US labour market preview: health improves but remains fragile

Following the fiscal and monetary stimulus that pulled the U.S. economy out of recession in the third quarter (but the growth rate, +2.8%, was lower than the previous estimate of +3.5%), economists now almost unanimously agree that the labour market upturn will be key to ensuring a continuation of the ongoing recovery into the months ahead. This is in tune with the Fed’s thinking, as indicated in the minutes of the November 3-4 FOMC meeting. Indeed, only better employment conditions will likely translate into a sharp upswing in private consumption, which account for 70% of GDP. By contrast, a persistently negative labour market environment would likely trigger a further increase in foreclosures, which would weaken further private consumption and increase the savings rate.

Not surprisingly, this week’s major macroeconomic data release will be the publication of the November’s U.S. labour market report on Friday 4.

Encouraging signs on the labour market trend came last week from initial jobless claims, down from 501,000 for the week ending November 21 to 466,000. The four-week moving average, which traditionally smoothes out weekly volatility, dropped to 496,000 from 513,000 the previous week. Although the figure remains far from levels usually associated with job-creation, it gives clear evidence of a turnaround that could mark the beginning of unemployment downtrend in the medium term.

Another positive signal on the labour market outlook was the increase above 50 of the employment sub index in the ISM manufacturing confidence Index. Indeed, the data showed that an increasingly larger number of companies are considering returning to hire in the coming months.

Nevertheless, consumers appear to be less optimistic about employment prospects. The “jobs hard to get” sub-index included into the Conference Board’s consumer confidence index, a good leading indicator of unemployment trend, has worsened further in November, up from 49.4 to 49.8. Therefore, consumers do not expect a sharp labour market upturn near term but they fear it will deteriorate further.

As regards the November figure, though a further drop in non-farm payrolls seems to be inevitable, a continuation of the recent improvement in employment conditions, with job losses shrinking below 150,000 units (vs. Bloomberg’s consensus estimate of 125,000) from 190,000 in October and the unemployment rate on hold at slightly above 10%, would be welcome news.

However, the labour market (and a consequent net creation of jobs) should not turn the corner any time soon despite the strong increase in corporate productivity and profit margins in the third quarter of this year. Before returning to hire companies will likely raise the number of hours worked by existing staff and transform the contracts of those employees who have accepted a reduction in the hours of work not to lose their post from part-time into full-time work. According to the latest data by the U.S. Bureau of Labor Statistics, in fact, the average hours worked per week have decreased from 33.8 pre-recession to 33 and 9.3 million part-time workers are longing for a full-time contract.

A rapid and sustained improvement in the labour market has also being hindered by capacity utilization in recent months. The chart below shows that the labour market has deteriorated less than anticipated by the collapse in capacity utilization to 68.3% - the lowest level in the past 40 years. For example, at the time of the December 1982 record low of 70.9%, the unemployment rate climbed to 10.8%, well above the present value. With capacity utilization at 70.7% in November, a further improvement in this data, which is obviously closely correlated with the economic cycle, is necessary to record lower unemployment rates.

On the other hand, even in the face of a continuation of the upturn in economic activity throughout 2010, unemployment conditions would take time to get better. Indeed, the jobs to be created for new entrants to the labour force (about 100,000 per month) should be added to the jobs needed for those who have lost them in the past two years (over 7 million).

The November FOMC meeting minutes, for example, showed that the Fed members’ average estimate is for a decline in the unemployment rate to 9.5% in late 2010. With a projected workforce increase of 1% in 2010 (to 155 million), the Fed’s central estimate implies a creation of some 2.5 million jobs over the next 14 months. A considerable advance - though certainly not enough to recover the ground lost in the past two years. Under this scenario, the recession that began in December 2007 would have ended well before the third quarter of this year, which is highly unlikely given the recent development in industrial production and household income. The unemployment rate continued to rise during the 14 months subsequent to the end of each of the last two recessions. Considering the last six recessions, the unemployment was either in line or exceeded the Fed’s predictions only in two cases (in 1975 and 1982). The Fed’s forecast of a 9.5% unemployment rate at end-2010 could therefore prove to be overly optimistic.

All in all, the November labour market data should provide two key indications. First, the worst for the U.S. economy, and ultimately for the labour market, should be over. Second, the recovery should be very slow and the fallout from the crisis should be felt for several years. According to leading U.S. newspapers, President Obama is understood to be under increasing pressure to implement new programmes to ease labour market conditions.

