From the December-January 2010 issue of Treasury & Risk magazine

Expect Anything But Smooth Sailing

The U.S. economy is finally showing signs of life. GDP grew 2.8% in the third quarter, breaking a string of four quarterly declines in a row, the longest since the Great Depression. But the outlook for this year is still far from rosy. Treasury & Risk asked economists Diane Swonk of Mesirow Financial, Michael Dueker of Russell Investments and Ken Goldstein of the Conference Board to look into their crystal balls. The 3% growth Swonk is forecasting is tame by historical standards in the wake of a recession, she says, but notes that credit is still hard to come by, especially for consumers. Dueker doesn't expect inflation to be a problem but sees the dollar remaining under pressure. And Goldstein says the economy still faces stiff headwinds as high unemployment and demographic changes limit consumer spending.

Sweating Out a Possible Double Dip

By Diane C. Swonk

Real GDP is forecast to grow at a 3% average rate in 2010, which marks a turnaround, but is still dismal given the depth of the recession. If history were any guide, we should be seeing growth closer to 6% or 7% by now. Moreover, the composition of growth this year isn't exactly reassuring. Much of the "rebound" comes from marginal increases in the beleaguered housing market and a slowdown in the pace of inventory liquidation. Producers actually cut back even more than consumers in 2009 and, in some sectors, are starting to replenish bare shelves. The auto industry is a particularly good example. The drawdown in inventories associated with the bankruptcies of General Motors and Chrysler was only exacerbated by the Cash for Clunkers program last summer. Even used cars are becoming hard to find. The only true bright spot is exports, which have already begun to pick up in response to stronger growth abroad. Those gains are contingent, however, on the global economy remaining on a recovery path.

In fact, the risk of a double-dip recession remains high. The primary risk is a secondary tightening of the credit markets as banks scramble to deal with a surge in commercial real estate write-offs and a cyclical increase in defaults. Credit remains particularly tight for consumers and small businesses, which doesn't bode well for employment gains going forward, as the United States relies on small businesses for much of its job creation. The tightening of credit related to the new consumer protection laws was particularly severe, as lenders eliminated home equity lines of credit, cut credit lines on credit cards, increased fees and severely slashed the number of credit cards outstanding (see chart) to bolster profits ahead of the Dec. 1 change in the law. As a result, debit cards have now exceeded credit cards in volume, which suggests more of a cash-and-carry than charge-and-leverage economy going forward.

An increase in lending by the Small Business Administration could help, but only on the margin. Most small businesses rely upon consumer credit markets to manage their cash flows. Those that do not are complaining how difficult it is to actually find a bank that specializes in small business lending. Large multinationals have a particularly poor track record when it comes to small business lending, which is much harder to commoditize in terms of risk than other types of lending.

There is also considerable risk of a collapse in asset prices. Hence, the Fed's push to make banks stress-test their balance sheets against an asset price bust. The greatest risk, however, is not on bank balance sheets but in the hands of junk bond holders, since junk bond spreads have narrowed and their risks have risen the most in recent months.

So why have any hope at all? Because there is such a thing as bottom. Indeed, it appears in some sectors, such as autos and housing, we have overshot, and pent-up demand is building. Vehicle sales are particularly weak, and financing in that sector appears to be easing. Moreover, much of the pickup in construction activity associated with the fiscal stimulus passed last year is ahead of us. This, coupled with even easier monetary policy--the Fed plans to continue to expand its balance sheet and ease up on the quality of commercial mortgage backed loans it buys--will help provide a leg up in 2010.

What about inflation? Growth is expected to remain too weak and the velocity of money too slow to trigger much in terms of inflation anytime soon. It is almost as if all the money Ben Bernanke dropped from his helicopter got caught in the trees (or on the top of skyscrapers in Manhattan), out of the reach of most of us on Main Street. (Sorry all you gold bugs--I must remind myself to sell my old wedding bands before the price of gold peaks.)

That said, the Fed is under attack, and inflation will re-emerge as a problem over the medium term (next three-to-five years) if the central bank can't keep Congress out of its books. The dollar's status as a reserve currency, in particular, would be compromised if global investors actually believed that Ron Paul might be successful in clipping the Fed's wings.

What if I am wrong? I can only hope so. I would much rather see the economy stronger and inflation be a concern sooner, than have to deal with the austerity I fear that we are in store for.\

Fed's Low Rates Leave Dollar Limping

By Michael Dueker

The first thing to watch in 2010 is whether the U.S. economy enjoys a period of snap-back growth. Following a typical recession, a good portion of the output lost during the recession is reversed through a period of strong growth that is well above the trend growth rate of about 3%. On average, enough snap-back growth takes place to reduce the permanent GDP loss from recessions to less than 1.5%. The output shortfall during the recent recession totaled 7.8%, so it would take a lot of snap-back growth to get the permanent output loss down to even 3%.

An interesting feature of transitions between ordinary growth, recession and snap-back growth is that if the economy goes straight from recession to ordinary growth, it is likely to skip the high-growth phase altogether. Russell Investments' forecast projects GDP will grow 3.1% from the fourth quarter of 2009 to the fourth quarter of 2010. The forecast of ordinary growth this year suggests that the U.S. economy is likely to skip the snap-back growth phase and instead experience a jobless recovery. In this low-growth environment, companies that demonstrate an ability to pay solid dividends are likely to be rewarded more than companies that rely on growth prospects for their equity valuations.

