January 1, 2011
The Holy Grail: Equity-Like Returns Without Taking Equity-Like Risks
Too often, nobody cares about risk adjusted returns until the risk is realized.
We want the hope of riches, and we also want freedom from the fear of poverty. Those are typically mutually exclusive goals. But in 2010 this was an available option, and Berkshire Money Management took advantage.
In 2011, to achieve equity-like returns we will need to throw more caution to the wind and build up equity positions.
On October 11, 2010 we posted an update to our 2010 Outlook, which had a subtitle that read “The Only Problem with Dividend Payers: Nobody Cares About Risk Adjusted Returns”. That second-half of that title, as I thought about it more, was wrong. More accurately, “Nobody Cares About Risk Adjusted Returns Until the Risk is Realized.”
An obvious example is that a lot of investors would have described themselves as “Aggressive” in 2007 as they preferred to always remain in the stock market and willing to take the risks associated with being there. But then after risk was realized in 2008 & 2009, many investors re-described themselves as something more “Conservative.” Every body is a long-term investor until they see short tem losses.
This is not a new psychological phenomenon for investors. The World’s Work, a magazine published a century ago, warned investors about the false hope that they could easily replace safer investments with those offering the possibility of higher returns, without accepting a significant degree of higher risk. A New York bond broker once wrote an article for the magazine to say that he was unable to sell the bonds of a city in upstate New York because bonds in Philadelphia offered higher returns.
The story was simple. The New York bonds were safer as they were backed by an existing rail line. The Philadelphia bonds were more risky as they were tied to a proposed airline route. The World’s Work followed the story to its conclusion. Three years later, the bonds offered through New York made the money promised. The Philadelphia bonds became worthless as the entity went bankrupt, and after the property was sold off there was nothing left for the bondholders.
We want the hope of riches, and we also want freedom from the fear of poverty. Those are typically mutually exclusive goals. But in 2010 this was an available option. Sometimes discretion is the better part of valor, and there is a rare no-brainer opportunity to recognize equity-like return, without having to take equity like risk. That was achieved for calendar year 2010.
We expect 2011 to be different.
Berkshire Money Management (BMM) tries to talk with clients several times per year, and I (Allen Harris) try to sit in on at least one of those conversations in a more formal discussion regarding our economic & market expectations, and how that will directly impact the strategy used in each client’s portfolio.
While conversations are specific to individual clients, there are typically themes that carry through those conversations as BMM typically works from a base-case scenario. When we had these conversations in the beginning of 2010 the theme was that 1) we are going to have a significant and painful correction starting in April 2010, but that would most likely only be a big disruption to the primary bullish trend (*), and 2) the market would shake off this big disruption and returns for 2010 would end up in a range of high single-digits to low double-digits (some something like 7-13% returns).
Both of our stock market calls turned out to be shockingly accurate for 2010. Using this as a base-case scenario, we shared with clients our rationale for relatively conservative portfolios (i.e. lots of yield via junk bonds and preferred stocks). (Not to mention, unless you are the most aggressive of investor it makes sense to not be one hundred percent in equity one hundred percent of the time anyhow). The idea was that with junk bonds yielding about 10% at the beginning of the year, and preferred stocks yielding about 7% at the beginning of the year, BMM clients could get what we called “equity-like” returns without having to assume full equity-like risk. In other words, our base-case scenario for 2010 would allow us to get what we considered to be generous returns for clients without having to assume big risks. For example, at mid-year (June 30, 2010) the S&P 500 was down about eight percent for the year. An eight percent decline is fairly significant. BMM encourages you to review your mid-year returns compared against that decline – we believe you will be happy that we consider ourselves not just investment managers, but also risk managers.
And there has been a lot of risk over the last decade. The Dow Jones Industrial Average was up 10% in December 2010, but it is up only 7% for all of 2001-2010. And there were a lot of ups and downs in between. While we enjoy these types of one-month returns like we just saw, BMM specializes in longer-term trends, which explains a lot of our success.
In 2011, compared to 2010, we will be throwing a little more caution to the wind and building up equity positions. We won’t alienate our dividend/interest-paying strategies, but we will certainly be allocating more investments toward growth-assets than we did in 2010. Why? Two reasons. 1) Our downside risk is considered to be significantly less in 2011 than 2010, and 2) our upside reward is considered to be significant more than in 2011 (more on both later).