Why should we overweight Eurozone Government Bonds

The expansionary monetary policy that the Fed and the ECB will likely continue to pursue going forward, the steep yield curve and the weak US Dollar should be taken into due consideration when evaluating the outlook for the European and US bond markets. The first two show that both countries enjoy a similar scenario: yields should be little changed for several months and then experience a flattening of the curve, the scope of which will depend on inflation. Due to the strength of the Euro against the US Dollar, investors should not invest in the U.S. bond market until the dollar’s negative trend reverses.

The prospects for the European bond market appear to be rosier. Given that interest rates will likely rise slightly and gradually, we recommend overweighting the short and medium end of the curve in the Euro area. By contrast, the long end of the curve would face greater risks should inflationary pressures mount. Only a deflationary scenario, which is highly unlikely to materialize for the time being, would suggest investing on the long end of the curve. In the medium term, higher gold prices and the rise in the expected future inflation rate as implied by the TIPs show that the market is beginning to fear a pick-up in inflation in the months to come. Reducing the duration of portfolio securities to focus on Euro-denominated medium-term stocks (3-5Y), seems to be a viable solution.

Emerging markets Government bonds are likely to perform in line with major international stock markets. Indeed, the former have largely benefited from a lower financial risk premium and expectations that the worst for the global economy may be behind. With U.S. government bond yields unlikely to rise sharply in the near term, the uptrend shown by emerging market government bonds would come to an end should financial market tensions resurface and the global economic upturn prove short-lived.

Equity market outlook remains positive

The stock market outlook remains rosy despite last week’s widespread uncertainty, with the major indexes suffering from mild profit-taking and the publication of some negative data on the U.S. economy. Mounting expectations that the ongoing economic recovery will gather further pace in the first half of 2010 are the main reason behind the persistent uptrend in stock indices. Notwithstanding a high degree of scepticism towards the duration of the economic recovery - some economists indicated that it only depends on the fiscal and monetary stimulus implemented by the governments, emphasizing the risk of a relapse into recession in the coming quarters -, the leading international institutions are revising up their estimates for 2010 and 2011. Last week, the OECD upgraded its 2010 growth forecasts for the biggest international economies (the 30 member countries are now seen gaining 1.9% vs. +0.7% last June) and for the first time released its growth projections for 2011, which foresee a continuation of the global recovery (+2.5%).

The equity market upswing also reflects the acknowledgement that major central banks will continue to pursue an expansionary monetary policy going forward. The Fed, ECB and BoE are not seen raising rates in the first half of 2010 and might even leave them unchanged until late next year. As the Bank of England Governor Mervin King suggested speaking about UK economy during the presentation of the latest “Inflation Report”, a short-lived return of the UK GDP to its pre-crisis level would not be enough to make up for what the country has lost over the last two years.

Expectations that major central banks will not tighten rates for a long time are impacting the Government yield curve: the differential between the 10-year and 3-month government Bond yields is over 300 basis points in the U.S. and UK and more than 280 basis points in the euro area.

The graph below shows that a very steep yield curve has been traditionally followed by a very positive performance during the following 12 months in the S&P 500, the leading indicator for the overall U.S. stock market.

As we suggested in the post S&P500: a mildly positive outlook, the S&P 500, with an average P/E ratio for the past 10 years of 19 (broadly in line with the post-WW2 average), does not look overvalued, despite the strong rally staged in recent months. Given the positive outlook for the S&P 500, with a consequent positive impact on the whole of international indices, we recommend overweighting other equity indices. Indeed, the weak dollar is a great concern for the U.S. stock market. Over the last few months, there has been a strong reverse correlation between the US Dollar and the S&P 500. The equity market rebound has combined with a fall in the greenback and vice versa. Therefore, a new rise in equity markets might prompt a further drop in the U.S. currency, even though many indicators (including the OECD’s Purchasing Power Parity) have suggested that the US Dollar is more than 20% undervalued against the Euro. By contrast, emerging markets, which are benefiting from a reduction in the size of the financial risk premium, should be favoured more than the developed countries by the international recovery, even due to currency appreciation. Although the risk/return profile of emerging markets has worsened in the wake of the sharp rise since last March, we recommend betting on a continuation of the emerging markets uptrend.