The second item to watch for is a non-event. With this much slack in the economy, the Federal Reserve is likely to remain on hold and leave the federal funds rate near zero throughout 2010. The November 2009 issue of Blue Chip Financial Forecasts showed Russell's forecast of a 0.4% fed funds rate in the first quarter of 2011 was the lowest on the panel. Given recent statements by Fed policymakers, we expect to have more company soon in this stand-pat forecast of short-term interest rates.

Accompanying this interest-rate forecast is a sanguine view of U.S. inflation, which we do not expect to rise above the top of the Fed's comfort range--a 2% year-over-year increase in core personal consumption expenditures price index--for at least two years. Nevertheless, given the likely concern in bond markets that the Fed is keeping rates too low for too long, there could be a mild inflation scare that would raise long-term interest rates by 100 basis points by the end of this year, even while short-term interest rates remain near zero. Absent strong real growth, even a modest increase in long-term rates carries the potential to put the brakes on equity returns for a time. Think of 1994, when a bad year for long-term bonds held down stock prices, and 1995, when the end of the inflation scare resulted in a breakout year for stocks. Given the risk of an inflation scare, companies might aim to lock in long-term financing rates prior to the end of the first quarter of this year.

The third thing to watch for this year is a weak U.S. dollar. With the United States lagging behind other countries in raising short-term rates, the dollar will continue to come under downward pressure. This is true in the short run even though the dollar appears to be undervalued relative to many other major currencies in terms of the real exchange rate (the exchange rate adjusted for cumulative inflation differentials). The opposite occurred in 1984, when the roaring recovery and comparatively high interest rates in the United States led to a temporarily overvalued dollar.

Following dollar depreciation in the short run, a typical analysis would suggest that the real exchange value of the dollar would eventually be restored to its long-run level in one of two ways: The dollar could appreciate against other major currencies, or U.S. inflation (here are those inflation fears again) could exceed that in other major countries, without a commensurate decline in the dollar. An interesting third possibility, however, is that the real exchange value of the dollar could take a permanent hit, like the devaluation of the British pound in 1967. Of course, the dollar's actual course could be a combination of these three adjustments.

To the extent that a permanent depreciation of the real exchange value of the dollar takes place, however, American companies will only benefit if it leads to increases in productivity and export growth and lowers the level of external public debt. A "competitive devaluation" could raise productivity by increasing market scale through exports and by attracting foreign direct investment at lower entry cost to foreign firms.

Labor Market Slow to Mend

By Ken Goldstein

The recession ended in 2009, which makes 2010 a year of recovery. Normally, the economy experiences a quarter or two of pent-up demand in the immediate post-recession period, boosting the overall pace of economic activity. Not this time around. Why not?

One big factor is the fundamental change in consumer behavior. To be sure, it is a shock to most consumers that the recession caused the unemployment rate to double (from roughly 5% before the recession set in to an estimated 10.5% when it finally peaks in the first half of this year). Even more than that, wage growth was very slow to pick up after the 2001 recession and now has slowed again sharply. But the larger factor is the dawning realization of how long it will take for the labor market to regain its footing--certainly until well into 2012, and possibly even longer.

There is a Gordian Knot that will only slowly be unraveled. In the slow economic environment of this year and next, corporations will have a hard time exerting pricing power, which limits their revenue. The dilemma companies are facing is whether to increase wages or hire more workers. Slow economic growth and slow prices will not deliver enough revenue to do both. If it took several years to regain wage and job growth after the 2001 recession, and this recession was far more severe, logic suggests recovery on wages, profits, jobs and overall economic growth will take longer. This year will certainly start on a very weak note given these stiff headwinds.

What's more, the demographics have shifted. The population is growing slowly (no more than 0.9% per year), even as aging baby boomers exit the labor force. The demographic shift is one reason why home and car buying aren't likely to come back strong in the next year or two. The money not going into new homes (or furniture and appliances for those homes) or new cars is money likely to stay in savings. One thing to watch is whether this money stays in checking accounts or whether households invest in mutual funds and the like.

For all these reasons, consumer spending is likely to increase by no more than 0.5% to 1% in 2010. With two-thirds of the economy growing that slowly, overall activity is likely to grow no more than 2%. Economists generally say that when the economy grows no more than 1.5%, it feels like a recession to most consumers and businesses. In other words, the recession will be over this year, but one would need to really focus to perceive that. Coming off the worst recession in more than half a century, that is certainly not good news.

With the economy growing this slowly, businesses will struggle to exert pricing power. That means no more than 2% percent inflation, at best, and many analysts think it won't even be that high. If the economy is growing no more than 2%, and inflation is no more than 2%, then historical evidence suggests that corporate profits cannot increase by more than 8%.

For profits to increase even that much, there must be either continued very strong productivity growth or continued cost cutting. And while some of that is surely taking place during the current recovery, an 8% rise in profits is still below the long-term average. It is very hard to see what would sustain a rally in stock prices in this kind of economic environment.

In short, 2010 will be tough year for con-sumers but even tougher for the financial markets. One does not go through the worst recession in more than half a century and come sailing out in clear calm waters. Expect anything but clear sailing in the markets not only this year but next year as well, with no guarantee that 2011 or even 2012 will be that much better. Perhaps a new cycle is ahead, but it is not just around the corner.


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