2010 in Review: Pushing the Costs Down the Road

As 2010 dawned, the biggest debate among market participants about the year to unfold centered on Fed policy. Quantitative Easing had been announced in March of 2009 and was set to expire in March of 2010. Economists and pundits argued about just how the Fed would extricate itself from this massive bond purchase operation and most expected the fed funds rate to begin heading higher well before 2011 arrived. On the fiscal front, policy stimulus measures were supposed to wear off as the year progressed, and tax rates were set to rise as the calendar turned to 2011.

Propped up as it had been by loose monetary and fiscal policies in 2009, the U.S. economy inspired little confidence that it could stand on its own two feet as 2010 got underway. And though both stock prices and longer term interest rates had risen substantially as 2009 drew to a close, the horrors of 2008 were still fresh enough in folks’ minds to make them wonder when the next shoe would drop. Investor worries ran the gamut, from withering deflation to currency debasement and inflation. Not many prognosticators had much faith in their forecasts for 2010 and neither did this one.

What came to pass was a year in which most worries went unrealized. The Fed never did reverse QE 1, nor did it raise short term interest rates. The Bank of Bernanke instead saw fit to expand its balance sheet further via QE II. Our elected officials in Washington debated lower tax rates, corporate largess, and renewed government spending for most of the year before deciding in December that the word “compromise” meant “all of the above”.

The year’s biggest scare came not on this side of the Atlantic but in Europe. Greece, Ireland, and the other so-called PIIGS threatened the type of defaults that might destroy the European Union itself. And yet, despite legitimate worries about the fiscal ills in peripheral Europe, the EU, ECB, and IMF stitched together just enough in the way of aid and bailouts that the currency known as the euro survived. Though each fire in Europe was doused with liquidity, the actions taken didn’t assure investors that Portugal, Spain, and others were safe. Many U.S. states, cities, and municipalities were in similar trouble for most of 2010. But, despite some disquiet in the Municipal bond market late in the year, there were none of the credit events that cause a bond insurer’s heart to skip.

If 2010 had any theme at all, “kicking the can down the road” was as apt as any, especially in the industrialized West. Before I review the particulars of each prediction I made for 2010, it may be helpful to review the rationale behind them. The following is the final paragraph accompanying my guesses for 2010:

“The thesis underlying most of these predictions (for 2010) is that the Fed will keep the funds rate low and do little more than talk about exits. They, as well as elected officials from both parties, will keep trying to postpone the painful costs of the 2007-2009 bailouts. Kicking the can down the road is the one truly bipartisan policy in Washington , and it was Alan Greenspan’s M.O. during his entire tenure at the Fed. If I am wrong, and the FOMC does vote to begin reversing its QE purchases in March, then some of the pain I see coming sometime after this spring will instead arrive with this year’s thaw. Maybe I’m wrong about Mr. Bernanke, and maybe he’ll decide to do the right thing by grounding his fleet of money-dropping choppers. But to quote Jim Grant, ‘Helicopter’ is who he is.'” (01/06/10)

Here are last year’s predictions and how they panned out (in red):

2010 Outlook:

U.S. Economy: Fed will keep short rates near zero, so recovery continues early in year. Risk of GDP slipping back toward zero increases as year progresses, but any “double dip” recession may be a 2011 story — when higher tax rates take effect. Even if the U.S. economy displays surprising strength in the first half of ’10, the resulting increase in long term interest rates should forestall that growth later this year.
Fed did keep short rates near zero. Economy did continue to recover before starting to slip back during the summer, but bailouts in Europe and QE II helped arrest the slide. I didn’t see coming the December deal to extend the Bush tax cuts for two more years..

