economic outlook.

• The Uncertainty Continues
• The Wild Card
• Hot Money Cooling Down
• Fed Policy and the U.S. Outlook
• Looking Ahead

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The Uncertainty Continues

For the second time in the last 12 months, the United States appears to be turning the proverbial corner. Just six months ago, many market participants were fearful that another recession was imminent. The Federal Reserve’s Federal Open Market Committee did not go so far as to project a recession (it rarely does), but in its August 9 statement, the Committee did dampen its assessment of the recovery by noting that “economic growth so far has been considerably slower” than had initially projected and that it now expected a “somewhat slower pace of recovery over the coming quarters.” The positive momentum in the first quarter of 2011 was quickly derailed by surging oil prices, a tragic earthquake and tsunami in Japan, a nasty debt ceiling debate in the U.S. Congress, and the ever-worsening debt crisis in Europe. However, economic data began to beat expectations (albeit lowered expectations) in the third quarter, and the markets shrugged off concerns of another U.S. recession, despite the growing worries over the global economy. Initial jobless claims, which are viewed as a leading indicator of the labor market, closed 2011 at the lowest levels since June 2008.

As 2012 arrives, investors are once again wondering whether the U.S. economy is strong enough to withstand the many headwinds it faces. Will European leaders finally begin to work together on a comprehensive plan that has any chance to resolve the current crisis in both the near and long term and bring calm to the global financial markets? Will U.S. political leaders cooperate with each other and provide a roadmap for fiscal policies that are conducive to long-term economic growth? Will China’s economy continue to land softly, or will it experience another real estate bubble burst similar to the West? The December 13 FOMC statement officially acknowledged the non-domestic headwinds when it said that “strains in global financial markets continue to pose significant downside risks to the economic outlook.”

The Wild Card

The greatest wild card in these uncertainties is Europe. The crisis it faces is very deep and complicated; and while the markets have been very patient up to this point, one bad policy mistake (or worse, one too many) could trigger something far more severe than what has been experienced thus far. Of course, the lack of good policies is becoming more problematic than the many political, fiscal, and monetary blunders. Many people have asked how much of an impact a European meltdown would really have on the U.S. economy; and while projecting the exact impact is nearly impossible, the result of such an event would certainly be more than negligible. Along with the United States, Europe has one of the two largest consumer bases in the world, and a severe recession/depression in the region would definitely have a negative effect on U.S. companies operating in that area. Additionally, large European banks provide loans to U.S. businesses, and a reduction in these sources of financing would ultimately have a negative impact on the U.S. economy. Goldman Sachs’ chief economist, Jan Hatzius, recently predicted that the combination of bank counterparty risk and a reduction in credit extended by European banks alone would subtract 1 percentage point from U.S. GDP growth in 2012. With most estimates for 2012 GDP growth in the 2 percent range, a reduction of 1 percentage point would have a significant impact. Further, the triggering of a credit crisis in the European financial markets similar to what occurred after Lehman Brothers’ failure in 2008 would likely push credit spreads wider for all debt issuers. If U.S. companies’ interest costs rise, they would likely maintain their bottom line by reducing other costs (namely, labor costs), which would strike another blow to an already struggling U.S. labor market. Of course, timing is everything, and predicting the timeline of events in Europe has been very difficult. At the moment, the markets continue to expect Europe to eventually do what is necessary. But every time the leaders get together to announce a new “grand” plan, the markets end up disappointed when those leaders fail to deliver on their rhetoric.

Several eurozone nations have grown government spending to levels that have created “structural” deficits. In other words, those countries’ economies could be running at full capacity and production (maximum GDP growth) and still not be able to generate enough additional government revenue to achieve a 3 percent budget deficit or better (original eurozone requirement). To fund the increases in government spending, those countries had taken advantage of cheap and clearly mispriced financing in the European sovereign debt markets in the years leading up to the 2008 financial crisis, and, in the process, have amassed large debt burdens relative to the sizes of their economies. As these economies contracted following the U.S.-led global financial crisis in late 2008, the budget deficits grew more severe as tax revenues declined and government spending continued to grow (unemployment benefits, etc.). The financial crisis of 2008 also led investors to re-evaluate credit risk in their portfolios, and this was particularly true in the European sovereign debt markets. Since the inception of the euro in January 1999, banking regulators assigned the same risk weighting (0 percent) for all eurozone issuers. So, as far as a European bank investor was concerned, a Greek debt obligation would carry the same risk weighting as a German debt obligation, according to regulators, even though Germany’s fiscal health and economic potential was far greater than that of Greece. From the time that Greece entered the eurozone in January 2001 until the failure of Lehman Brothers in September 2008, the average spread between the Greek 10-year note yield and the German 10-year note yield was only 30 basis points (bps). Now that investors have effectively turned their back on the debt of Portugal, Ireland, Italy, Portugal, and Spain (PIIGS), yields have moved sharply higher, and the rising interest costs become a much more burdensome component of a budget already in the red. This is unsustainable for those countries, and it is why the European Union (EU), European Central Bank (ECB), and the International Monetary Fund (IMF), referred to as the “troika,” has had to step in to provide more cost-effective funding while those economies recover. However, if an economy is running a “structural” deficit, more time will do nothing to resolve the situation.

