Markets in 2009, the Role of Fiscal Policy

The MPSIF Economic Strategy team maintains a particularly negative outlook for the US economy. Our view differs from those analysts surveyed by Bloomberg as they are fairly optimistic on the state of the US economy, seeing a pick-up in growth by the third quarter of 2009. Unlike the consensus view, the Economic Strategy team believes that the market should continue to deteriorate in 2009 as the macroeconomic headwinds facing the economy will worsen before they get better. Several reasons support our view:

First, private consumption's negative growth trajectory (-3.8% Q308 and -3.5% Q408) is unlikely to reverse soon. This has dramatic consequences for the US economy as historically, consumers have represented 2/3 of GDP. A recovery path is unlikely for a variety of reasons. On the income side, labor market indicators continue to be soft as unemployment rose to 7.6% and disposable income continued its decline. Wealth factors also continue to weigh down on consumption as households' main assets (homes and stocks) suffered dramatic falls during the last year. Finally, consumption has been hampered by lower credit availability (rationing, tighter standards and disappearance of home equity withdrawals). Sluggish consumer spending is already being reflected in an increase in the savings rate which should continue to rise to compensate for the excess borrowing that characterized the 2000-2007 period.

Second, despite better corporate health in comparison to prior recessions, private investment is unlikely to pick-up some of the slack and is already falling considerably (-20% 4Q08). With profits expected to fall (13.3% projection by S&P), uncertainty in the economic environment and limited credit availability, firms will most likely cut back significantly on their capital expenditures and continue their reduction of inventories.

Third, the housing recession continues without a clear bottoming and therefore residential investment (down 23.6%) will continue to contract economic activity. The two main catalysts necessary for home buying, credit from the banks and a consumer willing to make big ticket purchases, are both in tight supply. The Treasury has been buying Fannie and Freddie paper to lower mortgage rates and the home builders are offering teaser rates to prospective buyers. A bottom still seems far as nine months housing inventory remains in the market, whereas a six month's supply is usually considered normal.

Fourth, external demand continues to dampen as the world economy continues to deteriorate. Recently, the IMF downgraded its global growth projection for 2009 to just 0.5%, the lowest since World War II. The Euro zone and the UK fell into recession in the middle of 2008 and are not expected to post a positive growth until early 2010. Policy measures in this region have not been as aggressive as in the US. Despite recent fiscal stimulus measures equivalent to 2% of GDP, Japan's economic output tumbled -12.7% annualized in Q4 2008, the sharpest decline since 1974, and Q1 2009 growth is expected to post another double digit decline. Japan's industrial sector is facing steep declines, rising unemployment is keeping consumer spending soft and the surge in the yen continues to hamper export growth. As for emerging economies, the decoupling theory proved to be an illusion as all of the economies are experiencing an important slowdown. China, India and Brazil have responded with countercyclical policies while Russia is in the middle of a currency crisis. Linkages to developed economies and the sharp decline in commodity prices will continue to limit growth in these economies.

With such a gloomy outlook in the private sector, the role of government intervention is definitive in shaping the current environment. Regarding monetary policy, the Federal Reserve has been very active in undertaking bold actions that support the real economy and financial markets. Interest rate reductions in the US have been accompanied by similar reductions in the other developed economies. Reduction in interest rates and the Fed's quantitative easing policy have provided much needed liquidity to the markets and have translated into lower Treasury rates. Despite monetary policy being an important backstop during this crisis, we believe monetary policy power is limited as long as the credit channel continues to be broken and as long as solvency issues (of households and financial institutions) persist in the private sector.

Finally, we believe fiscal policy can have substantial effects on the economy in at least two ways.

First, fiscal policy can be a countercyclical tool that can stimulate the economy, particularly in the second half of 2009 and the first part of 2010. In this regard, President Obama, signed the American Recovery and Reinvestment Act of 2009. This controversial $787 billion "stimulus bill" offers a combination of tax breaks and federal spending initiatives with a primary goal of creating and saving a total of 3.5 million American jobs. Nearly $282 billion of the bill is dedicated to individual and business tax cuts. On the spending side, some of the many widespread initiatives include $112 billion in energy and infrastructure upgrades, $71.2 billion in labor, health services and education, $57.3 billion in unemployment benefits and $25.1 billion in health insurance assistance. The effectiveness of the bill will depend on how fast the spending initiatives can be executed and to what extent tax cuts will be saved.

Second, fiscal policy can guarantee the existence of an independent financial system and generate the confidence necessary for market recovery.

In summation, we believe that the market should continue to deteriorate in 2009. A recovery by mid-2009 is unlikely as macroeconomic fundamentals remain weak without a clear sign of improvement. Fiscal policy will play a key a role in smoothing the economic cycle, particularly in the second half of 2009 and throughout 2010.

The views presented here are those of the authors only.