S&P expects that the world economy will recover (see chart above). But it's likely that it will look different once it does. For example, the events of the past two years likely have accelerated the relative decline in US economic influence, as Asian economies have continued to grow while America's has contracted. In addition, the dollar's position as the dominant world reserve currency is under threat. In fact, if recent trends are a precursor, the global financial system could shift its headquarters from New York and London toward Asia, especially if changes in regulation make Asia more attractive as a headquarters for financial companies.
The consumer is no longer king
The economists expect that consumer spending likely won't be the main engine of recovery that it was after the past few recessions. American consumers are currently spent out because their ability and willingness to take on more debt has been weakened by their loss of wealth and by banks' increased caution in making loans. Consumer spending will rise, but it will trail rather than lead the rise in GDP and household income.
A sluggish increase in consumer spending will likely mean a sluggish improvement in the economy. The US went into this recession with a 1.7% saving rate in 2007, with household debt at a record 136% of disposable income. From 1960 to 1990, the household saving rate averaged 8.9%. The economy still grew at a healthy pace through most of that period, but the structure of the economy differed. Consumer spending averaged 63% of GDP, not the 71% of today's America.
The economists do not expect a return to the pre-1990 saving rate. A higher percentage of retirees suggests a lower saving rate because retirees are spending down their previous savings. The saving rate could stabilize near its current 4.7% level, however, which would be near the average of the 1990s. Household debt, which has dropped for an unprecedented five consecutive quarters, to 128% of disposable income in the third quarter of 2009, will likely continue to decline, at least relative to income, limiting Americans' ability to live beyond their means. The higher saving rate is healthy in the long run and necessary if the US is to reduce its reliance on foreign capital, though for the next few years, it likely will significantly limit growth prospects.
The Burden of Debt
S&P says economists almost all wish that Americans would save more because nearly half of those approaching retirement are underfinanced, according to the Center for Retirement Research (CRR) at Boston College. The number of unprepared near-retirees rose significantly with the recent dive in asset prices (both homes and stocks). And baby boomers don't have much time to rebuild their wealth before they reach 65. Part of the solution will be later retirement. The CRR reports that the average boomer now expects to retire at age 65; two years ago, it was at 63. But two more years of saving probably isn't enough to retire on unless the saving rate is very high, especially because the average US life expectancy is now 79 years.
The assets of consumers will rise with the recoveries in stock and housing prices. S&P expects household debt to continue to decline relative to income, bringing the debt to income ratio back below 120%, which would still be higher than at any time before 2004. The higher saving rate, though modest, will gradually lower the share of consumption in GDP to 68% from its current 71%. S&P's base forecast anticipates that a continued move of the trade account toward balance plus a rise in capital spending, to more than 15% of GDP by 2013 from 12% currently, will partly offset this decline. But not entirely.
Debt, Equity and Risk
S&P says corporations are also likely to become less leveraged. Regulatory changes will force some of the shift as the Federal Reserve and Congress try to rein in overleveraged financial firms. But in the long run, government borrowing will raise financing costs, forcing firms to rely more on earnings to support capacity expansion. At the same time, however, an aging population will demand more income from its investments, potentially making it more difficult for firms to retain earnings while still satisfying shareholders. The probable result will be continued high leverage for the safest nonfinancial firms but reduced leverage ratios for financial firms (because of regulation) as well as for smaller, less creditworthy firms (because of investors' reduced appetite for risk).
This will force all but the most prosperous companies to rely more on "vanilla" borrowing, such as bank loans and corporate bonds, and less on securitizations and other more complex types of borrowing. Regulatory changes will determine how much financial activity will shift back to the banks from the bond and securitization markets. But the net result will probably be a rise in the effective cost of capital to corporate borrowers, especially those that have less-than-stellar repayment reputations.