Eurozone economy improves thanks to big economies

Data released Friday 12 confirmed that the Eurozone, as well as the U.S. (+3.5 % q/q annualized) and China (+8.9% y/y), joined the global recovery in the third quarter. In line with the improvement recorded in industrial production, Eurozone GDP grew 0.4% q/q, only slightly lower than the +0.5% q/q expected by the consensus. German GDP, +0.7%, came in substantially in line with market expectations, while French GDP, up 0.3% q/q, fell short of expectations of +0.6% q/q. This was the second consecutive quarter of growth for both countries, which therefore confirmed that the worst may be behind them. Italian GDP gained 0.6% q/q in Q3, below consensus forecast of +0.8% q/q, but its first increase after five quarters of contraction.

The ongoing recovery is highly likely to persist into the coming quarters. The European Commission has recently revised higher its 2010 economic growth forecasts, with the Eurozone economy seen improving by 0.7% from -0.1% projected in April. The ECB Survey of Professional Forecasters is even more optimistic, with an expected growth rate of 1% in 2010. According to the European Commission and other major international organizations, economic growth rates will differ from one country to another. In particular there is a clear divergence between the recovery expected for the Euro area’s leading countries (Germany and France are seen improving by 1.2% and Italy by 0.7%) and the so-called peripheral countries (Ireland -1.4 %, Greece -0.3%, Spain -0.8% and Portugal +0.3%). These projections offer clear evidence that the countries that, more than others, benefited from the housing and credit market bubbles have still a long way to go before they pull themselves out of recession and that a return to growth, albeit below the average for the whole Eurozone, should not materialise before 2011. Therefore, the -0.3% q/q in Spain’s Q3 GDP did not come as a surprise. With the unemployment rate seen exceeding 20% in 2010, the chances of a quick upturn in the Spanish economy look slim. Indeed several factors may continue to penalize the peripheral countries over the coming years. First, the sharp growth posted in the last few years, due to a higher increase in the labour cost per unit of manufacturing output than in other countries, has lowered the peripheral countries’ competitiveness against the Eurozone countries through a devaluation of the real exchange rate. Second, given the bursting of the housing bubble, which slackened consumer spending and therefore inflation, real interest rates in these countries are higher than in the rest of the Euro area. Hence, while the housing bubble was being inflated, the ECB monetary policy was over-expansionary for the peripheral countries but excessively restrictive for the biggest countries in the region. Now the situation could paradoxically reverse.

For these reasons, the task of pulling the Eurozone economy out of recession is in the hands of its major countries. Specifically, Germany appears to be the leading candidate to act as the driving force – not only for its big size. Unlike other countries such as Italy, Germany might still implement a large fiscal stimulus to revive its domestic economy, with the deficit/GDP ratio that could mark the 3% threshold in 2010 (without falling back to this level until 2013) and the debt to GDP ratio that could reach 80% in 2011. In this direction goes the new fiscal stimulus announced by the Merkel’s administration aimed at boosting consumption and investment to rebalance an economy excessively skewed towards exports. Thanks to the efforts to contain labour costs, Germany has enhanced its own competitiveness and boosted exports (as proven by its huge current account surplus) in the last few years but has seen the investment/GDP ratio decline from 21% in 2000 to 18% in 2009, while the household consumption/GDP ratio has hovered around 55% over the course of the past 15 years. Nevertheless, given the sharp decline in consumption in Germany’s major export markets, the country’s export-driven growth model may be put at risk in the medium term. Policies aimed to stimulate domestic demand and investments, would be necessary at a time when they could shrink further in the face of the global downturn. Indeed, the Office for National Statistics’ announcement that Q3 growth was driven by a recovery in exports and by an increase in business investment comes as a very positive indication. Personal spending which weakened in Q3, may improve slightly in the coming quarters in spite of the negative trend shown by the labour market should German families decide to reduce their savings rate (over 11% of disposable income in 2008). Another boost to German domestic demand could also be provided by a continuation of an expansionary monetary policy by the ECB. Due to a rising Euro against major international currencies, in fact, the Monetary Conditions Index (MCI) is well above its historical average. Furthermore, considering that inflation might stay below 2% throughout 2011, the Taylor rule does not seem to require a rate hike until late 2010.

