We're raising our outlook for 10-year Treasury yields to 3.25% for year-end 2010 and 4% through 2011; previously, we expected a yield trajectory 25bp lower (i.e., 3% and 3.75%, respectively) (see US Economic and Interest Rate Forecast, December 3, 2010).
The key reason for the change: We think that the tax deal/fiscal stimulus package announced this week will be enacted soon, with important implications for growth, the budget and monetary policy. As we noted earlier this week, we estimate that the fiscal package would boost real growth from our 3% baseline to 4% over the four quarters of 2011, with some growth payback in 2012 (see Tax Deal Could Boost Growth to 4% Next Year, December 7, 2010).
We Are Making That 4% Real Growth Scenario Our New Baseline Forecast, Given That Enactment Seems Likely
We'll flesh out full details soon - when the dust settles a bit more on the debate over specifics. Not surprisingly, at this writing the debate is heated. While the Senate seems likely to approve the deal next week, House Democrats are rebelling against two key provisions: first, and most important for GOP approval, the two-year extension of the 2001 and 2003 tax cuts for taxpayers with incomes over $250,000, and second, the adoption of the Kyl-Lincoln estate tax proposal. Keeping in mind the principle that votes in Washington are often secured by throwing more sweeteners onto the pile; it would not be surprising to see a few add-ons to lure the rebels into the fold.
It's about Growth and its Consequences, Not about Sovereign Risk
Disentangling the sources of the recent and coming increase in rates is important, but difficult. It's important because the source will determine what are the effects of higher rates on the economy and risk appetite - including the so-called crowding-out effect. Stepped-up fiscal stimulus can boost yields through its effect on the outlook for: 1) growth, 2) Treasury supply, 3) monetary policy, and 4) US creditworthiness. In our view, the jump in rates this week primarily reflects the perceived influence of the fiscal package on future economic growth. Evidence supporting our view includes this week's 30bp rise in real rates since the package was announced, along with a further rally in risk assets and the dollar. While that is hardly conclusive evidence, the fact that risk premiums (such as the VIX) have drifted lower also supports that view.
But other factors could also be playing a role. Concern over the lack of fiscal discipline is one such factor. And short-term factors we've cited before - investors caught wrong-footed into the bond sell-off and little appetite for risk towards year-end - have also contributed to the recent rise in yields. However, if deteriorating creditworthiness was the main source of the back-up in yields, we suspect that the dollar and risk assets would be weaker and both risk premiums and sovereign CDS spreads would be higher. None of those has occurred. In our view, sovereign risk is unlikely to come into play any time soon, although at some point a lack of fiscal discipline could well move into the spotlight. In fact, adoption of the tax-cum-stimulus proposal will likely lead to a slightly earlier-than-anticipated need to hike the debt ceiling, as discussed below.
Degree of Crowding Out Depends on Source of the Yield Increase
Any fiscal stimulus program leads to some degree of a ‘crowding out' offset. In other words, at least a portion of the direct economic benefit associated with a tax cut or spending increase will be offset by an accompanying rise in yields. To the extent that this rise in yields reflects expectations for stronger economic growth, the offset should be minimal. In economists' lingo, such an effect would be considered endogenous. On the other hand, to the extent that a rise in yields reflects supply concerns (in this case, either more issuance from the Treasury or less buying by the Fed) or some other exogenous factor, there could be a more significant ‘crowding out' impact.
Rules of Thumb Suggest Minimal Crowding Out
According to standard macroeconometric rules-of-thumb, an exogenous 30bp rise in Treasury yields would shave about 0.2pp from annual GDP growth over the following 1-2 years, leaving the unemployment rate about 0.3pp higher than it would otherwise be. As we believe that the lion's share of the recent rate move has been endogenous, the amount of offset should be smaller than the 0.2pp rule of thumb. But to be conservative, we have incorporated the 0.2% in our estimates. Moreover, there may be important positive collateral effects on the upside in this case - such as a reduction in investor and business policy uncertainty - that could help to spur hiring and risk-taking. (For a discussion of the ways that policy uncertainty can be the enemy of growth, see Policy Uncertainty Clouds the Outlook, February 6, 2010.)