(*) In our 2010 Outlook we called the timing and magnitude of the top with eerie precision. We were, however, more concerned with the magnitude of the drop. We expected something greater than a 21% correction, but the market only dropped 16%. Specifically we wrote:
“Consistent with our expectation of a strong start to 2010, a correction, on average, could be expected to begin on April 6, 2010. The rationale for this view is straightforward, and explained in more detail in “Cash For Stocks”… A probable worst-case scenario would be a 1977-like decline of about 21% after “only” reaching 1,200 points on the S&P 500 (which would rival the 1975 advance) in April of 2010 (bringing the market down to our Risk-Level of 950 points sometime in September of 2010).”
Global Outlook
For the global stock market trend, we stick with our year-ago forecast, that the fourth-quarter of 2010 would see a rejuvenated stock market that would rally into 2011.
By mid-year (up to possibly August) stocks may no longer tolerate the global uptrend of Treasury and mortgage rate yields. Currently, with optimism already high (a contrarian bearish indicator) and valuations stretched, a peak could be expected. Going longer-term, any sell-off later in 2011 would be followed by rallying into 2012.
Berkshire Money Management has a habit of formally reviewing our 12-24 month outlook four (4) times per year. In between, of course, we are having hour-long daily conversations about the information du jour, the interpretation of such data, and how that may (or may not) affect our formal view of existing strategy and/or current investment positions.
Given that we at BMM are not traders (when we buy an investment we typically want to hold it for at least a year; one position we hold for many clients we have actually held for nearly a decade) you may wonder why we spend so much time analyzing the economy and the market. After all, most other investment advisers buy something and preach “don’t worry, you’re in it for the long term”.
As we always say, BMM is not only an investment management team, but also a risk management team. Most of our clients are already rich; they aren’t paying us to make them rich. Yes, they do want us to make them more rich (mission accomplished, thank you very much), but an important part of what BMM does is to make sure clients continue being rich – that they don’t lose their money. Think of BMM an investment firm and an insurance company – you pay us not only to buy the right things for you, but you could consider that part of the management fee is also an insurance premium that prevents your portfolio from participation in crashes like 2002 or 2008.
BMM was in cash for both of those crashes, and we were in cash early – early as in 12-18 months early. Just as the rest of the world was feeling most optimistic and were scrambling to buy whatever stock they could get their hands on, we went against “crowd psychology” and reduced equity positions. When trying to predict what the markets are going to do in the year ahead, we do so with a great deal of confidence. But what we are always most confident of is that we will be surprised by developments that nobody can predict. So rather than us taking any of our own projections too seriously, we stay flexible by remaining focused on daily updates of indicators and regression models, which continue to drive our allocation decisions.
It is particularly interesting for us to come up with our annual outlooks because it is that time of year where everybody else is doing the same. This gives us an easy opportunity to measure crowd psychology. We are self-proclaimed contrarians to extreme crowd thinking (emphasis on “extreme” because that is where we can find the biggest risks as well as the biggest rewards). But crowd psychology can, and does, change as the year progresses. Therefore, for the sake of managing the risk of your portfolio, we spend more time looking at your investments as well as the broader economy and markets than, we think, most other firms (definitely more frequently than the “buy-and-hold, ride-out-the-crash, don’t-worry-about-it-you’re-in-it-for-the-long-term firms”). Because, after all, as they say in boxing, it’s the punch that you don’t see that knocks you out.
With that in mind, theses pages illustrate our expectations for 2011 (with a summation at the end). For the global stock market trend, we stick with our year-ago forecast, that the fourth-quarter of 2010 would see a rejuvenated stock market that would rally into 2011. Our best guess is still that as the year gets started, stocks will continue to move higher, as will interest rates of countries’ reserve banks (note: we phrased the interest rate scenario that way because quite frequently we hear from investors that the notion of “higher interest rates” – any kind of interest rates – are bad for “bonds” – any type of bonds; it’s only bad for the particular interest rate that is associated with a particular bond. We know, it’s complicated – we find that most investors don’t “get it” when it comes to interest rates and bonds. But there are lots of different types of interest rates and lots of different types of bonds. The bottom line here is that it’s not good for Treasury bonds, but it is o.k. for corporate bonds).
