Risky Terrain Ahead
Double-dip recession risks are on the rise, says Mark Zandi, chief economist for Moody's Analytics. However, policy makers may be able to skirt the sinkholes and establish better economic traction-with at least modest endowment returns for higher education.
By Judith H. Van Gorden
The U.S. economy is sputtering and recession risks have risen considerably in recent months, according to financial guru Mark Zandi.
As chief economist for Moody's Analytics—an independent research subsidiary of the ratings agency—Zandi serves as a source for policy makers, businesses, journalists, and the public, and is frequently quoted in national and international publications. Zandi also conducts research that focuses on macroeconomics, financial markets, and public policy. He is the author of Financial Shock (FT Press, 2009), an exposé of the financial crisis, as well as the forthcoming book, Paying the Price, which provides a road map for meeting the nation's daunting fiscal challenges.
In February 2012, Zandi will be a keynote speaker at NACUBO's Endowment Management Forum (see sidebar, "Hear Zandi at the 2012 Endowment Management Forum"), where he will share his expert analysis with thought leaders in higher education. Here, he offers Business Officer his take on the economy's bumpy road.
Zandi estimates the odds of a double dip in 2012 at somewhere around one third-an "uncomfortably high probability." What happened to the rebound?
"The economy got hurt earlier in the year by the surge in oil prices and the Japanese earthquake, which significantly disrupted the vehicle manufacturing part of our economy, which had been key to growth so far in the recovery," laments Zandi. "In that kind of weakened state, confidence got undermined by the spectacle in Washington over the debt-ceiling limit and the downgrade of U.S. long-term debt by Standard and Poor's."
The downgrade unnerved mom-and-pop investors, says Zandi. "Institutional investors weren't too surprised, but I think individual investors were taken aback, and that caused a great deal of volatility in financial markets and equity markets, and has undermined confidence."
Because other rating agencies didn't follow, he refers to the downgrade as a psychological rather than a substantive hit to the U.S. economy. "Now, if another major rating agency, like a Moody's or a Fitch, were to downgrade, then, of course, the impact would be much more substantive," he says. "There would be a greater requirement on investors to reduce their Treasury holdings. And, that would be much more disruptive."
Looking at various indices, he judges that the economy came to a halt in August. "I don't think that businesses are laying off workers," he says. "That would be a recession. But, I do think they've stopped hiring." He also voices concern over the fact that consumers—while they haven't stopped spending—have become much more cautious with their dollars.
Despite this tightening, he believes the economy's underlying fundamentals are improving. Zandi predicts a recession can be avoided if "policy makers don't make more mistakes and we don't get hit by something unforeseen.
If policy makers do the right thing over the next few months, the economy will gain traction.
"The economy's balance sheet is repairing itself quickly," he continues. "Businesses, in particular, have done a very good job of getting their cost structures down and reducing debt. Their balance sheets are very strong—about as good as I've ever seen them in aggregate. Households have de-levered very rapidly ... and the banking system is on much sounder ground."
Zandi adds that it never hurts to have good fortune on your side. "If policy makers do roughly the right thing over the next few months, and we have a little bit of luck, those better fundamentals will start to shine through and the economy will gain traction."
To stave off a recession, Zandi believes that Congress and the administration must simultaneously accomplish two goals before year-end.
"First, they've got to execute on the debt-ceiling deal, which means that the supercommittee that has been formed has to come up with another $1.3 trillion to $1.5 trillion in 10-year deficit reduction," he explains. "They've got to do that by the end of November, and the rest of Congress and the president have to sign on to it by the end of December. Otherwise, under the debt-ceiling deal, there will be automatic spending cuts, and it would be rather messy."
Congress and the administration need to accomplish this task as dexterously as possible. "I don't think the collective psyche can bear going through what we did in late July, early August again. I think that would be just too much. It would push us all over the edge and we would be back in recession. The supercommittee will figure that out. I think they recognize how close to the brink they took us."
Zandi is encouraged by the caliber of people on the supercommittee, as well as the director, Mark Prater, a Republican tax expert who has served as chief tax counsel for Republicans on the Senate Finance Committee for nearly two decades and is said to be respected by both parties. "I would consider them very serious people," he says when describing members of the supercommittee. "They've got strong views, but they're well intentioned. I'm encouraged by the process so far."