Survey Support for Our View
To assess what is in the price, this week we conducted an (unscientific) survey of traders, salespeople, strategists and clients in an attempt to better understand the Treasury market reaction to the announcement. We received 80 responses. The question posed was: How much of the sell-off in Treasuries that has occurred since the framework of a fiscal package was announced on Monday evening would you attribute to the following four factors?
Here Are the Choices and the Results
The results are supportive of our view: The mean response attributed almost as much weight to the implications for growth (38%) as to the combined implications for Treasury supply (30%) and LSAPs (14%). A catch-all ‘all other' category was smaller (17%). The median results show an even more pronounced tilt to the growth explanation, although the shares obviously don't add up to 100%. By the way, the responses for ‘all other' were all over the map, leading to a relatively wide gap between the mean and the median. Two respondents attributed 100% of the recent market move to ‘all other', but nearly half of respondents (38) assigned it a zero impact.
Possible Market Disruptions Lie Ahead
Adoption of the tax bill will likely lead to a slightly earlier-than-anticipated need to hike the debt ceiling. This appears to be setting up as a real political donnybrook that could trigger significant market disruptions. Any disruptions to auctions and associated cuts in Treasury supply could promote temporary declines in Treasury yields. At present, the Treasury is about $500 billion below the current $14.3 trillion debt ceiling and, assuming the pending tax deal is enacted, we estimate that the limit will be hit in March. However, at that point the Treasury can unwind the Supplementary Financing Program (SFP) and use other accounting mechanisms that have been employed in the past in order to continue to operate normally until May or June. At that point, the Treasury will likely run out of options, and the threat of cancelled auctions, a federal government shutdown, and missed coupon payments will begin to loom large. In fact, a replay of the 1995-96 stand-off on the debt ceiling now seems like a high probability.
A significantly improved economic growth outlook for 2011 from the surprising inclusion of substantial new fiscal stimulus measures in the tax cut extension agreement on top of further indications of a 2H10 growth acceleration in the incoming economic data sent Treasury yields soaring to six-month highs over the past week. Our baseline forecast of 3.0% GDP growth over the four quarters of 2011 assumed a temporary extension of the lower income portions of Bush tax cuts and a limited additional period of funding for extended unemployment benefits. If gridlock had resulted in no agreement and a big tax hike next year, our alternative baseline saw 1H11 GDP growth falling to near 1.75% (see US Economics: Will ‘Sunset' Darken the Outlook? September 3, 2010). And we saw that the risk expiration of the latest period of funding for extended unemployment benefits at the end of November could additionally knock 1Q GDP growth by a point (see US Economics: Will Expiration of Extended Unemployment Benefits Hurt the Recovery? December 1, 2010). Instead of this downside risk scenario of GDP growth falling towards 1% in the early part of 2011, the surprisingly broad agreement to extend all of the Bush tax cuts for two years, replace the Making Work Pay tax credit with a twice as large cut in payroll taxes in 2011, implement the president's pre-election proposal for 100% upfront business depreciation from September through 2011, and funding extended unemployment benefits through 2011 pointed to upside of 1-1.2pp to our baseline +3.0% 2011 GDP forecast (see US Economics: Tax Deal Could Boost Growth to 4%+ Next Year, December 7, 2010). This would build on what increasingly appears to have been a solid acceleration in activity in 2H10. Incorporating the results of an extremely strong wholesale trade report and a much bigger-than-expected narrowing in the trade gap, we now expect 3Q GDP growth to be revised up another half-point to +3.0%, and we boosted our tracking estimate of 4Q growth to +4.2% from +3.5%.
