscal year, up 40% from F2009. In fact, the increase in coupon issuance during the year ahead should be about equal to the amount of total issuance in a ‘normal' year (such as F2008). That step-up in supply, coming as the Fed concludes its Treasury buying program and as the Fed tapers its purchases of RMBS, constitutes a key source of uncertainty in our analysis. The overall data on government dissaving are not sufficient for us to gauge the impact on rates of large budget deficits and the Treasury issuance required to fund them.
Inflows from global investors to increase again. Despite strong export gains, rising oil and other import prices likely will combine with rising imports and shrinking US surpluses on services and investment income to widen the nominal current account deficit. As represented by the GDP accounts, we estimate that the corresponding inflows from global investors will rise by about 0.6% of GDP to 4.2% over the four quarters of 2010, or by about US$110 billion. Yet that inflow won't likely come easily in today's context. Concerns about sovereign credit risk and fiscal sustainability imply that global investors will demand a concession to buy US debt. Although the US won't default on its debt, investors are always handicapping the risks of owning even the benchmarks for global sovereign credit.
Ex ante, investment is poised to increase more than saving; higher rates required to clear market. At first blush, the increased saving that we expect may sound bullish for interest rates. What many fail to appreciate, however, is the extent to which investment outlays will rise over the course of the next year in spite of the rise in rates. Housing, of course, is credit-sensitive, but credit availability and collateral requirements are as important as interest rates. The fact that traditionally measured housing affordability has skyrocketed and yet housing is staging only a modest recovery from a record plunge speaks to the importance of credit availability. Our hunch is that improved availability in the coming year means that housing demand will improve even as rates rise.
For Corporate America, there is a parallel story. Capital spending plunged in the recession to an unprecedented degree, and new investment is needed to rebuild capital stocks. The ‘accelerator' of rising output on a sustained basis and improved corporate cash flow will also drive capex higher. Moreover, empirical work suggests that corporate capital spending is relatively insensitive to changes in interest rates. Finally, we believe that companies will shift from a record 10 quarters of liquidation to accumulating inventories by year-end. Combined, this shift to sustainable growth in housing, business investment and inventories will result in a significant increase in private credit demand.
The upshot is that the necessary balance between rising saving and rising net investment is unlikely to occur at today's interest rates. Finally, two other factors are expected to lift real interest rates. First is a repricing of the likely path for short-term interest rates. Currently, fed funds and eurodollar futures are pricing in a 90bp move up in rates by year-end 2010, and a cumulative move by year-end 2011 of about 200bp - less than what we expect through year-end 2010. As a result, we think the market has more repricing of the yield curve to do. Second, uncertainty over fiscal credibility and inflation will lift term premiums and likely add to the looming pressure on real yields.
Abundance is back: that should help Latin America surprise to the upside on growth and keep the region's currencies strong in 2010. The upswing in economic activity next year may be exaggerated as the region bounces off a weak base; we estimate that Latin America's largest economies contracted by 2.6% in 2009. Accordingly, we would caution against extrapolating from the 2010 growth record to construct a view that the region's long-term growth potential has improved sharply. But starting points matter, and Latin America's starting point for 2010 means that it should enjoy a much stronger recovery than most developed economies. After all, unlike many developed economies, Latin America is not saddled with significant fiscal costs to deal with a debilitated banking system, nor with the knock-on effects of a housing bubble that burst.
The Birth of an Asset Class
Latin America is also likely to benefit in 2010 for another reason: the birth of emerging markets as an asset class. It may seem odd to speak of emerging markets being born in 2009; after all, for nearly two decades now there has been a group of market strategists and economists who have identified themselves as emerging markets specialists. But we would argue that for both good reasons as well as bad, a much wider group of investors are likely to treat emerging markets as an asset class in a way that had not taken place until today. Indeed, we suspect that the single greatest beneficiaries of the Great Recession are emerging economies, which are likely to see increased investor interest translate into inflows.
There is good reason for this long-overdue recognition by a wider investor base of emerging markets. Despite some setbacks and calls for greater protectionist measures, particularly in the past two years, the economic fact of global labor markets - linking primarily China, but also India and Central Europe and Russia to the developed world - remains largely intact. And that, in turn, leaves most of Latin America as a beneficiary.
However, we believe that there is some sloppiness in the evidence marshaled in favor of Latin America in particular and more broadly of emerging markets. The gap between growth rates in emerging and developed economies is likely to be exaggerated at this point in the cycle as Asia roars back, while the US and Europe are saddled with the clean-up costs of a credit bust. Further, because the Great Recession was short-lived, it never tested our concerns that a prolonged global downturn could lead to severe deterioration within Latin America and many emerging economies.
