Morgan Stanley 2010 Outlook: From Exit to Exit

By Richard Berner | New York & Joachim Fels | London
This year was all about the exit from the Great Recession. Next year will be all about the exit from super-expansionary monetary policy - we expect the major central banks to start exiting around mid-2010. The prospect and process of withdrawal may have unintended consequences: we think government bond markets will be the first victim. A tale of two worlds. We forecast 4% global GDP growth in 2010, but this masks two very different stories. One is a still fairly tepid recovery for the advanced economies. The other is a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% in 2010. In short, we think that the themes of global rebalancing and EM growth outperformance have staying power and have even been bolstered by the crisis.

In the pieces that follow, our global economics team presents its views on how each region will fare in the coming year as the world continues to recover. This is the final edition of the Global Economic Forum for 2009. We will resume regular publication beginning in the first week of 2010.

Global Forecast Update: 2010 Outlook: From Exit to Exit
By Joachim Fels, Manoj Pradhan & Spyros Andreopoulos | London
This year was all about the exit from the Great Recession - and, as we had expected at the start of the year, it worked courtesy of massive global policy stimulus. Next year will be all about the exit from super-expansionary monetary policy - we expect the major central banks to start exiting around mid-2010. Yes, they will likely be cautious, gradual and transparent. However, the prospect and process of withdrawal may have unintended consequences: we think government bond markets will be the first victim. While we believe that the exit will be the dominant macro theme next year, we identify five important economic themes in our global economic outlook that, in our view, will be highly relevant for investors in 2010.

A tale of two worlds: We forecast 4% global GDP growth in 2010, up only marginally from three months ago (see the previous Global Forecast Snapshots: ‘Up' Without ‘Swing', September 10, 2009). True, if this turns out to be about right, it would be a fairly decent outcome, especially compared to the widespread doom and gloom earlier this year. However, it falls short of the close to 5% growth rate in the five years prior to the Great Recession, and it will be the product of unprecedented monetary and fiscal stimulus, which poses substantial longer-term risks on various fronts. Moreover, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies - the ‘triple B' recovery we discuss below. The other is a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% in 2010 (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% this year. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, as our China economist Qing Wang has been pointing out for a while now, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, we think that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis.

A ‘triple-B' recovery in G10: In contrast to our upbeat EM story, we forecast barely 2% average GDP growth in the advanced G10 economies in 2010 - a triple B recovery where the three Bs stand for bumpy, below-par and boring. On our estimates, GDP growth has averaged around 2% in the G10 in the second half of this year and won't accelerate much from that pace next year - hence our ‘up' without ‘swing' characterisation from three months ago remains valid. The two reasons why we think the recovery in advanced economies will be of the ‘triple B' type are that it is likely to be creditless and jobless. Creditless recoveries - defined as a situation where banks are reluctant to lend and the non-bank private sector is unwilling to borrow - are the norm following a combination of a credit boom in the preceding cycle and a banking crisis; and creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, we expect a jobless G10 recovery, with unemployment in the US declining only marginally next year and rising further in Europe and Japan. Unemployment may well stay structurally higher over the next several years in the advanced economies as many of the unemployed either have the wrong skills or are in the wrong place in an environment where the sectoral and regional drivers of growth are shifting.

More growth differentiation within the G3: Beneath the surface of what we call a lacklustre ‘triple B' recovery in the advanced economies lies a differentiated story for the three largest economies within this block - the US, the euro area and Japan. We expect significant growth differentials between these countries in 2010, which may well become a topic for currency, interest rate and equity markets again. We see the US as the growth leader among this group next year, with output expanding by 2.8% in the annual average of 2010. The euro area economy looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) next year and is forecast to actually fall back into a technical recession in 1H10. One reason for relative US outperformance is that the creditless nature of the recovery affects the US private sector by less because banks (as opposed to capital markets) play a smaller role in financing the economy than in Europe or Japan. Another reason is that US companies have been much more aggressive in shedding labour this year than their European or Japanese counterparts, so the US labour markets looks set to recover (albeit slowly) next year, while we expect unemployment to rise further in both Europe and Japan. Further, European and Japanese exporters should feel the pain from this year's currency appreciation, whereas US exporters should benefit from this year's dollar weakness.

