Longer-term Commentary – January 11, 2011 – Forecast

2011 – Forecast from the Mount

January 11, 2011

By this point in time you’ve probably read so many “Year Ahead” forecasts you could easily write your own. Or perhaps you haven’t actually read full reports but used them as sleep aids. Some are very good at that. On television, multiple economists and market pundits have been on air and delivered forecasts like they were reading the Ten Commandments. 

1. Stocks shalt go higher by 10% or greater.

2. Thy ten-year Treasury note shalt yield 4% or more.

3. More men shalt labor and bringeth down the Unemployment Rate to 8.5%.

4. Ben Bernanke will keepeth the funds rate at 0-.25% until late 2011 or early 2012.

5. Thou shalt not covet thy investment bankers’ bonuses; they earned them.

6. The government shalt spend less but tax cuts will resulteth in stronger growth.

7. Businessmen will cease hoarding money and invest in the future. 

8. The housing market will riseth from the dead through an unexpected miracle.

9. The money-lenders will finally decide to lend money to the worthy masses.

10. If we falter, the rest of the world will lead us to the Promised Land as the de-coupling theory hath prophesied.

With apologies to Moses, I think that about covers the consensus forecast. The point is that forecasts are not to be taken as gospel, no matter what the source or how seriously delivered. But forecasts are good at helping us set parameters for expectations, both high and low, and provoking us to think about how we can manage through uncertainty. At least that’s how I’m justifying giving you one more forecast – mine.

Instead of burying you in numbers and data (I’ll do that on the course of the year), I want to hit on the key topics that I think will be important for 2011, and I’ll venture a guess on how they will play out. There are so many moving parts to the year ahead; we know there will be some big surprises, both good and bad. I’ll try to help identify some indicators you should watch for signs of unexpected changes. Finally, I will add the 11^th Commandment for 2011 –

11. Thou shalt do good and have a good time.

Time to Run With or Away from the Herd?

As FDR never said, “We have nothing to fear but fearlessness itself.”  It’s been many years, perhaps since the beginning of 2000 (dramatic pause for remembering), that the consensus on the outlook for the year has been as overwhelmingly bullish. Among Wall Street’s mainstream analysts, “bearishness” seems to be defined as those expecting only a 10% gain for equities. From investor polls, surveys, etc. of all sectors of investors, amateur and professional, bullish readings are at extreme highs and bearishness at extreme lows. If you can worry about only one thing in 2011, you might want to consider this ominous development. Can that many people be the right?

The fact is, that many people can be right for a while. Facts eventually overwhelm inflated and unmet expectations. We’ve often seen markets seemingly defy logic merely due to the strong beliefs and expectations held by the majority. I’ve seen this in bonds and stocks multiple times over the years.  In fact, last year’s stock market outperformed the economy. What should have mattered was jobs. Yet the economy could only generate over one million jobs. The Unemployment Rate fell from 10% to 9.4%, but that was primarily due to the Bureau of Labor Statistic’s lowering of the available labor pool by roughly 2 million people. Effectively, by lowering the pool by 2 million, the BLS is saying is that not only did 2 million people check out of the work force, but so did an additional 1.2 million that should have been added to the work force due to demographics. That’s over 3 million people who should be have been counted as unemployed but weren’t.

Income growth was non-existent. Hourly earnings barely match our low inflation rate, and 70% of the “new” jobs created were at rates far below the jobs they replaced. The fact is that many construction jobs and manufacturing jobs are never coming back. The replacement jobs are typically in the lowest levels of the service industry. With such a weak backdrop from 2010 in something so fundamental as jobs and income — and so many potential potholes still ahead on the road to true prosperity — stocks rallied and headed into 2011 at bullish extremes. Why?

The Fount of All Bullishness – Free Money

While equity analysts are off-the-charts bullish, the economic consensus doesn’t reflect boom times with 3% GDP growth seen by most. On the job front, economists are calling for a year-end Unemployment Rate of something just under 9%. That doesn’t sound like boom times to me, but the market is looking at things differently.

After the rally in stocks began in late August, a lot of folks have forgotten why the rally started in the first place. Prior to the rally commencement, stocks were actually down 6% on the year as economic numbers had weakened considerably and the memories of the Greece crisis and “flash crash” weren’t quite distant enough. Job growth was inconsistent and on the low side, and there was great uncertainty about the Christmas sales season. Enter Ben Bernanke. In late August the Chairman first hinted at QEII. That was all the market needed. The free-money express was coming back. That promise drove markets across the globe higher. The first quantitative easing that started in March of 2009 was directed at bringing down rates, particularly mortgage rates. But it soon became clear that Ben’s goal for QEII was quite different. As the weeks of speeches and interviews unfolded, Bernanke didn’t hide the fact that he wanted the stock market to go higher. He felt (and still feels) that higher asset prices were the only defense left against a deflationary mindset becoming embedded. Higher asset prices = greater confidence = increased spending by business and consumers = avoidance of the spend-later mindset.

