2. ‘BBB recovery' in the G10. We expect the recovery in the advanced economies to be creditless and jobless, making it bumpy, below-par and boring.
3. G3 growth differentiation. We see the US as the growth leader among the G3, the euro area to lag behind, and Japan to double-dip.
4. ‘AAA liquidity cycle' remains intact. Central banks will crawl rather than rush towards the exit, so global liquidity continues to be ample, abundant and augmenting.
5. Sovereign and inflation risks on the rise. The next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.
From Exit to Exit
Last year was all about the exit from the Great Recession - and it worked courtesy of massive global policy stimulus, as expected. This year will be all about the exit from super-expansionary monetary policy. As we laid out in more detail in the final issue of The Global Monetary Analyst on December 16, we expect the major central banks to start exiting around the middle of this year.
Yes, they will likely be cautious, gradual and transparent, but the prospect and process of withdrawal may have unintended consequences: We think that government bond markets will be the first victim. While the exit will be the dominant macro theme next year, we identify five important economic themes in our global economic outlook that should be highly relevant for investors in 2010.
1. A Tale of Two Worlds
We forecast 4% global GDP growth this year, which would be a fairly decent outcome, especially compared to the doom and gloom that prevailed for much of last year. However, it falls short of the close to 5% average annual GDP growth rate in the five years prior to the Great Recession, and it will be the product of unprecedented monetary and fiscal stimulus, which poses substantial longer-term risks. Importantly, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies, the other a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% this year (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% in 2009. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, as our China economist Qing Wang has pointed out, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, we think that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis.
2. ‘BBB Recovery' in the G10
In contrast to our upbeat EM story, we forecast barely 2% average GDP growth in the advanced G10 economies this year - a ‘BBB recovery' where the three Bs stand for bumpy, below-par and boring. On our estimates, GDP growth averaged around 2% in the G10 in 2H09 and won't accelerate much from that pace this year. The two key reasons why we think the recovery in the G10 will be ‘BBB' are that it is likely to be creditless and jobless. Creditless recoveries - where banks are reluctant to lend and the non-bank private sector is unwilling to borrow - are the norm following a combination of a credit boom in the preceding cycle and a banking crisis. Creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, we expect a jobless G10 recovery, with unemployment in the US declining only marginally this year and rising further in Europe and Japan. Unemployment may well stay structurally higher over the next several years in the advanced economies as many of the unemployed either have the wrong skills or are in the wrong place in an environment where the sectoral and regional drivers of growth are shifting.
3. G3 Growth Differentiation
Beneath the surface of a lacklustre ‘BBB recovery' in the advanced economies lies a differentiated story for the three largest economies - the US, Europe and Japan. Significant growth differentials between these economies in 2010 may well become a topic for currency, interest rate and equity markets again. We see the US as the growth leader among this group, with output expanding by 2.8% (annual average) in 2010. The euro area looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) and is forecast to actually fall back into a technical recession in the first half of this year. One reason for US outperformance is that the creditless nature of the recovery affects the US less because banks (as opposed to capital markets) play a smaller role in financing the economy than in Europe or Japan. Another reason is that US companies have been much more aggressive in shedding labour last year, so US labour markets look set to recover (albeit slowly) this year, while we expect unemployment to rise further in both Europe and Japan. Further, European and Japanese exporters should feel the pain from last year's currency appreciation, whereas US exporters should benefit from last year's dollar weakness.
4. ‘AAA Liquidity Cycle' Remains Intact
The beginning of the exit from super-expansionary monetary policies will likely be the dominant global macro theme in 2010. We expect the Fed, the European Central Bank and the People's Bank of China to move roughly in tandem and raise interest rates beginning in 3Q10, with the Bank of England following in 4Q. Some, like India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. Given the remaining fragility in the financial sector, central banks are likely to approach the exit in a cautious, gradual and transparent manner, so any hikes will likely be telegraphed well in advance, partly through twists in the crafted language and partly through cautious draining of excess bank reserves.
The end of easing and beginning of exit can be expected to cause wobbles in financial markets - one reason why we see bonds selling off sharply this year. However, official rates are likely to stay well below their neutral levels throughout 2010 and, probably, also in 2011. Hence, monetary policy is only expected to transition from super-expansionary to still-pretty-expansionary. This would leave the ‘AAA liquidity cycle' (ample, abundant and augmenting) - the main driver behind last year's asset price bonanza and economic recovery - fairly intact this year. The metric we follow to validate or refute this view is our global excess liquidity measure, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded last year, and we expect it to rise further, though at a much lower pace, through 2010.
