Goldman's Economists Score 7 Out Of 10 For 2011

Since the 2012 Outlooks have now slowed to a drip, its appears retrospectives are the stocking-filler of choice for the week. Goldman's economist group reflects on their '10 Questions for 2011', released at the end of December 2010, and finds they were correct seven times. The tricky thing about judging the 'score' is the magnitude of the error - or more importantly the magnitude of the question's impact on trading views. Jan Hatzius and his team have had their moments this year, for better or worse, in economic sickness or health but they have largely been accurate at predicting Fed policy (or should we say 'directing/suggesting' Fed policy), but were significantly off (along with emajority of the Birinyi-ruler-based extrapolators from the sell-side) on growth (high) expectations and inflation (low) expectations. Nevertheless, the lessons learned from over-estimating the speed of healing from the credit crisis and the disin- / de-flationary effects of a large output gap (which BARCAP would argue is not as wide) when inflation is already low and inflation expectations well anchored are critical for not making the same overly-optimistic mistake into 2012.


US Daily: A Retrospective on "10 Questions for 2011"

Today's comment reviews the 10 key questions for 2011 that we posed a year ago, our answers at the time, and what actually happened.

It has been a mixed year. On the positive side, our views on Fed policy have proven accurate. On the negative side, we were too high on growth and too low on inflation. Adverse supply shocks, including the upheaval in the Middle East and the Japanese earthquake in March, explain part of these misses. But we also overestimated both the speed of healing from the credit crisis and the disinflationary effects of a large output gap when inflation is already low and inflation expectations are well-anchored.

In the last US Economics Analyst of 2010, published on December 31, we posed “10 Questions for 2011.” In today’s comment, we review each of the questions, our answers at the time, and what actually happened.

Question 1: Will we finally see a "real" economic recovery?

Our answer: Yes.

Verdict: Incorrect. Ultimately, 2011 felt much like 2010. A strong performance in the winter was followed by a sharp slowdown in the spring, renewed recession worries in the summer, and some signs of reacceleration in the fall. From the perspective of our forecasts, the main difference was that we predicted the slowdown of 2010 but failed to predict the slowdown of 2011. In fact, we thought that growth would accelerate to a 3.5%-4% annualized pace in the course of 2011.

However, real GDP grew just 1.2% in the first three quarters of 2011 and our current activity indicator (CAI)--an alternative measure of growth that takes into account a broader range of data--grew 1.9% in the first eleven months of 2011. Depending on which of the two measures we use, this implies that growth has fallen short of our forecast by 2 to 2-1/2 percentage points.

What explains this miss? We see three factors:

1. Adverse supply shocks account for a 3/4-point miss. We estimate that the nearly 30% increase in seasonally adjusted gasoline prices between November and April--largely due to increased supply worries in the wake of the "Arab spring"--shaved 1-1/2 percentage points from real disposable income growth in the first half of the year. With little change in the saving rate at the time, most of the real income hit fed through into weaker consumer spending growth. In turn, with little change in net trade, most of the consumption hit fed through into real GDP. (Note that this implies a real GDP hit of about 1 percentage point, since the level of consumption is about two-thirds that of GDP.) The supply-chain disruptions following the East Japan earthquake of March 2011 also weighed on growth for a while. For the first three quarters of 2011, we believe that adverse supply shocks may have subtracted 3/4 percentage point from growth.


2. Fiscal retrenchment accounts for a 1/2-point miss. When Congress extended the 2001-2003 tax cuts for another two years and passed the temporary fiscal measures--especially the payroll tax cut--at the end of 2010, we thought that this meant a roughly neutral fiscal stance in 2011, with slight net stimulus from the federal government offset by slight net restraint from state and local governments. However, we now believe that fiscal policy has subtracted about 1/2 percentage point from growth in 2011 so far. The official GDP data show that a reduction in government spending, concentrated in the state and local sector, has subtracted 1/2 percentage point from growth; meanwhile, there seems to have been little change in overall tax rates after accounting for income, payroll, and sales taxes. Overall, this suggests that fiscal policy subtracted 1/2 points more from growth than we expected.