The medium term outlook for France and Italy looks rosy. France, which the European Commission expects to grow as much as Germany in 2009 (1.2%), will likely continue to be led higher by private consumption, while investment should stay stagnant. In Italy, a major positive came from OECD leading indicator, the highest within a panel of European countries in September. Notwithstanding the well-known structural problems facing the Italian economy and highlighted by the sharp increase in the real exchange rate in the past few years, and the country’s huge public debt, the Italian economy could surprise to the upside going forward.

S&P500: mildly positive outlook

In the last few weeks neither good economic news (Q3 GDP grew 3.5% q/q annualized against consensus expectations of 3.2% q/q annualized) nor encouraging quarterly results (over 80% of the S&P 500 companies have so far beat consensus expectations – their best showing since 1993 according to Bloomberg agency’s calculations) were enough to push the S&P500 to a new 2009 high. As fears that the economy might enter a severe depression - which led the market to its lowest since 1996 in March - receded, the US stock market now appears to be increasingly more dependent on the continuation and strength of the economic recovery under way. Leaving aside short-term movements, which are mainly triggered by speculative factors, the medium-term S&P500 performance is highly reliant on corporate profits. The chart below, for example, shows that the S&P 500 and the corporate profits of its constituents have followed a similar trend over the course of the past 20 years.

Looking back at the early 1950s and considering national accounting profits after taxes and adjusted for inventory valuation and capital consumption adjustments instead of S&P500 corporate profits, results are substantially the same, though profits outperformed the S&P500 (dividend distribution is not taken into account). The only period in which profits and stock market did not move in the same direction was during the '70s, when, due to the high inflation, profits grew sharply while the S&P 500 was substantially flat (in spite of substantial price volatility), in line with the negative performance delivered by all financial assets. Therefore, investors fear a return of inflation to values more in line with those last seen in the '70s. Nevertheless, this scenario now seems to be highly unlikely despite the recent return of tips-based inflation expectations to above 2%. If the stock market trend will depend primarily on profits, an analysis of the S&P 500 outlook can only start from their future potential performance.

Standard & Poor's estimates for earnings as reported (net of write-downs of extraordinary items) for 2010 are extremely cautious: following the 197% bounce in 2009 (they slumped 77.5% in 2008), profits are expected to edge up 2.9% in 2010 but to jump 34% in 2011. Operating profits projections are much more optimistic: after gaining 12.6% in 2009 (-40% in 2008), profits are seen improving by 33% in 2010.

However, a more reliable barometer for understanding the earnings outlook of U.S. companies is the analysis of national accounting data, as it is less influenced by the budget choices of individual companies. To analyse the earnings outlook we have used two variables that have a good track record in projecting the trend in profits, as shown in the graphs below: profit margin, defined as the ratio between national accounting profits and nominal GDP, and the yield differential between 10 year and 2 year Government Bonds.

Though not nearing the 1982 recession trough, over the past two years profit margins have achieved a level usually followed by a higher average weighted earnings growth in the following 5 years than the long term average (8.4% versus 7.3%). Reassuring signals also come from the analysis of the yield curve. The steepness of the Government yield curve, with the ten-year yield 200 basis points above the 2-year yield suggests that profitability should rise sharply in the next 3 years. Therefore, positive earnings growth in the years ahead might be jeopardized only by a marked fall in nominal GDP, which should coincide with a major deflationary phase.

Although a positive earnings outlook is a good precondition for a S&P 500 uptrend going forward, investors are growing increasingly worried about the equity market valuation in the wake of the recent rally. The ratio price/average earnings of the last 10 years partially confirms these fears. After plunging to 13x in March, the ratio rose to 19x in October, slightly above the 18x long-term historical average. Therefore, the S&P 500 seems to be fairly valued at current levels. Considering that the corporate profits outlook appears to be rosy for the equity market and that the S&P 500 is fairly valued, it is important to project the index performance in the years ahead to assign the right weight within the portfolio. We will use a model derived from John Bogle (founder of Vanguard mutual fund group) to estimate the S&P500 performance in the next 10 years. The model takes into account the average earnings of the past ten years and the average annual earnings growth of the past 30 years. It subsequently calculates the S&P500 weighted average growth rate so that at period end the index is in line with the average of the past 30 years. The chart below gives clear evidence that the model has historically been able to anticipate the S&P 500 performance for the subsequent 10 years. At current prices, the weighted average earnings growth over the next 10 years stands at 6%, which should then be added to the annual dividend, now at around 2%. Should these projections be confirmed, the equity market performance in the years ahead would be in line with the historical average. Given also the low level of interest rates (the ten-year U.S. Government bond is at 3.53%), we would recommend assigning at least a neutral weight within institutional investors’ portfolios.

