For financial advisors and their clients, the crucible test in the year ahead will be the extent to which financial markets provide decent portfolio returns. In order to do this, I feel it is important to take a broad view of the economy and financial markets and to discuss the conditions around which markets might thrive. I believe there are three important tests that investors should watch for in 2010. Together, these tests, or milestones as I refer to them below, will help shed light on the potential for meaningful portfolio returns for investors this year.
To begin, let’s return to the exercise I carried out last year when I set out three 2009 milestones for financial markets and economic performance. They were:
- U.S. housing prices stabilize
- Credit markets normalize
- U.S. economy resumes growth
Each of these milestones was passed in 2009 and an economic recovery appears to be underway. U.S. housing prices, as measured by the S&P/Case-Shiller U.S. National Home Price Index, have risen for two consecutive quarters, following eleven quarters of declines. Credit spreads, the difference in yields between corporate bonds and government bonds, have dropped sharply from their multi-decade highs reached in December 2008 and the London Interbank Offered Rate , or LIBOR (the interest rate at which banks typically lend to one another), has also dropped to below pre-crisis levels. And, the U.S. economy grew by 2.2% in the third quarter of 2009, after four consecutive quarters of economic contraction.
For 2010, I’ve set out three new milestones that will indicate a move from recovery to sustained economic expansion. I’ve included one for the economy, one for financial markets and one for economic policy.
- Sustained U.S. economic growth – quarter-to-quarter real U.S. GDP growth averaging at least 2.5% in 2010
- U.S. credit growth – a resumption of business and consumer credit growth in the United States
- U.S. Federal Reserve and federal government begin a retreat from stimulus – an increase in the U.S. Fed benchmark interest rate (Fed Funds) from its current 0 to 0.25%, and a shrinking U.S. federal government budget deficit.
These milestones are more complex than those we set for last year. That is a result of the dynamics of economies beginning a recovery and economic policies starting their exit from stimulus. The milestones are also U.S.-centric. This doesn’t mean that what happens in the rest of the world isn’t important. The health of economies and financial markets in the rest of the world is arguably more important in this recovery than in any other in recent memory – especially in the emerging economies and most especially in China. But, there are at least three good reasons for us focusing on the United States for signs of progress:
- the problems started in the U.S.,
- the U.S. was among the hardest hit by the financial market crisis and subsequent recession, and
- the U.S. remains a central player in the global economy and financial markets.
Let’s take a closer look at each of the milestones.
The first milestone, quarter-to-quarter real U.S. GDP growth averaging at least 2.5% in 2010, reflects the nature of the recovery that is expected. This is by no means a barn-burning rate of economic recovery. Indeed, it represents a weaker rate of recovery than has been witnessed throughout most of the post-war period. It is however a reflection of the two characteristics of growth we’re looking for: decent, though not exceptional growth, and some consistency. We look for an average of over 2.5% in the expectation that growth is not going to be absolutely consistent from quarter to quarter – in fact, it almost never is. But, the achievement of this milestone would pretty much preclude the realization of the pessimists’ worst fears – the U.S. economy might move back into contraction following a couple of quarters of growth, or into what some call a “double dip”.
The second milestone, a resumption of growth in U.S. business and consumer credit, would reflect two developments. On the business side, it would reflect the resumption in demand for business credit – something that has been sorely lacking in the recession – and that in turn would provide some evidence of an upturn in business investment, a necessary source of growth in the recovery. On the consumer side, a recovery in the growth of credit would indicate an increase in demand, but more importantly, an increase in supply. The point here is that banks, having made large numbers of loans that have gone bad, have been reluctant to lend to consumers. And, while no-one is looking for American consumers to binge on credit as they have in the recent past, growing consumer and business credit is a necessary condition for economic recovery, since increasing demand for credit is a sign of increasing confidence on the part of the borrowers.
The third and final milestone involves both monetary and fiscal policy. While the stimulus has been crucial in getting the U.S. economy and financial markets back on their feet, it is equally important for the stimulus to be withdrawn in the right way and at the right time. Too much stimulus, for too long, would raise the possibility of economic over-heating and an unwanted rise in inflation. As well, both the Fed and the U.S. federal government need to get back to their respective ‘neutral’ policy stances in order to reload their policy ammunition for what ever economic/financial market issue might lie down the road, and, specific to fiscal policy, to move toward the point (i.e. a balanced budget) where the U.S. government can begin dealing with the mountain of additional debt it has accumulated over the course of the crisis.
There is also a much broader, symbolic significance in reaching the third milestone. A change in monetary and fiscal policy will highlight policymakers’ confidence in a self-sustaining recovery and that highly stimulative policies are no longer needed. The first increase in the Federal Reserve’s benchmark interest rate – the Fed Funds Rate – will mark only the first step in moving interest rates back to more normal levels, and when it happens, it will mark a crucial piece of judgment by the Fed that economic conditions are appropriate for it to do so.
On the government budget side of things, spending restraint will be an essential component in moving U.S. public finances back to a sustainable state. But, revenue growth is also important to watch because one of the reasons the U.S. government went into deficit in the first place – a reason that any government goes into deficit in a recession – is that revenues have fallen off. Companies make less money, or no money at all. People lose jobs, or work less hours, their incomes decline and they pay less tax. So, the first indications that revenue growth exceeds spending growth will be another meaningful indicator of economic recovery.
As important as the U.S. is, we should spend a moment on what to look for in relation to Canada’s return to sustainable growth. Much of the current analysis points out that economic growth will be focused on domestic demand. Canada’s exports got hammered in the recession and the prospects of a relatively modest recovery in its largest export market – the United States – along with a relatively high Canadian dollar mean that Canadian exports will face some headwinds in 2010. A notable bright spot on the Canadian export front is that other geographic areas of the global economy will likely recover faster than North America and Canada is well placed to expand its export presence there.
Canadian monetary and fiscal policies will need to be pulled back from their current strong stimulative stance. The Bank of Canada may be in a position to raise its benchmark rate for overnight funds just a little sooner than the U.S. Federal Reserve because the economic damage from the recession appears to have been less severe in Canada. Also, the Canadian federal government has indicated publicly that it recognizes the most important component of returning to a balanced budget in Canada will be government spending restraint.
In short, a recovery is a dynamic process. There will inevitably be bumps in the road. Just as there were many opinions in 2008 and 2009 as to how deep and how long the recession would be, there are many opinions as to how the recovery will unfold in 2010. Every recovery has its own characteristics. One specific to this one is the importance of the stimulative monetary and fiscal policies being maintained long enough to give the recovery substance and being withdrawn in a timely fashion to ensure its sustainability. Ultimately, when we add everything up, the indications are that we should have higher expectations for 2010. At the same time, what we have been through in the past couple of years suggests that sensible caution should also be part of our mental tool kit. Investors who had long-term investment plans dealt much more easily with the financial crisis and economic downturn than those who didn’t. As we cross the 2010 milestones, those same investors should also do better in the recovery.