3. A longer "hangover" may account for the remaining 1-point miss. The preceding two points explain perhaps 1-1/4 points of disappointment, but this still leaves approximately another 1 percentage point. An obvious candidate explanation is the European crisis, which has intensified beyond most people's expectations (including ours) this year. But we think that this explains only a small part of the miss. Instead, a more plausible story is that the "healing" in private domestic demand has simply progressed more slowly than we had expected at the end of last year, when measures of underlying final demand had started to pick up at a fairly impressive speed. In other words, the "hangover" from the bubble seems to be lasting even longer than we thought.


Question 2: Will the housing market recover meaningfully?

Our answer: No.

Verdict: Correct. Although housing starts and home sales did rise slightly through 2011, the increase has fallen short of what we would call "meaningful." Moreover, house prices have fallen on net, and some measures show a reacceleration in the pace of decline in recent months. We expect a somewhat better performance in 2012, with starts and sales growing more noticeably and home prices stabilizing late in the year.

Question 3: Will the trade deficit shrink substantially?

Our answer: No.

Verdict: Correct. The trade deficit has been essentially unchanged in 2011, as both exports and imports have grown at impressive 10%+ rates through the year. We expect more of the same in 2012.

Question 4: Will the unemployment rate fall?

Our answer: Yes.

Verdict: Correct (but partly for the wrong reasons). The unemployment rate fell from 9.8% in November 2010 to 8.6% in November 2011, which is actually somewhat below the 9% we expected a year ago. The larger-than-expected decline occurred despite weaker-than-expected GDP growth, as the labor force participation rate fell by another 1/2 percentage point to 64.0%, the lowest since 1983. Going forward, we expect the unemployment rate to move sideways to higher as growth stays sluggish and participation stabilizes.

Question 5: Will inflation move back toward 2%?

Our answer: No.

Verdict: Incorrect. Both core and headline PCE inflation rose significantly in 2011 and now stand at 1.7% and 2.7%, respectively. Part of our error was due to the bigger-than-expected increase in the prices of oil and other commodities, as well as the surge in automobile prices following the Japan earthquake. But we also underestimated the upward pressure on rents in an environment of still high but gradually declining excess supply of housing; in particular, our expectation that excess supply in the owner-occupied sector would also hold down rents in the renter-occupied sector (via an arbitrage relationship between the two sectors) proved incorrect. More broadly, we probably overestimated the disinflationary effects of a large output gap at a time when inflation is already very low and inflation expectations are well-anchored. All that said, inflation now does seem to be slowing again, and we see the core PCE deflator back at 1.3% by the end of 2012.

Question 6: Will profit margins rise further?

Our answer: Yes.

Verdict: Correct. When measured as after-tax profits as a share of GDP, profit margins rose from 6.8% in the third quarter of 2010 to 7.3% in the third quarter of 2011. When measured as S&P 500 earnings per share in percent of revenue per share, margins rose from 8.3% to 9.0%. Going forward, we expect margins to flatten out both on a top-down and bottom-up basis.

Question 7: Will QE2 end on schedule, i.e., in June 2011 with total holdings of $600bn?

Our answer: Yes.

Verdict: Correct. Fed officials did stop the program on schedule at $600bn. Since then, they have embarked on "operation twist," whose effects on financial conditions are similar to QE in our view, and we expect them to return to QE in the first half of 2012.

Question 8: Will Fed officials start to “exit” from their current policy stance by raising the funds rate or shrinking their balance sheet?

Our answer: No.

Verdict: Correct. Despite some hawkish signals early in the year, Fed officials ultimately embraced a "lower for longer" view and are currently indicating no rate hikes until "at least mid-2013." With the short-term rate discussion settled for the time being, we moved to a view of further easing in August, which occurred in September via "operation twist."

Question 9: Will the 10-year Treasury note yield end 2011 above the current level of 3.4%?

Our answer: Yes.

Verdict: Incorrect. Despite our bullish call at the front end of the yield curve, we predicted an increase in rates at the longer end (albeit a moderate one that was below the forwards at the time of our "10 Questions" note). At least part of this was due to the worse-than-expected domestic growth performance and the greater "flight to quality" in the wake of the intensifying European crisis.

Question 10: Will the state and local budget crisis derail the recovery?

Our answer: No.

Verdict: Correct. The widespread fears about state and local finances at the end of 2010 did not materialize. Municipal governments have not defaulted in large numbers, and municipal bonds outperformed most other sectors of the fixed income market in 2011. While continued fiscal tightening was responsible for much of the improvement, the negative impact on GDP growth from state and local spending has actually diminished a bit in the last few quarters and should continue to do so in 2012.