As a result, businesses will likely have more equity and less debt, even in traditionally highly leveraged sectors such as real estate. The economists say the higher funding costs to small firms probably will increase the cost of doing a startup, which will probably slow economic growth: Most of the rise in private employment has historically come from small and mid-sized companies. The economists do not expect the impact to be enormous, but the direction seems clear.
Returns and Risk
Financial returns over the next decade will likely be modest. After the heady days of the 1980s and 1990s, when the stock market returned 19% a year, returns were slightly negative during the past decade, which contained the two worst bear markets in postwar history. S&P expects after-inflation returns to remain weak during the new decade, reflecting excess world savings and more sluggish economic growth. A flood of liquidity in the market lowers returns because too much cash will be chasing too few investment opportunities.
The move of baby boomers into retirement could exacerbate this trend. Retired Americans will sell-off their assets to finance their retirements (which is, after all, why they acquired the assets), which will depress asset prices. They will also likely switch to safer, more liquid investments, depressing stock prices. After all, investing for the long term has a different meaning when you're 80 than when you're 40. Not all of America's 70 million baby boomers will shift their investing patterns at once. But over the next 20 years, S&P expects that this transition will be significant.
Nominal returns in both the stock and the bond markets will depend to a large extent on inflation, according to S&P. There seems little near-term risk of high inflation; recessions are good at keeping prices low. However, as the economy gradually returns to lower unemployment, perhaps five years from now, inflation will likely accelerate. The political pressure for the US to inflate its way out of high government debt will be substantial, even though the rising interest rates caused by higher inflation would make the tactic unlikely to work. Higher inflation isn't a sure outcome. In Japan, for example, prices have continued to decline for two decades despite government debt approaching 200% of GDP, showing that deflation remains a risk. But the Federal Reserve has been more aggressive in expanding credit than the Bank of Japan was during that country's economic crisis 15 years ago, which slants the US risk toward inflation.
The recent turmoil will also likely raise risk aversion for a few years which is a major change from the recent past. The quest for yield and a quarter-century of relatively calm markets had made investors complacent. The spread between the yield on speculative-grade corporate bonds and presumably safe US Treasuries hit a record low 260 basis points (bps) in early 2007. The subprime mortgage problems sent spreads back up to more normal levels, and then the failures of Fannie Mae, Freddie Mac, Lehman Brothers, and AIG sent them to a record high of 1,700 bps in October 2008. Spreads have now come back down to under 700 bps, still well above their historical average of 520 bps, but at a normal level for recessions. S&P expects spreads to come back down to normal as the economy recovers but not to go back to the extremely low level of three years ago.
The Demographic Burden
S&P says the aging of the US population is a recurring theme in its view of the future, but it's hard to exaggerate the profound effect it will have on the new economy. The leading edge of the baby boom is now 63 and beginning to retire. One reason the economists expect the US saving rate to remain well below its historical average is that retirees generally spend more money than they earn. So their negative saving rate will partially offset their children's positive saving rates.
The move of the baby boomers into retirement means that 20 years from now there will be only three workers in the US for every retiree, down from the current five. The need to feed not only your own family but one-third of a retired family will add to the pressures on workers. Living standards will be cut, in S&P's estimation, by the needed redistribution of income to the elderly population.
Health care costs will be the biggest age-related issue, as spending on health care will likely continue to rise much faster than GDP (unless new health care legislation changes that). The US government already pays a higher percentage of GDP (8%) on health care than Britain does. And this covers only about 30% of the population (retirees, government employees, and low-income Medicaid recipients), whereas Britain's spending covers nearly all of its citizens. With Washington paying most of the health expenses of those over age 65, the government's share almost certainly will continue to rise relative to both GDP and total health costs. Costs will accelerate even more in about 20 years, when baby boomers start hitting their mid-80s and requiring long-term care. The elderly now account for nearly two-thirds of Medicaid costs.
Such rising costs will make it even more difficult for Washington to deal with fiscal imbalances. This will increase the chances that government borrowing will start to crowd out private investment over the longer run, thus reducing US GDP growth for a generation or more.