Crawling towards the exit, but triple A liquidity cycle remains intact: As stated above, we expect the beginning of the exit from super-expansionary monetary policies and its implications to be the dominant global macro theme in 2010. We will discuss details of the likely monetary exit strategies across countries in next week's year-end Global Monetary Analyst. Here, it suffices to say that we expect the Fed, the ECB and the PBoC to move roughly in tandem and raise interest rates from 3Q10, with the Bank of England following in 4Q. Some, like the central banks of India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. Generally, given the remaining fragility in the financial sector, central banks are likely to approach the exit in a cautious, gradual and transparent manner, so any hikes will likely be telegraphed well in advance, partly through appropriate twists in the crafted language, and partly through some cautious draining of excess bank reserves. Importantly, while the end of easing and the beginning of the exit can be expected to cause wobbles in financial markets, and this is one reason why we see bonds selling off sharply next year, we point out that official rates are likely to stay well below their neutral levels (even factoring in that these themselves are likely to be lower now than they have been in the past) throughout 2010 and, probably, also in 2011. Hence, monetary policy is only expected to transition from super-expansionary to still-pretty-expansionary. This would leave what we have dubbed the ‘triple A' liquidity cycle (ample, abundant and augmenting), which we have identified as the main driver behind this year's asset price bonanza and economic recovery, fairly intact next year. The metrics we follow to validate or refute this view is our global excess liquidity measure depicted in the chart below, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded this year and we would expect it to rise further, though at a much lower pace, through 2010.

Sovereign and inflation risks on the rise: Fifth, but not least, we think that sovereign risk and inflation risk will be a major theme for markets in 2010. The current issues surrounding Greece's fiscal problems are only a taste of things to come in many other advanced (note: not emerging) economies, in our view. We note that fiscal policy looks set to remain expansionary in all major economies next year, as it arguably should be, given the ‘triple B' recovery which still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability, and rightly so. Importantly, the issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: most of the government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales, they can instruct their central bank to print whatever is needed (call it quantitative easing). Thus, in the last analysis, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks in the year ahead, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.

Exit Strategies for the Global Central Bank
By Manoj Pradhan | London
Faced with the prospect of a deepening global recession and strong deflationary forces, the Global Central Bank (GCB) delivered unprecedented monetary easing in 2008 and 2009. Rates were pushed down faster and lower than they have ever been in many parts of the world, and unconventional easing was employed when the zero bound for interest rates precluded further conventional easing. Even if the decisions were not made collectively, the policy stimulus spoke with one voice. And asset markets and the global economy responded.

The next challenge for the GCB, naturally, is to take away excessive monetary stimulus at the appropriate time, i.e., when the recovery is sustainable, and in a way that keeps inflation and inflation expectations on a benign path. National and regional differences are likely to be a dominant theme going forward, and divergences in policies of national central banks will likely be scrutinised closely. However, there is little doubt that the global monetary impetus unleashed by ultra-expansionary monetary policies will be a common theme in the exit strategy for practically every national central bank.

Peloton still holds firm: The common ground that central banks share because of global liquidity is curiously similar to strategies of a cycling peloton (see "The Peloton Holds Firm", The Global Monetary Analyst, November 4, 2009). Cyclists usually cluster together to collectively fight wind-drag. Huddling together has spillover benefits to the entire group. Front riders usually have a lot more flexibility but then battle the most with headwinds, while riders at the back have to react sooner to unexpected changes in speed or conditions. Central banks too have been clustering together to get the benefit of excess liquidity spillovers. Early movers like the Bank of Israel, the RBA and the Norges Bank have had to deal with the dual headwinds of currency appreciation and insufficient traction in their domestic debt and equity markets, both of which are linked to their counterparts in the major economies. Excess liquidity is likely to remain in place for the foreseeable future, which means that central bank strategies are also likely to be impacted by the dynamics of the monetary peloton.

G10 versus EM: One reason why excess liquidity will continue to play a dominant role in exit strategies is the difference between the growth profiles of the G10 and EM (especially AXJ) economies. The ‘BBB' (bumpy, below-par and boring) recovery in the G10 will keep central banks there from hiking aggressively, and will almost certainly mean that policy rates will remain below their neutral levels for all of 2010. Our team expects the Fed and the ECB to hike rates starting in 3Q10, both ending the year with policy rates at 1.5%. The BoE is expected to raise rates in 4Q10 by 75bp to 1.25%, and even this forecast is contingent on the outcome of the election in early/mid-2010. In Japan, the election in 2009 and the fiscal consolidation that the new administration is likely to espouse are partly responsible for the technical recession that our Japan economics team expects in 1H10. Consequently, the BoJ's next move is likely to be a cut rather than a hike, with the policy rate likely to be lowered by 5bp to 0.05% in 2Q10. A first hike is expected only in 3Q11.

Both the rate cuts and expected rate hikes focus strongly on the growth challenges to the economy. It is important to keep in mind that the extent to which central banks cut rates was a function of both the starting point as well as the zero bound. New Zealand and Australia policy rates were at 8.25% and 7.25% before the recession, while many of the other G10 economies effectively hit the zero lower bound when they cut rates. On the way out, central banks appear to be keenly focused on the growth prospects for their respective economies, but will be aware of the growth as well as the monetary policy spillovers from the major economies.