By mid-year (up to possibly August), however, stocks may no longer tolerate the global uptrend of bond (i.e. Treasury) yields. Currently, with optimism already high (a contrarian bearish indicator) and valuations stretched, a peak could be expected. Going longer-term, any sell-off later in 2011 would be followed by rallying into 2012. Unfortunately, then we begin to see a resumption of the bear market lasting into mid-2012. But that’s a long way off considering the available opportunities between now and then.
For now, the outlook is bullish, as reflected by our earlier sentiment that we may reduce some yield-oriented investments in exchange for more growth-oriented investments. We are fortunate to have a rally that is supported by both seasonal and cyclical tendencies, but the real evidence is improving economic conditions around the globe.
Regarding the earlier comment about optimism already being high, it is; but not yet at an extreme. Much of the optimism is investor optimism, which gives you the sense that the market could stall soon and pull back 3-4% pretty easily. But consumers remain cautious – very cautious. In June 2009 BMM proclaimed that we would be out of the recession in the Summer of that year. The National Bureau of Economic Research (NBER), the unofficial official arbiter of economic cycles, a few months ago cited June 2009 as the end date of the previous recession. Yet here we are, eighteen months later, and many (if not most) American consumers feel as if we are still stuck in a recession.
This is important because of the truthful adage that stock prices “climb a wall of worry,” thus the consumer’s worry is a positive sign for the global stock market trend, in so much that it has bottomed and is improving. As the consumer confidence numbers suggest, investors have priced in a lot of bad news, leaving stock markets poised to respond positively to economic improvement. Ideally, when using contrarian analysis, you want to get more aggressive when things are still bad, but a) the rate of getting worse slows, or b) things actually begin to get better.
Interest Rates
Treasury and mortgage rates are expected to rise.
Corporate bond rates are expected to decline.
Earlier we referred to our prediction that as the year gets started stocks will continue to move higher, as will interest rates of countries’ reserve banks. A more common way to phrase that sentence is to drop the “of countries’ reserve banks” and just say “interest rates will rise.”
But that would be misleading; at least it has been misleading to many people we have talked to. Somewhere along the way many (if not most) investors heard and remembered the phrase “it’s bad for bonds if interest rates go up.” And that is true if (and only if) the interest rates in question are specifically linked to associated bonds. For example, if the U.S. Federal Reserve raised the federal funds interest rates then it is bad for Treasury bonds (that common phrase works). But if the U.S. Federal Reserve raised interest rates then it could be a good thing for corporate bonds? Why is that so? It is so because of the rationale of the Fed for raising their rates – things are getting better, so there is less risk out there, and because there is less risk corporations can issue bonds at lower rates, actually pushing down corporate interest rates, making the corporate bonds themselves go up in price.
Clear as mud? Don’t worry about it. All you have to do is just throw away that frustratingly confusing umbrella-like adage about the inversion of bonds and interest rates (except when you are being very specific about the interest rates of particular bond category).
Just as the decision for the Fed to raise their interest rates (the Federal Funds rate) would be a positive omen for corporate bonds due to the Fed’s rationale for their action (i.e. the economy is gaining lots of traction) it, too, would initially be good news for stock prices. There should be some emphasis there on “initially”. Because initially stocks would rally based on moving away from a sluggish economy and deflation fears. But as optimism grows, stock prices may become worried that too much growth could spark inflation. For U.S. stocks, the ten-year Treasury can probably climb to just over 4% (as it did in April 2010) before we have to worry too much about equity exposure.
Currently the ten-year Treasury is about 3.3%, so there is room for stock prices to run as stocks can withstand the rate pressure. But that is likely to change later as inflation expectations increase. Rising interest rates could be the major influence that leads the stock market to a cyclical top around the middle of 2011.
Emerging Markets
In our “Third-Quarter Update for the Economic Outlook for 2010” we dedicated three pages worth of data and rationale on Emerging Markets. If you have not yet had a chance to read it, or if you would enjoy a refresher, please do go back and read it – three months later it remains relevant.
Projections for the S&P 500
Our projections for 2011 have us putting a little more risk in portfolios. As we said in the Outlook for 2010 and are reiterating here, we expect the fourth-quarter 2010 rally to run into 2011.
We have what is an uncomfortably aggressive Risk Level of 1,215-points on the S&P 500.
Similarly, our upside Reward Level is embarrassingly high at 1540-points.
We do take some comfort in this ridiculously bullish forecast in so much that the percent move from Risk to Reward would be consistent with normal volatility (the median move between a given year’s low and high).
It’s quite likely that a mid-year (August?) high would mark the end of the cyclical bull market that started in March 2009 and the start of a new cyclical bear market.
