100 hands are better than two Economic outlook to 2010 By Ernie Ankrim, Ph.D., Senior Markets Advisor Russell Investments July 2009 President Harry S. Truman is claimed to have said he wanted a "one-armed economist," because his economic advisors typically gave him advice stating, "on the one hand... and on the other hand..." They knew every forecast carries with it a sizable possibility of error in a variety of directions. Like Truman, many of us wish we could predict the future. More than ever, in these volatile times, shell-shocked investors are asking, "what's next?" To start, let's acknowledge that what we've been going through the last two years is different than any experience we've had in the last 70 years. While a simple, one-armed forecast might be easy to understand in such an unusual environment, it would have a great chance of being dramatically wrong. Rather than offer my, or any other single description of what lies ahead, I thought it might be more useful to see what 50 economists think about the prospects for the U.S. economy by the end of 2010. The June 10 issue of "Blue Chip Economic Forecast"® examines forecasts on the U.S. economy through the end of 2010 from the economists of 50 different investment and academic organizations (including Russell's own Mike Dueker).¹ The economists offered forecasts on 19 different measures of economic conditions. I summarize their views by looking at the expected environment at the end of 2010 and by considering their forecasts on GDP growth rates, consumer price index inflation rates, interest rates on 10-year treasuries, and unemployment rates. I've divided these 50 forecasts on the basis of their expected GDP growth rates. I labeled those 12 with the strongest expected GDP growth as "optimistic;" the 12 with the weakest expected GDP growth as "pessimistic;" and the remaining 26 of the 50 surveyed as "middle." As a starting point, we already know that we've been in an official recession that began in December 2007. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) is the official arbiter that determines the beginning and end of recessions. This committee historically has identified these points in time between eight and 12 months after the fact (we were informed of the December 2007 beginning of the recession in December 2008). This means that even if the recession was ending today, we probably wouldn't know that for sure until sometime in early 2010. I expect — with serious possibilities of forecast error — that it will end sometime in the fall of 2009. If I'm right, the recession will have lasted between 20 and 22 months, making this the longest recession since the 43-month Great Depression of the 1930s. Since then, the U.S. has suffered 12 recessions. The longest of these were the 16-month recessions of 1973-75 and 1981-82. So what do economists in the Blue Chip Indicators Survey predict for the rest of 2009 to 2010? This table summarizes those forecasts: Blue Chip Economic Forecasts® (June 10, 2009)     Year-end 2010 forecasts (%)     GDP   CPI   10-yr treas.   Unemp. rate Optimistic   2.75   1.95   4.03   9.42 Middle   1.86   1.64   3.52   9.68 Pessimistic   1.04   1.50   3.43   9.92 GDP Looking out until the end of 2010, sadly, most optimists don't believe we'll find ourselves back to the 1973-2009 average of 2.8%. In fact, only four of the 50 respondents believe the economy will exceed the 36-year average. Sadder still is the prospect foreseen by the pessimists, who predict 2010 year-end GDP at 1%, not even half of the long-term average by the end of next year. Even if we are out of the recession, pessimists believe the economy will be growing at a very slow rate.Middle-of-the-road economists aren't optimistic, but not quite as down on prospects as the pessimists, believing that the economy will be growing at over half the long-term rate, but still below average at 1.9%. CPI No matter who we are talking about — optimists or pessimists — none believe the inflation threat that has begun to creep into conversations is a present danger. Oil prices moved up, but movement of one commodity is not inflation. Inflation, a broad-based increase in prices, typically rises if the economy is moving along at a stronger pace, so it's not a coincidence that pessimists believe we'll have a low rate of inflation. If people aren't buying, we won't see higher prices. Actions by the Federal Reserve, which have maintained low interest rates and pumped a massive amount of liquidity into the system without a corresponding impact, have sparked talk of future inflation. However, in the present environment, businesses are reluctant to invest in capital and plant expenditures until they see stronger signs of recovery. Likewise, risk-averse consumers have reduced spending and are either struggling with the prospect of job losses, paying off debt, or both. This sounds responsible, but it means the economy is growing slowly, and all the money injected into the system has yet to pump up prices. Based on modest growth expectations, the respondents see no material threat of inflation in the next 18 months. 