Overall prognosis: A game of two halves; good for all in the first half, less good for some – especially the West and Japan – in the second.
My essential prognosis for 2010 is that, whilst the US, Europe and Japan will NOT have a double dip recession in the sense that they will again endure two quarters of negative GDP growth, they will experience softness in the second half of 2010, creating a skewed ‘W’ growth profile for 2008-2010. Whilst this will weigh more on sentiment in the West and Japan, it will not impinge on eastern growth. That said, in Q3/4, equity markets everywhere are likely to pause or even decline in sympathy, though again more so in the West and Japan than in the East generally.
1. Currencies: Expect a stronger US Dollar (or at least a less pronouncedly weak US Dollar) in the first half of 2010 but only against the usual suspects £, €, Sw Fr and the Japanese ¥. To blunt domestic inflation, China will again allow marginal appreciation of the RMB prompting the China Club (Sing $, Kor Won, Taiwan $, etc.) to ease up also on FX intervention; too; stealthy India will do the same. The second half will see the US Dollar again weaken materially as an even tepid return to growth restimulates demand for imports (esp. oil) and so weighs on the US’s current account deficit. Declining participation by foreigners in Treasury auctions will also weigh on the Dollar. Commodity currencies will be firm throughout the year, but more so in the second half than the first, see diagram 1 – FORECASTING TRENDS FOR 2010 Diag.
2. Bond yields and the risk free rate: Continued funding of deficit shortfalls (met by continued Fed debt repurchases, i.e. monetisation) cause bond market indigestion and so further yield back up. Prematurely, this will start to do some of the Fed’s “Exit Strategy” work for it. Incumbent US politicians and even the Fed itself will decry this, as it will boost mortgage rates and the cost of capital, especially with mid-term elections looming. With little inflation facing the West, the ECB only tightens – minimally – in Q4; the Fed blusters, blinks and stays put. See diagram 2.
3. Economic growth: In the US, the second half will be more bumpy than the first, as mortgage rates and the cost of capital edge up before the recovery has gained proper purchase, so becoming self sustaining. Faltering US GDP growth requires a second stimulus package, partly negating the drag caused by the cancellation of the Bush tax cuts at the end of 2010. Expect Q3/4 data disappointments in the West, especially the US, see diagram 3 – FORECASTING TRENDS FOR 2010 Diag.
Why? A combination of the inventory rebuild boost wearing off; the banking system still not lending much to consumers; option ARM mortgage resets in the US (see diagram 4 overleaf); fading effects of the stimulus package; bond markets suffering from indigestion and so restricting sovereign debt issues and so fiscal stimulus; weaker bond markets forcing the Fed to hint at accommodation withdrawal; trade sanctions on China rebounding via lower US dollar asset purchases, esp. of Treasury Bills; and pronouncedly positive base effect of strong Q3/4 2009 washing out of the numbers. In Europe, export-oriented economies will outperform the build-houses-and-consume brigade. But for the PIGS, the exporters would battle with an even stronger Euro. The UK will see short-term growth prospects dim but longer-term ones improve after a weak Tory election victory. In Emerging Markets, growth will rebound strongly, with China and India, in particular, beating forecasts. As the year ages, commodity-rich countries will strengthen their growth profiles too, in line with rising commodity prices.
4. Global trade: Generally positive for 2010 but US trade policy (tariffs, quotas) will cause China to retaliate indirectly by recycling less of its surpluses into Dollar assets, so further weakening the US Dollar. Indeed, low-level ‘trade wars’ will become a feature of 2010 worldwide. Watch from China-ASEAN trade to accelerate in the wake of their free trade pact. Resource exporters will also see trade with Asia rebound strongly.
5. Emerging markets: Two types of Emerging Markets will emerge this year:
a. the water-skiers: those mainly current account surplus generators (plus India) who are pulled by their own growth motor-boats, often powered by an emerging middle class getting a taste for consuming more and saving less, and
b. the wave-surfers: those dependent on foreign capital to balance their current account deficits, and who are driven by the wave of liquidity that is the carry trade.
Medium term, the former group will materially outperform the latter, despite some experiencing occasional pull backs driven by over-valuations; amongst the latter, a few are even likely to get dumped by wipe-outs. All will generally perform well, though they could pause, even stumble, if a Western pull-back becomes contagious.
