The 2010 Market Outlook. The road to normalization passes through the Fed’s balance sheet. Key Points:
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The road to normalization passes through the Fed’s balance sheet.
1. The recovery is underway and will be sustained in the absence of more financial landmines or policy missteps in Washington. Housing and mortgage imbalances pose the biggest organic threat to the recovery.
2. The tempered tone of the recovery fits the mold of other post-1990 recoveries at least in part because of an ongoing restructuring of consumer balance sheets that bodes for moderate consumer spending and a housing sector has pulled out of a nosedive, but continues to be burdened by significant imbalances and mortgage distress.
3. The threat of deflation appears to have subsided. The impressive productivity growth and slack in the economy will continue to suppress inflation pressure. The decline in the dollar has played a significant role in easing deflationary pressures, and could trigger an inflation revival should it persist.
4. Monetary policy in 2010 will be characterized by nuance early in the year and forceful implementation of the Exit Strategy late in the year. We expect the FOMC to keep the fed funds rate in the current targeted range of 0% to 25 bps for most of 2010 before eventually tightening in the fourth quarter of 2010. We also expect the FOMC to take very deliberate and transparent steps before utilizing all available tools in the eventual implementation of the Exit Strategy.
The U.S. economy is in the second quarter of a recovery that will be sustainable in the absence of another round of financial distress or policy missteps in Washington. To date, the recovery has been similar to the two prior post-1990 recoveries, as growth has been moderate and the labor market has continued to struggle since the onset of the recovery. The economy grew at a 2.2% rate in Q3 and appears to be on track to grow at a 3.5% to 4% rate in Q4. Including an expected deceleration in growth in the first half of the year, GDP growth will approach 3% in 2010, and gain momentum as the year progresses.
Consumer spending accounted for more than 2 percentage points of the 2.8% increase in Q3 GDP growth, but consumer activity is unlikely to continue to be as robust in the quarters ahead in the absence of more targeted stimulus. Due primarily to the continued struggles in the labor market, a restructuring of consumer balance sheets and festering mortgage distress, consumer spending will moderate. We expect consumer spending to contribute less to GDP growth and comprise a smaller share of overall GDP than was the case in Q3 of 2009 or has been the case in recent decades. Slower inventory liquidation and eventual inventory accumulation will also contribute to growth. Residential investment will make a modest contribution, while the housing and mortgage markets continue to work out a myriad of imbalances, but nonresidential investment and net exports will continue to provide a drag.
The Q3 growth of 2.8% was similar to the performance of the economy in the first quarter of the recoveries that ensued the 1990/1991 and 2001 recessions when the economy grew 2.7% and 2.6%, respectively. Q3 GDP growth was well below the 5.3% average growth rate of the first quarter of the recoveries in the 1970s and 1980s. The pre-1990 recoveries were also marked by a recovery in the labor market that has been absent in the post-1990s recoveries, including the current recovery.
The economy has lost more than 700,000 jobs since the end of the recession, and the unemployment rate has continued to rise. The labor market will begin to generate payroll growth early in 2010, but the unemployment rate will continue to rise before peaking late in Q1. The weak labor market and consequential modest income gains are primary reasons why targeted fiscal stimuli in the form of Cash-for-Clunkers and the first-time homebuyer tax credits have been necessary to jump-start consumer spending. Gradual improvement in the labor market will provide support for consumer spending, but the persistent stressed mortgage overhang and ongoing restructuring of balance sheets will limit the upside to spending.
While the economy will begin to generate payroll growth in the months immediately ahead, it is also likely that the unemployment rate will continue to rise before peaking late in Q1. While the peak in the unemployment rate tended to coincide with the trough of recession prior to 1990, the peak in the unemployment rate has tended to lag the recovery and stay high longer in recoveries since 1990. The lingering high unemployment rate will weigh on consumer sentiment and spending.
Over the past year, the overall CPI has fallen 0.2%, while the core CPI has risen 1.7%. The YoY CPI was down by as much as 2.1% in July, but the threat of deflation appears to have subsided and the headline CPI will be in positive territory immediately ahead. The decline in the dollar has played a significant role in easing of the deflationary pressures. July Import prices were down 19.1% on a year-over-year basis, but moved back into positive territory, with a solid assist from the dollar. Should the dollar continue to weaken, it would continue to provide insurance against deflation going forward. It will also pose a risk to an uptick in inflation were it to persist.
For the past year, the Federal Reserve has kept the federal funds rate at “exceptionally low levels.” With a steady target funds rate between 0% and 25 bps, the effective fed funds rate has averaged 16 bps to-date with year-end just around the corner. At the first FOMC meeting of 2009 on January 28, the FOMC policy statement indicated that economic conditions would warrant “exceptionally low levels of the federal funds rate for some time.” On March 18, Fed policymakers altered the policy statement to say “that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” The “extended period” language has been the key phrase of each policy statement since that time.
Prospects are that the Fed will continue to hold the fed funds rate near the zero bound well into the second half of 2010. The Jefferies view is that Fed will begin to raise the fed funds target in Q4, but prepare the market for the gradual implementation of a less accommodative policy stance well in advance of the implementation of a more restrictive posture. The first step in the long road toward a less accommodative posture will begin with a replacement of the “extended period” language with its predecessor “some time.”
This raises the question, what will this mean for monetary policy? It has been our understanding that the term “extended period” implied three FOMC meetings. Hence, every time the policy statement has utilized the “extended period” langue, it suggested that the FOMC viewed it unlikely that it would feel compelled to change policy for at least another three FOMC meetings. So, a reversion to the “some time” language would suggest that economic conditions were showing sufficient signs of improvement that the FOMC foresaw the possibility of initiating the Exit Strategy within the three meeting time frame.
3-month rate of change in the OECD leading indicator (%RHS) coincides with ISM (LHS)