In recent reports, we have been talking about the four pillars that inform our view that the U.S. economy will exhibit slower than normal growth for the next several years. Three of these pillars involve excess debt that needs to be worked off by consumers, banks and governments. The fourth pillar, under-saving by boomers for retirement, requires strong financial markets, increased savings and a stable or rising real estate market to fix. We are happy to report significant progress in resolving some of these structural problems. Let’s look at the good news first.
Consumers’ progress on their debt load is perhaps most striking. After reaching an historic peak of 13.9% in 2007, the percent of consumers’ income devoted to debt service has dropped to 11.9%, nearly back to its pre-2000 long term average. This reduction was achieved through repayments, lower interest rates, defaults and lack of growth in the base. Until October, aggregate consumer debt had fallen every month since late 2008. While still slow, this indicator grew in October and November, supporting holiday sales. If we can make headway on the employment front and see consumer incomes grow, we could see even more progress by consumers in handling their debt, clearing the way for more spending.
With the U.S. stock market up about 90% off of its lows in early 2009, boomers who stayed invested have recovered a substantial portion of the savings they lost in the Great Recession. And with the savings rate now stabilized at a mid-single digit rate (up from zero pre-recession), individuals are restocking their savings at a healthy rate. However, the uncertain state of the residential real estate market means that home equity remains an unreliable form of retirement savings. A lasting impact of the Great Recession, however, will be that boomers were reminded how fragile their savings picture really is and that working longer might be a desirable thing to do.
The picture for banks is mixed. Many larger banks have rebuilt their capital bases to the new higher standards and seem past the worst in terms of loan losses, at least outside of residential real estate. The larger banks also have the resources to cope with the blizzard of new rules arising from the Dodd-Frank financial reform bill.
For smaller banks, though, the picture is less bright. Long a bastion of real estate lending, many of their loan problems remain in work out. And capital is less available to them via the public markets. If that weren’t enough, Dodd-Frank raises their cost of doing business dramatically. In the banking business, talk has changed from “too big to fail” to “too small to exist.” With community banks often the source of lending to small businesses, we fear the availability of credit will continue to be restricted for some time to come.
Having helped the rest of the economy struggle through the Great Recession, many governments now find themselves in dire financial straits. Federal governments from the U.S. to Ireland to Greece to Japan are awash in deficits, with austerity programs and growth incentives running at odds with each other. While we believe it was smart to extend the Bush-era tax cuts, the Federal government is paying a higher price for its heavy debts as the Federal Reserve’s latest round of quantitative easing was met with substantially higher interest rates. (And all those who poured tens of billions into bond funds in 2009 and 2010 suffered bruising paper losses in a very short time.)
The budget problems of many large U.S. states have now come sharply into view as the press has homed in on the excessive promises -- and concomitant lack of funding – made to current and retired employees. Virtually no progress has been made in reconciling this problem even as state and local governments face declining property tax revenues as property values are marked down to reflect current market conditions. Increases in sales and income tax receipts in 2011 will provide a bit of relief. But with federal stimulus money running out in 2011, state and local governments face the prospect of draconian service (read, jobs) cuts to try to match revenues and expenses.
So there is reason for real optimism as we move toward resolving the structural problems left in the wake of the Great Recession. As we have previously reported, corporations are in great shape – earnings are strong, balance sheets are solid and revenues are growing. When we combine business investments with a solid, if not strong, contribution from consumers, we expect to see the U.S. economy grow around the long term trend (about 3%) in 2011. The biggest risk we see to the domestic economy is the lack of progress on employment and the real possibility that government sector cutbacks could make the problem worse in the near term. Residential real estate remains a wild card.
Looking back to the 1990s, it is fascinating to see how much has changed on the international front. Emerging markets have become the drivers of worldwide growth even while they have their fiscal houses in order. The developed markets of the U.S., Europe and Japan have become the laggards, with large, structural debt problems. In the short term, it is possible that markets have overplayed the stories of the emerging middle classes of India and China and the resource rich economies of Australia, Canada and Brazil. However, we believe these economies will be the primary source of global growth in the years ahead. In 2011, we expect to move client portfolios even more toward these growing economies as opportunities arise.
With a new spirit of cooperation in Washington (we’ll see how long that lasts!) and a realization that there is a great deal of work to be done to get our economy into jobs-producing mode, we are heartened that the spirit of optimism that has broken through near the end of 2010 will continue to drive the economy forward in 2011. Of course, markets often run ahead of the good news so we would not be surprised to see some consolidation of the gains in the first half of 2011.
The bigger change we will be watching for is whether the nearly 30 year rally in long term bond prices is finally over. If we are starting a long economic recovery with higher input prices (oil, grains and a broad range of other commodities), then we could see interest rates start back up the long down staircase they have been on since the early 1980s.