The further surge in Treasury yields in response to these developments reflected a big move in real rates, in line with the growth driver of the losses, with longer-dated TIPS inflation breakevens pulling back somewhat. Even with the higher medium-term growth outlook, the unemployment rate will likely only fall towards 8.75% and the core inflation rate rise to a bit above 1% by mid-2011. So, we think that the Fed remains firmly on pace to complete its $600 billion net balance sheet expansion through 2Q, and we expect Tuesday's FOMC statement to reiterate this. But the likelihood of an extension of QE beyond June would clearly be significantly reduced if we were to see growth accelerate to over 4% in 1H11 after a much better outcome for 2H10 than was widely expected when the Fed began moving towards renewed easing in August (during this time we cut our 2H GDP growth forecast from +3% to +2-2.5% in response to the run of soft data in the summer but are now over +3.5%). Moreover, while the MBS market was able to perform much better in the middle part of the week after doing terribly in the early week rates market plunge, MBS yields ended the past week at six-month highs near 4.1%, which will likely continue rapidly moving 30-year mortgage rates up to near 4.875% from the record-low weekly average of 4.17% in early November, sharply slowing mortgage refinancing activity. So, even if the Fed continues buying $75 billion a month in Treasuries to grow its portfolio, the additional buying to reinvest MBS prepays and agency maturities is likely to be much lower than the $30 billion during the current month. In addition to the likelihood of less Fed buying next year, clearly the stimulus plan would boost Treasury supply next year, probably leaving the F2011 deficit little changed from the $1.29 trillion deficit in F2010 instead of the narrowing to $1.13 trillion we previously expected. While we expect that the majority of the additional funding needs will be met through a smaller further paydown in T-bill supply, it could also extend the current period of stable coupon sizes and delay and reduce the renewed reductions we were previously estimating would begin in 2Q. This more negative supply/demand picture weighed additionally on Treasuries, and this was reflected in a significant narrowing in swap spreads during the week.
For the week, benchmark Treasury yields rose 11-34bp, with 5s and 7s lagging. The 2-year yield rose 15bp to 0.62%, 3-year 25bp to 1.02%, 5-year 34bp to 1.96%, 7-year 34bp to 2.68%, 10-year 28bp to 3.29%, and 30-year 11bp to 4.43%. The lagging intermediate part of the curve had seen a big additional richening after the New York Fed said after the November 3 FOMC meeting that QE2 buying would be concentrated there, leading to a big rush into these issues and into curve-steepening positions like 5s-30s, which has left the Street badly positioned during the big post-FOMC sell-off that accelerated this week. A month of terrible performance by the MBS market before a rebound mid-week and a big resulting build-up of mortgage convexity-related selling needs has also been a significant problem for the intermediate part of the Treasury curve. Meanwhile, losses at the short end were smaller, but these were still major moves for the previously much more anchored 2-year and 3-year, and they reflected a big adjustment in Fed expectations. The November 2011 fed funds contract plunged 10bp to 0.40%, pricing a likelihood that the Fed will hike short rates to 0.50% by the November 2 FOMC meeting. A 16bp sell-off in the Jan 2012 contract to 0.495% prices a certainty that Fed tightening will start next year. A faster move towards policy normalization is also expected after the first hike next fall, with the spread between the rates on the Dec 10 and Dec 11 eurodollar futures contracts rising 22bp on the week to 61bp, Dec 11 to Dec 12 by 18bp to 90bp, and Dec 12 to Dec 13 by 8bp to 105bp. Meanwhile, the better performance by the long end came after decent buying through the week and a very strong 30-year auction, as long rates have apparently risen enough to spark interest among pension funds and other real money investors. The move up in yields for the week mostly reflected higher real rates, with the 5-year TIPS yield up 25bp to 0.12%, 10-year 31bp to 1.10%, and 30-year 17bp to 1.93%. This lowered the benchmark 10-year inflation breakeven 3bp to 2.20%. With the shorter end of the TIPS market outperforming, the pullback in the 5-year/5-year forward inflation expectation was larger, about 15bp.
