Forecasting the future: Knowing about known unknowns

The Jakarta Post ,  Jakarta   |  Sat, 12/30/2006 2:21 PM  |  Opinion

Paul Donovan, London

It seems probable that, when economic historians look back on the opening decade of the current century, they will regard this as a time of significant structural shift. New patterns of behavior, in both the real economy and the financial markets, are being established around us. It is an exciting time to be an economist -- but also a difficult time. As investors (rightly) demand forecasts for the future that reflect higher and higher levels of certainty, economists feel less and less secure in what they are projecting. Economists look to the past to provide guidance for the future. The problem is that the past (at least, the immediate past) may provide little insight into the new, changed world in which we find ourselves.

The situation can be summarized in the somewhat notorious expression coined by former U.S. Defense Secretary Rumsfeld -- ""known unknowns"". We know that there are things changing in the global economy (the ""known"" part of the phrase). What we don't know is how they will resolve (hence ""unknown"" knowns).

Consider the current situation. The U.S. has seen unprecedented levels of home ownership, unprecedented levels of indebtedness, and a rapid rise in house prices over the last five years. This is ending, and it is difficult to determine how the U.S. consumer will react to what UBS expects will be a 10 percent drop in U.S. house prices in 2007. The world economy has been dependent on the U.S. consumer to drive growth to a remarkable degree, and it is unclear how the global economy will respond to the stalling of that engine of growth.

The dependence on the U.S. consumer has led to the imbalances of the global economy as represented by the U.S. current account deficit -- at around 7 percent of GDP, a level that is without parallel in the 176 years of recorded U.S. economic history. This deficit in turn has led to over half the actively traded U.S. Treasury market being owned by foreign investors (again, without precedent), itself in part a function of the dramatic accumulation of reserves by Asian central banks. Chinese central bank reserves exceeding a trillion dollars (as they did in 2006) is without parallel for any country.

In Europe the economy is still adjusting from the structural changes of monetary union, with considerable debate about how the economy is coping. Added to this, there has been a significant change in population -- Western Europe has the fastest rate of population growth it has experienced since in 30 years, as a result of migration from Eastern Europe. The trend rate of growth (UBS contends) has risen with a higher rate of labor productivity.

Meanwhile Japan is emerging from the dark period of deflation that dogged that economy in the 1990s. The attempts to normalize monetary policy are raising concerns about the sensitivity of the Japanese consumer. The last few years have seen growth encouraged by significant investment, in particular from the service sector. As this structural investment cycle concludes (as most economists believe it will in 2007) there is less certainty about what replaces it.

How are financial markets reacting? Not as one would expect. Volatility has been unusually low -- and critically, unusually low across all asset classes. Credit spreads, for both corporate and country debt, remain at very low levels. There is uncertainty about the future, as my conversations with all sorts of investors, all over the world continue to demonstrate. However, a casual glance at the risk premia financial markets would indicate an undue degree of confidence in the future. Financial liquidity is reducing risk premia, and it is possible that investors are confusing liquidity with low risk.

So what are the known parts of the unknowns ahead? There are seven key ideas that I think can be applied to the economy and financial markets.

1. The U.S. economy will continue to slow down. The U.S. housing led slowdown is clear. Already consumption is weakening in those areas that have been sensitive to mortgage refinancing, like autos and home improvement. The negative wealth effect has yet to run its full course.

2. The rest of the world can not compensate. Household cashflow growth is slowing in Europe in the face of higher interest rates from the ECB, tighter fiscal policy, and subdued income growth. Japan's consumer has disappointed so far, and seems unlikely to be able to replace U.S. consumer demand. China is an important consumer of raw materials (and is not expected to slow domestic demand any further), but simply is not rich enough to replace the U.S. consumer. The 65 million middle class in China have a per capita income of around US$6,000.

3. Central banks will shift their positions. In the United States, which is leading the growth slowdown, we expect the Federal Reserve to cut rates aggressively. We are expecting a cumulative 1 percent reduction in Fed funds, to take the target rate to 4.25 percent by the end of the year. The European Central Bank (ECB) is not expected to follow the Fed in easing interest rates, but after a further increase in February we see rates on hold for the remainder of 2007. The Bank of Japan, similarly, is expected to make one rate increase (in January, taking the call rate to 0.5 percent), before holding for the remainder of the year. Australia should see unchanged rates, while the Bank of England should ease in the face of a softer labor market and falling inflation pressures. We also believe Indonesian interest rates will fall.

4. The dollar will continue to weaken. U.S. consumer growth should slow -- but so too will growth in the rest of the world. UBS does not see a decline in the U.S. current account deficit, but instead another increase in nominal dollar terms. As a result, the pressure to find the finance for the U.S. current account position is expected to push the dollar down further against both the euro and the yen. However, the dollar's decline should remain relatively orderly, with central banks continuing to provide a significant degree of support.

5. Commodity prices should remain fairly firm. Although global growth is slowing, the composition of growth is adjusting. First, more of the world's growth will be generated by relatively intensive consumers of commodities (like China). Second, more of the world's growth will come from industrial activity (industrial production is projected to slow less than is GDP). Finally, the dollar is expected to continue to decline, which supports (dollar) commodity prices.

6. Global bond markets should remain relatively strong. Although there may be a tactical correction in the near term, when the UBS monetary policy outlook is validated by central bank action, there should be further support for government fixed income markets. With the exception of Japan, G7 government bond markets are likely to continue to experience very flat yield curves (encouraged by institutional demand for longer dated bonds).

7. Global equity markets could perform better than fixed income. Although the slowdown in growth suggests a slowdown in earnings growth, the economic scenario is one of soft landing rather than recession (assuming that policy makers respond appropriately to the evidence of economic weakness). This should allow some increase in price to earnings ratios -- from historically suppressed levels. The multiple expansion outweighs the consequences of slower earnings growth, and allows a stronger equity performance.

Although this is a scenario based on slowing growth, it is also a benign scenario. This is the fabled soft landing -- an outcome often sought but rarely achieved. Although the U.S. is likely to grow at 2 percent next year, this is not a recession. Prompt action by the Fed, coupled with a labor market that is relatively good, should prevent a worse reaction from taking hold. Europe, Japan, and China all slow with the U.S., but not to the same degree (mitigating the damage at a global level). Markets do not react in a disorderly fashion.

Where is the risk? The risk is in the lack of risk. Markets are pricing for the best case scenario, and in the view of most economists are not attributing any probability to alternatives. This is not unprecedented -- financial markets are not perfect at pricing risk, and often underweight risk scenarios. However, if markets do chose to price in a higher probability of a risk event in 2007, then there will be a more volatile response from assets.

It is right to focus on the positives for 2007. The benign slowdown has played out almost exactly as it should so far, and the base case must be that (with appropriate policy responses) it continues on this course in 2007.

However, what we know about 2007 is matched by the uncertainty of the outcomes -- the known unknowns. There is also the risk of something totally unforeseen hitting the market, from a political, military or financial market cause: The unknown. That is not factored into financial markets at all -- nor is it likely to be until it is too late.

Therefore, pity the poor economist. It is an exciting time to be working in the profession, but uncertainty and structural change are uncomfortable companions to economics.

The writer is Managing Director of Global Economics, UBS Investment Research. This is a personal view. He can be reached at paul.donovan@ubs.com.

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