Economic Update

Richard Hoey
Chief Economist

November 3, 2009

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Evidence continues to accumulate supporting our thesis that the U.S. and global recessions are over and that sustained economic recoveries have begun, both in the U.S. and worldwide. The "global emergency rescue" of the financial system and the economy was a major success, at least from a short-term cyclical perspective and probably from a long-term perspective as well. Aggressive global policy stimulus in the form of central bank liquidity actions, monetary stimulus and government fiscal stimulus occurred in many different countries and succeeded in calming the financial crisis, ending the recession and starting a global expansion. Macroeconomic policy is stimulative in nearly every country in the world and we expect this harmonic of simultaneous macroeconomic stimulus to generate sustained expansion in nearly every country in the world in 2010.

There are a number of key issues. A summary of our views on these key issues follows. We expect a sustained global expansion at about a 4% real GDP growth rate in the last half of 2009 and the four quarters of 2010, with financially strong countries leading and "debt hangover" countries growing more tentatively. We expect a sustained U.S. economic expansion at a real GDP growth rate of 3% to 3.5% in the last half of 2009 and the four quarters of 2010. The sustained U.S. expansion should be at a pace somewhat above the long-term trend growth rate near 2.5%, but well below a normal rebound after such a severe recession. The economic recovery should be "above-trend but below-normal." We believe that a double dip recession is quite unlikely. We disagree with forecasts of a major further rise in the personal savings rate in the U.S., as income growth may be too sluggish to support it. We believe that the developed economies face a "job-light recovery," with labor markets only slightly stronger than in a "jobless recovery." The official U.S. unemployment rate should peak in the spring of 2010 near 10.5%, followed by only gradual improvement. The persistence of high unemployment in the developed economies should create recurring "trade skirmishes" and concerns about the risk of a "jobs trade war."

We believe that high current budget deficits are not a major problem, but that high long-term structural deficits are a very serious problem about which little serious policy reform is likely in the next few years. In our view, stimulative monetary and fiscal policies have largely worked to reflate real economic activity and securities prices. However, we believe that they are not likely to cause a major upsurge in U.S. inflation any time soon. We do expect a "headline headfake" as the 12-month rate of consumer price inflation reflects first the fall from $147 crude oil and then the rise from $30 crude oil.

We concede that, at the worst of the financial crisis, there was some risk of a global depression, although that was not our forecast. However, we believe that risk has passed, as we anticipated. We expect a trend of gradual financial recuperation to persist, despite residual pressures from collateral deflation in residential real estate and commercial real estate. Federal Reserve policy remains anti-deflationary in the context of a collateral deflation. Our most likely case is that the Federal funds rate will start its cyclical rise in late 2010. We believe that the 28-year-long Treasury bond bull market is over, to be followed over the next decade by a "secular neutral" trend in bond yields. With respect to the dollar's exchange rate against currencies of other developed countries, we believe that the dollar is now in the final quarters of a major multiyear decline. We believe the decline will have run its course before the end of 2010 as the markets begin to anticipate future Fed tightening. We are unsure how weak the dollar may be in the meantime.

What kind of economic recovery is likely in the world and U.S. economy? The IMF has revised up its 2010 global growth forecast to about 3%. We believe that the most likely outlook is that the global economy has begun a simultaneous worldwide expansion and that the global growth rate in 2010 should be closer to 4%. The synchronization of economic weakness in nearly all countries during the financial crisis intensified global economic weakness, but now the synchronization of policy stimulus and recovery in nearly all countries should make a positive contribution to the strength of the recovery.

Evidence in support of our expectation of simultaneous global expansion has strengthened. Leading indicators and purchasing managers' surveys have been rising in many parts of the world. Risk spreads in the bond markets have narrowed. Yield curves have steepened. Stock prices and commodity prices have risen. Consumer and corporate surveys have improved. Real GDP has begun a sustained rise in most countries. The global expansion should be led by emerging and emerged economies with strong balance sheets as well as by some commodity-exporting countries, while those countries suffering from a housing bust and a debt overhang should expand at a more tentative pace.