But policy rates are not the only kind of monetary easing that have to be unwound: Active QE continues to expand central bank balance sheets (ceteris paribus) as asset purchase schemes at the Fed, the ECB and the BoE slowly near their targets. In contrast, again, the BoJ could actually step up its purchases of JGBs to combat what seems to be another bout of sustained deflation. Reducing their respective balance sheets will mean either successfully absorbing the liquidity at the disposal of commercial banks consistently over time, selling some of the assets purchased, or issuing securities to mop up liquidity. None of these options is without side-effects or risks. Just like policy rates, unwinding QE too quickly will risk a strong market reaction and risk economic recovery, while waiting too long creates inflationary risks (see "QE2 - Size Matters", The Global Monetary Analyst, March 25, 2009 and "Reversing Excessive Excess Reserves", The Global Monetary Analyst, October 28, 2009). It is important to note, however, that there are significant differences among central banks as far as unwinding QE is concerned - for more details see Berner/Greenlaw (The Fed Will Exit in 2010, December 7, 2009), Bartsch ("Executing the Exit", The Global Monetary Analyst, November 11, 2009) and Baker/Sleeman ("UK: Later 2010 Rate Rises", The Global Monetary Analyst, December 2, 2009).

Central banks in emerging markets have slightly different issues to deal with: Major EM economies are racing ahead, and the risk is that central banks there could hike sooner than expected. Strong growth in the EM world means that economies with flexible exchange rates face currency appreciation as well as more capital inflows as they talk of higher rates, while economies with fixed exchange rates import easy monetary policies from the major central banks, which also bring with them capital inflows. The end result for both is that a meaningful monetary policy tightening would imply more rate hikes than usual, something that most EM central banks are probably unwilling to do. Mostly unencumbered by a patchy recovery, this doubly easy monetary policy in EM is a strong basis for expecting continued economic and asset outperformance.

The central banks of China, India and Brazil are all focused on upside risks to economic growth and asset prices, which could hasten their exit. The PBoC is expected to use tools such as reserve requirements in addition to its policy rate instrument to tighten policy. The policy rate itself is expected to be hiked just twice over 2010, taking rates from 5.31% to 5.85% in 2H10 and keeping them on hold thereafter throughout 2011. Brazil is likely to exit a shade earlier, raising rates by 50bp in 2Q10 to 9.25% and then further to 11% by the end of 2011. The RBI, on the other hand, has been worried about inflation problems for a while now and is expected to raise rates in 1Q10. Being an early mover in the peloton, it is well aware of the currency appreciation issues as well as possible ‘perverse' capital inflows that may be attracted to rising yields. Finally, the Central Bank of Russia is still in easing mode. Our Russia team is looking for 150bp of rate cuts in 2010 and a first rate hike only in 1Q11.

Exit from ultra-expansionary policies does not mean a move to neutral: Barring a major policy error, the exit from ultra-low interest rates should not mean a removal of accommodative monetary policies. The GCB is unlikely to move rates back to neutral in 2010 - and there appear to be no dissenters on this ‘vote'. As the experience of front riders in the monetary peloton has shown, sharp interest rate hikes when major central banks are still in expansionary territory creates headwinds via currency appreciation and reduced policy traction in asset markets. Very few of the smaller economies will be able to hike aggressively, given these headwinds and weak export sectors in 2010, while monetary policy in the larger economies will be constrained by the BBB recovery. Thus, the ‘AAA' liquidity cycle (ample, abundant, augmenting) is likely to remain largely intact in 2010. The slow exit to a relatively less expansionary stance and the arrival of a sustainable recovery will be a key combination that will support growth and asset prices, in the G10 and even more so in emerging markets.

The major players in the peloton will begin to assert themselves - with implications for others: Excess liquidity supplied by major central banks will continue to be a driving force in 2010, and other central banks have little choice but to be highly cognisant of the changing dynamics. As the major central banks start to tighten in 2H10, the rest of the world will likely inherit rising bond yields and likely softer equity markets. This is nothing short of a de facto tightening for other central banks, most of whose economies and financial markets are linked to the major ones. There are at least two implications that arise from this move. First, the front riders who are already a pace ahead will be reined in as the peloton catches up, probably requiring that the early hikers pause or at least slow down their tightening campaign. Second, central banks that are likely to tighten around the same time as the major central banks will have to be nimble, tightening by less if the major central banks are more aggressive than expected, or vice versa. Both of these implications will have an impact not only on market pricing of policy rates, but also on currencies. Interestingly, investors may view these as plays on the smaller economies, or an alternative and probably less crowded way to play moves by major central banks.

However, inflation risks will slowly emerge as a worry: As growth shows signs of being sustainable, goods prices should find some support and markets will likely start worrying about the inflation-output trade-off. On three occasions in 2H09 (the dovish response of central bankers to the pricing in of rate hikes in August-September, the dovish statement after the previous FOMC meeting and Fed Chairman Bernanke's speech on November 16), the rally in front-end rates was accompanied by a widening of long-term breakeven inflation rates. 2010 is likely to see more of the same since central banks are unlikely to be aggressive in their exit strategies.