5. Sovereign and Inflation Risks on the Rise
We think that sovereign risk and inflation risk will be major themes for markets this year. Greece's fiscal problems are only a taste of things to come in other advanced (not emerging) economies, in our view. Fiscal policy looks set to remain expansionary in all major economies this year, as the ‘BBB recovery' still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability. The issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: Most government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales, their central banks can print whatever is needed (call it quantitative easing). Thus, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.
Last year was a challenging one for the US Treasury market, despite fears of deflation and double dips. In our view, the challenges will escalate significantly this year. We think that US real 10-year Treasury yields are headed significantly higher, as the Fed exits from its current policy stance and economic growth proves moderate but sustainable through 2011. Our strategy teams believe that sustainable growth and a ‘triple A' liquidity cycle will continue to provide favorable fundamentals for risky assets, at least in the near term. But rising rates and even a gradual move away from ultra-accommodative monetary policy will challenge valuations, especially for equities, in the second half of the year.
Theme 1: Real yields headed higher. We think 10-year Treasury yields will rise to 5.5% during 2H10 despite our low inflation, moderate growth scenario. Real rates are well below long-term norms, on our estimates, and 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 (for details, see The Case for Higher Real Rates, December 15, 2009).
Long-term real risk-free rates tend to fluctuate around 3%. They should reflect returns on capital, potential real growth, and a ‘term premium' to compensate investors for taking on duration risk. Weak investment has pushed rates below those norms and, on the supply side, the Fed's Large-Scale Asset Purchase programs (LSAPs) have kept rates lower than they would otherwise be.
We think that coming changes in saving-investment (im)balances point to higher real yields. When investment rebounds, even modestly, we think that real interest rates will rise 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.
Slight rise in saving would still leave it close to record lows. Our analysis of the four sources of saving - personal, corporate, government and saving from abroad - indicates that net national saving will only just return to positive territory in 2011.
• Healthy income and modest wealth gains coupled with consumer caution will push the personal saving rate up to about 5.5% (representing about a US$120 billion increment to saving).
• Rising corporate profits will also contribute modestly to private saving, but much will be paid out in dividends, so undistributed profits (the net corporate contribution to national saving) likely will decline as a share of GDP in 2010.
• Government red ink (dissaving) is likely to decline by US$100 billion to about US$1.3 trillion in 2010. But there is a one-two punch for interest rates in the federal budget: First, federal deficits will remain well above all past records for at least five years, and there is yet no credible plan to reduce future deficits. Second, Treasury debt managers are dramatically shifting towards coupon securities to boost the maturity of the debt. Gross coupon issuance - the best gauge of the supply burden confronting the market - likely will top US$2.5 trillion in FY10, up 40% from FY09. Now that the Fed has ended its Treasury buying program, this shift to coupons will magnify the impact on rates of large budget deficits and the Treasury issuance required to fund them.
• Inflows from global investors will increase slightly, by about 0.6% of GDP to 4.2% over the four quarters of 2010, or by about US$110 billion. Yet that inflow is unlikely to come easily. Concerns about sovereign credit risk and fiscal sustainability imply that global investors will demand a concession to buy US debt. The US won't default, but the risks of owning even the benchmark for global sovereign credit will affect the price.
Ex ante, investment is poised to increase more than saving; higher rates are required to clear the market. This saving increase won't restrain real rates because we expect investment outlays to rise even faster. Housing is credit-sensitive, but improved credit availability and rising jobs and income will lift housing demand even as rates rise. Likewise, empirical work suggests that corporate capital spending is relatively insensitive to changes in interest rates. And other forces will likely promote a capex revival: Companies need to rebuild depleted capital; the ‘accelerator' and improved corporate cash flow will also contribute. In addition, we believe that companies will finally shift to inventory accumulation by year-end. In all, sustainable growth in housing, business investment and inventories will boost private credit demands, and today's interest rates are unlikely to equilibrate saving with investment.
Finally, we expect two other factors to lift real yields. First, uncertainty over fiscal credibility and inflation will lift term premiums. Second, a repricing of the likely path for short-term interest rates is coming. Currently, fed funds and eurodollar futures are pricing in roughly a 100bp move up in rates by year-end 2010 - or about 50bp less than we expect.