6. Equities: Most recoveries from severe bear markets experience a second down-leg. If this happens in 2010 – and I sense it will in the second half as there is too much gung-ho hubris around – the West will be hurt more than the others, though all could suffer if funds return to the “safety” of US Dollar “securities”. In particular, watch out for the negative base effects of Q3 and Q4 weighing on US and European equity sentiment.
7. Property: The US property crash will experience a second down-leg with economy-wide implications. The tepid strength of the economic rebound will be temporarily outweighed by the negative pull of the mortgage resets, see diagram 4. – FORECASTING TRENDS FOR 2010 Diag.
8. Commodities: Coal (coking then thermal) will be the biggest winner, then iron ore then copper. Oil will do well when it breaches $100/bl later in the year, though the colder the northern winter, the sooner this might happen, as stocks will be run down earlier. In the second half of 2010, when the US Dollar will again show pronounced weakness, watch gold and the platinum group metals. In this demand recovery phase, supply constraint will be the key determinant of likely price performance. World commodity demand will be ahead of forecast, mostly because Asia will grow more strongly than current consensus forecasts. That growth will also be more independent from western trends.
9. Western sovereign debt wobbles: This will be the story of 2010. Western debt issuers – and especially the deficit running Anglo-Saxons – will start to test the limit of the East’s patience and so test the capacity of debt markets to finance their seemingly never-ending and ever-growing need for deficit financing. Within the Eurozone, the patience of the surplus running North will be sorely tested by the deficit running South. Sovereign bond issues from weaker members of the West and a few amongst the rest (the PIGS, Iceland, Eastern Europe, Mexico, Argentina…) will see yields ratchet upwards and issue sizes contained, see diagram 5, 6 and 7 – FORECASTING TRENDS FOR 2010 Diag.
10. Keynesian democracy starts to test its limits: This is a multi-year story and will play out with increasing clarity and intensity as the coming decade progresses. The back-to-front logic, where the developed world core does not send net investment to the periphery but, instead, consumes 70% of the savings generated by that periphery, will start to reach its inevitable conclusion: break down.
With the Keynesian rounding error – the ongoing annual budget deficits of western democracies and Japan – edging upwards in an era when inflation is still well contained and if anything edging downwards, the East in particular is going to start saying “enough”, or at least demanding much higher yields for those savings that the West wants to borrow from the East.
Higher yields will compound the plight of the West as its cost of capital will concomitantly rise, so weighing on its economic growth.
In addition – and this is an increasingly likely and powerful proposition – the East will consume more and save less as well as instead recycle more of their own savings into its own developing bond markets, thus short-changing western sovereign debt markets.
Either way, the exorbitant privilege afforded to the western democracies whereby its deficits are funded by outsiders will gradually be withdrawn.
The result for western democracies and Japan will be rising bond yields with aging populations, an improving eastern skills and knowledge base relative to that of the West and the overall erosion of western pricing power, in part reflected in a rebalancing of currency values from West to East. This combination will create a sour cocktail for those low-threshold-for-economic-pain western political systems. And this sourness will become even less politically palatable if continued fiscal incontinence and continued commodity price strength eventually causes inflationary expectations and then inflation itself to re-ignite in both the West and Japan. Weakening western currencies could then close the loop and turn this trend into a vicious circle against the West and in favour of the East and commodity-rich countries.
This process will take time to play out. But – as the democracies of Iceland whose Parliament, the Althing, dates back to 930 and claims to be the world’s oldest, and Greece (how ironic considering democracy’s origins!) are already hinting – the systems of the West are not sufficiently robustly built so as to be able to survive and prosper on an extended diet of economic cold turkey.
As if all this were not enough, at some point in this process, the dam wall of home bias, which is holding back the residual savings of the West to a far greater degree than economic fundamentals would already tend to warrant, will start to crumble. The carry trade we know today will pale in comparison to the flood from West to East that will result when this dam wall bursts.
Michael Power, Phd (Economics), MA (International Business and Law), BA (Politics, Philosophy and Economics) is Strategist, Investec Asset Management.
