There’s always uncertainty about how economies and financial markets are going to perform, but there has seldom been as much confusion and different interpretations of data as there is now.

Case in point: a convincing argument can be made that the U.S. is still in recession and, at best, is likely to grow only very slowly for many years. But a convincing argument can also be made that U.S. growth will be around 2.5% next year and 3%-3.5% in 2012-13.

Positioning your clients in this environment is daunting — unless you’re convinced the U.S. will rebound fairly quickly. And the performance of the U.S. economy is key to global economic recovery. The economic health of many nations — including Canada — depends to a large extent on the U.S., mainly because these nations rely on exports to the U.S.

Although Canada would be pulled down by a return to recession in the U.S., our good economic fundamentals should keep us from having as rough a time. Germany, for its part, is in relatively good shape, but many other European counties could experience serious difficulties. U.S. weakness also would probably slow growth rates in emerging markets

Says Carlos Leitao, chief economist and strategist with Laurentian Bank of Canada in Montreal: “You need a lot of prudence in the near term.”

One of the risks in the economic outlook is that, with mid-term elections coming up in the U.S., Washington will not renew the tax cuts initiated by former president George W. Bush and might start to cut spending — which, Leitao and other economists say, would almost certainly push the U.S. back into recession.

Another risk is that businesses and consumers will begin to believe the current talk of a double-dip back into recession, which could erode confidence in the economy and create the recession they are fearing. Beata Caranci, deputy chief economist with Toronto-Dominion Bank in Toronto, puts the odds of this at 33%, given the power of emotion.

Here’s a look at three broad scenarios for U.S. growth:

> The Pessimistic View. David Rosenberg, chief economist and strategist with Gluskin Sheff & Associates Inc. in Toronto, thinks the U.S. is still in recession and needs to go through a major restructuring. This would entail U.S. households reducing their debt by another US$5 trillion on top of the US$1 billion already paid off.

The U.S. personal savings rate is currently 6%, vs 1% in 2005. If it stays there, it would take 10 years to pay off the US$5 trillion; if it rises to 10%, paydown would take six years. The U.S. would grow very little over whatever time period is required.

This analysis is based on Rosenberg’s belief that U.S. consumers need to reduce their debt to around 67% of annual personal disposable income — the average in the 1952-97 period. Debt was 126% of personal disposable income in the first quarter of 2010, down from a peak of 136% in the fourth quarter of 2007.

With Americans continuing to reduce their debt burdens, consumer spending, which accounts for 70% of U.S. gross domestic product, will be weak and the unemployment rate won’t come down — and may move up, possibly to 12%-13% during the next few years from an estimated 9.7% this year.

> The Optimistic View. Jean-Guy Desjardins, chairman, CEO and chief investment officer with Fiera Sceptre Inc. in Montreal, doesn’t think Americans have to reduce their debt nearly as much as Rosenberg does. Desjardins looks at debt-servicing costs as a percentage of personal disposable income — and, by this measure, Americans have already done most of the work they needed to. The ratio is down to less than 12.5% from 14% in late 2007/early 2008. Once it’s below 12%, which he thinks will happen in the next year or so, he expects U.S. consumers to start increasing their spending more aggressively than most analysts anticipate, although not at a booming pace. Nevertheless, he thinks, the retail shopping sector will produce enough GDP growth in 2010 — around 2.5% — to start moving the jobless rate down, probably by half a percentage point.
@page_break@The reason there would be no retail spending binge is that as soon as the consumer is in good shape, U.S. governments will have to reduce their deficits and debt — and that will require spending restraint and tax increases, which will constrain GDP growth. Desjardins expects the U.S. GDP growth to gradually accelerate over the next three to four years to 3%-3.5%.

Desjardins’ scenario assumes that: the just completed Basel III global banking system agreement produces greatly increased confidence in banking systems around the world; the confidence leads China to continue to appreciate its currency, making the U.S. dollar and U.S. exports more competitive; and the U.S. comes out with a credible deficit- and debt-reduction program.

> The Moderate View. Many economists aren’t as optimistic as Desjardins yet agree that the U.S. is in recovery mode.

These economists don’t see a return to recession unless there’s a plunge in confidence. Their forecasts for U.S. GDP growth next year is around 2%, vs Desjardins’ 2.5%, with gradual improvement thereafter.

Caranci, for example, is forecasting 2.6% GDP growth in 2012 as a whole. But, by the end of that year, she thinks, the economy will be growing at a 3.2% quarter-over-quarter pace in the fourth quarter, at which point she expects the unemployment rate to be down to 9.4% from an estimated 9.7% for this year and 2011. She notes that there are some signs of credit easing, but admits there’s no hard evidence of this. Small businesses, normally responsible for about half of the jobs created in any given period, continue to have difficulty finding financing.

So, in this uncertain economic environment, what factors should you consider in making asset-allocation decisions for your clients?

> Cash. A lot of cash and other short-term liquid instruments are unattractive because their returns are so low. Some analysts, including Desjardins, favour cash over bonds. He thinks bond investments could be a “disaster.” He expects the Bank of Canada’s overnight target rate to move up to at least 2.5% from today’s 1% in the next 12 to 18 months.

> Bonds. Returns aren’t great, but Leitao and some other strategists recommend overweighting fixed-income investments for now because they are convinced that interest rates won’t move up quickly.

Rosenberg particularly likes corporate bonds. With non-financial corporate balance sheets in the best shape in 50 years, corporates offer good yield over government bonds, he says. This includes some non-investment-grade bonds — Rosenberg says BB-rated issues currently offer the most lucrative risk/reward return. He recommends premium income funds, with a mix of hybrid bonds, preferred shares, bonds and dividend growth stocks.

> Equities. Overweighting in equities makes sense if you are betting on decent U.S. GDP growth in the next few years, as Desjardins does. Note that he suggests overweighting U.S. equities because they are more undervalued than other stocks and because he believes U.S. consumer spending will be stronger than investors expect.

Although less optimistic than Desjardins, Avery Shenfeld, chief economist with CIBC World Markets Inc. in Toronto, also likes equities, pointing out that the yield on stocks that pay good dividends and whose earnings are growing are more attractive than bonds.

Some holdings of emerging markets and resources stocks could also be a good idea. Even Rosenberg favours these. He recommends precious metals stocks because of their potential strength as investors worry about drops in the US$.

But, he also says, it would be a “big mistake to bet against emerging markets or sector growth dynamics in Asia.” On the sector side, he favours agriculture as well as energy and base metals, because food demand will be strong, given the population growth and rising standards of living in developing countries.
IE