Fiscal Deficits and Government Debt
S&P says any reduction in debt for households and corporations will be more than offset by higher government borrowing. The $1.4 trillion US deficit in fiscal 2009 and the similar deficit expected in fiscal 2010 won't have much impact on interest rates because of the weak economy. However, as the economy recovers and households and firms try to borrow money again, probably by 2011 or 2012, interest rates will likely be pushed higher.
The economists expect to see a combination of tax hikes and cuts to entitlement programs as it becomes clear that the government cannot continue to borrow the required sums without major damage to the economy. The tax increases will cause some economic damage--but less than continued deficits would. Entitlement cuts could be either good or bad for total growth. For example, raising the retirement age for full social security benefits could actually increase growth by keeping older workers in the labour force.
International Deficits and the Dollar
S&P says bond yields are low at the moment, in part because of the enormous international imbalances. The massive trade surpluses of the oil-producing states and China and Japan have created a large pool of essentially stateless money, which circles the world in search of yield. The surpluses reflect high saving rates in these countries.
Balancing these high savings countries are those with trade deficits and low national saving rates. The US still has the world's largest trade deficit, though this deficit has been cut sharply, to a forecast of 3% of GDP in 2010 from 6% in 2006, by a combination of the US recession, a weaker dollar, and lower oil prices.
Many of the countries with trade surpluses are becoming nervous about the share of their reserves that are held in dollars, and they are thinking about diversifying. Their motive would be to reduce risk. However, moving significant reserves out of the dollar into the euro would cut the value of the dollar and thus the value of their existing reserves. At the same time, it would also raise the value of the euro, thereby making the new reserves more expensive-- and maybe artificially expensive if the euro ultimately came back down.
The economists say the euro is really the only alternate candidate for a reserve currency. The yen is problematic because Japanese bond yields are so low and Japan is running a trade surplus, which makes it difficult to accumulate large quantities of yen. The pound sterling is a possible alternative, but the market for it is relatively small. The Chinese government has suggested the Chinese renminbi, but a reserve currency needs to be fully convertible into other currencies, and it seems unlikely that the Chinese government would accept such a loss of control in the medium term. S&P expects to see the mix of reserves held by major governments shift toward fewer dollars and more euros, with some increasing admixture of yen, pounds, and perhaps renminbi. Although gold is a possible reserve asset, the costs of storing it and the lack of new supplies make that unlikely. However, the prospect of central banks buying more gold could help keep gold prices high for a while.
If the euro were to become a more prominent reserve currency, the impact on European economies would be negative, according to S&P. Because a stronger currency lowers import prices, it lowers inflation and raises the standard of living. However, it also makes it harder to export, thus hurting production and employment. And the problem most developed countries face today is much more a lack of employment than the threat of inflation.
The economist say they do have some concern that significant currency adjustments could push politicians toward protectionism, which is usually driven by job issues. When times are good and unemployment low, voters don't care about trade deficits; they like cheap imported goods. But when layoffs begin, voters blame imports for job losses. If Europe and the US are both suffering from high unemployment and trade deficits, protectionist moves against the surplus countries would seem to us to be a political danger.
There might be no easy way out for anyone, however, given the current political and economic environment. One downside for the US of being the reserve currency nation is that its balance of payments becomes the residual in the world trade accounts. If the surplus countries invest their reserves in dollars, the capital inflow of these reserves drives the dollar up and creates a trade gap that mathematically has to balance the inflow of capital.
The positive side of this is that investment from Asia into the US has permitted strong capital spending despite low personal and national saving rates. But this dependence on foreign capital is potentially disruptive if foreign investors are scared away from investing in the dollar. It isn't clear how much of the low US saving rate stems from the inflow of funds rather than the other way around, but the two seem related.
