>From Financial Recovery to Real Recovery (CITI)

■ A solid gain in real output is evident in 4Q 2009 without the help of substantial one-off stimulus. Consumption, trade and (less favorably) inventories have all surprised to the upside in recent reports.

■ Employment data could show outright gains, if mild, before long.

■ Inflation expectations receded meaningfully in early December, and consumers noted a highly favorable pricing backdrop in the latest Michigan survey.

■ Downside surprises to the inflation path beyond November headlines may further cement recovery expectations, which have boosted all risky assets in tandem.

■ Real-side economic recovery, albeit gradual, will follow. But the speed and scope of 2009’s market turnaround makes a repeat performance highly unlikely.

■ In particular, credit markets have sharply outperformed equities, with BBB-rated long-term corporate total return since early 2007 +22.8% vs -18.0% for the S&P 500.

Early Cycle Recovery, Mature Market Rally
A negative feedback loop of tightening financial conditions and ever-worse real economic fundamentals is now showing the earliest hints of reversal. While the wounds in labor markets and consumer balance sheets run deep and sectorlevel problems remain, enough healing seems to have taken place that fundamentals bear a chance of surprising somewhat positively in the coming year. Such true positive feedback effects are typical of sustained expansions. Far from “one and done,” a solid gain in real GDP in 3Q could be followed by a quarter of growth in excess of 3% either in 4Q or 1Q 2010 (Our forecast for the two-quarter period averages 2.8%. Pricing and production data will help further quantify tracking estimates for 4Q 2009 GDP this week).

Labor market data suggest mild outright gains in employment may be possible soon, not at some distant period ahead (see figure 1). While recovery in some data series are more pronounced than others, surveys of both current and expected economic conditions by consumers improved significantly through early December. Total consumer spending continues to grow, post the removal of one-off stimulus (see figure 2). Consumption, trade and (less favorably) inventories have all surprised to the upside in the most recent reports.

While consumer-related share prices have risen sharply for nine months already, the rebound in consumer spending has been deemed impossible by enough market participants and pundits that it remains truly noteworthy. (Please see last week’s Morning Comments for discussion.) Real consumer spending appears to be on track to grow as much as 2% in 4Q 2009 above the level of 3Q, which rose 3% with “cash for clunkers” inducement. Three months ago, we expected real consumption to nearly flatten (+0.2%) on payback from the strong 3Q gain.

Of particular interest in the latest Michigan sentiment data, consumers noted their long-term inflation expectations fell back toward record lows (+2.6%). They also noted the highest prevalence of price discounting for consumer durables on record (see figure 3). Downside surprises to U.S. inflation data might seriously jar perceptions of a long-promised inflation rise that away from crude oil and commodities has yet to materialize. Stable purchasing power removes another threat of recessionary relapse.

To read the full report: PORTFOLIO ECONOMICS