Zandi encourages endowment managers to ensure that their institutions' investments are internationally diversified. By his estimates, emerging economies now account for about half of global GDP.
Secondly, Congress and the administration must find ways to stimulate growth by taking some of the near-term spending cuts and other fiscal restraints off the table. Zandi believes that without change, the current fiscal policy will cease being a source of growth and become a very significant drag. "In 2012, the current policy will shave about 1.7 percentage points off of real gross domestic product growth," he says.
To scale back restraint, he suggests an extension of the payroll tax holiday through 2012 and an extension of emergency unemployment insurance. He explains that despite the controversy and disincentive effects, emergency unemployment insurance is a net positive for the economy, adding that it may be time "to provide a little bit more help to hard-pressed state and local governments by helping states with their busted unemployment insurance funds, so that these states don't have to start raising taxes on businesses to replenish those funds."
According to his calculations, these actions could reduce about half the restraint that's coming next year. "So, instead of 1.7 percentage points, it will be .8 or .9 percentage points, which is still significant and a drag, but I think makes it more likely we'll make our way through next year without backtracking into a recession."
Of course, policy makers will have to pay for their programs, he points out. "If they do, for example, extend the payroll tax holiday for another year, that's going to cost about $100 billion to $120 billion. That means the supercommittee is going to have to come up with an additional $100 billion to $120 billion in deficit reduction over the next 10 years to pay for it. So, whatever is added to the deficit in the near term will have to be taken away in the future. Otherwise, I don't think it will get through Congress, and it won't be signed."
He emphasizes that it's imperative for policy makers to accomplish these two actions—following through on the debt-ceiling deal and scaling back fiscal restraint—and soon. "And they have to do it in a reasonably graceful way."
Federal Reserve's Options
Zandi believes the Federal Reserve could also play a key role in helping to jump-start the economy. In addition to promising to keep the fund rate target low through mid-2013, which he classifies as a "bold" but "helpful" step, Zandi believes that Federal Reserve Chairman Ben S. Bernanke may consider three other near-term options to bolster the economy:
- Lower the interest rate on reserves. However, Zandi thinks this option could be problematic because the federal funds rate is already pretty low and some money market funds may not be able to cover their operating costs if the rate drops further.
- Implement Operation Twist. This option, which the Fed announced as a strategy at its September meeting, involves taking the proceeds from maturing Treasury mortgage-backed securities and reinvesting them in longer-dated Treasury securities. "It's a form of quantitative easing," he explains. "It's an effort to bring down long-term rates. I think there's roughly $20 billion to $25 billion a month in securities that mature on their balance sheet. So it's meaningful. It's real money."
- Expand the balance sheet. If it doesn't appear that the economy is reviving and inflationary pressures are abating, the Fed's final option may be another round of full-blown quantitative easing, which involves using the balance sheet to purchase more Treasury securities. "At this point, I think there's probably slightly better than even odds that they're going to have to go down the QE3 path and engage in another expansion of their balance sheet," probably sometime later this winter, he says. "But, that's a close call."
If the Fed opted to buy corporate bonds or nonconforming mortgages, Bernanke would have to obtain congressional approval, according to Zandi, because the Federal Reserve Act specifies that officials can purchase securities assets only if there is no credit risk. "If they take any credit risk, they're going to have to get funding to pay for it. And, to do that, they need congressional approval. So, that would get a lot more complicated," he says.
The Need for Tax Reform
As part of the debt-ceiling deal, policy makers agreed to reduce the deficit by about $4 trillion over 10 years. Since they agreed to $900 billion in August and the supercommittee is charged with finding another $1.5 trillion, "we're still $1.6 trillion short of the $4 trillion goal," he clarifies. "That's our bogey."
Without legislation, the Bush tax cuts will expire on Jan. 1, 2013. Allowing the tax cuts to expire could generate a lot of revenue—even more than the $1.6 trillion needed—but no one's very excited about allowing that to happen, he says. "Ideally, it would be great if policy makers could agree to tax reform, meaning, essentially, broadening the tax base and eliminating deductions, credits, and loopholes in the tax code."
Zandi maintains that the revenue generated by tax reform could help pay down the deficit and lower marginal rates. "Particularly for businesses, the corporate marginal rates probably are too high in the context of global competition," he emphasizes.