The funds for QEII are scheduled to be exhausted in June under the current program. But market analysts believe that at any hint of weakness, Bernanke will push for QEIII. They might have a point. As some of you might remember, I thought that the economy would run out of steam in the 2^nd quarter of last year, which was about right. Further, I thought the weakness would extend into early 2011. I knew that further fiscal stimulus was off the table with the rise of the Tea Party but I didn’t count on Bernanke pushing another quantitative easing program – with the direct goal to raise asset prices, not lower rates.  But will Bernanke, or more appropriately, can Bernanke pull another QE out of the hat if the economy starts tailing off again this coming spring?

The December FOMC Minutes indicated the Fed does not see economic conditions as even close to ending the program early. That is very reassuring to the bulls. The market view is also any economic weakness would spark QEIII. But politics might come into play this year. In the House, the committee that has some oversight responsibilities for the Fed will be chaired by none other than Ron Paul. Rep. Paul is on record as favoring dismantling of the Fed. While that is unrealistic, he is in a position to make life difficult for the Fed Chairman. The Fed is not supposed to be influenced by politics. But with the political winds shifting, that separation will grow murkier. I don’t believe Bernanke will be able to push through QEIII.

Where is this leading?  One way or the other, the free money binge will be over – either through politics or economic performance. While tightening is still in the distant future, the turning off of the free money spigot is effectively the beginning of tightening. At the same time QEII expires, the lack of fiscal stimulus will begin to be felt. I don’t believe that the Republicans will cut much from spending, but the last of the old fiscal stimulus funds will be exhausted. State and local governments are facing shortfalls this year that are estimated to be somewhere between $125 and $175 billion. Since raising taxes at the state level is out of the question, as is money from the federal government, this leaves only cuts to spending at that level.

The federal personal payroll tax cut will offset some of the drag from the shrinking states, but most of that tax benefit will be saved or perhaps spent very unproductively. The price of oil has been rising and is forecast to rise further through 2011. Remember that every 10 cent hike at the pump drains the economy of $10 to $15 billion. Gas at $4 a gallon wouldn’t be a huge negative in an expanding economy with wages rising, but that’s not the world that consumers live in these days.

The point is that the economy and the stock market has been living and breathing on money from Washington and the Fed. Come mid-year, both will be left without that oxygen. What bothers me is that this is eerily similar to the 1930’s. Yes, I can hear the groans out there now, but bear with me. From 1935 to mid-1937, the stock market rallied by 80%. Yes, 80%. Starting in 1937 the stock market and economy were deemed “cured” and no longer needed the government’s and the Fed’s support. By mid-year it was clear that was not the case. Within nine months, the Dow lost half its value.

As Mark Twain said, “History doesn’t always repeat itself, but it does rhyme.”  If the stock market and economy in the year ahead don’t rhyme with the 30’s, it’s going to be because the economy has truly recovered enough to stand on its own and weather some bumps along the way.

The Big Themes Hold

Secular change in consumer — As most of my long-time readers know, my first overriding theme since late 2008 has been that the housing/financial crisis caused a secular change in American consumers from free-spending to at least moderately frugal. We have an entire generation who have seen their vision of their lives in retirement change dramatically in just the last three years. We also have children of those retirees and near-retirees who are witnessing the impact. I feel this has fundamentally changed the American consumer.

I see nothing that changes that opinion. Certainly we’ll see splurges from time to time, but this economy will not recover quickly on the backs of consumers. Consumers have made some progress in repairing balance sheets and reducing debt, but severe damage remains. From the peak in 2007, consumer wealth declined from $79.8 trillion to $63.1 trillion in the 1^st quarter of 2009. Wealth is currently estimated at $68.8 trillion. Debt to income ratios have improved from roughly 136% to 124%, but look at that in context of longer-term ratios of roughly 90%. Consumer balance sheets are better, but only on a relative basis.

According the Commerce Department’s measure of Consumer Confidence, readings have been remarkably stable for over the past eighteen months. Unfortunately, the stability has been at levels that are below typical recession levels of 70 and dramatically shy of normal recovery levels of 95-100. The average reading for the past eighteen months has been 52.4. Consumer spending has been better than that level of confidence would seem to justify, but what is really being bought?  Autos sales have certainly improved but remain 3-4 million units short of what we used to consider a normal year. Most apparent, the lack of confidence shows up in the housing market. With mortgage rates low throughout 2009 and 2010, not a dent was made in the housing supply overhang. Why?  Because consumers are still adjusting to lowered expectations that they see as the future — job uncertainty, stagnant wages, and big lingering worries about home values and retirement plans. The consumer will still splurge from time to time but on smaller items and in smaller doses. This isn’t a recipe for disaster. It’s just a recipe for a few years of minor ups and downs in the economy.

Weak job growth and weak income growth — The job outlook is no better for 2011 than it was in 2010. Good Christmas sales should give hiring a very short-term boost as it did early in 2010 when businesses restocked inventories. We can hope that this inventory rebuilding cycle will be more sustained than the cycle of 2010, but there is no reason to expect any continued surge in hiring. Big businesses are being rewarded by the stock market for net income, not growth of revenues.  Big business won’t start to target revenue growth, beyond buyouts, until Wall Street starts to reward efforts to expand through organic growth.