Away from the empire of the Rising Sun

As in the case of major international economies, Japan showed reassuring signs of recovery over the summer, though the process of economic normalization appears to be far from over. The country’s industrial sector improved sharply, with production up 1.4% m/m in September (against consensus estimates of +1.1% m/m) from +1.6% m/m in August. Nevertheless, industrial production dropped by 18.9% on a year earlier. Another positive signal came from a sharper than expected (+0.9% m/m versus 0.2% m/m) increase in retail sales for September. As in the case of industrial production, retail sales fell 1.4% from the same period a year ago but improved on August (-1.8%). Retail sales are also seen improving further in the coming months due to the resilience shown by the labour market, with the unemployment rate unexpectedly down from 5.5% to 5.3% in September. Therefore, national accounting data due November 16 will likely confirm that Japan has joined all the other countries emerging from recession in Q3.

Although the Japanese economy should continue to show signs of improvement in the short term, its medium-term outlook remains clouded in uncertainty. First, Japan has a long way to go before solving the problem that has plagued its economy the most over the last few years: deflation. The national data for September showed that deflation persisted into September, -2.2% y/y for the cpi measure and -1% y/y for the cpi core. The October’s data for Tokyo even suggested that a further deterioration might be likely in the short term, so that some economists believe that Japan will not move out of deflation for at least two to three years. Indeed, private consumption is highly unlikely to recover any time soon, so as to trigger an increase in retail prices, as the improved employment scenario combined with a 1.6% y/y wage cut in September.

Against this backdrop, there are slim hopes of a recovery led by domestic factors and only a significant improvement in exports could trigger a sharper upturn in the economy.

But exports are hampered by the yen's sharp appreciation in recent months, particularly against the U.S. dollar and, consequently, the Chinese Yuan, which is pegged to the U.S. currency. Compared with the June 2007 peak, the yen has advanced by over 27% against the US Dollar, eroding profit margins for the nation's exporting companies. Based on OCSE Purchasing Power Parity estimate, at current levels the Yen is overvalued by over 30% against the U.S. dollar.

Therefore, a devaluation of the yen is the most efficient way to spur growth in Japan’s economy in the short term even though it appears difficult to implement, given that almost all major international economies rely more or less explicitly on their currency devaluation to revive the economy.

In the medium term, the major cause for concern for the Japanese economy is the high level of public debt. According to the International Monetary Fund estimates, in fact, public debt may rise to 218% of GDP this year, and reach 227% and 246% in 2010 and 2014 respectively. The sharp increase in the supply of government bonds is likely to intensify tensions in the bond market going forward as purchases by domestic investors may soon fall. The savings rate of Japanese families declined from 15% in the ‘90s to around 2% today because of the ageing population and workforce reductions. These tensions have already begun to emerge, with yields on ten-year notes up 11 basis points in October and the cost of the insurance against default in Japan in the credit default swap market exceeding the levels seen in the U.S., Germany and the UK. An increased securities offering and softer domestic demand could therefore lead to increased yields, with severe repercussions on the public budget and investor portfolios. Considering also the possible devaluation of the yen in the medium term and the low bond yields, we warmly recommend not to invest in the Japanese bond market.

China: a 2010 clouded in uncertainty

The latest economic data published in Asia have shown that the major economies of the region have emerged successfully from the crisis of recent years. Smaller countries such as the Philippines and Indonesia have completely avoided plunging into recession, Singapore emerged from the crisis in the second quarter, while South Korea’s GDP grew 2.9% in the third quarter of this year. India, thanks to increasing flows of direct investment, is likely to come as a positive surprise in the coming months. All this has resulted in an upward revision to IMF’s economic growth estimates for Asia both in 2009 and 2010. The Washington Institute now forecasts 2.8% and a 5.8% growth in Asia in 2009 and 2010 respectively against earlier estimates of 1.2% and 4.3%.

