The three ‘Rs': Against this backdrop, we think that the global macro debate in 2011 will revolve around three ‘Rs' - rebalancing, reflation and reconciliation - which encapsulate our key themes above. Further progress from the pre-crisis unbalanced global economy to a more balanced one is a pre-requisite for making this recovery sustainable over the next several years. During the rebalancing process, central banks will likely keep policy very expansionary, which should support the ongoing reflation of the global economy and financial markets. However, debt-laden governments are facing the huge challenge of reconciling conflicting claims by their creditors (private and public bondholders) and stakeholders (pensioners and other recipients of public transfers, users of the public infrastructure, taxpayers and public servants) on their limited resources. Which choices governments will be making between the various options - default, engineer strong growth, fiscal austerity, monetisation and/or force lenders to fund them at low interest rates - will likely be key for economic and market outcomes in 2011 and beyond.
Rebalancing: Our country economists forecast some good progress on the road to rebalancing in the upcoming year. In China, consumer spending will become the biggest contributor to GDP growth, contributing more than half of the 9% GDP growth we forecast for 2011, and the current account surplus should shrink by a full point to 3.6% of GDP. In the US, conversely, net exports are expected to make a positive contribution to GDP growth, reversing this year's drag on growth. More broadly, external imbalances are likely to shrink in most countries, largely reflecting the rebalancing from consumption to exports in the countries with current account deficits and vice versa in surplus countries.
This ongoing process of rebalancing from export-led to domestic demand-led growth and vice versa has two important implications. First, it requires a shift of resources (capital and labour) from the external to the domestic goods-producing sectors or vice versa, which takes time and thus weighs on growth in the meantime. This is especially true in high-income economies where workers' skills and the capital stock are often sector-specific. Hence, the ongoing rebalancing is contributing to the ‘BBB' nature of the recovery in mature economies. Second, as capital is often sector-specific, the sectoral shift in the drivers of growth requires new investment in the expanding sectors and should thus support capex globally, despite the fact that there is still considerable spare capacity in the (relatively) shrinking sectors.
Reflation: The combination of undesirably low inflation in the US, deflation in Japan, the ongoing sovereign debt crisis in Europe and a BBB recovery in virtually all of the mature economies implies that G10 central banks will keep their foot on the monetary accelerator for much or all of 2011. With official interest rates near zero in major economies and quantitative easing in various disguises continuing at least in the G3, monetary policy looks set to remain super-expansionary and will support the ongoing reflation of the global economy, in our view. True, we see many EM central banks, including the People's Bank of China, raising interest rates in the upcoming year. However, in most cases we think the tightening will be moderate in order to prevent a sharp deceleration of economic growth and/or excessive exchange rate appreciation.
Given these constraints on EM monetary policies, the AAA global liquidity cycle should remain intact. Yet, these constraints also imply that the risks to our relatively benign inflation outlook for EM economies are tilted to the upside.
Reconciliation: While rebalancing and reflation should provide support for the global economy and markets in 2011, the reconciliation of the many claims on debt-laden governments remains a gargantuan task for governments and a major source of downside risk to the outlook. In principle, governments have five options to deal with unsustainable debt trajectories: they can default, engineer strong growth, tighten fiscal policy, monetise and/or force lenders to finance them at low interest rates. Of these, default or restructuring is likely to be avoided at all costs in 2011, given the severe systemic consequences - but that doesn't mean markets won't be nervous about potential defaults in the future, especially in euro area member states that are not true sovereigns any more. Engineering strong growth is virtually impossible for any length of time, given the BBB recovery. And a massive tightening of fiscal policy also looks unlikely in most countries outside of the European periphery, as many governments lack the public support to implement draconian measures à la Greece or Ireland.
This leaves most governments with only two options - monetise (if your central bank agrees) and/or take measures to ensure continued access to cheap funding from other sources. As our colleague Arnaud Marès has argued, the latter is inherent in financial regulation that requires banks, insurance companies and pension funds, explicitly or implicitly, to increase their holdings of government bonds for financial stability purposes. Alternatively, cheap funding could come from the IMF and/or other governments as in the recent cases of Greece or (less cheaply) Ireland. And the former option - monetisation - is inherent in quantitative easing, which raises longer-term inflation risks if the banks' excess reserves that are created in the process are not withdrawn in a timely fashion once banks start to use them to lend and create deposits.
