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Potential for Big Upside Economic Surprises for USA in 2011

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In light of new data, economists have been furiously revising their GDP growth forecasts upward. But their predictions are still too tepid. Here's why.

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Up until one month ago, consensus GDP growth forecasts for the US were at about 2.6% -- hardly anything to get excited about in terms of the impact on employment growth, inflation, or corporate earnings. However, in the past few weeks, in light of new data, economists have been furiously revising their forecasts upward, and I expect that by the end of December, consensus forecasts will probably reach around 3.25% for 2011.

Such forecasts are far too tepid, in my view. My own base case scenario is for US GDP growth of 4.75% in 2011 with most risks skewed to the upside. GDP growth above 5.75% is a real possibility.

The Key Factors for US Upside GDP Growth Surprise

1. GDP run rate is clearly accelerating past 3.0%. The run rate for GDP growth in the fourth quarter of 2010 is well above 3.0%, and is clearly accelerating, according to virtually every available concurrent or advance measure of economic activity.

2. Tax compromise will boost growth significantly. I think most people have not yet understood how stimulative the tax compromise will be to US GDP growth in 2011. First of all, the 2% cut in payroll taxes will provide a very significant boost to consumption. Second, the extension of unemployment benefits will not really be a marginal boost to growth, but it certainly eliminates a major looming risk to the recovery. Third, nobody really knows what effect raising the top marginal rates would have had on growth, and at least this source of uncertainty has been eliminated.

Most importantly, the tax provisions allowing full or partial expensing of capital expenditures in 2011 could provide a huge boost to investment spending by businesses. After the crisis of 2008-2009, US firms have been extremely reticent to upgrade or purchase new equipment. As a result, there is significant pent-up demand. The "bonus depreciation" rules will cause many business managers to pull the trigger on investment projects. Furthermore, corporate cash levels are at all-time highs and access to credit has become normalized thereby facilitating such investments.

Overall, I believe that the tax compromise bill -- particularly the payroll tax cut and the "bonus depreciation" provisions -- will boost 2011 GDP growth by at least 1.0% above its current run rate. Indeed, the overall boost could actually exceed 1.5%.

By the way, I am not saying that the tax compromise is or is not good long-term policy; I am merely saying that it will jazz growth in 2011.

3. Consumption is set to accelerate sharply. For all the endless talk about the overleveraged US consumer, the fact of the matter is that this was always somewhat of a myth. About 30% of Americans have no debt whatsoever and another 45% have debt burdens that are well within reasonable levels. Twenty-five percent of Americans have some sort of debt problem, but the decrease in consumption due to strains within this cohort has already been fully absorbed by the economy and this is no longer acting as a drag on growth statistics. To the contrary, the 25% that have been in trouble have been busy restructuring the past couple of years, and spending from this segment is actually set to begin to grow modestly from depressed levels.

Even the non-segmented statistics show that Americans have deleveraged very substantially in the past two years. As can be seen below, their financial obligations as a percentage of personal disposable income have fallen very sharply and are now at levels that are below the historical average since 1980.



This and other data show that that Americans have the means to spend at rates that are in line with trends of the past few decades. But, will they? I certainly believe that they will in 2011. American consumers have been postponing expenditures for over two years now, which means that there is significant pent-up demand. The implication is that as soon as consumers feel that the economic recovery is solid and that their jobs are relatively secure, they are going to make significant expenditures. This is going to impact consumption numbers in a big way.

Those that doubt that this could occur should take a look at the gangbusters 2010 holiday shopping season data. This is just a preview of what could be coming in 2011 as consumers shed some of their inhibitions. Remember, the 2010 holiday spending occurred in the context of a relatively anemic economic recovery and relatively high levels of perceived job insecurity. As explained below, growth in 2011 will be much more vigorous and the employment situation will improve substantially, thereby greatly increasing not only overall incomes but the propensity to spend as consumers gain confidence in their economic security.

I expect accelerated consumption to boost GDP by around 1% from the current run rate in 2011.

4. Foreign trade will be a bright spot for the economy. US exports are surging and should continue to grow strongly in 2011. Furthermore, import growth is slowing as domestic production is replacing imports in many instances. There are many factors underlying these incipient trends in the US trade accounts, not least of which are vigorous global growth (particularly in emerging markets) and a weaker USD.

Global growth should remain strong in 2011 and the USD should continue to weaken against most of the currencies of the US's major trading partners, with the possible exception of Europe. While increased exports should provide a solid boost to GDP, the rate of import growth in 2011 will be a wild card. Even if net exports do not boost GDP statistics substantially in 2011, the knock-on effects of increased activity in the external sector will boost consumption and investment through increased business spending on employment and equipment, thereby indirectly boosting GDP.

I believe direct and indirect effects from acceleration of foreign commerce could add north of 0.5% to GDP in 2011.

5. Employment could be the real surprise in 2011. Virtually nobody is expecting vigorous employment growth in 2011. If my predictions above prove correct, I think employment growth could provide a completely unexpected boost to the US economy and thereby have an electric effect on financial markets.

In an article entitled Prospects for a Strong Recovery in Employment, I laid out a detailed case for larger-than-expected employment gains. I recommend readers review it. In it, I explain that during the 2008-2009 crisis, employment declined by much more than the reduction of economic activity would have warranted. Indeed, GDP is already back to pre-crisis levels, but overall employment is way below pre-crisis levels (-7.4 million jobs).

It has been my view that to a significant degree, outsized productivity gains in late 2009 and 2010 were due to unsustainable understaffing by firms, and that as soon as business confidence normalized, employment would grow disproportionately. I believe that this dynamic of employment "catch up" was underway in the early part of 2010 through May, but the severe financial crisis in Europe and the related global financial markets' turbulence interrupted this trend and caused US businesses to postpone hiring decisions fearing spillover effects for the US and global economy.