In the G10, the decline in potential output growth complicates monetary policy in two ways. The accompanying decline in the natural rate implies that policy rates have less room to go upwards before they reach neutral territory. This is likely to make central banks more cautious as the level of rates goes meaningfully above their current values of near-zero. Second, a fall in potential output growth directly implies that the output gap could close at a brisk pace as the recovery becomes entrenched, taking away some of the headwinds that inflation currently faces. Further, in an earlier note we have argued that inflation expectations are not well anchored. This is evidenced by the strong divergence in views among investors and even professional forecasters (see "Priced for Perfection... For Now!" The Global Monetary Analyst, November 18, 2009).

Emerging markets also face inflation risks, particularly those with fixed exchange rate regimes. These economies import the expansionary stance of the major central banks via the fixed exchange rate. In the absence of nominal exchange rate flexibility and aggressive interest rate hikes, macroeconomic adjustment is likely to happen via the real exchange rate, i.e., by pushing up prices in EM faster than in the G10. In a nutshell, until the ultra-expansionary monetary stance - through traditional policy rate tools as well as unconventional measures - is successfully reversed, inflation risks will likely remain in the system. Not because central banks cannot act aggressively, but because they may not.

United States
The Fed Will Exit in 2010
By Richard Berner & David Greenlaw | New York
Slow exit initially means steeper yield curve. The Fed will begin the gradual exit from its ultra-accommodative monetary stance in 2010. Three forward-looking factors will drive policy decisions: Inflation expectations are starting to rise, slack in the economy is narrowing, and the outlook for inflation will begin to change by mid-2010. We think officials will implement the exit strategy in two stages: First, the Fed will start to drain reserves when Large-Scale Asset Purchases (LSAPs) end. Second, it will begin raising the policy rate in 3Q, to 1.5% by year-end and 2% in 2011. Normally, the start of a tightening cycle will flatten the Treasury yield curve. Not this time, at least initially. We agree with our colleague Jim Caron that forward yield curves are too flat because the market expects the Fed to tighten aggressively (see 2010 Global Interest Rate Outlook: the World Is Uneven, November 30, 2009). While we expect more tightening by year-end than is in the price, we think the Fed's gradual exit, a rise in private credit demand and a significant shift to coupon issuance will boost Treasury yields by as much or even more than the policy rate by year-end. With growth risks tilting from balanced to somewhat higher, the rising rate scenario may unfold sooner rather than later.

Fed commentary reinforces the notion that any rate increases, at least through mid-year, are more likely to be at the back end of the yield curve than at the front. Fed officials have yet to indicate any change in their extremely accommodative policy stance. They have made their intentions abundantly clear in post-FOMC meeting statements, in the minutes of FOMC meetings, and in speeches. At the November FOMC meeting they affirmed that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period". With inflation likely to stay below the Fed's preferred level for some time, and the growth outlook improving but still uncertain, the costs of moving too soon are probably higher than those of being somewhat late, so Fed officials would rather err on the side of accommodation. Thus, at the upcoming FOMC meeting on December 15-16, officials likely will acknowledge the improvement in the economy, but probably will make only minor changes to the language in the statement following the meeting. More significant changes are likely in early 2010 when there will be additional signs of progress toward recovery in the labor market and inflation expectations have likely edged up a bit more.

Starting the exit still leaves the stance of monetary policy extremely accommodative. While officials are ready in an operational sense to implement their exit strategy, implementation is several months off. Indeed, far from exiting, quantitative easing will continue to add stimulus for the next few months. Barring any change in the current timetable, the Fed will continue to purchase about US$250 billion more RMBS and agency securities in its LSAP programs through the end of March 2010. The additional purchases will boost the Fed's overall balance sheet to US$2.5 trillion from US$2.25 trillion currently, and we assume that as a byproduct the Fed will also allow excess reserves to rise to about US$1.3 trillion from US$1.1 trillion. In addition, the timetable for exit is conditional on the outlook. As discussed below, the Fed is closely monitoring three criteria for exit, and we expect them to be met gradually.

However, ending the LSAPs does not mean that broadly defined monetary policy will suddenly become more restrictive. The LSAPs were aimed at boosting economic activity by keeping longer-term private interest rates lower than they would otherwise be. As Brian Sack, who runs the Fed's Open Market Desk, noted last week, the process works for Treasuries by narrowing the term premium, or the expected excess return that investors receive for their willingness to take duration risk. For mortgage-backed securities, the LSAPs remove the negative convexity of MBS associated with prepayment risk from the market, keeping rates lower than they would otherwise be. These portfolio balance effects operate through the levels of Treasuries, MBS and Agencies held on the Fed's balance sheet as a result of the LSAPs. To be sure, the purchases themselves, or flows of those securities, might also have an impact on rates. But the important point is that the impact on interest rates will persist after the purchases end, and will only fade slowly as the portfolio passively runs off. While the Fed could sell securities from its portfolio to reverse those effects, officials have given strong indications that such actions would constitute an extremely aggressive move toward restraint that is unlikely to be needed.

