Summary
Like a roller coaster car getting pulled up to the peak, so I feel about the U.S. economy in 2011. Low taxes and expansionary monetary policies are the pull. But, just like on a roller coaster, I fear what happens once we go over the peak and confront the loops and swirls of fiscal realities and volatile market prices.
2011 likely brings rising asset prices, apparent improving economic activity, and growing job creation fueled by loose monetary and fiscal policies. Price wars likely bruise consumer companies without pricing power. Concerns that likely undermine economic growth include states losing federal funding and muni market pressures; European inflation and debt problems; and Congress putting politics ahead of the economy (such as not raising the debt ceiling).
Specifically, my outlook is summarized by the following:
(1) Bullish on equity markets into at least 2Q11, with a couple potential corrections.
(2) Inflation building from the bottom-up in the economy. Commodities, material companies, and companies deeper in the supply chain with pricing power more attractive investments.
(3) U.S. consumer is healthier now after paying down a portion of debt, but remains vulnerable to higher interest rates, economic shocks, and changes in tax policy that lower take-home income.
(4) International remains attractive.
Potential Stomach Drops include
(1) State and Municipal Finances (debt, deficits, tax changes)
(2) Volatile asset prices with sudden drops in equities and commodities as excess money sloshes around asset classes. Rising influence of fickle ETF money flows on commodity prices.
(3) Discretionary consumer companies squeezed between rising costs and cost-conscience customers.
(4) Housing hit by higher interest rates and possibly the increasing potential of removal of the mortgage deduction.
Overview
Sagflation: Increasing price volatility plus economic stagnation.
I remain skeptical of government driven recoveries that promote cheap and abundant money, as is the case with the current accommodative monetary policy. It encourage inflation and discourages sound economic decisions by businesses and individuals. Milton Friedman emphasized that "unemployment is . . . a side effect of the cure for inflation," so that if a central bank "cured" unemployment by inflating, it "will have unemployment later." Examples of poor investment decisions abound over the past decade, including dot-coms and housing. My point is that the investment base of this country is built on some rotten foundation, which until fixed will likely undermine solid recoveries. Not to say we can't have boom times in specific sectors for short periods of time (ie. bubbles), but any recovery will likely be spotty or lead to deeper downturns. My investment decisions incorporate this overall theme in the background.
Inflation, by most broadly accepted standards, is not an issue at the moment. Deep a little deeper and the story becomes more worrisome. Overall the Consumer Price Index (CPI) was up 1.1% year-over-year in November, a number easy to brush off as indicating all is calm. Sifting through the components of the CPI, however, raises some disturbing trends, food at home up 1.7%, gasoline up 7.3%, fuel oil up 11.1%. Many people factor out these components because they are volatile. Fine, but these components also hit the consumer squarely in the pocket-book and are not easily avoided. Furthermore, over 40% of the CPI is comprised of housing-related expenditures, which have not been rising due to the glut of houses on the market after the last bubble.
Digging deeper in the supply chain shows the Producer Price Index (PPI) for finished goods rising 3.5% in November. Even more worrisome, prices for crude materials for further processing rose 12.8% in November! In my view, there is a tension right now between rising costs and a glut of retail units relative to consumer demand. Why the glut of retail units? The abnormally low interest rates that encouraged builders to build, retailers to expand, and consumers to spend. This means one of 3 things could happen:
(1) World demand for commodities and unfinished goods falls, lowering prices
(2) U.S. consumer demand picks up, in which retailers pass along cost increases
(3) U.S. consumer demand remains tepid, world demand remains strong and U.S. retailers are squeezed - resulting in a shake-out of retailers who can't hold margins.
Only option 2 results in near-term CPI acceleration. Only option 1 result in inflation pressure going away. Option 3 results in a mixed bag of economic hardship with signs of inflation hitting near-term and even more long-term. In other words, Sagflation.
Where does sagflation eventually lead us? If the current policies are maintained for the next decade, I believe ultimately to the fall of the U.S. consumer and the rise of the Chinese consumer. Pressures like a falling dollar, some discussion of national sales tax, and removal of middle-class tax breaks on things like housing likely hurt the U.S. consumer. Long-term, this may not be a bad thing as the U.S. reverts back to its historical engineering and manufacturing strength, but the change will likely hurt.
U.S. Treasuries
Expect yields to rise through first half of 2011, possibly to 5% and even 6% on the 10-year bond if inflation spreads more broadly in the economy. Drivers include improving economic outlook, debt spending, aggressive monetary policy that encourages inflation. A key thing on which to focus are prices on credit-default swaps, which can highlight growing concern over defaults versus concern of accelerating inflation. A wild card is Congress and its willingness to play chicken with the debt ceiling. Calmer minds likely prevail, but who knows with some truly strange theories floating around Congress.
U.S. Dollar
Volatile as a perceived improvement in the U.S. economy and heightened international tensions likely conflict with rising debt levels, aggressive monetary policy, and rise of the Chinese yuan.
"You hear that Mr. Anderson?... That is the sound of inevitability." - Agent Smith, The Matrix
My view expressed on October 14 about the yuan eventually rising more rapidly against the dollar appears to be building some momentum as China is exhausting more and more options for taming rising inflation. The crux of the problem, in my opinion, is the relatively fixed exchange rate between the dollar and yuan. The rigidity of the exchange rate effectively transfers the loose monetary policy in the U.S. over to China. Since real growth in China remains near the high-end of sustainability, the loose monetary policy translates into higher inflation. China has been trying to offset the loose U.S. monetary policy by raising reserve requirements, government crackdowns on price gouging, and interest rate hikes. An easier route, and inevitable in my view, is a rising yuan. As U.S. economic growth improves so can China raise the yuan since Chinese exporters should benefit from U.S. growth. So I see the yuan appreciating versus the dollar in 2011.
Commodities
Divergence of commodities with more fundamentally driven commodities continuing to perform well during the first half of 2011 and more speculative commodities like gold under-performing as investors rotate into stocks. Gold may perform better in the second half of 2011 if inflation accelerates and political/ economic events worsen.
U.S. Stock Markets
Besides a few corrections, I am generally quite bullish about at least the first half of 2011 due to the twin engines of expansionary monetary policy (low rates) and expansionary fiscal policy (low taxes and subsidies). Beyond the first half of the year I become increasingly bearish as the three D's - Debt, Deficits and Defaults - increasingly push into the minds of investors, in my view.
In terms of sectors, I plan to under-weight consumer discretionary and home builders since I believe there remains a glut of supply in these markets and rising interest rates likely apply brakes to any recovery. Additionally, I believe retailers are a mine-field right now. Generally it seems as though investors are over-weighting consumer discretionary as they play a recovering economy. From spending times in stores I have been struck by the number of sales with discounts of 20-50% store-wide in many locations. These observations combined with rising costs for materials and supplies, as discussed earlier, suggests that weaker-than-expected margins may surprise investors despite healthy sales.
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