Sunny, with a Chance of Relapse

At the very least, 2009 created a rare sense of unanimity among economists. With the country in its worst recession since the 1930s, and unemployment at a 26-year high, economists of all stripes agreed: the economy was a disaster.

Thankfully, 2010 should be a lot less historic. That also means the outlook for the new year is a lot less unanimous. On average, the 58 economists surveyed by Bloomberg in early December expect that the U.S. economy will muddle along at the 2.6% average annual growth rate of the past 20 years, that consumer prices will rise 2.1%, and that joblessness will remain at 10% for the year.

But these are just averages, and they obscure two distinct—and extreme—views of where the U.S. economy is headed. The first camp—let's call them the history-repeats-itself crowd—sees the economy bouncing back strongly next year, growing 3.5% or more. After all, that's what happened in the mid-1970s and the 1980s as pent-up demand powered the economy forward after steep contractions. The second set of economists argues that this time, it's different. They foresee a restrained rebound as shell-shocked workers shy away from shopping and banks keep a tight rein on credit. The result, they say, is growth next year of about 2% or less in the wake of an economy that shrank by an estimated 2.5% in 2009.

If the history lovers are correct, stocks may continue to be a good place to put money. If the revisionists are right, bonds may be the market to be in. What it may come down to is a bit of both: The economy is likely to start out strongly as production ramps up from recession levels only to fade as underlying weaknesses crimp growth. That's a view shared by Mohamed El-Erian, chief executive officer of Newport Beach (Calif.)-based bond giant Pimco. "I'm more bearish than the consensus," says El-Erian. "I think we start the year at 3% [growth] and then end up at 2%."

RAPID REBOUNDThe optimists pin their hopes on something called the Zarnowitz rule. Named after the late economist and business cycle theorist Victor Zarnowitz, it posits that deep recessions are usually followed by rapid rebounds. "A tremendous amount of activity was put on the back burner," says Stephen Stanley, chief economist at RBS Securities in Stamford, Conn. "We're going to have a lot of pent-up demand coming through."

Typically, companies slash stockpiles after a recession hits because they don't want to be stuck with products they can't sell. When demand starts to stabilize, they ramp production back up and rebuild inventories so as not to miss out on potential sales and profits.

That's likely to happen in spades in 2010, the history followers say. Through mid-2009, cuts in inventory acted as a drag on the economy for six out of seven quarters—the worst record since the government began keeping score in 1947.

In the third quarter, that pattern changed. Inventory cuts waned, allowing the economy to grow. Companies may soon start to rebuild stockpiles. "We're in a sweet spot with regard to inventories," says David Hensley, director of global economic coordination at JPMorgan Chase (JPM) in New York.

It's not just inventory that companies have cut too deeply, says Dean Maki, chief U.S. economist at Barclays Capital (BCS) in New York. Amid warnings from doomsayers that the U.S. was headed for another Depression, business slashed spending on factories and equipment and pared payrolls more than was justified by the contraction of the economy. Calculations based on Okun's law, which was developed by the late economist and White House aide Arthur Okun and links joblessness to output, arrive at the same conclusion—that unemployment should be lower than it is. "As the economy starts growing, it's no longer going to be acceptable for CEOs to tell shareholders, 'we survived,'" Maki says. "They're going to have to look for ways to expand their business and their sales."

Even housing will add to growth in coming quarters, according to the optimistic view. Faced with a collapse of the market, homebuilders cut back on construction so much that a mild revival of demand could turn things around. Residential construction accounted for a record low 2.5% of gross domestic product in the first nine months of 2009, below the post-World War II average of 4.7%.

The rebound in housing and the economy will stoke inflation and prompt the Federal Reserve to start raising interest rates in the middle of year, Stanley says. He sees the federal funds rate, the rate commercial banks charge each other for overnight loans, at 3% by the end of 2010, up from the Fed's current target of zero to 0.25%.

ON THE OTHER HAND...The pessimists brush aside talk of a housing rebound and inflationary pressures. Rather than focusing on the cyclical forces that propel recoveries, they're concentrating on structural impediments that could hold the economy back. "This business cycle is different," says Jan Hatzius, chief U.S. economist at Goldman Sachs (GS). "The downturn was driven by the bursting of a bubble."

The collapse of home prices, down more than 25% over the past three years, has destroyed trillions of dollars in wealth and left consumers more inclined to save than spend, naysayers argue. While the savings rate rose to an average 4.5% near the end 2009, it's below the 7% average of the last 50 years, so the rate may rise. "A lot of households are being more frugal," says Nariman Behravesh, chief economist at IHS Global Insight (IHS) in Lexington, Mass. "That's good for household finances but not so good for growth in the short run."

Sky-high unemployment will also act as a brake on consumer outlays. "The biggest job losses were in construction and manufacturing," says Bart van Ark, chief economist at the Conference Board. "Many of those jobs are gone forever." Permanent layoffs—layoffs of workers who don't expect to regain the same job—hit a record 55.1% of those out of work in November.

Banks are also likely to be cautious in handing out credit as they dig out from under the wreckage of the financial crisis. "What we need to do first is clean up the overhang of toxic assets that sit in zombie-like banks," says Rajeev Dhawan, director of the economic forecasting center at Georgia State University's Robinson College of Business.

The number of "problem" banks that may have to be taken over by the government climbed to 552 at the end of the third quarter to the highest level in 16 years, according to the Federal Deposit Insurance Corp. The agency also reported on Nov. 24 that the amount of bank loans outstanding fell 2.8% last quarter, the biggest drop since the FDIC started keeping records on bank loans in 1984. With bank credit tight, the Fed has little reason to lift interest rates, reason the pessimists. Hatzius expects the Fed to hold rates near zero through all of 2010 and 2011.

The economy may well start out the year with a bang. The thing to keep an eye on will be the quality and sustainability of growth. Pimco's El-Erian notes that if the economy is being powered by temporary factors, such as companies restocking shelves, investors may want to be cautious. If instead final demand is rising, with consumers and companies spending more, then happier days may indeed be here again.

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