We assume that the Fed will implement the exit strategy in two stages. First, using large-scale reverse repurchase operations, officials will begin to drain excess reserves (held primarily on deposit at the Fed) from the banking system at the end of 1Q. The purpose is to bring the fed funds rate up to the level of the interest rate paid on excess reserves. As the LSAP portfolios begin to run off, reducing the asset side of the Fed's balance sheet, the volume of reserves in the banking system would not change unless the Fed takes such action. The gradual draining of reserves will also signal that policy will eventually be moving towards restraint. The second stage of the exit strategy will involve raising the policy rate: Assuming that the criteria for exit are satisfied, we expect rate hikes will start in 3Q, with the policy rate going to 1.5% by year-end and to 2% in 2011.

What are we and the Fed watching to trigger exit? Three related criteria will set the timetable for exit: Changes in inflation expectations, and changes in the outlook for slack in the economy and for inflation itself. In our view, all three are starting to change. An ultra-accommodative monetary policy and its adjunct, a weaker dollar, have begun to boost inflation expectations; capital exit is helping to lift operating rates, and growth will soon move above trend. So, while core inflation itself will decline for the next few months, these factors should promote a bottoming in inflation and a change in the inflation outlook.

Exit scorecard. Inflation expectations are gradually rising; 5-year 5-year forward breakeven rates have moved up close to 2.5% in recent weeks, and 5-10 year median inflation expectations measured by the University of Michigan's consumer surveys have drifted up to 3%, or the high end of the recent range. That gentle rise is far from alarming. But it does reflect an incipient tension between the current stance of monetary policy and the improving economic and inflation outlook, and we believe that inflation expectations will continue to rise until the Fed signals a shift in policy. Economic slack by any measure is still at record levels, with the ‘output gap' at more than 6% of GDP. Industry operating rates have risen from their lows to 70.7%, but are still below previous record lows, and the unemployment rate at 10% is still at a 26-year high. Meanwhile, we think core inflation is headed lower in the near term, thanks to the slack in labor and product markets, including housing. From current levels of 1.7% (CPI) and 1.4% (personal consumption price index), we expect core inflation to decline to 1% by early in 2010. But an improving economy will narrow all three measures of slack, and together with the ongoing rise in commodity and import prices, that change should alter the inflation outlook for the second half of 2010 and 2011.

The case for sustainable growth. Four factors should promote sustainable growth through 2011: 1) Monetary policy has fostered improving financial conditions and market healing; 2) fiscal thrust is poised to translate into fiscal impact; 3) strong growth abroad will lift US exports and earnings; and 4) economic and financial excesses are abating. On the last point, housing and inventory imbalances are diminishing, companies have slashed capacity, and employment is now running below sustainable levels.

Healing in financial markets, credit crunch abating. We think that the combination of aggressive policy stimulus, the dramatic improvement in the functioning of financial markets, higher prices for risky assets, and the recent slower pace of tightening bank lending standards will increase the chances for sustainable recovery. To be sure, the Fed's Senior Loan Officer Survey indicates that banks were still tightening lending standards in October, but at a slower pace, and it's pace that matters for growth. Tight lending standards are still depressing the level of lending and thus output, but their effect on growth is abating. We find that a 10-point drop in the proportion of banks tightening standards allows a one percentage-point increase in bank lending growth (see Calibrating the Credit Crunch, November 20, 2009).

Lasting fiscal impact. A second support for sustainable recovery comes from fiscal policy. We have emphasized that there are significant lags between fiscal thrust and fiscal impact, so that the effects of fiscal stimulus will not soon peter out as some have argued. Measured by the change in the cyclically adjusted federal deficit in relation to potential GDP, fiscal thrust should fall to about zero by the middle of 2010, and if the Bush tax cuts sunset as scheduled on December 31, thrust could turn into significant fiscal drag. However, we suspect that there are lags of 3-9 months between thrust and impact, so that fiscal impact will remain positive well into 2011. That is especially the case for infrastructure outlays, which at the state and local government level are only starting to show improvement in monthly data through October. Signs of relief are also showing up in state and local government jobs; they have risen by 35,000 over the past two months after declining by 143,000 in the previous year. In addition, there is upside risk to fiscal thrust itself, as Congress just enacted an extension to and expansion of the first-time homebuyer tax credit through April, plus increased jobless and Cobra benefits, and prospects have improved for a tax credit or other measures to boost employment.

Strong growth abroad. A key narrative in our global recovery story is the notion that growth in the emerging market economies will continue to outstrip that in the developed world. Strong EM growth is part of the reason why we believe US exports and earnings will grow vigorously. That is far from conventional thinking, as we are conditioned to believe that the US economy will be the engine for global recovery. Yet EM economies now account for 36% of world imports, up from 24% in the 2002-3 recovery. Contributing to our forecast of 3.7% aggregate global growth in 2010, EM economies are growing at a 5-6% pace, three times the pace of DM economies.