Breakthrough tax deal. Congress has approved the recent tax/fiscal stimulus deal, which will add about 1pp to growth in 2011 relative to our earlier baseline, pushing our forecast to 4% over the four quarters of next year. Implementation of the deal, which could begin on January 1, will shift the mix of stimulus from monetary to fiscal policy, so that the Fed will likely be less inclined to extend the current LSAP program beyond 2Q11. And it suggests that yields will gradually continue to move higher, to 4% by end-2011.
As widely discussed, the deal will extend the expiring income tax cuts for all taxpayers for two years. In addition to extending several other expiring provisions, it includes three key temporary elements which add new stimulus - a one-year payroll tax holiday for employees, a 13-month extension of emergency unemployment benefits, and full expensing of business investment outlays for 2011. These will boost growth in 2011, partly at the expense of 2012. We estimate that their expiration at end-2011 will net to an offsetting drag of about 0.5pp in 2012. Together with other expiring provisions, the new stimulus amounts to about $400 billion above our December 3 baseline assumptions over 2011-12, or about 1.3% of GDP in each year. We illustrate the estimates of the budget impact of all provisions; these are similar to what we published last week, but refined by the Joint Committee on Taxation and Congressional Budget Office.
Why should this plan have more bang for the buck than ARRA? The fiscal stimulus enacted in the American Recovery and Reinvestment Act (ARRA) of February 2009 (Pub. L. 111-5) did not seem to add much oomph to the economy relative to its size; why should this smaller one produce more results? In our view, there are two reasons. First, the nature of the stimulus matters: Most of the latest stimulus (about 0.7pp) results from the new proposed payroll tax holiday for employees. Such cuts accrue mostly to lower-income, budget-constrained taxpayers and show up quickly in spendable income, so they are more likely to be spent.
In contrast, the Making Work Pay (MWP) tax credit that was a key part of ARRA was disbursed slowly, and some empirical work suggests that taxpayers spent only about 13% of the incremental income, which partly showed up in withheld taxes and partly in rebates when taxes were filed. Similarly, consumers spent about one-third of the one-time tax rebates in the 2008 stimulus package. In addition, the MWP credit at $60 billion was smaller than the proposed payroll tax holiday. Likewise, while ARRA's grants to states and healthcare insurance premium (COBRA) assistance provided a helpful buffer for governments and individuals, these funds tended to be saved rather than spent. Finally, outlays for the famously ‘shovel-ready' infrastructure projects featured in ARRA took as much as a year to show up in spending.
A second reason why the current stimulus is likely to be more potent involves the state of financial conditions affecting households: We believe that liquidity-strapped consumers, suddenly denied access to borrowing in the credit crunch, were more likely in early 2009 to save their tax credits and other forms of stimulus or use them to pay down debt. In contrast, the deleveraging process for households and lenders is far more advanced today.
Indeed, four factors already are promoting sustainable growth. First, balance sheet healing is more advanced and, courtesy of the Fed's new asset-purchase program, financial conditions are gradually becoming easier. Debt-to-income and debt-service-to-income ratios continued to decline in 3Q. The Fed's Senior Loan Officer survey indicated that banks' willingness to lend to consumers has continued to improve and that banks have eased lending standards for consumer loans. The glaring exception is that mortgage credit is still tight; indeed, in 4Q banks signaled tighter standards for mortgage lending. And the ongoing issues around mortgage ‘putbacks' continue to keep origination criteria from loosening.
Second, stronger global growth finally seems to be boosting US output. Following a period in which surging imports overwhelmed domestic demand, and net exports depressed GDP by 3.5 and 1.8pp in 2Q and 3Q, respectively, we expect a sharp reversal in 4Q, with net exports contributing 3.2pp of the estimated 4.3% growth in that quarter. Some of this volatility is statistical, as Dave Greenlaw and Ted Wieseman will demonstrate in a forthcoming note. But much is fundamental, as hearty growth abroad and slower growth in US domestic demand augur a narrower trade gap.
Third, the time-honored cyclical dynamics of recovery, delayed by the credit crunch and the legacy of the financial crisis, are finally promoting the hand-off from rising output to increased hours, employment and income. While November's employment canvass was disappointingly weak in nearly every respect, including a downtick in the workweek, a broader perspective shows that rising hours have supported moderate gains in wage and salary income, and the improvement in a variety of labor market indicators - declines in jobless claims, rising job openings and surveys of hiring plans - points to renewed job gains. Finally, pent-up demand for capital spending is healthy; in the recession, capex slipped well below depreciation expense. Together with the acceleration we expect in economic activity, and the business expensing provisions of the new tax deal, that pent-up demand should spur hearty gains in capex in the coming year. And we think that improving fundamentals will boost capex outlays in 2012 despite the inevitable ‘payback' in outlays after the tax expensing provision expires.
