From time to time, Morningstar publishes third party content under our "Perspectives" banner. If you are interested in Morningstar featuring your content, please contact Online Editor Holly Cook (holly.cook@morningstar.com). Here, Michael Dicks, Chief Economist at Barclays Wealth, explains why their forecasts for 2010 are rather below consensus and why 2010 could turn out to be a game of two halves, with equities and other riskier asset classes doing quite well in the first half, but struggling more, and perhaps suffering, in the second.
A year ago, in our Annual Outlook for 2009, we described prospects as being for a “long, hard slog”. We thought that policymakers would be successful in their efforts to avoid a second Great Depression, but reckoned that the costs of doing so would be large, reflecting the rapid build-up in public debt. This, we felt, would ensure that the recovery would be sluggish, particularly for the advanced economies.
This forecast has played out in much the way that we gauged that it would--with, for example, many of the big emerging markets living up to their names but many of the advanced economies’ recoveries somewhat retarded in nature (or in the UK’s case, still elusive). We also now have much more information with which to quantify the long-term costs of the crisis. The news here is bad: they are going to be much bigger than initially envisaged. As a result, the next full business cycle is probably going to be rather less beneficial, in terms of boosting living standards, than the last: “trend” growth has dropped.
The short-term outlook
As economists have grown in confidence that a recovery really is taking
place, they have tended to raise their estimates for how fast the
expansion might proceed in 2010--with, for example, the average
(“consensus”) forecast for the United States’ growth rate up from 1.9%
six months ago to 2.7% today. We, too, have nudged up our so-called
“modal”, central scenario, forecast--i.e. the single-most-likely set of
outcomes for the economy.
But, in three main respects, we remain rather gloomy compared with most people:
1. Our central scenario projections are generally slightly less positive than the consensus’s. We do not think that growth is likely to be very strong in 2010, meaning that hardly any inroads are made into the spare capacity built up during the recession. Thus we believe that unemployment will remain high in the advanced economies.
2. Around these central forecasts for 2010, we see far more downside risks than upside ones. It is not hard to come up with a long list of what might go wrong. We worry, for example, that a first rate hike might lead to a sharp rise in bond yields, or that fiscal tightening could easily have a more depressing influence on confidence than anticipated. Exchange rates could be a source of risk too, if policymakers feel that they have to intervene. We give a 40% probability to such an “ugly” scenario, compared to just a 10% probability of the better-than-expected “good” one (See our three scenarios here). So, we assign the central scenario a 50% probability--uncomfortably close to that of the “ugly” scenario.
3. The probability of a crisis will build during 2010. Although it might seem natural to think that the probability of a dire scenario falls over time, as more quarters of growth are recorded, in fact the opposite is true. The main reason why is that, faced with resistance to a more fundamental shift, currently, policymakers are trying to recreate the “old” world, which was clearly unsustainable in a number of respects, such as in its reliance on “rich” (US) consumers to spend and “poor” (Chinese) ones to save. The longer that that continues, the higher the probability of a train crash.
The single-most-likely central scenario
As always, with the household sector comprising about 70% of the US
economy, the US consumer will be key.
History suggests that most of the rate of change in real consumer spending, from year to year, is due to shifts in real after-tax income rather than shifts in the proportion of their income that consumers save. So, all else equal, were wage growth to continue, this would normally be expected to prop up consumption.
In fact, we are forecasting only a slight fall in nominal and expected real wage growth. After all, wages tend to respond only slightly to the amount of spare capacity in the labour market (i.e. unemployment).
But any complacency would be misplaced. The rise in the oil price is already pushing up headline inflation. So, actual real wages, measured against the cost of the basket of goods and services that the average US household typically buys, are set to drop smartly. That may take consumers by surprise.
US consumers will also have to cope with major fiscal tightening. In 2009, consumers were given substantial policy support. Of the two percentage points of GDP of fiscal easing in fiscal 2009, 1.2 percentage points took the form of measures that boosted consumers’ purchasing power or lowered the price of consumption (such as the “cash-for-clunkers” programme). But in 2010, by contrast, the cyclically-adjusted financial deficit is set to narrow by 0.5% of GDP (split about equally between consumers and corporates) with yet more aggressive tightening likely in 2011 and beyond.
The take-home pay of American households is therefore set to fall by about 2% y-o-y in early 2010. But it may feel even worse if consumers get a good sense of what is coming down the road: one of the biggest fiscal tightenings ever attempted.
The implication of this is that private consumption can only increase in 2010 if households decide to reduce the proportion of their incomes that they save, from the current level of around 4.5%. It is possible that US consumers now feel secure enough to do this, encouraged by the recovery in equities, and signs of a turnaround in the housing market. A sharp drop in the savings ratio, however, would be a big surprise, given the state of the labour market and households’ understandable concerns about the future. All in all, then, only a small increase in consumer spending is likely in 2010.
Meanwhile, the US corporate sector is doing rather better--enjoying stock market gains and a resurgence of profits. But, it must also deal with a huge amount of spare capacity and a still-high cost of credit. These factors should put a brake on investment. For exports, thankfully, the story is a rather more upbeat one. On aggregate, foreign demand will expand more strongly than home demand, and the dollar’s decline has also transformed the US’s competitive position. (In common currency terms, the US’s unit labour costs have dropped by about one-third since 2002.) Thus, export volumes should expand a healthy 9% or so in 2010.