What is the outlook for the U.S. economy? In the Postwar period in the U.S., mild recessions have been followed by mild recoveries and severe recessions have been followed by strong recoveries. If one were to go by historic precedents, the extremely severe U.S. recession, which has just ended, might be followed by a real GDP growth rate of 8% or more in the following four quarters. We doubt that will occur this time. We expect a real GDP growth rate in the U.S. of about 3% to 3.5% from mid-2009 to the end of 2010. We believe that the long-term trend growth rate in the U.S. is about 2.5%. Because growth is likely to be only slightly above this long-term trend growth rate, the U.S. recovery should be regarded as below normal relative to past Postwar rebounds. The recovery in the U.S. should be "above-trend but below-normal."

Unemployment rates are likely to remain high in many developed countries. After the three most severe Postwar recessions in the U.S. (1957-1958, 1973-1975, 1981-1982) reached bottom, real GDP grew at an average growth rate of about 8% in the first four quarters of the subsequent expansion. This was about 450 to 500 basis points above trend. In each of these cases, real consumption rose more than 6% in the first four quarters of recovery. The well-above-trend growth rate in these prior cycles strengthened demand for workers. In contrast, U.S. economic growth in the current expansion might be only modestly above trend, due to weak income growth, the negative wealth effect from lower house prices, the reduced share of highly cyclical manufacturing employment in the labor market, and the weakness in both the supply of credit and the demand for credit. While the demand for credit to refinance old debt is high, the demand for credit to finance new spending is relatively weak. Despite strong improvement in the availability and terms of credit for corporate borrowers, availability and terms for small businesses and consumers are still somewhat strained. The result is likely to be a weak pace of economic recovery and a long period of high unemployment. We expect the U.S. unemployment rate to peak near 10.5% in the spring of 2010 but then to decline only gradually. Despite the weak dollar, a number of factors and policies are acting as a drag on U.S. competitiveness, which should tend to mute the pace of recovery in the labor market.

The initial stage of the coming U.S. economic recovery is easier to understand as an exhaustion of sources of extreme weakness than as the sum of sources of strength. A key to understanding current economic realities is that while the changes in key variables (real GDP, production, operating rates, income) are shifting from negative to positive, the levels of many economic variables will remain deeply depressed relative to normal. The good news is about the direction of change, but the bad news is about levels.

Auto sales have been so severely depressed for so long that there has finally been some buildup of pent-up demand. Another sector where the downtrend is showing signs of exhaustion is U.S. residential construction, which we believe has begun a sustained recovery. Although we expect an "L-shaped" pattern in house prices, we believe they have begun the bottoming process. As severe liquidation of inventories gives way first to a slower pace of liquidation and eventually to modest positive accumulation, the contribution to real GDP growth should swing from negative to positive. This process began in the third quarter, but should persist over the next year. The outlook for capital equipment spending is also improving. The private structures component of capital spending should remain weak, given the serious problems in commercial real estate. State and local spending is likely to stay sluggish for an extended period of time.

Some analysts argue that the savings rate will continue to shift dramatically higher. We think that further increases may be more muted than is currently expected by many economic pessimists. We believe that (1) consumers will desire to raise their savings rate, (2) it is advisable that they succeed in doing so and (3) there are likely to be adverse long-term consequences if they don't. Nonetheless, we don't expect that much more of an increase. Income growth may prove so sluggish that they prove unable to achieve their savings objectives. Interest rates are low and many dividends have been cut or eliminated, creating an income challenge for many, especially those who are retired. In addition, wage inflation is on a decelerating trend, creating another challenge for income growth.

Commercial real estate is under stress. There are serious difficulties in refinancing commercial real estate. One result of the financial crisis and Great Recession was to lower demand for commercial space and drive up vacancies, thus weakening commercial rents. As bankruptcies of tenants continue and leases roll over at lower rents, cash flows are likely to drop.

What is most needed to limit the magnitude of "collateral deflation" in commercial real estate is the "macro fix" of a sustained economic expansion. Even though we believe that this will occur, the financial losses in commercial real estate are expected to be severe given the likely severity of the decline in cash flows. Unlike residential real estate, however, commercial real estate is not the core of consumer net worth, limiting the spillover impact on consumption.