I believe that as firms gain confidence in the strength of the US and global economies, hiring will accelerate strongly as there is a significant pent-up demand for labor at US companies.

Various indicators are showing incipient signs that employment could really take off. In addition to the indicators reviewed in the cited article, surveys by Manpower, Bank of America, and the Business Roundtable are showing net hiring intentions for 2011 at very strong levels. I was particularly impressed by the Bank of America survey that revealed that company CFOs at large firms were expecting strong hiring in their own companies despite being quite downbeat about the prospects for the US economy in 2011. This is precisely the sort of divergence that could make this data more significant.

I would like to say a word about such divergences. Currently, there is a general pattern manifesting itself in surveys that measure people's opinions about the economy (e.g. consumer sentiment, CFO forecasts). Such opinions about the strength of the general economy are still at extremely depressed levels; this, despite the fact that the respondents' actual behavior is reverting to normalized levels. I view these as bullish divergences because, in general, consumers, managers, and entrepreneurs know a whole lot more about their own economies than they do about the macro economy. Furthermore, economic behavior and data tend to exhibit auto-reverting tendencies, and as such, aggregating data on people's behavior now (and/or their intended immediate behavior) will tend to be much more predictive of their future behavior than their stated predictions regarding others' (or even their own) behavior in the future. Finally, people are trend followers and their opinions tend to change only after the facts are already fairly obvious.

People's opinions about growth will tend to lag actual growth in the initial stage of a cycle. The catching up of perceptions regarding economic growth with actual economic growth is one of the phenomena that actually drives and defines a self-sustaining economic cycle.

In this same vein, small-business confidence is still depressed by recent norms, but has been trending very strongly toward the mean in the past few months -- a fact that is very important since 70% of job growth comes from the small-business sector. Finally, indicators such as new unemployment claims, job openings, and quit-rates are signaling a possible imminent turn in the labor market.

Based on my own eclectic mix of macro econometric and qualitative forecasting models, I think average net monthly job gains could surpass 325K per month in 2011.

The effect of such a prediction is highly significant to a GDP growth forecasting. Not only does increased employment boost income and consumption, it increases the sense of security of those people that have jobs, thereby boosting overall consumption. A boost to employment of the above magnitude could have a net marginal impact on GDP of 1.5%, above and beyond the factors cited previously.

Risk Factors for US Growth in 2011

1. Rising interest rates. Strong GDP growth in the US and elsewhere in the world will ignite fears about inflation and cause interest rates to rise. In my opinion, at current rates of inflation, the US economy can handle nominal 10-year Treasury yields as high as 4.25% without any major impact on growth. Indeed, the US economy can withstand even higher yields if inflation were to accelerate as it is real, not nominal, interest rates that really matter to growth. For example: If inflation were to accelerate to 3.0%, 10-year bond yields at 5.0% would be manageable, particularly if short-term interest rates stay low for a prolonged period, as I expect they will.

Still, accelerating inflation and rising interest rates could become an issue and begin to have a cooling effect on US growth in the second half of 2011.

2. Oil-price shock. With the US growing at a fairly low rate, oil prices are already above $90. A US growth surprise could cause oil prices to spike. Oil prices beyond $150 per barrel are not unthinkable, and they could pose serious problems for the US economic recovery through their impact on consumer and business sentiment.

3. European crisis. Europe is not well. The fate of Europe hinges on Spain and things in the economy of the Iberian nation are quite precarious. In the event of a crisis in Spain and Europe, turbulence in financial markets could negatively impact general business and consumer confidence in the US. Furthermore, a strong dollar is a net negative to US GDP growth.

Having said that, it is my view that the situation in Europe would have to become absolutely disastrous for the recovery in the US to be jeopardized. US bank exposures to European credits are relatively light, and funding should not be a major concern given the activist stance of the US Fed. Furthermore, the "flight to quality" effect on US interest rates would partially offset deterioration of US net exports vis-à-vis Europe.

In sum, crisis in Europe can cause some havoc in financial markets, but it is unlikely to derail the US economic recovery through direct fundamental channels.

4. China inflation / growth slowdown. As I pointed out in my article, Why Inflation In China Could Get Out of Control, high rates of inflation in China will soon become a reality. The only viable solutions to this problem will entail a slowing of the Chinese growth rate to below 7% per annum. I do not believe global markets will take too kindly to the end of Goldilocks in China and the introduction of a perennial inflation versus growth dilemma. Thus, Chinese problems could have some indirect effects on US economic activity through the medium of global financial markets turbulence.

But fundamentally speaking, this developing situation in China is a neutral or net positive to the US in terms of growth. First, a growth slowdown in China would cool off global commodity prices, a net plus for the US which is a major importer of commodities. Second, high inflation in China makes it far more likely that Chinese authorities will allow a major revaluation of the yuan. This would be quite stimulative to US growth.

Conclusion

The US economy is poised to surprise very strongly to the upside. This sets up a very strong contrast to the generalized fears of a double-dip recession and the deep pessimism that pervaded financial markets throughout the summer of 2010.

I do not believe investors have fully priced in the dramatic turnaround in US economic activity and employment that I foresee in 2011. While consensus estimates for US GDP growth have risen dramatically in the past few weeks from about 2.6% to somewhere north of 3.0%, it is my view that the US economy will grow at a 4.75% real annual clip.

While there are substantial risks that could negatively affect this relatively bullish forecast, I actually believe most of the risks to this forecast are to the upside.

The implication of these forecasts for financial markets? It's pretty obvious: Bearish for bonds, bullish for stocks. Among stocks, sectors that are economically sensitive and that are US-based global exporters should be favored.

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No positions in stocks mentioned.
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