With considerable overcapacity in the economy, firms seem unlikely to be able to raise prices much during the next year or two. As noted above, higher oil prices will push headline inflation higher in the early part of 2010. But, from the second half of the year onwards, the downward trend in inflation for other items will likely dominate the overall number, with headline inflation fading to around 1% by end-year.
Such an outcome could prove to be mildly supportive for equity markets, helping stocks to eke out gains of a little over 10%: i.e. about half the magnitude that they recorded this year. Bond yields are likely to trend higher, reaching perhaps 4.5% by year-end. That would be consistent with the Fed starting the process of normalising official rates in 2010, with a first rate hike in the autumn or early winter, and it attempting to do so in such a way so that it does not “freak out” markets. We assume in our single-most-likely scenario that it is successful in this regard. We also assume that the other G4 central banks do much the same thing. The dollar, we surmise, will “find its feet” again--not soaring, but probably strengthening slightly.
Risks just as important as the central scenario
This sort of scenario would actually be a fairly positive follow-up to a
much better 2009 than many feared. But it is worth thinking about what
could still go wrong. Here are four potential problems:
1. The Fed gets it wrong about raising rates. What might be intended as a nudge on the brakes could still run the economy into a ditch, if long-term interest rates rise too forcefully in response.
2. The US Treasury gets it wrong on fiscal tightening. Were bond markets to fret about debt and deficits, prompting sharper-than-currently-planned fiscal tightening, this could easily take a percentage point off growth. But if this tightening still didn’t calm market fears of big future deficits, bond yields might rise still further, hurting growth substantially.
3. The consumer gets cold feet. There is a chance that we are entering a new world, in which consumers are permanently more prone to save, and respond noticeably to even the slightest negative surprise.
4. Foreigners lose confidence in the United States. Were demand for US assets to drop sharply, the Fed could be forced to raise rates to help protect the value of the dollar; rising risk premia might cause the longer-end of the bond market to sell off; and the authorities may turn “isolationist” in terms of economic policy. This would not be a pretty sight.
Implications for investors
Cash: In all of the scenarios that we see as plausible, we can be
pretty sure that cash will deliver low returns.
Bonds: When it comes to government bonds, in our central scenario they will register a small loss, suggesting that investors should be underweight. If an “ugly” scenario develops, however, they could end up recording very healthy gains, albeit most likely only after losing value as yields rise initially. So, it may well be best to be nimble when considering how large a proportion of bonds to hold in one’s portfolio. Starting out underweight, but looking to go overweight if the “ugly” scenario looks like playing out looks sensible.
Credit: When it comes to credit, with spreads now almost back to what we deem to be “fair value”, the case for being overweight looks pretty unconvincing. Any substantial rise in government bond yields would hurt the asset class, and in a leveraged fashion. So, being close to neutral may well be warranted.
Equities: A key issue is whether or not equities are worth the extra risk compared with, say, holding cash. Clearly, were the central or “good” scenarios to play out, the answer is “yes” (see this chart). But, if the “ugly” one were to transpire the answer is a firm “no”. All in all, we suspect that it might be right to start 2010 overweight equities. But if, as we expect, risks do rise during the course of the year, then investors should look to go back to neutral, and seriously consider switching to an underweight position.
Commodities: As regards commodities, we recommend staying overweight for now, but again with the proviso that it would not take much to cause us to reverse our position. Gold prices, however, may well drift lower.
Real estate: Looking ahead, we doubt that the US housing market will do much over the next year or so, in terms of capital gains. As for the REITs market, being a leveraged form of equities, we prefer to adopt the same stance as we do for the main equities market--i.e. stay overweight for now, but watch out for the need to go back to neutral, and perhaps quickly. Commerical property's huge refinancing needs are also likely to cast a long shadow.
Foreign exchange: On currencies, it appears to us that all of the world's major currencies suffer from much the same problem: policymakers would like to avoid their currencies rising from here, and would prefer them to slowly depreciate. That suggests the "rest-of-the-world" currencies should appreciate. But remember that many policymakers in emerging markets are resisting market forces when these place upward pressure on their currencies. Moreover, in an "ugly" scenario, it is possible that the dollar again acts as a "safe haven" in attracting capital, and that many emerging-market currencies shed value.
Conclusions
All in all, like many sports events, 2010 may well turn out to be a
"game of two halves", with the risks that we fear remaining in the
background early on, but gradually raising the spectre of a "double-dip"
as the year progresses, and perhaps even materialising. This suggests
that it might be best to start 2010 with the sorts of positions that we
have been recommending of late, which have proven fruitful. However,
during the second half of 2010, investors should look to switch
gradually away from overweight-equities positions and into safer asset
classes such as bonds. As the risks of an accident are quite high,
investors should try to be nimble--remaining aware that abrupt
reallocations may be required during 2010, and perhaps with very little
warning.
Disclaimer: All views expressed in this third party article are those of the author(s) alone and not necessarily those of Morningstar. Morningstar is not responsible for the comments nor will it be liable in any way for any information provided by the author.