Exiting excess. Progress on reducing four areas of excess also increases the odds for sustainable recovery (see Exit from Excess: Setting the Stage for Sustainable Growth, September 14, 2009). First, housing imbalances are shrinking. Single-family homeowner vacancy rates declined from their peaks of 2.9% to 2.7% in 3Q, and further declines likely occurred this quarter; the inventory of unsold new homes dropped to 6.7 months' supply. We do worry that rising foreclosures could increase housing imbalances and the pressure on home prices, given the ‘shadow inventory' of yet-to-be foreclosed homes, reckoned by some to be 5-7 million. But the bust in housing starts has slowed growth in the housing stock to less than 1%, and with demand improving, fundamental imbalances are dwindling (see Assessing Housing Risks, November 30, 2009).

Second, inventory liquidation peaked in 2Q, and while companies continue to shed inventories that remain high in relation to sales, a slower pace of liquidation will add to growth through 2010. The swing in inventories added 0.9 annualized percentage points to growth in 3Q, and we estimate that it will add almost two percentage points at an annual rate to 4Q growth. That support won't end quickly, as production is still catching up with demand; in 3Q, GDP was still 1.1 percentage points below the level of final demand. We expect the production-demand gap to close over the course of 2010, adding 0.6 percentage points to 2010 growth through a slower pace of inventory liquidation, and a shift to inventory accumulation should add about 0.4 percentage points to growth in 2011.

Third, companies are reducing excess capacity at record rates: Capacity in manufacturing, excluding high-tech and motor vehicles and parts industries, has shrunk by 1% over the past year - a pace far exceeding the post-tech bubble bust. And capacity in another industrial subaggregate - including primary metals, electrical equipment and appliances, paper, textiles, leather, printing, rubber and plastics, and beverages and tobacco - has contracted by a whopping 2.7% over the past year. As a result, operating rates are rising again, up 250bp from their spring lows, helping to arrest the decline in inflation and laying the groundwork for renewed capital spending gains.

Jobless recovery less likely. Finally, we've argued that past aggressive payroll cuts make a ‘jobless recovery' less likely. Rising jobs and income are critical to promote a self-sustaining recovery. Rising income is needed to support consumer spending and to reduce debt/income and debt service/income ratios. It will also raise ‘cure' rates for delinquent mortgages and help consumers qualify for a loan.

In our view, past job cuts have virtually eliminated what were minimal hiring excesses and are likely now creating some pent-up demand. To gauge excess, we cumulate the errors made by a relatively standard relationship used to forecast labor hours worked and employment; positive cumulative differences suggest a labor overhang. After moving to zero in 2Q, the cumulative errors are now sharply negative. Moreover, early estimates indicate that non-farm payrolls were 824,000 lower in the year ended in March 2009 than currently estimated. That implies, if those revisions were all in private payrolls, that the current private job tally is 650,000 lower than at the trough in the last recession in July of 2003. As we see it, that implies some underlying pent-up demand for labor that should materialize in 1Q10.

That move to positive payroll growth may now be underway. Non-farm payrolls declined by just 11,000 in November, and with revisions, the 87,000 average decline in the past three months was the smallest since February 2008. Three other signs of solid improvement in labor markets emerged in November: a 52,000 surge in temp hires, typically a leading indicator of labor demand; a 12-minute jump in the private workweek, also a classic early sign of improved demand; and a partial reversal of October's jump in the unemployment rate, which now stands at 10%. A 0.6% surge in hours worked helped boost weekly payrolls (wage and salary income) by 0.7%, the biggest gain in two-and-a-half years. It's important to note that this improvement in labor markets has to go much further to assure recovery, especially to bring the jobless rate down close to full employment. But the recent rebound has been just as rapid as was the plunge when the recession began - an encouraging sign.

Don't get us wrong: There is still pain out there for consumers and lenders, and other headwinds to growth. But tracing the chain from rising growth abroad to US output, employment and income demonstrates that there is more to this recovery than cars, housing and other spending.

The case for higher real yields. Four factors should boost real longer-term rates significantly over 2010: 1) the circumstances surrounding the Fed's exit strategy, which will trigger a repricing of the likely path of the policy rate; 2) sustainable growth that will begin to lift private credit demands; 3) massive Treasury borrowing and a shift to coupons; and 4) uncertainty over fiscal credibility and inflation, which will lift term premiums.

Currently, fed funds and eurodollar futures are pricing in an 88bp move up in rates by end-2010, and a cumulative move by end-2011 of 205bp. While that is significantly more than what markets expected a few weeks ago, it is less than what we expect through end-2010. As a result, we think the market has more repricing of the yield curve to do.