A key issue for the outlook for 2010 is the transmission of monetary ease into the U.S. economy. In 2009, the securities markets were major channels for transmitting monetary ease into the economy. There was a sharp drop in the cost to corporations of new equity capital and debt capital, as a result of the stock market rally and the narrowing of credit risk spreads on both investment grade bonds and high yield bonds. Corporate balance sheets were strengthened initially through equity financing and "long funding" of short-term debt. Now that profits are rising, many major companies are in a financially strong position and able to adopt a longer term perspective on business opportunities and risks. As a result, we believe that capital spending is at an inflection point from a decline to a sustainable expansion.

However, that is not the complete story, as the terms and availability of credit for consumers and small businesses has not improved to the same degree. The availability of auto credit has improved due to substantial government support, but other consumer debt is not as easy to obtain. The small and mid-sized banks are more stressed than the large banks by weakness in commercial real estate and some small and mid-sized companies themselves are owners of commercial real estate for their own use. Some specialized lenders to these markets are under stress. We expect a slow recuperation of credit availability to these sectors over the course of 2010, a critical factor in our forecast of a moderately favorable economy in 2010.

The U.S. faces huge budget deficits today (a minor problem) and huge budget deficits forecast for years to come (a major problem). While the current budget deficits are cyclically appropriate, the persistent budget deficits are inappropriate. Some fear a future spike in inflation, some fear a future spike in real interest rates (interest rates minus inflation) and some fear a foreign exchange crisis. Our view is that the high budget deficits of today do not preclude a substantial economic recovery at an above-trend but below-normal pace. We are not optimistic about any early shift to a more disciplined fiscal policy. However, we believe that the U.S. has "demographic flexibility" which could mitigate the aging of its population to the degree it chooses to modify its immigration policy over the coming decades.

Another controversial issue is climate change. Climate change negotiation can either raise or lower the risks of a "jobs trade war," depending upon whether the outcome is conflict or cooperation. The relative competitiveness among countries is influenced by the level and expected trend of relative labor and non-labor costs, relative taxes, exchange rates and relative carbon costs. Carbon tariffs have already been proposed in the U.S. and Europe to offset potential carbon cost advantages of foreign suppliers. Carbon tariffs should gain growing attention as the debate intensifies about the impact of climate change issues on relative competitiveness and relative employment growth. A persistently high unemployment rate in developed countries is likely to increase protectionist sentiment and raise the risk of a "jobs trade war." We believe that the key to limiting the risk of a "jobs trade war" is for the global economic expansion to be sustained at a good pace, maintaining hopes for a future fall in the unemployment rate.

Views about future inflation in response to recent monetary policy and expected future monetary policy are at the core of many current debates about the economic and market outlook. Six key aspects of the inflation outlook are (1) the commodity supercycle thesis, (2) the money growth perspective, (3) the output gap perspective, (4) the inflation expectations perspective, (5) the public opinion/political perspective, and (6) the currency perspective.

There is increased demand for commodities from emerging market countries, but it is still early in the global economic expansion. Barring a major military incident in the Middle East, we expect energy prices and other commodity prices to churn in neutral in the near term, as the supply/demand balance appears adequate at this phase of the cycle.

Inflation pessimists expect a major acceleration of inflation in future years in response to the rapid acceleration of reserve growth and money supply growth that has occurred in response to the financial crisis. However, the large increases in the Fed's balance sheet, the monetary base and money supply are not being mobilized quickly into debt-financed spending given the combination of a reluctance to borrow and a reluctance to lend. Procyclical tightening of financial regulation and orderly deleveraging should contribute to a relatively sluggish recovery in private credit growth in the early stages of economic recovery.

Another perspective on inflation is linked to the output gap, an economic measure of the degree to which actual output falls short of the potential capacity to produce goods and services. The severity of the recent global recession is such that it is clear that the world faces a major output gap with an excess supply of both productive capacity and labor. This is intensified by the continued government support in emerging markets for further increases in productive capacity and the continuing shift of low-skilled labor into the modern labor force in those countries.

Another perspective on inflation is that of inflation expectations. There are occasions when self-feeding and unstable expectations of inflation and deflation can contribute to a vicious cycle of worsening inflation or deflation, sometimes reinforced by major currency swings. At other times, long-term inflation expectations are "anchored" near a certain rate, dampening the tendency for actual inflation to deviate for long from that norm. In the aftermath of a deflation shock, Chairman Ben Bernanke wished to drive inflation expectations back up. So far, long-term inflation expectations have only risen back to normal. We expect a normalization of inflation expectations rather than either a deflationary or inflationary spiral.