The eurozone’s largest economy and benefactor is Germany, and German leaders are very resistant to any rescue efforts that do not involve the aid recipients adopting significant long-term austerity measures with enforceable recourse if the agreed-upon austerity steps are not met. In other words, Germany wants no part of being an enabler to a debt- and spending-addicted nation. So, why doesn’t Germany just walk away? Germany is still an export-driven economy, and the debt addicts in the European periphery are its customers. Additionally, a return to the Deutsche mark would also negatively impact German exports because the currency would most likely appreciate significantly in value. In turn, that would make its products much more expensive to foreign buyers (similar to what Switzerland has experienced over the last few years).

The situation in Europe is nearing its breaking point. Most people are in agreement that fiscal austerity and reform are absolutely necessary for any hope of long-term viability for the eurozone. However, these reforms cannot, and should not, occur overnight. Forcing a country that is already in recession to adopt a zero budget deficit immediately is likely to ensure a severe depression, if not outright anarchy. Additionally, the current legal and political structure in the eurozone makes enforcement of any austerity requirements effectively impossible, so some form of fiscal unification of the eurozone members is necessary and inevitable for long-term survival. The eurozone leaders took modest steps towards fiscal unity at the EU summit on December 9, 2011, but the comprehensive fiscal union that the markets are looking for to rebuild confidence in the euro has yet to emerge. In the meantime, the markets are looking for the ECB to finally step in and provide “shock and awe” by backstopping the struggling eurozone nations via massive debt purchases (i.e., quantitative easing). However, the ECB is legally barred from taking such actions according to the current eurozone treaties. Most insiders believe this obstacle could be removed relatively soon with Germany’s blessing, but the largest capital holder in the ECB is fundamentally opposed to “printing money” due to its historical battle with hyperinflation in the days of the Weimar Republic in the early 1920s.

The ECB arguably took covert steps toward quantitative easing when it announced on December 8, 2011, that it would provide an unlimited amount of loans to European banks at 1 percent for up to three-year terms, while loosening the collateral requirements for borrowing at the facility. Theoretically, this would allow European banks to borrow funds at 1 percent and purchase Italian and Spanish debt at 6 percent and higher yields, which the ECB hopes would drive those yields lower. This, of course, assumes that the banks are willing to take on the credit risk of those sovereign issuers; and there are still questions about whether or not the demand from banks would be enough to make a significant difference. So far, the banks are not taking this risk, with the ECB’s deposit facility, which pays 25 bps, experiencing record demand of €463 billion as of January 9, 2012. In the minds of many investors, the only way the eurozone has a chance of survival is if the ECB overtly and officially becomes the lender of last resort in the region, just as the Federal Reserve is in this country. Doing so would violate current treaties and inclinations of influential German policymakers, but the eurozone is simply running short of options. The creation of the three-year funding facility was viewed as a backhanded attempt by the ECB at quantitative easing and making the European banks the lender of last resort. However, the head of French bank Société Générale, Frederic Oudea, was quoted by Reuters on January 6, 2012, as saying that his bank would not be buying large amounts of French sovereign debt (much less Italian or Spanish debt); and Oudea also stated that it was not the responsibility of European banks to be “final investors” for governments. Oudea is effectively rejecting any attempt by the ECB to make banks the lender of last resort for the eurozone, which puts the ball back in the ECB’s court. The ECB alone cannot solve this crisis, but it may be able buy more time while policymakers attempt to overcome legal and political hurdles to mend fiscal imbalances in many parts of the monetary union.