Bottoming in inflation soon, gradual rise coming in 2011. Two factors should promote a bottoming in inflation soon and a gradual rise in inflation over 2011-12: 1) higher inflation expectations courtesy of the Fed, and 2) an acceleration to slightly above-trend growth that narrows slack in the markets for goods, services and housing. The continued slide in core inflation through October to 0.6% in terms of the CPI and 0.9% as measured by the Fed's preferred gauge (the PCE price index) leaves it well below the Fed's comfort zone. While the Fed doubtless welcomes the rise in market-based inflation expectations, it's not sufficient to make officials comfortable with the inflation outlook; indeed, the FOMC's central tendency of only 1.3% core inflation in 2012 and 1.6% in 2013 strongly suggests that it isn't thinking of an exit strategy from the current policy stance any time soon. Taken at face value, the FOMC's inflation outlook implies a ‘tighter' relationship between inflation and slack in the economy than does ours; we expect a faster, albeit gradual rise in core inflation to 1.5% over the course of 2011.
Four downside, two upside risks. Despite these supportive factors, there are four key downside risks to the outlook for growth. Most are familiar. First, housing imbalances remain the most significant single downside risk; a decline in home prices larger than the 10% we expect would disrupt further the supply of credit, menace consumer balance sheets, and thus threaten consumer spending. Second, state and local government finances remain fraught; faced with additional shortfalls, officials might cut spending and employment significantly further, especially as federal grants fade. The good news is that revenues are starting to improve, which should mitigate that risk. Third, if Europe's sovereign crisis were to intensify further, it would (as in the spring) promote renewed risk-aversion and tighter financial conditions. Finally, if China's monetary policy tightening were to go beyond the three additional moves we expect, it could trim market expectations for future growth.
Conversely, two forces might promote upside risks to our still-moderate growth scenario. First, a stronger global economy, especially if it shows up in US exports, could boost growth significantly. Second, a persistently weaker US dollar could accelerate that process - one that we expect will play out in the next two years in any case.
The Outlook for Output: Recovery Slows
Our GDP growth forecast for next year (1.6%), after likely 1.7% in 2010, remains below consensus (2.0%), the OBR (2.1%) and the BoE's central case (around 2.6%). We are a bit less ‘lonely' than we were a quarter or so ago. We have raised our forecast slightly (after stronger-than-expected GDP growth in 3Q) and there are a few more forecasters now with sub-2.0% growth forecasts.
The main drivers of our forecast for subdued GDP growth are weak consumer spending, a weak investment recovery (here, we remain significantly below-consensus) and fiscal tightening.
Key Debates and Key Themes for 2011
Key debates for 2011:
• Will fiscal tightening prompt a return to recession in the UK? Our answer: No, but it is very likely that GDP growth will slow in 2011, reflecting the impact of the tightening, and our GDP forecasts are close to flat in two quarters next year.
• Will the UK see further QE? Our answer: No, but this assumes a lack of significant contagion from euro area debt market problems. It also assumes that the UK does not dip back into recession next year.
Key themes for our outlook:
• Weak recovery: We think that the UK economy will recover more weakly than consensus, the OBR or the Bank of England expect.
• But we worry about inflation: Inflation is likely to remain well above target throughout 2011 and we think that rate increases (2H11) will be needed to keep inflation on track to hit the target. If the MPC keeps interest rates loose for much longer than we expect, there are significant risks of damage to the Bank of England's inflation-targeting credibility, in our view, and risks that much more harmful sharp rate increases will be required further down the line.
Key risks for our outlook:
• Contagion from problems in the euro periphery spreading beyond the euro area through UK bond markets, the UK banking system and/or much worse-than-expected euro area GDP growth (feeding through into greatly lower demand for UK exports).
• If spare capacity is large: The output gap is notoriously difficult to pin down. Spare capacity in the economy may be a lot larger than we think. In this case, our 2012 inflation forecast is probably too high and rate rises from the Bank of England are much less likely (but prospects for GDP growth in the medium term are ultimately better).
• Less ‘prudent' households: We expect the savings rate to rise, dampening consumer spending. As we have seen so far in 2010, there is a good chance this doesn't happen.
Consumer Spending: Not a Consumer-Led Recovery...