In the 2010 Economic Outlook we wrote:
“The stock market’s rally from the March 2009 low is expected to advance into the first half of 2010, approaching the Reward Level of 1,350 points on the S&P 500. Weakness is expected in the second half of 2010, as the S&P 500 corrects toward 950 points. (Note: The levels are extremes; the direction is more important than the levels in determining asset allocation.) “
The noted extremes were not reached on either the upside or downside, although the S&P 500 did get to 1,010-points on the downside. It wasn’t as extreme as we had feared, but there was plenty of reason for us to get more conservative (as we did in April 2010, and then more so after the “Flash Crash” in May 2010). Although our level of precision was extremely accurate, BMM can be faulted for sticking to the “no-brainer” safer strategies discussed with clients in early 2010 (if we had to make a bumper sticker out of the description of that strategy it would have read: “protect assets now, so there is more to grow later”). The stock markets rallied hard, real hard, starting in mid-September and had a wonderful December. And while junk bonds and preferred stocks participated with equity-like returns without the equity-like risk, we are cognizant that it is difficult for investors to measure and identify with risk-adjusted returns.
CNBC ran a series this year interviewing investing legends such as Warren Buffet, Bill Gross, Larry Fink, Stephen Schwarzman, etc about their worst trades. In other words, those “woulda, coulda, shoulda” stories we all have. And for 2010, BMM’s “woulda, coulda, shoulda” story was that we could have assumed more risk than we did. But as we have discussed with clients we would always prefer to be out of the market wishing we were in, than in the market wishing we were out!
Our projections for 2011 have us putting a little more risk in portfolios. As we said in the Outlook for 2010 and are reiterating here, we expect the fourth-quarter 2010 rally to run into 2011. We have what is an uncomfortably aggressive Risk Level of 1,215-points on the S&P 500. That is uncomfortably aggressive because it translates to nothing more than a three-and-a-half percent correction from current levels; it only brings the market down to the highs of April 2010.
We have never, ever caoe up with such an incredibly bold downside Risk Level. But, as suggested in the 2010 Outlook, etc. the direction is more important than the levels in determining asset allocation. The point here is that we see little downside risk for 2011.
Similarly, our upside Reward Level is embarrassingly high at 1540-points. Again, the direction is more important than the level in determining asset allocation. And to be clear, for both, as we always do, we come up with Risk Levels and Reward Levels – they are not necessarily specific projections, rather they are our best guesses as to what could be the worst case and the best case scenarios.
Still, we must admit, it is difficult for us to use a range of 1215-1540. It allows no room for anything less than a perfect market on the downside, and it supposes better than perfection on the upside. But the math we used to create our Risk/Reward range this year is no different than what we’ve used in the past and we have been very accurate in terms of timing and direction, even if extreme levels are not necessarily always met.
We do take some comfort in this ridiculously bullish forecast in so much that the percent move from Risk to Reward would be consistent with normal volatility (the median move between a given year’s low and high). A return to more normal volatility and more muted returns was one of the developments we expected for 2010; after the market dropped 38% in 2008 and then rose 23% in 2009. Admittedly that wasn’t too bold a guess. We expect a similar pattern in 2011, but with the rally lasting longer into this calendar year and the drop being less terrifying before the primary uptrend resumes.
With stocks already up for 2010 (even if possibly ready to correct in the first few weeks of the New Year), there are a number of bullish indicators that allow us to be comfortable defining a stock market range with limited downside and perhaps a surprisingly strong upside. The list includes:
Plans for another monetary infusion by way of another round of US Federal Bank quantitative easing (popularly called “QE2”) have been followed by a tax compromise that offers fiscal reassurance for the near-term, at a time when economic momentum is already picking up.
While long-term interest rates in the Treasury market and the mortgage market have moved up, a broad-based interest rate concern has not developed.
Short-term interest rates in the Treasury market and the federal funds interest rates have remained low, making the yield curve very steep and very profitable for the banking sector (which allows for easier access to credit, fewer failures, etc).
Credit conditions have become more favorable at both the corporate and individual levels.
Merger & Acquisition activity has picked up.
The currency markets have become more stable.
While the growth rate may diminish relative to 2010, the prospects remain good for steady earnings growth.
The S&P 500 is still close to fair value, allowing for price-to-earnings multiple expansion.
The trend is our friend.
