Published: January 05, 2011 in Knowledge@Wharton
The United States: Housing and Unemployment Risks
In the U.S., "the threat of a double dip [recession] has passed," says Wharton finance professor Richard Marston. The congressional compromise to extend the Bush-era tax cuts for two years should help the country's recovery, he predicts. "With the added stimulus of the tax bill, we will have continued growth in 2011."
Still, "there are some very severe downside risks," says Wharton finance professor Franklin Allen. One main concern is housing: Allen, Marston and other experts agree that the uncertain housing market will continue to be a drag on the economy.
"In the housing market, the data is going in different directions," Wharton real estate professor Susan M. Wachter notes. Some reports show sales picking up, while others show prices continuing to stagnate. "The bottom line is that we're bouncing along the bottom.... We're likely to be in a holding pattern." Fortunately, Wachter says, the weak housing market probably will not do too much additional damage to the economy, as most of the harm has already been done. New-home construction is not likely to go lower, for example.
According to Wachter, the housing market has enjoyed some stability because many lenders have been reluctant to foreclose and sell homes at fire-sale prices. A lender is typically willing to sell when a foreclosed property can fetch as much as the appraisers say it is worth, she says, but appraisers rely on backward-looking data that is quickly out of date in a volatile market, making it hard for the lender to know what a property is really worth.
Another problem, Wachter notes, is the recent rise in mortgage rates, which increases payments, makes homes less affordable and undermines sales. In addition, high unemployment reduces the number of potential buyers, she adds.
"The unemployment situation is still not good, and that's going to take a long time to change," Allen agrees. "There's been some upturn in consumer spending, but until things start looking better on the housing and unemployment fronts, I think [consumer spending] won't drive things forward."
While many U.S. retailers reported a good holiday season, it is not certain that consumers, who are the most important force in the economy, will continue to reverse the tight-fisted habits developed in the past few years, Allen says. Whether they have really loosened their purse strings or did so only for the holidays is unclear.
U.S. economic growth also could be hampered by ripple effects from the continuing debt problems in a number of European countries, Allen notes. In addition, economies are starting to overheat in some developing countries, especially China, he says. China has started to raise interest rates to curb inflation, but that could draw more foreign money into China, possibly depriving other countries of capital they need to speed growth while worsening China's inflation problems.
According to Marston, state and local governments in the U.S. face a debt crisis similar to those in Europe. "For a long time, government workers have piled up benefits that were not properly accounted for," he says. "This is as true in New Jersey as in Greece. With an economy not growing as rapidly as in the past, tax receipts are falling short. How this will play out in the case of state and local governments will be interesting. I think it's the main risk facing markets -- that they will be spooked by a default, or near default, here or there."
Allen is also concerned that the U.S. still does not have a long-term plan for dealing with its enormous federal budget deficit. "Until we have [a plan], that's potentially a huge problem," he says. The U.S. covers its deficit by selling government bonds, especially to China. Eventually, investors' recognition that this cannot continue indefinitely will cause bond prices to fall, driving up interest rates in the U.S. and other countries, and undermining economic growth, Allen predicts. "I think long-term interest rates will start going up, and then the dollar will start going down, and then inflation will start going up. The timing of all those moves will be very hard to predict."
Though the economy could continue to struggle, the stock market, which did well in 2009 and 2010, may continue to benefit from rising corporate profits, Allen notes. But he warns that earnings gains are largely due to cuts in labor that feed the high unemployment rate. "This is bad news for the economy as a whole."
Marston points out that by the end of 2010, the broad stock market had gained 86% from its bottom on March 9, 2009. "I expect further increases in stock prices this year," Marston says. "But let's face it: The best is behind us. The first 12 months of a rally following a recession are always the best."
Europe: Are Two Heads Better Than One?
In Europe this year, whoever takes over from Jean-Claude Trichet as head of the European Central Bank (ECB) in October will inherit a different set of issues than the French banker did when he began his term back in 2003, according to Allen. Back then, the euro zone's single currency was still in its infancy, and most Europeans were happy to give fiscal and monetary union the benefit of the doubt. But the European Union's big macroeconomic imbalances and debt crises that began with Greece's near-default last year and spilled over to Ireland, Spain, Portugal -- and potentially could affect Italy and Belgium -- have left plenty of skepticism over the lack of policy flexibility granted to members of the 17-nation euro zone (with Estonia the latest to join as of January 1).