We look for a relatively weak recovery in consumer spending (0.9% growth in 2011) for two main reasons: i) Likely weak growth in real disposable income; and ii) We expect the household savings rate to rise somewhat from 3Q levels (we expect a savings rate of 5.3% on average in 2011 from 3.2% in 2Q10, but remaining below the mid-2009 peak of 7.7%):
i) Weak real disposable income growth: Our labour market analysis supports our view that consumer spending growth is unlikely to be a driver of recovery in the UK (see The UK Labour Market: A Second Softening, November 25, 2010). We expect weak employment growth (public sector job losses, weak private sector jobs generation), higher unemployment and only a gradual recovery in wage growth (inflation and profit recovery versus higher unemployment). Combined with inflation likely above target throughout 2011 (largely reflecting January 2011's VAT rise), this should help to ensure weak real disposable income growth.
ii) We expect the savings rate to stabilise: The household saving rate fell sharply in 2Q10 (the latest available data), helping to prop up consumer spending growth despite a fall in real disposable income. We think that several factors will help to ensure that the household savings rate doesn't continue to decline. These include:
• Households, in aggregate, are still highly indebted.
• Credit availability is not buoyant. Households need to save a bigger deposit than pre-crisis in order to buy property and cannot count on credit to ‘see them through' tougher times to the same degree as pre-crisis.
• Around 20% of employees work in the public sector; income uncertainty will have risen significantly for many of those employees (and for those private sector employees whose companies have close links to the public sector).
• The social security ‘safety net' will become somewhat less generous, following changes in the Budget and Spending Review.
• We expect house prices to decline in 2011 by around 7% (with upside risks following changes to our interest rate forecasts; see UK Property: Concern for the Future, August 12, 2010). Much of UK households' ‘wealth' comes from housing. Lower levels of household wealth are associated with higher savings rates.
Investment: Caps on Growth in Each Main Sector
Our forecast for overall fixed investment (-0.2%) is one of the key areas where we remain more downbeat than consensus (3.6%). Government fixed investment is set to be cut sharply (we expect real growth of -16% in 2011). We expect only a weak recovery in home building (reflected in a weak recovery in household fixed investment - we expect 1.4% growth in 2011), held back by the transition between planning regimes. We expect a continued recovery in business fixed investment, but expect that to be more gradual than stellar (4.7%):
• Government fixed investment: The OBR's own estimate is that the government's budget plans imply that real government fixed investment will fall by 15% in 2011. Our forecast is slightly weaker, since we assume a higher deflator.
• Household fixed investment: In his August Property Report, our homebuilder analyst Michael Watts analysed the outlook for housing supply (effectively the bulk of household fixed investment). He concluded that new housing supply is unlikely to reach pre-crisis levels before 2015. In the near term, there is a transition period between planning regimes. Beyond that, several additional factors are likely to mean a weak housing supply recovery, including: government funding cuts for affordable housing, stricter building regulations and risks associated with coalition reforms to enhance localism in the planning system.
• Business fixed investment: Investment was cut sharply by firms over the recession, and we anticipate a continued recovery. However, in comparison to the scale of investment cuts during the recession, the recovery in investment we look for is relatively modest.
Firm finances are in good shape (in aggregate) and non-financial companies appear to have large amounts of cash (relative to liabilities and GDP), and this should help to fund an investment recovery.
However, there is still some spare capacity in the economy on most metrics and credit constraints are still assessed by firms to be above average levels of the past ten years. If firms are not convinced that they can count on a bank lending ‘safety net' (e.g., contingent credit lines) they may be reluctant to embark on significant investment projects. See Banks and lending availability below for more detail on the bank lending outlook.
In terms of risks, a ‘second credit crunch' may well become apparent should companies in aggregate start demanding significant capital for investment projects. Some of the loosening in credit conditions witnessed in firm and lender assessments into 2010, for example, may partly have reflected very weak demand (since March 2009, private non-financial companies have net paid back bank debt for all but three months).
Banks and lending availability: Our banks team thinks that loan growth is likely to remain muted in much of Europe, including the UK (see Global Banks Outlook 2011 - Expect Wide Differentiation, December 1, 2010): "First, if history is any guide, we should expect material further deleveraging in the UK, Spain and periphery as excess loan formation built up in the boom years is burned through. History suggests that it can be five years before loan growth turns positive after a banking crisis such as in Norway and Sweden. Second, European banks are peculiarly dependent on wholesale funding... The top 50 European banks have €1.4 trillion of debt that will mature over 2011-13". For UK banks, the large amount of maturing funding includes funding supported by official programmes, e.g., that related to the Special Liquidity Scheme.
Inventories: Fading Contribution
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