10-Year Treasury A combination of modest growth and muted inflation expectations lead economists to expect no significant increase in interest rates through 2010. This is most pronounced, of course, in the more pessimistic forecasts that see a lower forecasted treasury rate of 3.43% compared to the optimists, who, with higher growth and inflation expectations, expect the rate to be just over 4%. If either inflation picks up or growth surprises us, rates could rise. But for now that doesn't appear to be a strong possibility to these forecasters. Unemployment Unemployment rates tend to rise even after the economy has stopped declining. A lagging indicator of economic activity, unemployment doesn't change until other basic drivers of the economy have improved. Businesses usually delay layoffs at the beginning of a downturn. For example, as sales fall, their first response might be, "are we advertising correctly? Is this a short-term, isolated phenomenon?" As the economy worsens, however, they resort to layoffs. So unemployment doesn't rise significantly until the recession is well underway. Conversely, employers wait to rehire until they see sustained growth, and hiring continues to increase long after the economy has moved off the bottom. Even the most optimistic forecasters see unemployment rates at the end of 2010 at 9.4%, and it could be even worse if the middle-of-road and pessimistic economists' views of the economy holds true. The economists in the middle of the pack forecast an unemployment rate of 9.68% and the pessimistic forecasters predict the unemployment rate will be 9.92%, even higher than it is today. Of greater concern is that more than 25% of the respondents believe the unemployment rate will be more than 10% at the end of 2010. From 50 economic forecasts to four questions This analysis of economists' forecasts spurs four obvious questions: 1. Are worse or better scenarios for the future possible? Absolutely! Economists as forecasters do a reasonably good job. But they are human and make mistakes. Few, if any, correctly forecasted the dramatic economic contraction we saw during the last quarter of 2008 and the first quarter of 2009. Nouriel Roubini, an economics professor at New York University, offers very discouraging prospects for the economy going forward. And while his general stance has been pessimistic for years, as such, he was well ahead of most in forecasting the troubles we've seen in this recession. It's possible his more pessimistic views could be the reality in which we find ourselves in 2010. Ed Hyman, chief economist of International Strategy and Investments, has been the "Institutional Investor" First Team All -American Economist 26 out of the last 28 years. He leans towards more optimistic views of the prospects for economic recovery, calling for robust economic growth before 2009 is over. Both are credible experts. There will undoubtedly be surprises. However, the probability of extreme forecasts being correct is typically extremely small. Investment strategies that rely on such extreme outcomes carry with them a significant risk of disappointment. 2. If such modest prospects for future growth are accurate, why did recent equity markets rally so strongly? For the 90-day period from March 6 to June 5, the rally in equity markets was dramatic. The Russell 1000 rose 40% and the Russell 2000 jumped 50%. Indexes that track emerging markets soared 60%. With these strong results, you might think the economists' forecasts are inconsistent with our current experience. My view of this rally is that the market was previously acting (to quote the REM song) as if it was the "End of the World as We Know It." After two of the worst first two months in U.S. equity markets over the last 80 years, the market was pricing risk as if nothing but terrible news was ahead. The rally, I believe was not so much indicative that great news was ahead of us, but that prospects for the end of the financial world as we know it had been dramatically overplayed. (By the way, the second part of the REM song continues, "and I feel fine"). This well-described the turning point. This turn-around wasn't necessarily a trend but more a reflection that worst-case scenarios had been taken off the table. 3. With all this money the Fed has pumped in, what are the prospects of inflation after 2010? The history of using dramatic monetary growth to fix the economy is not encouraging. Nearly all extended periods of inflation have been spurred (at least in good part) by monetary expansion. On the other hand (you knew that was coming somewhere in this article didn't you?) the current subdued growth and inflation expectations might be offering the most generous reprieve for the Fed in dealing with this risk. An extended slow recovery might allow the Fed to begin withdrawing liquidity at a modest rate. With a more dramatic recovery, the Fed would be faced with the challenge of moving more quickly from the current position of massive liquidity (necessary to have kept our economy from deeper declines) to declining liquidity (required to prevent an onset of inflation). But if done quickly, we might face serious risks of a "double dip" recession, in which the new Fed tightening cuts short the nascent recovery. Our ability to get though this without experiencing rising inflation depends on the Fed's ability to successfully walk the tightrope: aiding recovery but avoiding inflation rates rising out of control into 2011. 