This week, we’re taking a look at research from Goldman Sachs (NYSE:GS) strategist Jan Hatzius of the 10 most important questions for the U.S. economy in 2013 in a two-part series. Find the first part, What’s Standing in the Way of the Next Bull Run by clicking here.
6. Are profit margins bound to shrink in 2013?
No. Corporate profits have grown at an 8% annualized rate during the past two decades, well ahead of nominal GDP. This has pushed profit margins to all-time highs. Basic economic intuition suggests that high profit margins should eventually mean-revert, as excess returns are competed away via higher investment or a swing back in the income distribution from capital to labor.
But while this may be the right long-term story, the forces of mean-reversion still look weak, and Goldman views modest further margin expansion as more likely. Nonfinancial domestic pre-tax margins — which account for the largest share of the historical variation of overall margins — primarily depend on the gap between price and unit labor cost inflation. With unemployment still near 8%, Goldman expects unit labor costs to grow below the rate of price inflation, and that should help margins.
7. Will core inflation accelerate significantly?
No. Goldman expects inflation (excluding food and energy) to stay around 1.5%, moderately below the Fed’s 2% target. This forecast is based on a model that explains core inflation by expected and lagged inflation, as well as the difference between the actual and structural rate of unemployment.
Of course, the outlook for headline inflation — including food and energy — is more uncertain. Goldman expects a modest acceleration from 1.5% to 2% as commodity prices rebound from their recent weakness, and there is always a risk of larger commodity price moves. But the analysts’ long-standing concern about structural capacity shortages in the oil market, which were responsible for many of the sharp oil price and headline inflation spikes of the past decade, has diminished greatly in the wake of the U.S. shale oil revolution.
8. Will there be a bond market scare over the budget deficit?
No. The large government deficits of the past five years are closely related to the dramatic balance-sheet adjustment in the private sector. The surge in the private sector financial balance from -4% of GDP in 2006 to +9% of GDP in mid-2009, which resulted from the bursting of the housing and credit bubble, led to a ballooning of the government deficit, according to the Goldman analysis.
In other words, the public sector deficit is mainly the byproduct of changes in private-sector behavior, not the result of an autonomous turn toward fiscal irresponsibility. This explains why the large government deficit of the past few years has coincided with unusually low interest rates, not the high rates that one would have expected if an exogenous increase in the deficit were to blame.
Goldman is not disputing the idea that the United States has a large long-term budget imbalance. But this problem is separate from the current deficit — and is mainly due to the sharp projected increase in federally financed healthcare spending.
9. Will the Federal Reserve stop buying assets?
No. The minutes of the Dec. 11- Dec. 12 FOMC meeting suggest that most Fed officials currently expect QE3 to end by late 2013. But Goldman analysts argue against making too much out of this. For one thing, it is important to remember that the outlook for monetary policy depends on the outlook for the economy.
The midpoint of the committee’s “central tendency” forecast for real GDP growth in 2013 is 2.65% — which probably implies growth of 3%-3.5% in the second half, given the obvious headwinds in the first half. If that turns out to be too optimistic, as it probably is, QE3 will probably last longer than Fed officials currently expect.
10. Will interest rates rise?
Not much. At the short end of the yield curve, Goldman does not expect any hikes in the federal funds rate until early 2016. This is later than the mid-2015 liftoff date expected by the median contributor to the New York Fed’s Survey of Primary Dealers and discounted in the Eurodollar futures market. At the longer end of the curve, Goldman analysts do expect a small increase in 10-year Treasury yields to 2.2% by the end of 2013. [Check out a trading idea here to benefit from a change in interest rates.]
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