The Frankfurt-based institution is expected to announce Trichet's successor this spring, and the appointment "will really matter a lot," says Allen. A frontrunner is Axel Weber, head of Germany's central bank who is seen as a close ally of German Chancellor and major euro proponent Angela Merkel. Another strong candidate is Mario Draghi, governor of the Bank of Italia, "who is extremely talented," notes Allen, "but I can't see the Germans allowing a southern European to head the bank."
All that will unfold as euro zone countries tumble through recovery at different speeds, depending on the range of austerity measures undertaken. But collectively, according to a recent report from Guillaume Menuet and Silvia Ardagna, analysts at Bank of America Merrill Lynch, "while the pace of recovery [in Europe] post the 2008 recession looks to be quite reasonable, overall levels of GDP have a long way to go before recouping output lost in the downturn." They add that the euro zone's "pre-crisis level of GDP is unlikely to be matched before the third quarter of 2012," and they forecast that GDP growth in the bloc will reach 1.7% this year, compared with 1.8% in 2010 and -4% in 2009. (Globally, they forecast GDP growth in 2011 to be 4%.) While by the spring the worst of the sovereign debt crisis is expected to be over, the analysts note that "since the existence alone of the [EU and IMF's financial] safety net has not proved a sufficient deterrent to arrest the contagion that threatens to engulf one country after the other, Europe must be ready to consider new solutions, including preventive action."
But thus far, for experts such as Allen, there are few signs that this is happening. "The level of the debate is going back to very basic stuff -- for example, they're talking about collective action clauses" to be included in sovereign debt contracts in order to protect investors. "It's good to have them, but that's not the main issue. It's financial stability." At the country level, "the politicians -- and the civil servants -- seem to have no idea about the dimension of the problem. What they have to do is basically revamp banking regulation to deal with ... sovereign debt," Allen states.
Beyond the traditional inflation-fighting concerns, the ECB's new head will need to guide the euro zone through a resolution of the region's sovereign debt woes. The 750 billion euro ($1 trillion) crisis-rescue fund the ECB and the International Monetary Fund put in place last May expires in 2013. According to Bloomberg, Weber expects the ECB to start withdrawing early this year some of its emergency measures, such as buying up the government bonds of the troubled countries to restore liquidity. What then? Will it agree to monetize the debt or allow countries like Portugal to default?
While the chances of the euro zone dissolving "in one go" are around 10%, predicts Allen, another option would be to have two euro zones overseen by separate central banks -- with France, Spain, Italy and the smaller countries staying with the current system, while the likes of Germany, the Netherlands and a few others join a new bloc. "In my view, that's probably the best solution to the problem," he says. "Rather than trying to force these very different countries with very different histories in terms of fiscal responsibility into one area, it would be much better to have two."
China Grapples With the 'I' Word
China watchers are beginning 2011 much as they did 2010 -- concerned about inflation. Though still low by international standards, consumer price inflation early last year was hovering at less than 2%. But since the massive monetary expansion of late 2008, liquidity continued to flood in, putting upward pressure on prices. Housing and food prices surged during the year, and a growing wave of discontent among workers seeking long overdue pay raises swept across the country. By November, consumer prices were up 5.1% year on year.
In a December report, London-based Economist Intelligence Unit (EIU) predicted that average year-on-year consumer price inflation will be 3.9% in 2011, helped largely by intense price competition among goods manufacturers. But this could change if, for example, wages increase and push up the cost of manufacturing, causing price hikes. Agriculture, which accounts for a sizable portion of the country's consumer price index, is arguably a greater concern. Local newspapers are reporting that blue-collar workers in cities like Shanghai are unable to stretch their meager paychecks to cover the rising costs of staples, such as milk and vegetables.
"Having stimulated the economy tremendously, the government now has to deal with the consequences of it," says Wharton management professor Marshall W. Meyer. He and others note that the country's enviable growth -- the EIU estimates that real GDP growth in 2010 will average 10.2% -- has been fueled by a massive expansion of money supply. The inflationary consequences have been largely hidden in the form of rising asset prices, he says.