Hot Money Cooling Down

While Europe has dominated headlines over the last several months, there are other global economic concerns on the minds of investors. The question of whether or not China will be able to “soft land” its economy and avoid a more severe recession has been on the minds of many market participants (including ours) for a while now. While much of the Western world was suffering through the aftereffects of the 2008 credit crisis that rocked the financial markets, China experienced significant economic growth, as well as a large increase in capital inflows from foreign investors. This has been dubbed by the markets as “hot money” because of the typically-short investment horizon of those investors (i.e., seeking short-term profits). This foreign capital inflow is sometimes difficult to track on a timely basis, but Exhibit 1 attempts to use data from foreign direct investments (FDI), central currency reserves, and trade balances to estimate the net inflow of hot money since October 2008 (Lehman Brothers bankruptcy). Since hitting a recent peak of $52 billion in January 2011, foreign capital inflows into China declined at a steady pace until a recent plunge to negative $39 billion in October. In the equity markets, China’s Shanghai composite index surged 103 percent from November 2008 to August 2009. Since last April, however, the index has fallen 30 percent as the economic growth outlook for the country has contracted and foreign capital investments have declined.


The big increases in hot money in early 2009 and mid-to-late 2010 corresponded with the Chinese central bank’s monetary tightening policies and the Fed’s quantitative easing efforts, which had a weakening affect on the U.S. dollar. Effectively, these investors were looking to capture the growth in Chinese asset prices, as well as the appreciation in the Chinese currency versus the dollar; however, the crisis in Europe and the relatively slower demand from U.S. consumers has had a big impact on China’s biggest customers for exports, which account for nearly 40 percent of China’s economic growth. Consequently, the Chinese government has begun to take steps to ease monetary policy; and due to the problems in Europe and the global economy as a whole, the U.S. dollar index is now at the highest level in 12 months. With diminishing expectations for Chinese currency appreciation and the weaker outlook for global economic growth, this foreign capital is beginning to migrate back to dollar-denominated assets (flight-to-safety).

There has been growing concern over the last two years that the influx of foreign capital helped fuel a housing bubble in China; but up until now, those concerns have not come to fruition. Construction spending in China began to surge higher in 2009 as a percentage of GDP, and housing affordability became a problem in several areas of the country. In response to rising inflation, including surging housing prices, the Chinese government began to increase reserve requirements for banks in October 2010, which reduced the money supply and made credit more difficult to obtain in the housing sector. Amid a slowing domestic and global economy, China’s central bank began to gradually reduce the bank reserve requirements in late 2011; however, many analysts feel it may be too little too late to stop a correction in local housing prices.

Regardless of whether or not China experiences a housing crash and a subsequent banking crisis, the country’s economy is clearly experiencing the negative effects of a declining consumer demand in Europe and the United States, as well as a decline in foreign capital inflows. On January 4, Chinese Premier Wen Jiabao warned that business conditions would be “relatively difficult” in the first quarter. Wen also said that he sees “downward pressure on our (China’s) economy and elevated inflation at the same time.” A slowdown in China’s economy reduces aggregate demand for energy and raw materials, which puts downward pressure on commodities prices. Notice in Exhibit 2 the recent decline in both Chinese equity prices, as measured by the Shanghai composite index, and global commodity prices, as measured by the Thompson Reuters/Jefferies CRB index, which tracks price changes in the futures market for a broad basket of commodities. The decline in both indices is likely explained, in part, by a combination of China’s slowing economy and end of the Fed’s second round of quantitative easing (QE2), which cooled the inflow of hot money. The decline in commodities prices eases U.S. inflation pressures, which may finally give some Fed policymakers the ammunition they need to justify yet another round of asset purchases (QE3).


 

Fed Policy and the U.S. Outlook

It is no secret that there are several FOMC members who are currently in favor of further accommodation of monetary policies in an effort to support economic growth. After more than three years of easing, the Fed does not have many more weapons in its monetary arsenal, but the markets have speculated for the last six months that the Committee may attempt to further cement expectations for the target federal funds rate to remain unchanged beyond the current “mid-2013” guidance and/or initiate another round of QE. Chicago Fed President Charles Evans has been the most vocal proponent of more easing from the Fed, acting as the lone dissenting vote in last two FOMC statements because of the lack of accommodative responses from the Committee. Evans has also been credited with the push for more transparency as it relates to the FOMC’s guidance for future changes in the fed funds rate. The markets expected this change to be implemented in early 2012, and the minutes from the December 13, 2011, FOMC meeting revealed that the Committee intends to add a forecast for the fed funds rate in conjunction with its current forecasts for quarterly GDP growth, unemployment, and inflation (see Exhibit 3). In essence, the FOMC would inform the markets of what changes in inflation and unemployment rates would trigger an increase in the fed funds rate. The changes would also include a prediction from each FOMC member on when the first rate increase would occur, as well as a narrative providing further rationale for the changes. Most members are expected to forecast no change in rates until at least mid-2014. If the median forecast for a rate change is indeed one year or more beyond the time frame currently mentioned in the official statement (mid-2013), the markets will likely interpret this as further accommodation.