That concept is a political stretch, he says, even though most people think it's a great idea. "You've got constituencies that are willing to go to the mat on any one of those tax deductions or credits," Zandi emphasizes. "There are things like with mortgage interest deductions, deductions for employer-provided health care insurance, and the now-famous deductions for corporate jets and energy companies. Those things have real constituencies and people who are willing to really die for them. And, so, it makes it difficult politically to get that done."
When and if push comes to shove, he predicts the Bush tax cuts will be extended for everyone except the folks in the top one or two income brackets. "These rates will revert back to where they were prior to the cuts in the 1990s, and that will generate precisely the amount of revenue—the $1.6 trillion you need—to hit the bogey."
What About Endowment Portfolios?
Despite its faults, the economy has not been structurally damaged by recent events, asserts Zandi. He feels confident that Americans aren't in store for a lost decade or a long period of meaningfully lower growth.
Because he is optimistic that the economy is on the verge of finding its footing, he anticipates that asset returns, in aggregate, will be roughly consistent with long-term growth in the economy on a nominal basis. "That should be about 5 percent per annum across all assets—cash to stocks to junk corporate bonds to commodities. And, that means that some asset classes that are riskier will do better."
He believes that equities will average returns about 7.5 percent in the future. While he perceives a 7.5 percent return as good news, he admits that many who earned double-digit returns a decade or two ago won't be happy with these results. "I think expectations are still trying to adjust to the new reality," Zandi says. "We're not going to get 8.5 or 9 or 10 percent on a per annum basis—at least not consistently."
In his opinion, in the 1980s, 1990s, and the first part of the last decade, asset returns were pumped up by steadily weakening inflation and falling interest rates. "Of course, none of those things are going to happen going forward," he says. "I just don't think you can count on multiple expansion. At best, the multiples are going to hold their own. And that's the key reason why I think, going forward, we will get more modest returns."
He encourages endowment managers to ensure that their institutions' investments are internationally diversified. "It's pretty clear that investments overseas will probably do better, underlying rates of growth in emerging economies will be stronger, and the U.S. dollar will fall in value pretty steadily against emerging currencies going forward," he says. "So that would argue for making sure that you're diversified in terms of your investments across the globe, because returns will be better in the rest of the emerging world."
In contrast, growth and asset returns in the rest of the developed world, including Europe and Japan, will be weaker than in the recent past. "I think they've got a lot of hard work to do," Zandi says, "and it's going to take a long time for them to iron out all of the political, social, and economic issues. Asset returns will reflect these trends and issues."
As a result, he predicts that the dependence of the U.S. economy on Europe and Japan will decline. "It already has in very significant ways, through trade, through investment, through capital flows. But, that's something that can be absorbed, and will be very, very clear 10 years down the road."
By his estimates, emerging economies now account for about half of global GDP. "Increasingly, U.S. businesses are turning their attention to Asia, Latin and South America, Europe, Russia, even Africa. So, I think that's where the action is, and that's where the growth is going to come from. These are young populations that are growing up very, very quickly."
Along the way, he foresees a few bumps. "I don't think China, for example, which is so key to the emerging world's growth prospects, is going to be able to pull off becoming a deep, well-integrated economy without making big changes in its political system," he insists. "So, it's not going to be a straight line."
Outlook for Inflation
One other factor that Zandi believes may help endowment returns is that in the next two or three years there probably will not be too much inflationary pressure, particularly with unemployment hovering between 9 and 10 percent. "I don't think there's going to be any wage pressure, which is what you need to get consistently strong overall inflation. So, I just don't see it."
However, in the middle part of the decade, he cautions that inflation may be above target for central banks, which have expanded their balance sheets in order to encourage economic growth. "Central banks are pressing on the accelerator as hard as they possibly can right now. And, it's going to be very difficult for them to take their foot off the accelerator in a way that they get it exactly right, and that we don't have some inflationary issues down the road. But, I think they'll be perfectly manageable."
JUDITH H. VAN GORDEN is chair of the planning committee for NACUBO's Endowment Management Forum in 2012. She is the former chief financial officer and treasurer of the Arizona State University Foundation, Tempe, and also is chief investment officer and treasurer emerita of the University of Colorado. The interview was edited by Margo Vanover Porter, Locust Grove, Virginia, who covers higher education business issues for Business Officer.