Reuters reported in mid-December that China has set a 4% target for consumer inflation next year, up from this year's 3% objective, "an indication that the government will desist from aggressive tightening even as price pressures mount."
According to Meyer, the government has some levers to pull, as it did when the country went through a similar cycle three years ago. "First, raise interest rates," he says. In October, the central bank raised benchmark interest rates by 25 basis points. "But they are still much lower than before the crisis and they will have to go up more," wrote Louis Kuijs, senior economist in Beijing at the World Bank, in a recent blog. A December Reuters survey of 26 economists found that most forecast that the central bank would raise rates before the end of 2010 (which the government did on Christmas Day) and twice in 2011 as part of a campaign to control inflation.
Another step is raising the amount of capital reserves banks must set aside, largely to help slow rampant lending to local governments and state-owned enterprises. The reserve requirement is about 19% today, says Meyer, "which is a big number." In December, the central bank raised requirements for the sixth time in 2010.
Third, says Meyer, the government is putting caps on the new loans banks can make. State media recently reported that the government set the ceiling for 2011 at RMB 7.5 trillion. But that's the same amount as 2010, which many observers believe was already surpassed by the fall of last year.
Even among more bullish observers, inflation is seen as problematic when set in a broader social context, notes Horst Loechel, economics professor of China Europe International Business School in Shanghai. "I'm quite optimistic about the Chinese economy. We'll see an average inflation rate of around 4%. This should be fine for an economy that is growing at around 10%," he says. "The main point for China in 2011 is how can they transfer the success of the country to the income of the people and really improve consumption levels."
Loechel notes that consumption levels as a percentage of GDP in China are dramatically low. "We're talking about 35% to 37%," he says. "In a normal economy, it's 60% to 70%, and even in India, you have more than 50%." Rising prices won't ameliorate that. "If we look at this overall picture, inflation has a role. It means decreasing purchasing power." The EIU says from 2011 through 2015, real GDP growth will slow to an average of 8.3% a year.
The need to mop up excess liquidity in the economy comes at a time when trading partners, particularly the U.S., insist that the currency is being kept artificially low in order to protect China's exporting manufacturers, says Allen. "The argument they're using -- that they can't let the exchange rate rise because of exports -- is becoming quite short sighted," particularly amid inflationary pressures.
With China allowing the renminbi to rise only slightly against the dollar in recent months, there's another side to the coin. "The purchasing power of the RMB is declining, and at the same time, [the U.S.] is encouraging China to revalue the RMB upwards," notes Meyer. "This strikes me as awkward. I would [ask] our policy makers to think about this. Normally, your currency would go down if you have hyperinflation, and we're telling them that it has to go up" due to the imbalance of trade. Both countries stand to lose from this, he adds, "obviously because of the [stagnant job growth] in the U.S., but the Chinese people may be paying an even bigger penalty by seeing their savings wiped out by inflation," he says. "I don't see anybody getting the big picture here."
Latin America's Commodity Boom
Provided that the ongoing Asian-led global demand for raw materials continues, experts predict that the majority of Latin American economies should have a relatively happy new year. Commodity prices are expected to be strong across the board, whether they are Brazil's and Argentina's agricultural commodities, Venezuela's oil, Chilean metals or obscure minerals like lithium that are abundant in Bolivia.
"Right now, it's about riding the wave of growth in emerging markets," says Wharton management professor Mauro Guillen. "The economies of the region are all very different from one another. But they are all benefiting from the commodities boom, the rise of China, and in the cases of Chile and Brazil, their own good policies."
Demand for commodities has helped to cause questions about some rather unruly governments, observers note. Take Venezuela's, for instance: The country's leaders have enjoyed political support for much of the last five years. But last year, amid more than 20% inflation and zero economic growth, Hugo Chavez's popularity hit a seven-year low as people wondered why the country had not benefitted from the commodities boom.