But investor attention remains focused on China’s economic growth. The recently published third quarter data has suggested that the worst may be behind for the Chinese economy. The most encouraging indication came from GDP, + 8.9% y/y in real terms from +7.9% y/y in the second quarter and +6.1% y/y in the first quarter. Indeed, it is commonly believed that the Chinese economy needs to grow around 9% a year not to record higher unemployment rates. Further signs of improvement came from industrial production, up 13.9% y/y in September, and exports, whose pace of decline slowed to 15.2% yoy from 23.4% in August. Retail sales should continue to move upward in the medium term (+15.5% y/y in September vs. +15.4% y/y in August), mainly driven by improved sales of cars (+44.5% y/y), furnishing (+34% y/y) and construction materials (30.2% y/y). A boost to private consumption (down from 67% in 1981 to 48% in 2007 as a percentage of GDP) to the detriment of exports was, in fact, considered key by most economists to help rebalance the Chinese economy when the crisis broke out.

However, many investors and economists fear that the ongoing recovery might not be due to the strength of the economy, as argued by Goldman Sachs economists, but only to the aggressive expansionary policy pursued by the Government and that 2010 may produce negative surprises.

In the face of last two years’ crisis, in fact, the Chinese government has implemented a USD586bn fiscal stimulus plan, mainly aimed at infrastructure construction, post-earthquake reconstruction and affordable housing building.

More importantly, major domestic banks and small regional banks have started easing credit standards following the directives enacted by the central government. In the first nine months of 2009, in fact, new loans amounted to 8670 billion yuan, compared with 3480 for the same period last year. Although new loans have began to slow in the second half of this year (from a monthly average of 1230 billion in the first half to 428 trillion in the first 3 months of the second quarter), loan growth remains significant, hence raising fears that the Chinese economy could soon begin to suffer from excessive indebtedness.

Chinese authorities are particularly concerned that a large share of these new loans were not used to underpin the real economy but to heighten speculation on financial and real estate markets, increasing the risk of new speculative bubbles. For example, China Business News, citing government sources, indicated that almost 20% of the new loans in the first six months of the year had been invested in the Shanghai stock market. New loans to the property market also rose sharply. According to the National Office of Statistics, house prices in 70 reference cities rose by 2.8% y/y in September, up from +2% y/y in August. The sharp improvement led Moody's upgrade its outlook for the Chinese residential market from negative to stable.

Considering also the higher-than-60% stock market rebound since the beginning of this year, the Chinese authorities appear to be ready to take action to prevent this trend from jeopardising the country’s financial stability.

The Commission for banking regulation will introduce new measures to ensure that the new loans are not used for purposes other than supporting the real economy. According to a draft reform published in the Commission's website, loans exceeding 300 thousand yuans (about 30 thousand Euros) would be paid directly to the counterparty. "This is the first step towards a removal of the expansionary policy and it was decided after the latest reassuring economic data" said Gabriel Gondard, Fortune SGAM Fund Management CIO in Shanghai to Bloomberg news agency. Nevertheless, market experts are divided over the Chinese authorities’ future economic incentives choices. For example, economists at UBS and Credit Suisse believe that reserves to be held at the Central Bank by commercial banks will be increased by the end of the year. By contrast, Stephen Roach, chairman of Morgan Stanley Asia, said that Chinese authorities aim to maintain social stability, which can be only guaranteed by sustained growth. A new economic downturn, a clear possibility in 2010 should the Government remove the fiscal stimulus, is, therefore, to avoid.

The trend of prices is another factor that helps maintain the ongoing expansionary policy in place. Despite the sharp increase in M2 money supply (+29% y/y in September), consumer prices (-0.8% y/y in September) are expected to edge up in 2010. Economists at Morgan Stanley, for example, see inflation averaging at 2.5% in 2010, with an upward pressure that should only come from a stronger-than-expected international recovery, which would push higher commodity prices. According to Morgan Stanley, the government will not raise rates ahead of any such move by the Fed, which is expected to start tightening in mid-2010, given the close relationship between the Dollar and the Yuan.