The improved US growth outlook provided a boost to risk markets over the week, but gains were restrained by the sharp back-up in Treasury yields and worries about the impact of China's policy tightening. The S&P 500 gained 1.3% for the week, with small gains Wednesday, Thursday and Friday resulting in a run of two-year high closes. Financials was easily the best-performing sector with a 3.8% surge. The cyclical industrial (+1.3%) and tech (+1.4%) also performed well, while energy and materials lagged as commodity prices fell on a strengthening in the dollar and China's rate hike. Credit gains were also steady but somewhat muted, with the investment grade CDX index tightening 5bp to 87bp (unlike stocks not quite through the prior recent highs in early November), while the high yield CDX index tightened about 60bp to near 460bp. The most surprising omission in the tax cut extension deal was an extension of the Build America Bonds program, which now appears likely to end on December 31 after recent press reports had indicated that an extension would be included in the agreement. Our muni strategist Michael Zezas sees BABs as attractively priced relative to corporates in an environment of elevated demand for higher long-term yields, which he thinks will give them more of a scarcity premium than an orphan discount, but the lack of ability to issue BABs will drive further supply pressures in long-end tax-free munis next year (see Muni Strategy Brief: BAB to the Future: Volatility and The New Old Muni Market, December 10, 2010). While he sees ongoing weakening in credit quality for state and local governments, he doesn't believe that the end of the BAB program represents a significant incremental credit-negative, as seemed to be reflected in substantial muni CDS widening. The 5-year MCDX index widened 34bp on the week to 218bp, the worst close in two months after a 70bp widening from the recent tights hit shortly after the FOMC meeting.
It was a light week for economic news, but the international trade and wholesale trade reports triggered sizeable upward revisions to our 2H10 GDP forecasts ahead of the expected 2011 acceleration, assuming the tax cut extension deal passes. Wholesale inventories surged a much higher-than-expected 1.9% in October, on top of an upwardly revised 2.1% gain in September. And this big inventory build did not result from a sudden slowdown in demand - wholesale sales surged 2.2% in October after a 0.5% gain in September, so the I/S ratio only ticked up marginally over the two months to a still quite low level. Incorporating these results, we see inventory accumulation adding another 0.2pp to 3Q GDP growth and subtracting 0.2pp less in 4Q. The trade deficit plunged $6 billion to a nine-month low of $38.7 billion in October, with exports surging 3.2% and imports dipping 0.5%. The export gain was broadly based, with big increases in industrial materials, food and autos, and solid rises in capital goods and consumer goods. While higher commodity prices provided a boost, most of the gain reflected higher volumes. On the other side, the decline in imports was more than accounted for by a sharp drop in petroleum products, entirely as a result of a pullback in volumes as imported petroleum prices were up significantly. Ex petroleum imports ticked up 0.5%. The real goods trade deficit narrowed $5 billion, nearly as much as the nominal deficit and much more than we expected, with real goods exports up 3.3% and imports down 1.5%. We now see net exports adding 3.2pp to 4Q growth, with exports gaining 13% and imports falling 10%. This reflects both the sizeable narrowing in the real monthly trade deficit in October relative to 3Q and also an expected reversal of what appear to have been seasonal adjustment problems with the BEA's translation of the monthly numbers to quarterly figures that resulted in real petroleum imports being reported up 78% in 2Q and another 43% in 3Q. The rise in capital goods exports was larger than expected, though, leading us to cut our forecast for business investment in equipment and software in 4Q to +4% from +6% and overall business investment to +1.8% from +3.4%. Incorporating the upside to inventories in 3Q and 4Q from the wholesale trade report and upside to net exports with partial offset to investment in 4Q from the trade report, we now see 4Q GDP growth tracking at +4.2%, up from +3.5%, and we forecast that 3Q growth will be revised up further to +3.0% from +2.5% instead of to +2.8%. This would leave 2H growth a bit better than +3.5%, an acceleration from +2.75% in 1H that we think will be extended over the course of next year with help from the new stimulus measures in the tax cut extension agreement.