Michael Roche, an emerging markets strategist at MF Global, a commodities trader and hedging firm, suggests that countries like Bolivia and Ecuador take a cue from oil powerhouse Venezuela. "If you're a country like Bolivia [or] Ecuador that has been pursuing a model for the benefit of the bottom fifth of the country, you start looking at a place like Venezuela and seeing that that model has done very little for the country. Because it has kicked out foreign oil companies, the country is now producing less oil and below quota," he says, noting that Chavez allies will likely prove to be less hostile to foreign investors and will look for more constructive engagements with resource multinationals next year.
Meanwhile, Wharton professor Felipe Monteiro predicts that some major non-commodity companies in Brazil will make additional headway into global markets. "A strong local currency, plus a downturn in the U.S. and European economies, makes acquiring international assets all the more attractive to big Brazilian companies," he says. Over the years, new names like beef major JBS SA have acquired assets in the U.S. and Europe. Monteiro wouldn't be surprised to see some banking names grow abroad through acquisition, citing government controlled Banco do Brasil. "Next year, we will see more of the big Brazilian names move closer to becoming true global companies with non-Brazilians serving on their boards."
It's not all positive south of the Rio Grande, however. Brazil's consumers are getting tapped out with delinquency rates on overdue consumer debts rising 3.5% to five year highs in November, according to information services firm Serasa Experian.
In Argentina, inflation is like Venezuela's -- more than 22%, making it hard for people to save and for companies to invest. The country remains on stand-by mode until the October 2011 elections, but political leaders have already made overtures to negotiate with foreign bond holders and the International Monetary Fund. "At this point, whoever wins will be better than the Kirchners, and then I think you see a return of investment in the country," says Monteiro, referring to current President Cristina Fernández de Kirchner and her husband, former President Néstor Kirchner, who died of a heart attack in October 2010.
The region might be generally faced with too much of a good thing, some experts point out. Higher growth and higher commodity prices are combined with worries that rising interest rates will lead to currency appreciation. These are risks to the region's inflation outlook, warns Nomura Securities in a note to clients on December 7, 2010. "A common inflation problem will be the major policy challenge for 2011," predicts Tony Volpon, Nomura's Latin America strategist in New York.
India: Muscling Ahead
In India, December 2010 saw corruption charges rise to a crescendo and a whole session of Parliament was lost as opposition parties, demanding deeper investigation into the scams, refused to let it function. None of the political parties wants a fresh election, so this government will continue. But its trajectory has obviously been affected. "The political climate is uppermost in the investor's mind," says Vallabh Bhansali, chairman of Enam Securities, a capital market services firm. "If there are policy logjams, they could create confusion."
But the economy is expected to muscle ahead regardless. Estimates of GDP growth vary from 9.7% (the IMF prediction for 2011) to 7.7% (the Credit Suisse prediction for fiscal 2011-12). Credit Suisse is a rare pessimist; almost everybody else has upped their forecasts. The government projection is 8.75%, with a possible 0.35% addition. "India is on a mission to get its annual GDP growth to 10%," according to Bundeep Singh Rangar, chairman of IndusView, an advisor to MNCs seeking opportunities in India. "A good monsoon [season] and a strong global recovery could make 2011 the year that India achieves that goal."
The Bombay Stock Exchange sensitive index (Sensex) should keep pace with GDP. "By the end of 2011, the Sensex is likely to be between 24,000 and 25,000," says Rajinder Sabherwal, who manages a macro fund called Magister Ludi Global. The New York-based Sabherwal, however, doesn't think India will be a top performer in the markets. "India is a defensive holding for us. It sells at a premium. To some extent [that is] justified, but [it] is vulnerable to inflation and rising oil prices. In emerging markets, we prefer Turkey, Russia, Thailand, Korea and Poland." Sunil Bhandare, advisor (economic and government policy) at the Tata Strategic Management Group, sees a 12% to 16% growth in the Sensex over current levels (around 20,000 at the end of December).
One big worry is inflation. Dharmakirti Joshi, chief economist at credit rating agency Crisil, says inflation will be the biggest challenge in 2011. His other concern is the impact of rising capital inflows on the rupee. Naresh Takkar, managing director and CEO of credit rating agency ICRA, also lists inflation as a top concern, especially in commodity prices. He sees improving international economic sentiment as a "double-edged sword" for India. "Sectors that are dependent on international demand will benefit, but commodity prices will see a further upturn," he says.