Our argument last year as we looked towards 2009 was that, given the trio of massive reserve accumulation, current account improvement and better fiscal results, Latin America had its house in better order than in decades and hence the shorter the global downturn, the better the region would emerge (see "Latin America: Sliding in 2009", EM Economist, December 12, 2008). If the downturn was prolonged, however, we argued that Latin America would suffer disproportionately, given much more limited space for counter-cyclical fiscal policy and the limited traction of monetary policy in the region. There would be less room for counter-cyclical fiscal policy, we argued, as risk-aversion would limit Latin America's access to greater debt financing just when it was needed the most. And limited financial intermediation would likely play a role in weakening the traction of any attempts at accommodative monetary policy.
As it turned out, the synchronized global downturn was short-lived, and it was China that began to lead other emerging economies out of the Great Recession. Nonetheless, we still believe that the principal drivers of the better growth that Latin America enjoyed during the second half of the past decade were a series of external factors reflected in a period of favorable financial and credit conditions, strong global demand and a remarkable surge in the terms of trade. Had the global downturn of late 2008 and early 2009 intensified and lengthened, we are not sure that the popular distinction between weak DM (developed markets) and robust EM (emerging markets) that is in vogue today would exist.
The global environment, as outlined by our global team of economists at Morgan Stanley, should prove to be very favorable for Latin America in 2010. Our global team expects the pace of the exit strategies in the developed world to be a "crawl" as central banks approach the exit in a "cautious, gradual and transparent manner" (see "2010 Outlook: From Exit to Exit", Global Forecast Snapshots, December 9, 2009). With "fragility" remaining in the financial sector, our global team expects monetary policy to move only from "super-expansionary" to "still-pretty-expansionary". This, in turn, should bode well for risk appetite, which along with the good growth recovery we expect for Latin America, should bolster investor interest in the region.
Risk to Abundance, the Risk of Abundance
We see two major risks to our forecast of good growth in Latin America in 2010 and strong currencies: one is external, the other internal. Because Latin America remains vulnerable to external conditions, if the global economy were entering into a period marked by excess savings, then this ‘paradox of thrift' could unleash a prolonged period of lower-than-trend economic activity. Latin America's growth profile would also suffer. Despite the recovery we are expecting in the region in 2010, we continue to monitor external conditions carefully.
The internal risk, however, is more dangerous precisely because it is less likely to be understood than the external risk around which a lively debate has already formed. The internal risk could be called ‘the risk of abundance'. Abundance forgives all. This, in turn, can lead to a dangerous situation in which policymakers make poor decisions which investors initially overlook. There is already a debate among investors about the wisdom of some of the measures that Brazil has taken to reduce its exposure to inflows. If, as we suspect, growth continues to surprise to the upside in Latin America, policy mistakes are likely to be forgiven - in the near term. Unfortunately, this can set the region up for even greater policy mistakes.
In the end, the greatest risk, in our view, is that the region's policymakers confuse the heady recovery likely to be experienced in 2010 with a path of sustainable, stronger growth, and this confusion leads to a failure to tackle the region's pressing structural reform agenda. Much more needs to be done to raise human capital, boost public and private investment in infrastructure and strengthen further the framework for a greater competitive environment in Latin America. The ‘risk of abundance' is not only that progress on the reform agenda stalls, but also that counter-productive measures are taken that ultimately increase uncertainty in the region. This is not our base case, but remains the risk that we think should be monitored most closely, especially in 2010 as growth rebounds.
Country Specifics
We expect Latin America to grow by at least 4.1% in 2010 and suspect that there is further upside risk to our forecast. In every major economy in the region save one, we expect growth to surpass the latest consensus. The only country where our forecast is not clearly above consensus is Brazil, where Marcelo Carvalho expects 4.8% growth in real GDP in 2010. Consensus may have moved too fast in Brazil and may suffer a setback following the release of a not as strong-as-expected 3Q GDP report in mid-December.
Indeed, in Brazil, Marcelo expects three main themes to capture observers' attention in 2010. Marcelo is focused on the risk of greater policy interventionism, the need for the central bank to begin to use monetary policy to avoid an overheating economy and market volatility surrounding the October 2010 general elections. All these concerns are already much talked about by investors in Brazil, but much less so among investors abroad, and are particularly absent as concerns among the larger new ‘non-dedicated' entrants to Brazil's markets. We think that all three themes are worth watching carefully, but suspect that good growth in Brazil combined with a healthy appetite abroad for risk means that these concerns are not likely to substantially dent an increasingly upbeat attitude towards all things Brazilian.