After the much weaker-than-expected November employment report that came after the much stronger-than-expected October results, there were a number of positive labor market indicators released over the past week pointing to continued steady underlying improvement. Initial jobless claims have seen large week-to-week swings recently, but the 4-week average hit another new low since mid-2008 of 427,500 in the first week of December, extending a steady move lower since August. The net hiring strength index in Manpower's employment outlook survey rose to 9 for 1Q from 5 in 4Q, the most positive net business hiring intentions in two years. The University of Michigan's consumer confidence index rose to 74.2 in the first part of December from 71.6 in November, back to near a cycle high after some softening in the summer. The report said that more optimistic views of the job market drove the improvement in sentiment, as it did last month. The highest proportion of respondents since 1983 said that they were hearing positive news about job growth, while the proportion saying they were still hearing about job losses has plunged to half its peak. The survey said that improving confidence about the job market explained a surge in the survey component measuring buying plans for durable consumer goods to a three-year high. Finally, the BLS' job openings and labor turnover survey (JOLTS) showed significant improvement, with the job openings rate (the number of open jobs relative to employment) rising to 2.5% in October, a high since August 2008, while the firing rate declined to 1.3%, a level last seen in 2007 and last bettered in 2006. We think it is likely that the November employment report understated the actual condition of the labor market after the October report overstated it. Taken over the two months, the average gain in payrolls was somewhat sluggish at 105,000, but the average gain in total hours worked was a solid +0.3% and aggregate earnings +0.4%. That's probably around the baseline outlook looking ahead to the December report, but with the jobless claims figures suggesting further underlying improvement in recent weeks. Note that if aggregate hours worked rise 0.3% in December, in line with the October/November average, then the annualized increase for all of 4Q would be +2.4%, so our +4.2% GDP forecast does not imply an elevated gain in productivity.
The economic data calendar is quite busy in the coming week, with focus on retail sales Tuesday and CPI Wednesday. The FOMC also meets Tuesday, and an uneventful post-meeting statement seems likely. The recent improvement in the economy and prospects for fiscal stimulus to support significant further upside next year (though less so compared to the Fed's 3.0% to 3.6% forecast than consensus) are making it increasingly less likely that QE will be extended beyond June. But we continue to think it is quite likely that the plan announced in November to expand the Fed's balance sheet by $600 billion remains on track and will be completed over the first half of next year, and we don't think that any meaningful change in the language in the FOMC statement on this is likely. Key data out this week include retail sales, PPI and business inventories Tuesday, CPI and IP Wednesday, housing starts Thursday, and leading indicators Friday:
•· We forecast a 0.3% rise in overall retail sales but a 1.0% surge ex autos in November. We look for sharp gains in key discretionary categories such as general merchandise and apparel - consistent with favorable company reports. Also, we should see a price-related jump at gas stations. The only notable downside this month is expected to be seen in the auto dealer component. However, this reflects a seasonal adjustment quirk - not a fundamental weakening in sales momentum. The October retail sales gain of +5.0% at auto dealers appeared to dramatically overstate the actual strength, and the seasonal factors point to a downside offset in November. We had been assuming a more modest advance in November retail control, and the upward adjustment pushed our estimate for consumption in 4Q to +3.0%.
•· We forecast a 0.5% gain in the headline producer price index and 0.1% uptick in the core in November. Upside in the food and energy categories should help to elevate the headline PPI this month. Meanwhile, the core is expected to settle down in November now that the start-of-model-year boost in motor vehicle prices, which pushed up last month's reading, is behind us.
•· We look for a 1.0% rise in October business inventories, with sharp gains at the manufacturing and wholesale stages. However, sales posted an even sharper jump, so the I/S ratio is expected to register a slight downtick. Finally, the September inventory figures are likely to show an unusually large upward revision - from +0.9% to +1.3%.
•· We forecast a 0.2% rise in the headline consumer price index in November and 0.1% increase in the core. Another uptick in gasoline prices is expected to push up the headline CPI in November. Meanwhile, with quotes for grains and vegetable soaring over the past few months, many analysts have been expecting some eventual elevation in food prices at the retail level. But, this appears to have been staved off in November by a drop in milk prices. The core is expected to register a ‘high' +0.1% this month, as the sharp declines seen in October for both used cars and hotels is unwound. This expectation reflects the recent new high posted by the Mannheim survey of auto auction prices and the rising trend evident in the STR gauge of hotel rates. Also, residential rent and OER should continue to bounce off their recent lows, given widespread indications of a firming in rental markets. Finally, the core is expected to hold at +0.6% on a year-on-year basis (but come very close to rounding up to +0.7%).