Some economists believe the payroll tax cut for businesses will boost hiring. Don’t believe it. First, it’s a one-year deal. Businesses aren’t going to ramp up permanent hiring for a one-year tax break. Second, by not hiring, businesses can use tax savings from existing staff expenses to add to the net revenue with absolutely zero effort or risk. Our best hope for job growth next year lies in the hands of small businesses, their confidence levels, and their ability to borrow from banks again.

State and local governments have shed about 240k jobs since the beginning of 2010. State and local governments will try to save jobs by sacrificing non-labor intensive spending (read that as programs for the needy). The job cuts to date in the state and local sector amount to little more than 1% of the total workforce. Does that make any sense in an environment of tumbling revenues and less federal support?  I’m still looking for a minimum of one million in total cuts in the sector.

When all is said and done, I believe job growth this year will be no better than 2010, and the risk is to the downside.

Financial system still vulnerable to shocks — It’s no secret that banks have played a dangerous game in delaying foreclosure losses. The government exacerbated that with some meddling, but the banks are responsible. This should be the year that banks finally start disposing of foreclosed homes and realizing the real losses. That’s assuming the courts don’t delay things until next year. Banks will also need to start getting real about commercial real estate loans, although banks do seem to have flexibility in frequent “restructuring” gimmicks.

But any big shock to the financial system is more likely to come from the foreign markets. It’s no secret that all the European Central Bank accomplished last year was to put band-aids on the sickly debt markets. Market vigilantes won’t be satisfied this year with band-aids. Portugal is next on the list that will be forced to seek help, but the vigilantes might not pass go, not collect $200, and go directly to Spain. Spain will be the real test. It’s no secret that Spain has been downplaying losses in real estate, and the economy has already weakened to the point at which the unemployment rate in Spain is 20%. There is no austerity program or short-term ECB bailout that will solve the problems in Spain. Perhaps the final solution will be favorable. I’m not sure what would be acceptable, but just covering up and delaying the tough decisions won’t last for all of 2011.

This, of course, brings us to the real problem. The financial issue with sovereign debt is not the impact on the individual country but the impact on global banks should they be forced to take losses and value the debt at market. The losses could easily exceed those produced by our mortgage fiasco. While the bulk of the losses will be on the books of European banks, those sovereign debt issues are owned globally. U.S. banks have roughly $375 billion in foreign debt. Not all of that debt is questionable, but in a crisis all will be painted with the same scarlet letter.

The best result is that the European Union gets together and resolves the debt issue through some joint guarantee and new method for issuing debt as a union instead of individual countries. But getting from here to there will entail some very big disruptions.

My best guess is that there are one or more severe disruptions to the financial system this year. I’m not predicting financial Armageddon, but I believe we’ll have some scares along the way that will shake up the complacency in global markets.

Europe isn’t the only potential trouble spot this year on the financial picture. There are reasons to fear some disruptive news and actions from China and many emerging markets. Do not forget how much speculative, leveraged money has flowed into emerging markets, some of that courtesy of our own Fed’s largesse. When something triggers a reversal of that money flow, many emerging markets can crack from the pressure. Remember the lesson of Iceland.

I believe that one or more financial scares are inevitable this coming year. We can hope to dodge bullets, as we have for the past two years, but financial setbacks will shake the roots of complacency and remind us all that we are still in the early stages of the great credit de-leveraging cycle.

Low rates to stay — As most of you know, I have been in the low rate camp for quite some time. That camp got a little crowded last summer, and I’m happy to see there are just a very few of us campers still left tending this fire. One thing that surprised me from early 2009 until late 2010 was how un-volatile rates were. I had expected lower rates, but I thought the path there would be much more erratic as the market grappled with the enormous debt issuance. I often spoke of “investor exhaustion” as a likelihood, as investors would simply avoid auctions from time to time. But we never really saw that until late 2010. We also saw selling in late 2010 as bond managers suddenly felt under pressure to reduce holdings of this out-of-favor asset.  I think the negative attitude toward bonds will persist well into 2011. But if historical patterns hold, the attitude toward bonds won’t turn positive until rates drop and bond prices are deep into rally territory.

In May of last year I wrote and spoke that I thought the ten-year Treasury note would hit 2% by the end of 2011. In September, it looked like that 2% might come much, much sooner than I had expected. Fortunately, the wheels reversed and rates moved back higher. Given the economic and financial conditions I described above, you won’t be surprised to learn that I am holding on to my call for a 2% ten-year note by end of 2011. I believe the high rates for 2011 have either already been set or will be set sometime in the first two months of the year.

Grazing the surface

I just noticed I’ve gone over 3,100 on the word count, yet I feel like I’ve just grazed the surface of examining what’s ahead this year and beyond. I barely mentioned home prices, inflation, and only superficially got into the international issues. I also avoided any talk of politics and events in Washington. (I’ll put that off as long as I can.)  But maybe some of this has stirred you to dig deeper on your own. Plus, this leaves many plenty of topics for me to explore in coming months.

No doubt this forecast will come with hits and misses. I’m not writing any of this on tablets of stone, except maybe that 11^th commandment.