It has been 30 years since Americans have felt the full pain of excessive inflation. They are currently experiencing the pain of excessive deflation, especially in real estate. In this context, many people do not see fighting inflation as a major priority.

There have been widespread concerns that dollar weakness could drive up U.S. inflation. In the current context, we do not believe that a low level for the dollar is very inflationary, although it made some contribution to higher oil prices. The supply capacity for consumer goods imports from emerging economies is quite ample and there is little chance of significant bottlenecks in the U.S. economy.

There has been a great deal of discussion about reserve diversification recently. Foreign countries have always had the flexibility to shift their currency reserves out of the dollar to other currencies or to utilize their excess currency reserves for other investments or for domestic spending. While the dollar has its issues, so do such competing currencies as the euro, the pound sterling, the yen, etc. We believe that the multiyear process of currency diversification is likely to prove orderly as long as the Federal Reserve retains credibility with respect to its management of domestic inflation risks. For now, we believe that U.S. policymakers are tolerant of a depressed level for the dollar in the current cyclical phase of depressed economic activity and "collateral deflation" in real estate. The Fed's true dual mandate is domestic employment and domestic price stability. The recent dollar weakness is not a near-term problem for either mandate. At a different cyclical phase, both the markets and the policymakers are likely to change their views. We expect the Federal funds rate to begin to rise by late 2010, which should trigger a shift in dollar sentiment at that time. However, over the next several quarters, we are uncertain whether the dollar will trace out a rounding bottom or might end its decline with a major overshoot, although we believe that the less dramatic pattern is more likely.

Some observers have argued that the recent financial crisis was unprecedented. We disagree. The recent crisis was one of a long line of financial crises over the decades. In the U.S., prior crises in the last four decades include the Penn Central commercial paper crisis of 1970, the oil price shock of 1974, the Hunt silver crisis of 1980, the Continental Illinois bankruptcy of 1984, the stock market crash of 1987, the savings and loan and junk bond crisis of 1990, the Mexican financial crisis of 1995, the combined Asian crisis, Russian default and Long-Term Capital Management crisis of 1998, the technology bust and the WorldCom/Enron bankruptcies at the beginning of the century.

The global history of repeated crises has been documented in such books as "Extraordinary Popular Delusions and the Madness of Crowds" by Charles MacKay, "Devil Take the Hindmost: A History of Financial Speculation" by Edward Chancellor, "Manias, Panics, and Crashes" by Charles Kindleberger and others and "This Time is Different: Eight Centuries of Financial Folly" by Carmen Reinhart and Kenneth Rogoff. The other lesson of history is that policy is powerful. It can create bubbles. It can create busts. It can also create expansions after severe financial crises. There will be a price to pay over the coming decade for all global macroeconomic stimulus now pulling the world out of recession, but the price will be less than would have been paid in the depression which could have occurred in its absence.

The U.S. has benefited from declining interest rates for nearly three decades. We outlined the logic for a persistent decline in long-term yields in our May 25, 1981 Forbes column, entitled "Last Chance This Century." Our view is that a 28-year secular decline of about 1400 basis points in yields on 10-year Treasury bonds has now ended. We believe that the decline from 16% on September 30, 1981 to near 2% at the end of 2008 has completed the secular decline in Treasury yields. The secular bull market in Treasury bonds lasted more than a quarter century, but we believe that it is now over. Some will label the next decade or two a secular bear market in Treasury bonds, since Treasury yields are unlikely to drop below their December 2008 lows. However, we believe the most likely bond market outlook is better described as a "secular neutral" trend in interest rates. Over the next decade, we would expect a "secular neutral" center of gravity for 10-year Treasury yields of around 4% to 4.5% with a normal range of about 100 basis points on either side of this center of gravity (and an extreme range of about 200 basis points on either side). We believe that the cyclical rise in long-term rates has begun but believe that it is premature to expect substantial further increases soon, even with the large Treasury calendar. The appetite for accumulating Treasury securities on the balance sheet of financial firms and intervening central banks abroad is not likely to ebb quickly if we are correct that the first Fed easing is likely to be delayed by concern about the risks of collateral deflation.

Mr. Hoey's comments are provided as a general market overview and should not be considered investment advice or predictive of any future market performance.