4. What happens to longer term interest rates? This is the only indicator of the four we've reviewed that incorporates expectations about the future (GDP, inflation and unemployment are descriptions of history). As such, current rates can reflect as much about expectations for the coming years as they do about the current monetary and economic conditions. If either the economy booms or inflation expectations pick up, they'll likely rise. However, with 10-year Treasuries currently yielding around 3.6%, the forecasts are in line with current levels and, as such, give little indication that inflation rates will rise anytime soon. For what it's worth and investment implications The Blue Chip organization each year awards the Lawrence R. Klein (1980 Nobel Prize winner in economics for his work in statistical forecasting) Award for Forecast Accuracy to the organization whose forecasts for that year have been the closest to what ultimately occurred. Recognizing that past success (in forecasting as in investing) is no guarantee of future success, a weighted average of the past 14 winners' forecasts are about halfway between the average of the "middle" and "optimistic." The good news is, if correct, this average would forecast a better GDP growth rate (2.2%) and a contained inflation rate (1.7%) at the end of 2010. The bad news is that, although they expect better GDP growth than the "middle," this group foresees almost exactly the same unemployment rate as the center of the Blue Chip Economic Forecast (9.69 vs. 9.68 for the "middle"). At the end of the day, with a range of economic scenarios, investors don't know which extreme to expect or if it will be the middle-of-the-road prediction that wins. In general, these forecasts would warn against trying to "inflation proof" your portfolio too quickly. They would also imply that returns to the safest assets (such as 10-year Treasuries) would likely be minimally rewarded unless the more pessimistic scenarios prevail. Considering these forecasts, it's prudent, as you work with your advisor, to hold a varied asset allocation in line with your risk tolerance. Include some assets served by strong economic activity, some domestic assets, as well as non-U.S. assets. In other words — the well-diversified portfolio. I find that after all this, we end up back to Truman's lament for a one-handed economist. The economy, with its variety of moving parts, doesn't offer simple answers. And since a black or white answer isn't available from me or any of our forecasters, your better bet is a balanced portfolio that recognizes the possibilities of the variety of scenarios in play and reflects the insight of many rather than hoping for the distinctive insight of the extreme. 1 Blue Chip Economic Forecasts® is published monthly by Aspen Publishers, 76th Ninth Avenue, New York NY, 10011. While 52 organizations responded to the survey, only 50 forecast out as far as 4th quarter 2010. These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only. Nothing contained in these materials is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. Please remember that all investments carry some level of risk including the potential loss of principal invested. Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment. Diversification does not assure a profit or guarantee against loss in declining markets. Treasury Bills ("T-bills") are short-term debt securities issued by the U.S. government with maturities of usually one year or less. Fixed income investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Russell Investment Group is a Washington, USA corporation, which operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. Copyright© Russell Investments 2009. All rights reserved. Securities products and services offered through Russell Financial Services, Inc., member FINRA, part of Russell Investments. For information on the Financial Industry Regulatory Authority, go to www.finra.org. First used: July 2009 RFS 09-2178			Subscribe to our Education Center RSS Learn more about using and subscribing to RSS   Comment on this perspective What is your impression of Ernie Ankrim's insights? Provide your feedback.   Why Russell? See the difference Russell's investment approach can make   Printer friendly version of this page Send feedback or comments Site Search

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