Continued rallying is suggested by our 2010 and our 2011 cycle composites (which are an aggregate of historical trends based on 1-year Calendar cycles, 4-year Presidential cycles, and 10-year Decade cycles).
Mid-Year Peak
So will there be a rough patch? Absolutely. But that is typical and ordinary and part of the cost of being involved with the equity market. But we don’t expect anything close the deviant levels of volatility seen in 2008 and 2009, when it reached levels only previously reached in the early 1970’s.
While the Risk Level would be around current levels (just about a four percent drop from year-end closing, which we could very well reach in the first few weeks of the New Year), the Reward Level is around the S&P 500’s 2007 high. With the U.S. market still in the midst of a secular bear market that started in 2000, more than marginal record highs would be not just unlikely, but historically impossible. Investors would not be likely to tolerate price-to-earnings multiple expansion much beyond those previous highs.
It’s quite likely, in fact, that a mid-year high would mark the end of the cyclical bull market that started in March 2009 and the start of a new cyclical bear market. Given our 2010 expectation for a 21% stock market drop that ended up “only” being a 16% drop, we do not want to come across as the investment management team that cried wolf. The truth is, 1) 16% is a big drop and was consistent with both our timing as well as explanation that the trend is more important than the magnitude, and 2) a mid-year peak would be consistent with historical tendencies.
By the middle of 2011, the cyclical bull will be nine quarters old. Of 34 cyclical bull markets since 1900, only 10 have lasted longer than nine quarters (2.25 years), and only two of those cyclical bulls have taken place within secular bears. After two years of a cyclical bull within a secular bear, the market’s performance has usually been flat or negative during the following year (an average gain of 1.4% over twelve months).
Closing Thoughts on the U.S. Stock Market
Berkshire Money Management follows the rule of not following the crowd at extremes.
Investor sentiment is high enough to convince us that the risk of a near term market pullback appears high. That day of reckoning may not begin today or tomorrow, but it is not at all unlikely to see it start in the days or weeks (as opposed to months) ahead.
The recent rally coupled with a likely pullback may present a better opportunity for culling under-performing investments from portfolios, with the expectation of reinvesting the proceeds into other investments that we have on our radar screen. This would make sense as our 2011 Outlook remains positive and any near term pullback should be limited.
Berkshire Money Management follows the rule of not following the crowd at extremes. Some would say that makes us contrarians, but it is important not to simply invest contrary to the market for contrarian’s sake. Mathematically, not following crowds at extremes makes a lot of sense. And that’s why we like to track and use a host of sentiment indicators.
For example, take into consideration that the price of anything, including stocks, is simply a function of Supply vs. Demand. If sentiment is very optimistic, that means investors and/or consumers believe the future is good and, therefore, they are going to invest their money. When every available investor has already put their cash to work, that translates into diminished Demand (everybody who could buy has already bought, so there is no room for additional demand) and leaves stock prices vulnerable to increased Supply (if investors begin to sell, there is no one left to buy the stock, thus no means to keep prices up).
Sentiment, by itself, though is a blunt timing instrument. High levels of bullishness or bearishness can be correct about the market’s direction (leverage can be used to buy more, new buyers can be drawn into the market; similar examples can be used on the downside). These measures are typically best used as contrary indicators only when confirmed by other indicators of a possible change in trend for the market indexes (and/or when sentiment trends change direction). With investor sentiment having grown over the past couple months, we consider this to be an instance where sentiment is, in fact, in sync with the market trend and is not fulfilling its role as a contrary indicator.
This is likely true because, as indicated, sentiment in all non-investor surveys is extremely bleak. But investor sentiment is high enough to convince us that the risk of a near term market pullback appears high. That day of reckoning may not begin today or tomorrow, but it is not at all unlikely to see it start in the days or weeks (as opposed to months) ahead.
We do not view the risk of the coming stock market correction as large enough to cause an actionable response in portfolio management (i.e. raising cash, selling equities and buying bonds). But the recent rally coupled with a likely pullback may present a better opportunity for culling under-performing investments from portfolios, with the expectation of reinvesting the proceeds into other investments that we have on our radar screen. This would make sense as our 2011 Outlook remains positive and any near term pullback should be limited.
Style Allocation
Riskier investments are likely to perform better in the first half of 2011.
Dividend Paying stocks are likely to perform better in the second half of 2011.