In Mexico, Luis Arcentales is very constructive and highlights three reasons. First, recent manufacturing data and leading indicators in both the US and Mexico point to sustained momentum into next year; given the strong links between the industrial sectors in both countries, Mexico is poised to benefit from the rebound in US manufacturing output and sales of North American produced cars. The improvement in export-linked areas of the economy should boost trade-related services and, over the course of next year, start to broaden into an improvement in domestic-focused sectors, for which Luis expects only a very moderate recovery at about half the pace of the past five years. Second, Luis expects to see others revise upward their growth outlook for 2010 towards his 3.8% estimate, which, in turn, should translate into a strengthening of the exchange rate towards 12.5 to the US dollar. Stronger growth should provide the authorities with additional fiscal maneuvering room. Third, contrary to market expectations and despite the inflationary shock caused by the tax reform, Luis expects that Banco de Mexico will keep its policy rate unchanged at 4.5% next year because of the temporary nature of the shock, the ample slack in the economy and downward risk to fuel price adjustments next year, which represent the most important source of potential inflationary pressure.
Chile's economy, after weathering the 2009 storm quite well, also seems poised to rebound briskly in 2010, according to Luis. A great part of the recovery - we see real GDP rising 5.0% next year (from 3.8% previously) - will likely be driven by a powerful inventory cycle following the unprecedented destocking that began in 4Q08 and that knocked off over 5 percentage points from annual GDP growth in the past year. Surveys of industry and retail indicate that inventories are no longer bloated. Meanwhile, consumer confidence is back in positive territory, reflecting strong real wage gains, looser credit conditions and a mild turnaround in labor markets; this improved backdrop, in turn, should sustain modest gains in consumption. Monetary policy is likely to remain accommodative throughout 2010 as the central bank is unlikely to begin tightening rates before 3Q amid signs of very subdued inflationary pressures and a strong currency, which is likely to reach 530 by the end of next year (from 590 previously). In the political arena, the presidential succession process is unlikely to lead to any major shifts in the prudent set of policies that has served Chile well in withstanding the recent financial and economic crises.
Argentina should experience a modest rebound in 2010 on the back of improvement in external conditions, particularly commodity prices and a strong Brazilian economic recovery, according to Daniel Volberg. Daniel now expects Argentina to grow by at least 3.3% in 2010, versus his previous estimate of 1.0%. Despite the modest rebound, Daniel warns that tax revenue growth should remain below expenditure growth through most of next year, contributing to further fiscal deterioration. Indeed, he warns that a fiscal shortfall is likely to be Argentina's main challenge next year, with provincial and federal fiscal positions rapidly deteriorating. This, in turn, should prompt the authorities to redouble efforts to regain access to debt markets, in part by restructuring the leftover defaulted debt, most likely in January. Although we estimate that Argentina will have enough internal resources to cover its debt obligations, the recent intensification of policy heterodoxy, our expectation of anemic recovery and a rising fiscal challenge may keep the balance of risks skewed to the downside in the next 12-18 months.
We expect a strong rebound in both Peru (4.9%) and Colombia (4.1%) next year on the back of a recovery in domestic demand. Daniel and Luis expect investment to be a key driver of growth in 2010 in both countries. However, with growth on the mend in Peru, Daniel warns that inflationary pressure is likely to begin to build in 2H10, and thus he expects the central bank to begin normalizing rates, hiking the target rate by 350bp to 4.75%. Meanwhile, in Colombia, Daniel warns that there has been disproportionate attention given to the restrictions on trade imposed by Venezuela. But we suspect that the domestic recovery as well as continued healing in global markets should be relatively more important factors. Given the more upbeat forecast for growth, we expect the central bank of Colombia to hike interest rates by 200bp to 5.5%, well in excess of most local forecasters, who are looking for marginal rate hikes of just under 50bp.
In Venezuela, we believe that concerns in 2010 may remain focused on debt servicing as well as the possibility of a devaluation of the official exchange rate. Despite mounting imbalances in the economy, Guiliana Pardelli and Daniel Volberg consider that Venezuela should be able to avoid a severe debt problem or a sharp devaluation next year. With the markets - particularly crude prices - and the global economy healing, the authorities are likely to have enough maneuvering room to maintain their commitment to a fixed exchange rate at Bs$2.15 and thus prevent a more serious spike in already-elevated inflation. In turn, the extra revenues derived from higher crude are likely to allow the authorities to keep spending, maintain debt servicing and boost dollar sales, in order to diminish the gap between the official and the parallel market exchange rate. While economic activity should improve, as private consumption recovers and government spending continues to rise, elevated inflation will likely continue to be a concern, amid loose monetary policy.
Bottom Line
Abundance appears to be back in Latin America. Part of the recovery is simply a bounce after the decline in early 2009, but part of the strength in the region is also the consequence of its increasing ties to China as well as the relatively healthy state of the region's small but growing banking system. While we believe that Latin America is still vulnerable to external conditions and we think it is far from settled how strong the global economy can be expected to be in 2011 and beyond, given the damage inflicted in the developed world from the Great Recession, it may simply be too early to expect those issues to come home to roost in 2010. If the liquidity cycle remains intact - with the move to an exit more like a "crawl" in the forecasts of our global colleagues - then Latin America is likely to enjoy a heady recovery sooner and stronger than many expect.
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