Theme 2: The Fed will exit in 2010. The Fed will begin the gradual exit from its ultra-accommodative monetary stance in 2010, as inflation expectations are starting to rise, slack in the economy is narrowing, and the outlook for inflation will begin to change by mid-2010. We think that officials will implement the exit strategy in two stages: First, the Fed will start to drain reserves when LSAPs end. Second, it will begin raising the policy rate in 3Q, to 1.5% by year-end and 2% in 2011 on our estimates (for details, see The Fed Will Exit in 2010, December 7, 2009).
Exit scorecard. Economic slack is close to record levels by any measure: The ‘output gap' is about 5.5% of GDP, industry operating rates at 71.3% are only slightly above previous record lows, and the unemployment rate at 10% is still at a 26-year high. Consequently, we think that core CPI inflation is headed to 1% from the current 1.7% pace. But market-based inflation expectations are gradually rising; 5-year, 5-year forward breakeven rates have recently moved above 2.5%. Furthermore, an improving economy is already narrowing all three measures of slack, and together with the ongoing rise in commodity and import prices, that change will alter the inflation outlook for the second half of 2010 and 2011.
Theme 3: Four factors should promote sustainable growth through 2011: 1) Monetary policy has fostered improving financial conditions; 2) The fiscal impact will last through 2011; 3) Strong growth abroad will lift US exports and earnings; and 4) Economic and financial excesses are abating.
Healing in financial markets, credit crunch abating. The combination of aggressive policy stimulus, the dramatic improvement in the functioning of financial markets, higher prices for risky assets and the recent slower pace of tightening bank lending standards should increase the chances for sustainable recovery. To be sure, banks were still tightening lending standards in October, but at a slower pace, and it's pace that matters for growth.
Lasting fiscal impact. A second support for sustainable recovery comes from fiscal policy. In our view, there are lags of 3-9 months between fiscal thrust and fiscal impact. As evidence, infrastructure outlays are only starting to show improvement, and state and local government jobs have risen by 35,000 over October-November. In addition, Congress has enacted more stimulus: They extended and expanded the first-time homebuyer tax credit through April, increased jobless and Cobra benefits, and prospects have improved for a tax credit or other measures to boost employment.
Strong growth abroad. Our global recovery story is ‘a tale of two worlds': We expect that growth in the emerging market economies, at a 6.5% clip, will outstrip by more than three times that in the developed world (see 2010 Outlook: From Exit to Exit, December 15, 2009). Strong EM growth will spur vigorous US exports and earnings growth. The US economy is not the engine for global recovery this time; EM economies now account for 36% of world imports, 50% more than in the 2002-03 recovery.
Exiting excess. Progress on reducing four areas of excess also increases the odds for sustainable recovery. First, housing imbalances are shrinking. True, rising foreclosures likely will increase housing imbalances and the pressure on home prices again. But the bust in housing starts has slowed growth in the housing stock to less than 1%, and with demand improving, fundamental imbalances are dwindling.
Second, a slower pace of inventory liquidation will add to growth through 2010. The swing in inventories likely added almost three percentage points at an annual rate to 4Q09 growth and should add 0.6 percentage point to 2010 growth. That support won't end quickly, as production is still catching up with demand; GDP in 3Q was still 1 percentage point below the level of final demand. The gap will close over the course of 2010, and a shift to inventory accumulation should add about 0.4 percentage points to growth in 2011.
Third, companies are slashing excess capacity: Capacity in manufacturing excluding high-tech and motor vehicles and parts industries shrank by a record 1.5% over the past year. As a result, operating rates are up 300bp from their spring lows, helping to arrest the decline in inflation and laying the groundwork for renewed capital spending gains.
Past aggressive payroll cuts make a ‘jobless recovery' less likely. Rising jobs and income are critical to promote a self-sustaining recovery; they will support consumer spending and reduce debt/income and debt service/income ratios. They will also raise ‘cure' rates for delinquent mortgages and help consumers qualify for a loan. In our view, past job cuts have virtually eliminated what were minimal hiring excesses and are likely now creating some pent-up demand. Allowing for estimated revisions to payrolls, the current private job tally is 560,000 lower than at the trough in the last recession in July 2003, implying some underlying pent-up demand for labor that should materialize very soon.
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