Looming supply-demand imbalance and shift to longer maturities will push yields higher. Rising private credit demands and higher Treasury coupon issuance will push real yields higher in 2010 and 2011. Private credit demands will revive when businesses' external financing needs - at a record-low -2.5% of GDP in 2Q - turn positive and when household deleveraging gives way to new mortgage and other borrowing, if only at a moderate pace. When companies switch from inventory liquidation to accumulation, and when capital spending revives, corporate spending will outstrip cash flow again.

Although the US federal budget deficit may have peaked in F2009 (both in dollar terms and as a percentage of GDP), Treasury coupon issuance will continue to be pushed higher. This reflects an attempt to gradually boost the average maturity of the Treasury debt outstanding from its current level of about 4 years up to 6-7 years. Such a swing would take the average maturity from a historically low level at present to a level that is historically quite high. Thus, not only is gross coupon issuance poised for another sharp jump in F2010, but the average maturity of the issuance will have to move higher if the Treasury is to move toward a 6-7-year average maturity for the outstanding debt.

In short, we expect upcoming auctions to tilt steadily toward longer maturities, much as has occurred in the most recent announcements. The shift from 20-year to 30-year TIPS also supported efforts to boost maturities. The trend to longer maturities is likely to continue through mid-2010. Beyond that point, we suspect that short-dated issuance (2s and 3s) may be reduced while longer-dated supply remains elevated.

Why does the Treasury want to lengthen the duration of its debt? Treasury bill issuance soared in recent years and the average maturity fell, as is typical when there is a sharp and sudden spike in the borrowing need. The Treasury now wants to rein in the bill supply and begin to normalize the maturity profile. Why is it planning to go beyond historical norms? Treasury officials appear to want to create a cushion of borrowing capability at the front end of the curve in case there is a sudden need for short-term funding. Also, even though the Treasury's public position is that it is not an opportunistic borrower - i.e., it doesn't try to time the market - it appears advantageous to attempt to lock in low long-term borrowing costs at present.

One downside, two upside risks to growth outlook. We see one potential downside risk and two upside risks to this outlook. Rising mortgage foreclosures may threaten home prices, wealth and credit availability. We are not sure if the ‘shadow inventory' of yet-to-be-foreclosed homes is as high as the most pessimistic estimates have it. But even if the number of pending foreclosures is half that size, they will add to a looming supply overhang of unoccupied houses, and such additions may promote renewed declines in home prices as they come on the market in the spring. On the other hand, there are two important upside risks: Quantitative easing may have improved financial conditions more than we think, as hinted in risky asset prices and issuance volumes, and Congress is already adding further fiscal stimulus, which may take effect as the economy is gathering significant strength. For example, the recent extension and expansion of the first-time homebuyer tax credit will last through April 30, 2010, and other fiscal initiatives to boost employment are possible.

Euroland
An Economy in Transition
By Elga Bartsch | London
In 2010, the European economy should transition towards a more sustainable, albeit still sub-par recovery. This economic transition will be reflected by a shift in the engines of growth from a swing in the inventory cycle towards an ongoing recovery in domestic demand and net exports. This transition is unlikely to be smooth, though. Hence, investors should brace themselves for potential setbacks in the course of the next few quarters. Our own quarterly forecast profile suggests a gradual slowdown in growth momentum over the course of next year. Until some domestic demand dynamics start to materialise, the European economy remains in what could be coined as the no man's land of the business cycle.

Monetary and fiscal policy decisions to move from triage treatment towards long-term rehabilitation, we think. Thus, exit strategies will likely be a focus for financial markets. With few exceptions (the UK, Spain, Ireland), we don't expect any meaningful fiscal policy tightening next year. Hence, the fiscal policy issue is mainly about preparing the budgets for 2011 and beyond. These are likely to bring more meaningful tightening in order to ensure a return to fiscal sustainability over the medium term. As such, they will be key in shaping medium-term growth expectations too. Monetary policy, by contrast, will likely start exiting its current ultra-expansionary stance in late 2010. The anticipation of the new tightening cycle should cause higher bond yields, flatter yield curves and wider country spreads.

From an inventory-led bounce in industrial activity to a broader demand-based recovery. As expected, the European economy emerged from recession in mid-2009. The ignition was triggered by a turnaround in the inventory cycle, a normalisation in global trade flows and a policy-induced stabilisation of the financial system. With the global economy clearly having turned the corner courtesy of buoyant growth in emerging markets, and with the euro's unrelenting ascent having been stopped for now, a revival in external demand is already coming through in the quarterly GDP reports. The key question for 2010, however, is whether the initial spark that ignited the engine will translate into a broader domestic demand recovery. Until these domestic demand dynamics materialise, the European recovery remains vulnerable. There is no mistaking the considerable headwinds still faced by both consumers and corporates. After a steep decline in 2009, we therefore look for what probably is best described as a stabilisation in domestic demand.