•· We expect overall industrial production to hold steady in November. Based on the employment report and industry figures on motor vehicle assemblies, we look for the manufacturing component of IP to edge down 0.1%. The motor vehicle sector is actually expected to be a significant drag this month, but this appears to merely reflect monthly volatility, because current assembly schedules point to a very sharp rebound in December. Otherwise, we look for strength in aerospace, machinery and fabricated metals to be partially offset by declines in oil refining, food and chemicals, adding up to a +0.1% result for manufacturing excluding motor vehicles. Finally, utility output is expected to be little changed this month following some big swings in prior months, as weather conditions were more in line with seasonal norms.
•· Although the employment report showed little change in residential construction jobs during November, we look for a 4% rebound in housing starts to a 540,000 unit annual rate. The gain is expected to be concentrated in the volatile multi-family category, which plummeted in October. With rental market conditions beginning to firm, apartment construction appears poised for a significant pick-up in the coming months.
•· Based on currently available components, the index of leading economic indicators should surge 1.1% in November, the biggest gain since mid-2009, extending an acceleration that began in September. Big positive contributions this month should come from supplier deliveries, the yield curve and jobless claims, with smaller adds from stock prices and the money supply. There are no negatives among the currently available components.
EM economies have had quite a ride over the last few years, but 2010 has been exceptional not just because growth has been strong, but also because it has been strong with no major hiccups along the way.
2011 is likely to be slightly different: With excess capacity now largely gone or going very quickly, unbridled growth is no longer an option. Accordingly, we set out five themes for emerging economies for 2011: i) EM versus DM growth rebalancing, led by cyclical EM underperformance; ii) Rebalancing within the EM world as economies move towards sustainable growth without overheating, which means lower growth for some, higher for others; This salutary rebalancing will allow EM growth to remain higher for longer; iii) EMflation scare means markets will likely worry about inflation even though core measures remain benign; iv) Second stage of monetary tightening as EM central banks move beyond just removal of extraordinary monetary stimulus to reduce monetary easing even further, but stop short of a tight policy stance; and v) Capital flows to continue, FX appreciation trend to persist and mild capital controls to be put into place.
Three main risks: The risks to these calls are that: i) EM inflation turns out to be more difficult to deal with; ii) DM growth surprises to the upside, causing EM policy-makers to tighten policy; and iii) Euro-zone periphery problems spread to the core and then to funding and/or export markets.
As the BBB (Bumpy, Below-par, Brittle) recovery in the G10 continues, the focus remains on the EM world as the engine of growth. Our year-ahead note today suggests that EM economies will remain the drivers of global growth, but the glaring outperformance will be toned down somewhat this year. Inflation worries, removing some of the monetary accommodation and currency appreciation in response to capital flows should keep growth in the EM world from overheating - a salutary development.
Theme #1: EM versus DM Growth Rebalancing: EM Underperformance in 2011
Absolute EM Outperformance Is Structural...
The absolute economic outperformance of emerging markets (EM) over developed markets (DM) should come as no surprise to anyone. Given the structure of emerging markets and the vast pockets of under-utilised resources, growth rates of 3% or thereabout which represent trend growth in most DM economies can feel like a recession to many EM economies. We expect the absolute outperformance of EM markets over DM markets to continue as a structural story.
...and Relative Underperformance in 2011 Is Salutary
On a relative basis, however, we expect the degree of this outperformance to narrow in 2011, thanks to EM underperformance. In other words, the ‘spread' between DM and EM growth should narrow even though DM growth is likely to fall from 2.6% to 2.2%. EM growth, on the other hand, will likely fall 1pp from 7.4% to 6.4%. The narrowing spread between DM and EM is therefore more of an EM story than a DM one. The AXJ region, with a 30% weight in the global economy and a 60% weight in the EM world, naturally dominates EM growth dynamics. We believe that a slowdown in the blistering pace of growth in the AXJ region and an even bigger fall in the smaller LatAm region will pull EM growth down to more sustainable levels and prevent overheating. The DM world, on the other hand, may actually see a small step up in growth if the newly proposed tax cuts in the US are implemented (see US Economics: Tax Deal Could Boost Growth to 4%+ Next Year, December 8, 2010).