The more controversial action on the part of the Fed would be another round of long-term asset purchases, presumably these would be Agency mortgage-backed securities (MBS). The last round of asset purchases did nothing but fuel inflation throughout the world by boosting risk markets (stocks, commodities, etc.), which caused even more harm to U.S. consumers still facing high unemployment and stagnant wages. The last round of QE was justified by the fact that core inflation was falling to record lows and pointing to potential deflation in the near future. With the deflationary history of the Great Depression still weighing heavily on the minds of Ben Bernanke and his colleagues, the Fed did what it felt was necessary to stimulate an increase in prices and avert deflation. Deflation can be nasty for a society with a large debt burden because in a deflationary environment, a person’s wages decline, but their liabilities remain unchanged. However, core inflation is nowhere near the record-low levels of late 2010, so the more dovish FOMC members have not been able to pursue this course, yet. Following the release of the December jobs report showing 200,000 jobs added and the lowest unemployment rate in nearly three years, New York Fed President Bill Dudley and Boston Fed President Eric Rosengren, both of whom are close allies of Chairman Ben Bernanke, still called for further accommodation from the Fed, with Rosengren specifically mentioning “further purchases of mortgage-backed securities.” Dudley and Rosengren are two of the most dovish members of the FOMC, so their comments are not surprising; but they will continue face strong opposition from the more hawkish Committee members (Lacker, Plosser, Fisher, etc.). However, if commodity prices continue to moderate and core inflation subsides, these members will make another push for QE3, and they will very likely be successful in doing so.

With regard to more MBS purchases, Rosengren said that the purchases would stimulate a “more rapid recovery in housing by reducing the costs of refinancing or purchasing new homes.” The average 30-year mortgage rate has been at or near record lows for three years now (see Exhibit 4), yet some policymakers still feel that borrowing costs are the problem? Perhaps Mr. Rosengren simply feels that lower rates could only help matters, but he and some of his economist peers fail to recognize or accept the many negatives that come with such a program. As mentioned previously, such policies have, in the past, weakened the dollar and artificially boosted asset prices in certain markets, which increases the risk of future bubbles. That seems like a great risk to take simply for the “hope” that it helps the housing market. (On a side note, the housing market troubles are a consequence of a supply and demand imbalance and tight credit conditions, not high mortgage rates.

Looking Ahead

It appears that the general theme of uncertainty in 2011 will persist in 2012. While the U.S. economy is stabilizing, it is unlikely that it will be on strong enough footing to withstand a shock from Europe or a global slowdown. The uncertainty lies in the timing of such events, if they occur at all. With nominal GDP of $15.2 trillion, the United States is still the world’s largest national economy; but if you look at the EU as a whole, it has a nominal GDP of more than $17 trillion. In a globalized economy, a severe recession or financial crisis in the largest world economy (EU) has a definite impact on the U.S. economy. However, economists are guessing every day at how much of an impact this would have. Europe is also home to 27 of the 50 largest banks in the world, so it is easy to understand why financial markets are so anxious by the unrest in the eurozone. In the United States, Congress is unlikely to make any significant policy changes heading into the 2012 elections. The two-month extension of the payroll tax cut provides some upward support to near-term GDP growth, but Washington will do very little to address any long-term budget and tax issues this year. The median economist forecast for first-quarter GDP currently stands at 1.9 percent, according to the most recent Bloomberg survey on December 9, 2011, and the median forecast for full-year 2012 growth is currently 2.1 percent. These are hardly robust figures, and it would not take much of an external shock to send growth below 1 percent or, worse, into negative territory. I still believe the odds of a recession in the United States in 2012 are below 50 percent, but every day that the European situation worsens, the greater the odds are that the world economy will suffer.

Both short-term and long-term interest rates appear firmly entrenched, and any investors holding out for higher rates in 2012 will likely be disappointed. The Fed is expected to further delay its expectation for “exceptionally low levels of the federal funds rate” beyond the current mid-2013 guidance, and the global economic weakness and subsequent strengthening of the dollar should lower inflation expectations, which have a large impact on the long end of the Treasury curve. Although Treasury yields are likely anchored across the curve for the near term, a European credit/financial crisis would widen spreads on most fixed-income sectors, with sectors with the most perceived credit risk and illiquidity widening the most (non-agency MBS, CMBS, high-yield corporate debt, etc.). Conversely, uncertainty can also present opportunity, and a widening of yield spreads for sectors with acceptable credit risk for an investor can provide more favorable returns.