As a result, in the short-term we are recommending a barbell approach of overweighting high-beta asset classes (i.e. emerging markets) as well as holding the safer Dividend Payers.
A cyclical bull market peak around mid-year (August?) that gives way to a new cyclical bear would be a detriment to the equity leadership we expect for the first half of 2011. While Dividend Payers would do well on an absolute prior to the change (still bullish), they would do well, at the very least, on a relative basis after the change (turned bearish).
That is to say that “riskier” asset classes may perform better in the first half of 2011, which makes sense as cash is put to work to satisfy new found risk appetite. In the second half of 2011, after the switch from cyclical bull to cyclical bear, look for Dividend Payers reassert their relative strength which, too, makes sense as the riskiest assets are sold and proceeds are used to seek yield.
This played out in the fourth quarter of 2010 as it was the garbage of the equity world that performed best – the riskiest companies, those with stock prices wielding the highest volatility, those with the highest likelihood of failure; those are the ones whose stock prices performed best.
Going back to the concept of easily getting equity-like returns without having to take on equity-like risk, that will change. 2010 was as much about the surety regarding return of principal as it was return on principal – we saw an extremely safe way to make money and we acted upon it. We hope that there are future years that offer us the same type of extremely low risk opportunities to make big gains, but it won’t be 2011. For those seeking equity-like return in 2011, equity-like risk will have to be taken. That will be especially true for the first half of the year. In the second half of the year we may very well find investment portfolios again favoring high-quality over low-quality. So if it’s a “safe risk” we are looking for, even though nobody cares about risk-adjusted returns, it will be the Dividend Paying equities that make the most sense.
Dividend Policy
A confluence of demographic, economic, and company-specific factors are converging to incentivize companies to increase dividends:
Cash Hoard. Companies have a record amount of cash on their balance sheets, both in nominal terms and relative to total assets, so cash is available to increase dividends.
Earnings & Economic Cycles. The dividend payout ratio (dividend/earnings) has plunged to 32%, versus its long-term average of 59%. While earnings growth could decelerate in 2011, earnings are unlikely to decline absent a double-dip recession (which we ruled out eighteen months ago), so more cash is probably on the way that could be distributed in the form of dividends.
Need of Yield. As baby boomers move into their retirement years, emphasis should shift from capital appreciation to income, resulting in a growing pool of investors who want dividends.
While dividends may grow, that does not necessarily mean that Dividend Payers will outperform Non-Payers in the short-term (i.e. first half of 2011). But longer-term we prefer Payers versus Non-Payers, and Growers over Cutters. We understand that these high quality holdings could face headwinds in the first half of 2011 (as they did in the fourth quarter of 2010). As a result, in the short-term we are recommending a barbell approach of overweighting high-beta asset classes (i.e. emerging markets) as well as holding the safer Dividend Payers. If our macroeconomic outlook comes to fruition, we will likely reemphasize Payers over Non-Payers.
Current Recommendations vs. Expected Changes
Our current asset class recommendations are reasonably close to our expectations for early 2011. We don’t expect massive amounts of changes to client portfolios – perhaps a good amount of trades to “tighten up” allocations while removing an asset class for short-term preference (reduce yield, increase beta), but nothing too radical.
In all, we believe our current recommendations are reasonably in line with expected changes, but changes should be expected.
2011 Economic Outlook
The Obama administration and congressional Republicans have agreed to a wide range of tax cuts and benefit extensions. The proposals will boost growth in 2011, likely ensuring new jobs to measurably reduce unemployment by this time next year.
The deal lessens the pressure on the Federal Reserve to engage in additional quantitative easing, still we expect a continuation of “QE2” and a growing federal deficit, but in the near-term, the economy will take that in stride as the recovery accelerates.
Given the deal is signed into law, real GDP is expected to expand nearly 3.5% in 2011, and payroll employment is projected to increase by 2.0 million (approximately double 2010 numbers).
The implication is that the economy will strengthen, confidence will improve, and the recovery will evolve into a self-sustaining expansion.
The planned compromise between the Obama administration and congressional Republicans will be good for the 2011 economy. The planned temporary tax cuts and spending increases will provide a substantial boost to growth in 2011, ensuring that the still-fragile economic recovery evolves into a self-sustaining economic expansion. After all final numbers are tabulated, real GDP in 2010 will have been close to 3%. We expect it to be half of a point stronger in 2011, possibly with one quarter hitting 5.0% (as it did in the fourth quarter of 2009).
