The first part of December is a busy time for economists. People want to know what’s going to happen in the coming year. However, nobody’s clairvoyant. Forecasts are certain to be wrong. We can only tell you what to expect. The outlook for 2011 has been especially challenging, as the ground has been shifting under our feet. The tax proposal, the rout in bonds, and simmering concerns about Europe would seem to have significant impacts on the growth outlook, and they do. However, as with any economic recovery, positive forces battle it out with negative forces, with the positive force eventually dominating. Along the way, the pace is typically uneven across time and across sectors. That implies some volatility in the markets as investors debate the strength of the recovery.

Let’s start with the negatives. The housing sector is expected to remain a constraint on the consumer. Mortgage delinquencies and foreclosures are expected to remain elevated for some time, but problems should fade as the year wears on. The danger is that home prices could fall further, which would exacerbate problems and (through the wealth effect) dampen consumer spending growth. Ultimately, a recovery in the housing market depends on a recovery in the job market. Even if the economy were to see rapid job growth (250,000 to 300,000 added payroll jobs per year) it would take years to recover the jobs lost during the downturn (and to absorb the millions of new entrants to the workforce in over the last few years). While the housing market problems will be severe for many households, the aggregate impact on the economy should not be too severe (not enough for a double-dip recession).

State and local government budgets remain severely strained. Pressures have resulted in significant job losses. State and local government payrolls fell by 250,000 in the 12 months ending in November (while private-sector payrolls advance by about 1.1 million). While many people are against the government in general, it’s important to note that the decline in government jobs has a multiplicative impact on the economy. What about the “massive” increase in the federal government? Excluding census workers, federal payrolls rose by a whopping 11,000 (or 0.4%) in the 12 months ending in November. Part of that reflects a 41,000 drop (-6.0%) in U.S. Postal Service workers. Non-USPS federal payrolls rose by 52,000 (+2.4%). Note that some of the federal fiscal stimulus was aid to the states, which will go away in 2011. So budget strains will remain severe.

The European debt crisis is a slow-motion train wreck. The EU and IMF set up a €750 billion backstop in the spring. We’re now seeing that backstop being implemented. Each of the troubled economies has its own set of issues. The major concern with Greece was that its troubles would lead to contagion. Ireland, Spain, and Italy would be much bigger problems. The rescue for Ireland doesn’t appear to have solved much – it merely kicks difficulties down the road. Moreover, the prescribed medicine, austerity measures, don’t make the patient any stronger. Europe’s problems are not going to go away anytime soon. For U.S. investors, the issue will cycle on and off the radar screens.

What about the positive forces? Despite widespread criticism (which undercuts its effectiveness), Federal Reserve policy remains accommodative. With bond yields sharply higher in the last few weeks, the Fed’s asset purchase may be seen as a failure to many. One of the main goals was to lower long-term interest rates, which would encourage more bank lending and risk-taking. However, inflation expectations were a major channel for the Fed’s asset purchases. Inflation expectations, which had drifted down from spring to summer, rebounded once the Fed began talking about additional asset purchases.

Higher interest rates are not necessarily a bad thing for the economy. It depends on why they are rising. The tax cut package is expected to add $800 billion to $900 billion to the federal debt over the next two years (depending on what’s in the final version). So increased government borrowing is a factor. However, the tax cut package will be supportive to growth – but more of a non-negative than a strong positive. All else equal, stronger economic growth implies higher bond yields. Most likely, the recent rise in bond yields is overdone. Investors may be too optimistic about the holiday shopping season and about the economic prospects for the first half of 2011.

Lawmakers are trying hard to prevent the tax cut package from being labeled as “stimulus,” which has become a dirty word politically – but that’s what it is. As stimulus, tax cuts are not as effective in the current environment (as any extra money is more likely to be saved than spent for those at the high end of the income scale). However, the extension of unemployment insurance benefits and the cut in the employee-paid portion of the payroll tax will add to disposable income, the main driver of consumer spending. Note that while the Bush tax cuts will be extended two years, the unemployment benefits and the payroll tax reduction last only until the end of next year. That implies, as the stimulus goes away, some drag in early 2012. The pending expiration of the Bush tax cuts will be a critical issue in the second half of 2012, adding to business uncertainty.

Economic recoveries are never straight-line expansions. They tend to be uneven across time and across sectors. That means a continuation of mixed economic figures over the near term and further volatility in the financial markets as investors attempt to gauge the underlying strength. Volatility creates opportunities.

 

 

(c) Raymond James

www.raymondjames.com