Historically, this hasn't been the case. Normally, developing countries have been capital importers, usually leaving the reserve country in balance or even surplus. Today, however, the massive surpluses run up by the oil-producing states and China and Japan amount to nearly $1 trillion. And though the US isn't the only trade deficit nation, it has a disproportionate share of the total deficit worldwide.
Assuming that the euro becomes a more popular reserve currency, the Eurozone will bear some of this burden. If Europe gains a capital surplus because of reserves being invested in euro assets, it must mathematically generate a corresponding trade deficit. With unemployment high and growth slow, the political pressures for protectionism would increase in Europe as they have in the US. The economists say that so far, calmer heads have prevailed, and actual protectionist moves have been limited.
Unless protectionism triumphs, S&P believes that the economic outlook for the next decade is for continued low interest rates, continued trade deficits in the US and Europe, and surpluses in Asia and the oil-producing countries. The dollar will likely dip below equilibrium while the rebalancing of reserves is occurring but then return to a more neutral level (about $1.30/euro) in the longer run.
S&P says a wild card in any economic outlook at this point is regulation. From the late 1970s through 2008, the world and US regulatory systems swung toward less regulation and free markets. The recent crisis has reversed that trend, and the pendulum now seems likely to swing toward more regulation. The problem at the moment is that businesses don't know how much more. And when in doubt, most business leaders defer investment and hiring, which could make an already slow recovery even weaker.
The economists say that new financial and other regulation will be more evolutionary than revolutionary. But they think that in the near term, adjusting to a new regulatory framework will slow the economic expansion. The longer-term impact will depend on how onerous the new rules are. If the health-care reform raises employment costs more than expected, or if financial reform makes loans less available to small business, hiring will slow. If climate-change legislation drains capital from investment, the entire US economy could suffer.
The systemic risks that the financial crisis laid bare are the major issue for national regulators. The increased interdependence of financial markets has rendered the current regulatory system dysfunctional, in the view of many experts. US regulators have tended to look only at the institutions under their direct supervision and not at the linkages between those and other financial institutions. Especially as financial institutions started operating in different markets, and answering to multiple regulators, it became too easy to play one regulator against another. S&P says at a minimum, a systemic regulator would be needed to solve this problem, one with authority to monitor the entire system and address future damage before events got out of hand. For better or worse, neither of the current bills in Congress adequately addresses this issue, in its view.
The globalization of financial markets makes the challenge even more formidable because no one regulator can have authority over the world's markets. This increases the need for cooperation between countries. Unfortunately, however, many of the proposed changes in financial regulation would make it less rather than more consistent worldwide. This will increase the incentive for financial firms to move operations to countries with more friendly regulatory systems.
Slower Economic Growth
The Standard & Poor's economists say all of the new burdens on the economy will slow growth. The question is: How much? Real US GDP rose an average of 3.4% per year from 1960 through 2007. They expect growth to average only 2.6% over the coming decade.
The slowdown will come from two sources. The most predictable one is the slower rate of growth of the labour supply as baby boomers shuffle into retirement. The labour force is forecast to increase only 0.7% per year over the next decade compared with 1.7% annually from 1960 through 2007.
Less predictable is the trend rate of productivity, which depends both on capital spending and improvements in technology. Capital spending will slow because of higher capital costs caused by heavy government borrowing and regulatory changes. Environmental regulations could divert some investment into spending on remediation, which would depress the measured growth rate. Productivity growth is unpredictable, but the economists anticipate a reversion to the mean after two decades of strong growth. Output per hour in the US is expected to rise at a 1.7% annual rate over the next decade compared with 2.2% from 1991 through 2007.
They also anticipate that the road back to pre-credit-crunch prosperity will be long and winding. The consumer seems unlikely to lead a strong recovery. US unemployment will drop back to about 5%, but not for some time. The only sector really supplying strength to the economy is the federal government, and it can't continue to borrow at its current pace.
In past decades, however, the US and world economies have proved resilient. So while the future isn't as bright it seemed during the bygone boom, neither is it as bleak as it seemed only a year ago.