Investment spending still struggles with subdued capacity utilisation and, what companies argue, are tight financing conditions. Yet, rising business confidence and rebounding corporate profits should suffice to create a small rise in machinery and equipment investment - consistent with repair and replacement and possibly some rationalisation projects - in the course of the year. Construction investment is a much more diverse story, driven by local property prices, public infrastructure projects and excess capacity issues. Public construction investment aside, we expect construction investment to lag behind capital goods investment next year. For the year as a whole, investment spending will likely stagnate due to a negative statistical overhang from 2009.

Consumer spending is to be dampened by a rise in unemployment, modest gains in wages and an increase in inflation. True, in terms of their debt load, balance sheets and savings rate, European consumers are in better shape than their US and UK counterparts. But, the lower number of layoffs recorded in Europe since the start of the recession suggests that part of the labour market adjustment is still to come - after all, activity shrank more sharply on this side of the Atlantic. Thus far, tighter employment legislation, voluntary labour hoarding and government-sponsored short-shift programmes have prevented an adjustment in labour costs. We see payrolls being trimmed further and expect the EMU unemployment rate to rise well into 2H10. Against the backdrop, and factoring in the expansionary fiscal policy measures taken by several governments, we forecast broadly stable consumer spending for 2010. After what likely will be a marked contraction in 2009, a stabilisation can already be regarded as an achievement in itself.

After a marked growth rise in the divergence between countries in 2009, we expect to see some renewed convergence in 2010. We expect export-oriented countries with sizeable industrial sectors, such as Germany and Sweden, to outperform in terms of headline GDP growth. However, the bigger bounce-back partially reflects that they were hit harder by the global trade slump than many of their counterparts. We expect other countries such as Spain and Ireland, who were hit hard by the financial crisis, to continue to underperform as they work their way through the aftermath of a property price bubble, a construction boom and a saving-investment imbalance. Both are making good progress though in rebalancing their economies and should be able to return to positive GDP growth in 2011.

We expect the ECB, the BoE and the Riksbank to start raising rates gradually in 2H. In total, we expect the ECB to and Riksbank to hike by 50bp and the BoE by 75bp by the end of next year (see UK Economics: Later Rate Rises, December 2, 2009). In conjunction with raising rates, central banks will also begin to unwind their quantitative easing (QE) measures. This unwinding might at least partially precede the first interest rate hikes but will unlikely be completed before the start of the new interest rate tightening cycle (see EuroTower Insights: Executing the Exit, November 11, 2009). The details of the unwinding of QE are largely determined by the QE strategy pursued during the crisis. The ECB and the Riksbank have resorted to passive QE via their various refi/repo operations. Hence, unwinding QE will affect the banking system directly and asset markets indirectly. Meanwhile, the BoE pursued a strategy of active QE, where it purchased assets directly in the open market. Unwinding these measures would thus likely affect markets more directly and banks more indirectly.

At this stage, there has been little indication that unwinding of QE or rate hikes are imminent. The ECB signalled that it is no longer willing to offer one-year funding at a fixed rate of 1% - instead opting for a tracker rate reflecting the average refi rate in 2010 - and that it will phase out its one-year and its six-month LTROs next year. The cornerstone of the ECB's QE, the fixed-rate tenders with full allotment (which allow the banking system to draw down unlimited funds from the ECB), will remain in place for as long as it takes though - at least until spring 2010. Under this operational set-up, the overall liquidity entirely depends on the bids submitted by banks - unless, of course, the ECB takes additional action (e.g., reverse tenders). Where the EONIA overnight rate and the EURIBOR money market rates trade relative to the ECB refi rate therefore depends on these bids too. Hence, in addition to the two factors that would normally drive EONIA - the ECB's decision on the refi rate and/or the deposit rate and the ECB's liquidity provision (notably the decision to drain liquidity from the system via conducting reverse tenders or by issuing debt certificates) - we have a third risk factor: banks' bidding behaviour. Thus far, overbidding by the banking system caused excess reserves to swell and pushed market rates well below the policy rate. But this bidding behaviour could change, potentially causing the market rate to jump higher.

The unwinding of QE will likely have marked effects on money markets, bond markets and country spreads. The heavy use of the ECB's refi facilities allowed banks to become big buyers of bonds. Since the start of the crisis, euro area banks have added about €330 billion to their holdings - effectively indirect QE via the banks. These purchases have likely helped to lower benchmark bond yields. But the main beneficiary probably was the EMU periphery. Less generous liquidity provision next year is likely to have repercussions on the euro area government bond markets. After intra-EMU spreads were characterised by a high degree of co-movement during the crisis, reflecting systemic concerns, we think that country-specific factors are likely to play a bigger role again in 2010. The start of another ECB tightening cycle should also contribute to wider spreads across the board, as it has done historically. Eligibility for the ECB's collateral pool, which is scheduled to revert back to A- at the end of 2010, could become another country-specific concern for investors.