Policy Support and the Balance of Risks Supports the Narrowing DM-EM Spread
With the notable exception of the euro area, where uncertainty is still quite high, the balance of risks for the rest of the G10 now appears to be tilted to the upside in 2011. We believe that monetary policy will continue to stay its course and provide AAA liquidity, and fiscal tightening seems more popular in market debates than it is with policy-makers.
In the EM world, however, the biggest risk is that of overheating. Central banks in the fastest-growing EM economies have stayed away from too much tightening as they balance strong domestic demand against weak G10 (and particularly US) growth. If the upside risks in DM materialise, that could also be the trigger for faster-than-expected EM tightening in order to prevent a ‘double whammy' of domestic demand- and export-led overheating. The balance of risks and the policy reaction to them also support this rebalancing.
External Rebalancing Already Underway
In addition to the coming growth rebalancing, a rebalancing of global current account imbalances has already begun. Many of the current account imbalances in the world have started to resolve themselves to less extreme levels, and we expect this theme to be an important one over 2011 (see Global Forecast Snapshots: 2011 Outlook: Rebalancing, Reflation and Reconciliation, December 8, 2010). As we have pointed out, the presence of current account imbalances themselves is not a reason to worry. Rather, it is only when these imbalances are the result of excessive consumption or savings or excessively risky investment that the problem arises (see Emerging Issues: Capping Current Accounts: Squeezing Toothpaste with the Cap On, November 30, 2010). And it is precisely here that much of the necessary rebalancing seems to be occurring, with savings in the US rising and the contribution of consumption to growth likely to rise in China (see China Economics: 2011: A Year of Reflation, November 21, 2010).
Theme #2: Rebalancing Within EM: Convergence of Growth Rates
Global rebalancing isn't the only rebalancing show in town. There is a trend towards rebalancing within the EM world as well. As always, it is a mistake to paint the entire EM world with the same brush. A little less vulgar generalisation is to split the EM world into two blocs - a first bloc of countries where the output gap is closed or positive, and a second where the output gap has yet to close.
At first glance, the number of EM countries where the output gap is closed or positive appear to be rather small, but their size accounts for three-fifths of the EM world. There are several countries where the output gap has yet to close and a few where the output gap is quite large still. Clearly, policy-makers would prefer to slow down growth to a sustainable level where the output gap is positive, as is the case for China and Korea. In Brazil, India, Poland, Peru and Taiwan, policy-makers would like to stay as close to a closed output gap as possible and are likely to resist strong growth going forward. Policy action here is likely to just tap on the brakes to ensure that growth does not surge again with the output gap already closed or even positive.
For the numerous countries whose output gaps are yet to close, growth has already been robust in many countries, but a temporary increase in growth until the output gap closes can be accommodated and is unlikely to worry policy-makers too much. Accordingly, we believe that the focus here will be on keeping policy from being excessively accommodative but accommodative enough to keep growth supported. The notable exceptions here are Hungary, Romania and Mexico, where the output gaps are still wide and negative and any and all growth would be welcome. Russia also has a wide output gap, and in spite of inflation concerns probably prefers to see higher growth for the near future. Another exception where the output gap isn't wide but policy-makers are focused on keeping policy as accommodative as possible is South Africa, where policy rates have recently been cut by 100bp to keep the currency from appreciating and taking away the impetus to growth.
In summary, the difference in the strategies that policy-makers have adopted in the two blocs will likely push growth in both blocs to a sustainable level. Over 2011, this should lead to a convergence of growth rates towards sustainable levels in the EM world, allowing EM growth to stay higher for longer.
Theme #3: EMflation Scare
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