The Council of State has shown that a continuation of government stimuli would be necessary to rebalance the Chinese industrial sector, which is skewed towards given sectors. As a first step, the government decreased the number of financing projects for the production of aluminium, steel and cement to prevent excess capacity. The challenge facing the Chinese economy in 2010 will therefore be to sustain economic growth while avoiding over-indebtedness. This will be crucial not only for the country’s but also for the global economy. Should a rebalancing of the economy fail to materialize, a renewed focus on exports would be inevitable.

U.S. returns to grow but still faces debt problems

For the first time since Q2 ’08, the U.S economy returned to grow in Q3’ 09, +3.5% q/q annualized, ahead of the +3.2% q/q annualized expected by the consensus of economists. Nevertheless, positive third-quarter GDP growth did not help dispel the uncertainty surrounding the US economic outlook as the fiscal stimulus implemented in Q3 comes to an end. Indeed, economic growth in Q3 was driven by the measures adopted by the Obama administration to rescue the residential and automotive sectors. A clear example is the 22.3% increase q/q annualized in third-quarter car sales thanks to the "cash for clunkers" programme, which accounted for 1% of total GDP growth. But car and home sales (-3.6% in September) returned to fall once the incentive programme ended.

Not surprisingly, the recent recovery has been looked with scepticism by consumers, as indicated by the Conference Board’s consumer confidence index, which dropped from 53.4 to 47.7 in October. The negative trend in the labour market was the main reason behind a weakening consumer confidence. Indeed, despite early signs of improvement in the economic cycle, the unemployment rate continues to remain high (9.8% in September), and is expected to deteriorate further in 2010 (above 10%). The persistent rise in foreclosures is another negative factor affecting consumers, who will likely further increase their savings rate above 3.3% of disposable income in the third quarter.

Economists, though believing that the worst is finally behind them, consider the Q3 ’09 improvement of a transitory nature and are looking for a further slowdown in Q4 ‘09, when growth should come in at 2.4% and stay at this level throughout 2010, before slightly improving to 2.8% in 2011. Therefore the "new normal" scenario set out by PIMCO bond manager Bill Gross, who projected the U.S. economy to experience many years of growth below the average of the last 60 years (3.4%), seems to be very likely.

The economic imbalances that have plunged the U.S. into recession and that are far from solved remain the most serious risk factor facing the medium-term U.S. economic prospect. As indicated by the latest GDP data, US economic growth continues to be highly dependent on personal spending, which has steadily accounted for 71% of GDP over recent quarters. With the unemployment rate likely to increase further going forward, estimating a sharp rise in personal consumption over the coming months remains somewhat risky, even though the recent stock market recovery has increased both the ratio of total household debt to total household assets and the ratio of net worth to disposable income. The household sector deleverage is likely to weigh on personal consumption and the labour market. Data from the Federal Reserve for the last few quarters, in fact, have shown that households are gradually reducing their debt pile (-168bn dollars from the record peak hit in Q2 2008), although the ratio to GDP remains close to 97% due to the GDP decline in the first half of 2009.

With companies also committed to reducing their debt level (-50bn in Q2 compared to Q1), the U.S. economy is highly unlikely to be driven by a sharp upswing in investment in the coming quarters.

While a narrowing of U.S. household and corporate debt is positive, a rise in federal debt is cause for concern. It accounted for 51% of Q2 09 GDP from 44% in 2008, and is seen mounting further in the months to come. According to the Congressional Budget Office, public debt held by private individuals should achieve 61% in 2010 and hit an all-time high of 67.8% in 2019. However, many analysts have projected an increase in the debt ratio up to 100% of GDP over the next few years. Consequently, even government spending should hardly be able to underpin economic growth in the quarters ahead.

All in all, only an increase in exports appears to be able to provide a boost to the economy, even though third quarter trade balance data showed that relying on net foreign demand may prove illusory. Indeed, a slight improvement in consumer spending was enough to widen the external deficit to 348bn dollars from 330bn in Q2 despite the weak U.S. Dollar, hence breaking a downward trend for net trade deficit that had lasted since 2007.

The problem of excess borrowing in the U.S. economy might be still far from being solved and weigh on economic growth for several years. As shown in the chart below, in fact, the total debt level, excluding state and local government debt, has neared 220% of GDP this year and is unlikely to decrease in the years to come. U.S. authorities might well decide to reduce the debt burden by increasing inflation. This would cause serious damage to the entire global economy, which would have to search for a new growth trigger.