Anybody who scoffs at three-and-a-half percent growth in US GDP with low interest rates should remember that in the 1990’s such a gratifying combination used to be called a “Goldilocks Economy”, a term of endearment for just exactly where we wanted economic growth and inflation to be – not too hot, not to cold; just right.
In all likelihood, the US economy would have made it through 2011 without falling back into recession, but this compromise improves those odds significantly. It is important to note that growth will be slower in 2012 than previously anticipated, as the deal encourages business to pull investment forward into 2011. Still, the economy will end up in about the same place (as measured by GDP and jobs) with or without the “pull forward” provision that allows businesses to accelerate expensing of equipment purchases made in 2011. It does help make 2011 more robust than it otherwise might have been.
As discussed earlier in this report, the US recovery is now eighteen months old, but many people still refer to the economy as one “in recession”. The sentiment is technically incorrect, but the feeling is understandable given that high unemployment weighs heavily on the national mood. Sentiment surveys indicate that households and businesses feel better than they did during the depths of the “Great Recession”, but they are still very nervous. Confidence remains below levels experienced at the bottom of all previous recessions.
The intent of the additional stimulus in 2011 is to ensure that the recovery evolves into a self-sustaining expansion, with enough job growth to generate the income and consumer spending gains needed to convince businesses to hire even more. The economy is not there yet, but the additional stimulus will help get it there.
Most components should contribute to growth, particularly consumption and equipment spending. Inventories should grow in line with demand. Residential and nonresidential structures should post small contributions to growth (though larger than most expect). Trade, however, will act as a drag on growth.
Despite the consumer still facing significant headwinds, consumption should be better, led by a continuing rebound in vehicles sales. Pent-up demand, along with better income and jobs growth, should keep sales above a 12 million unit annual rate. Aided by the aforementioned generous 100% expensing of qualified investments in the proposed stimulus bill, improved credit conditions, and growing profits, equipment and software spending should remain robust.
We do recognize that these forecasts are only “best guesses”. The economic outlook is fraught with uncertainty. Chief among the risks to consider is what happens in Europe. Although the aid packages to Greece and Ireland, along with continued bond purchase by the European Central Bank (ECB), provide temporary liquidity, they do nothing to address the long-term solvency issues (namely that European banks are still stuck holding many of these bonds, while their interest rates are now rising).
Also, now that new fiscal stimulus will be provided, there is uncertainty about whether the Fed will complete all of its planned purchases of $600 billion of Treasuries and, perhaps just as importantly, whether the Fed will do more than that after June. A failure to complete and/or extend purchases could put further upward pressure on long-term Treasury and mortgage interest rates, stifling a housing recovery. And if housing prices tumble at double-digit rates or more than the mid-single digit decline we expect during the year, some banks could require additional capital, reducing the availability of credit.
Inflation
As good as things are getting, they are not getting so good so fast as to spark worrisome inflation. As we did for 2010, we continue to see a period of low inflation in 2011, something close to 1.5%
We are concerned that the massive fiscal and monetary stimulus will fuel inflation. But we do not expect inflation (as measured by the traditional CPI, or Consumer Price Index) to be a problem in 2011, or even 2012. Why? Because there is what we call an “output gap”. An output gap is the difference between actual GDP and potential GDP.
For all the improvement we have had and for all the improvement that will come, actual GDP is still below potential GDP. Inflation is a problem when growth versus supply is a problem, and the excess of labor has been weighing on real wages and compensation. The excess supply of residential real estate continues to put a downward pressure on rents. The private sector, namely households and the financial sector, continues to reduce debt, whereas credit creation usually sparks inflation.
For as good as things are getting, they are not getting so good so fast as to spark worrisome inflation. As we did for 2010, we continue to see a period of low inflation in 2011, something close to 1.5%
Bottom Line: The global uptrend is likely to continue as 2011 gets underway, with outperformance by emerging markets. Unburdened by debt issues and still driven by growth expectations, emerging markets are likely to outperform. But as mid-year approaches, rising interest rates could start to threaten globally, in the debt-burdened secular bear economies as well as the faster-growing secular bulls. With optimism excessive by then and investors seeing broad evidence of overvaluation, the interest rate pressures could turn the trends in all regions, developed and emerging markets alike. Moving into 2011, we are staying aligned with the global uptrend, but we’ll be watching our indicators and models closely for signs of rising risk as the year progresses.