If inflation climbs, the Reserve Bank will have to hike interest rates. This could result in "some moderation" in the growth rates of investment and private consumption, according to Joshi. Bhansali also sees "a bit of a cyclical downturn in growth, but it may be only a few quarters or a few months."
It's on the reforms front -- inextricably linked to politics -- where there is the greatest amount of uncertainty. Much could happen. Joshi pins big hopes on the proposed new goods and services tax, which he describes as a "game changer." A slow approach would be just right for new banking licenses, suggests Rajesh Chakrabarti, finance professor at the Indian School of Business. "The dominant view is that caution and safety are key, and no rush towards greater liberalization is warranted." He also expects the recent corruption scandals to create a bigger role for the government, "as the false assurance of the cleanliness of the private sector is now gone."
"There are far too many policy reforms that are pending, but unfortunately, the parliamentary system has been bogged down by controversies, scams and corruption. No substantive reforms could move forward during 2010," says Bhandare. "Our political parties must realize the adverse consequences of their actions."
Middle East: Qatar and Saudi Arabia Lead
As Dubai slowly emerges from its debt woes, sentiment among Arab business leaders and government officials is one of cautious optimism. After largely managing to avoid the effects of the global economic downturn, the Middle East anticipates renewed growth this year.
Leading the region's economic pace will be Qatar and Saudi Arabia. Steady energy demand -- oil and natural gas prices are expected to rise in 2011 -- and economic opportunities within their borders have been an appealing mix for investors. The two countries received $44 billion in foreign direct investment in 2009, half the region's entire investment flow, according to the World Investment Report 2010.
Though garnering world attention with its successful bid to host the 2020 World Cup, Qatar already has a record of high profile investment plays, such as the $2.3 billion acquisition of luxury retailer Harrods. Qatar now has roughly $75 billion in external investments, according to research site RGE Monitor. Coupled with its efforts to diversify its economy beyond liquefied natural gas and crude oil exports, Qatar's GDP is expected to grow more than 20% in 2011, according to the IMF.
Saudi Arabia, meanwhile, has concentrated on internal investment, spending an estimated $70 billion on infrastructure in 2010 alone. Seeking to diversify its economy, the Kingdom has embarked on an ambitious plan to build four economic cities at an initial cost of $60 billion. It has also made progress liberalizing its economy -- real estate investors eagerly await passage of a planned mortgage law early in 2011, which analysts expect will set off a residential building boom in the country.
Such activity is a needed shot in the arm for the Islamic loan industry, which reached a five-year low in 2010. Qatar's World Cup preparations -- expected to cost $65 billion -- will bring new Islamic finance deals. Additionally, the successful restructuring of Dubai World's debt restored some confidence in the market, observers note. Providing a further boost will be the advent of more Western-based Islamic finance issuances, as markets from France to Australia revamp regulations to accommodate the industry.
There will also likely be "many more joint ventures in petrochemicals and refining to be announced between the Gulf states and the Pacific Asian economies," says Christopher Davidson, author and lecturer at the Institute for Middle Eastern Politics and Islamic Studies at Durham University. "This will strengthen the interdependence of the world's greatest hydrocarbon producers and consumers. [Also] expect a growing thirst for gas to supply domestic power stations. Gas will increasingly be imported to the region from further afield, such as Thailand and Indonesia."
The year will likely see resource strain as the growing challenge to the region. The United Arab Emirates, Egypt and Saudi Arabia have decided nuclear energy is the route to meet rising domestic energy demands, but few solutions are at hand to buttress water supply in the region, which is around 1,200 cubic meters per person per year compared with the average of about 7,000 worldwide, according to The World Bank.
Concerns about water use prompted Abu Dhabi's utilities authority in November to inform customers how much their water and electricity was subsidized. That trend will widen in the Gulf, with gradually increased social costs being passed on to residents in the form of higher municipal fees and shrinking subsidies. Inflation is a perennial issue, but aside from Saudi Arabia, which will likely increase oil production this year, the region is expected to see modest inflation gains.