Stocks: Trade in a wide but uneasy range. Upper end for S&P should be 1200 to 1300, while lower end should be 950 to 850. Stock picking (alpha) will be more important to returns than getting the market trend right (beta). I still prefer low-debt, high dividend paying stocks (e.g. Big Pharma), as well as companies with rising cash flows that give managements financial flexibility (with some exceptions, higher quality names do not appear to trade at high premiums to lower quality companies). I also like having exposure to what Nassim Taleb calls “positive black swans. Some of the best of these “spec plays” could be in small mining stocks (still decimated after ’08 rout), or in smaller biotechs with attractive pipelines (e.g. drug candidates beyond phase 2 — preferably beyond phase 3). Corrections of 5% to 10% can hit at any time (even in January), but either higher interest rates or higher tax rates on incomes (and capital gains!) loom as potential downside catalysts after spring. My own plan is to use rallies to take profits and/or establish hedges.
Good call on the high end (S&P topped out at 1263); not so good on the low end (low was 1011). Dividend payers and biotech worked; big pharma lagged. My “positive black swan” plays had a good year. Hedge strategies worked in the first half of the year, not in the second.

Bonds: Very tough environment in 2010 and bonds deserve a minimal asset allocation for now. At these levels, Treasury investors need either geopolitical turmoil or a relapse in the economy. Since either of these outcomes will only add to the massive issuance needs of the U.S. and others in the G-8, use rallies to shorten duration and look for high quality among corporates, senior bank loans, and municipal bonds issued by well funded locales. True credit analysis will continue to be of value, since nimble active management should outperform lumbering mutual funds.
This call looked pretty stupid in the run up to QE II, but the decline in Treasurys over the final two months helped avert seller’s remorse. Even so, the yield on 10 year Treasurys actually fell more than 40 basis points. Credit analysis did pay dividends, but Munis cracked at year end.

Dollar: Should weaken, but it could see intermittent rallies due to sovereign debit concerns (think: Europe), or increased geopolitical conflict (think: Iran ). Better than 50/50 chance the U.S. Dollar Index sets a new, all-time low in 2010. Favorite G-8 currency is the Canadian loon and favorite emerging market currency is Brazilian real, but the REAL question is how long can the imbalances of the dollar-centric, global fiat currency regime last?
Europe did indeed unravel in the spring (Greece) and fall (Ireland), but the dollar was little changed. Canadian dollar and Brazilian real both rose against the greenback. No regime change yet on the reserve currency front.

Commodities & Precious metals: I am still long term friendly towards commodities as a store of value, but components of the CRB index should be volatile in ’10. Energy and base metals might outperform early in year, but agricultural commodities should outperform as the year progresses. Gold will be volatile, but I think the barbarous relic will set another all time high this year. Responsible central banking (i.e. rising real interest rates) and fiscal discipline by sovereign governments represent the biggest long term threats to commodities, while “anti-speculation” legislation is a nearer term risk. The potential headwinds created by either monetary or fiscal discipline, however, are much less likely to materialize than the potential tailwind of currency volatility.
Gold did set a new high and agricultural commodities did have a very good year. The CRB index rose 17.5%

U.S. Housing Market: Subsidies, a Fed on hold for now, and various private capital solutions for upside-down borrowers will help U.S. housing during the first half of the year. Housing will flatten out or even suffer a relapse later this year as these tailwinds subside and long term interest rates start to rise.
Housing relapse was one of 2010’s sadder stories

The Fed: Stays “All In” by keeping short term rates on hold for most of 2010. Threats by the Fed to tighten monetary policy will be idle ones unless economic growth and job growth really surprise to the upside. Should the economy slip back, expect renewed Quantitative Easing. Mr. Bernanke seems willing to risk a funding crisis down the road in order to prevent a repeat of what he has said were policy errors by the Fed in the 1930’s (i.e. they tightened too soon)
Fed stayed on hold all year and we did get QE II instead of exit strategies.

Volatility: More subdued in 2010 than in past two years and should range between roughly 15/20 and 35/40 for the VIX. Geopolitical turmoil, or a disorderly fall in the U.S. dollar, are the biggest risks to the upper end of this range.
Lucky guesses on both ends of the range

Credit Spreads: Credit spreads still offer value, but not nearly as much as at this time last year. Solid credit analysis will expose relative value opportunities, but at least some profits should be taken if spreads continue to compress. Volatility caused by higher long term interest rates or disorderly currency conditions could present better investment opportunities.
Spreads did continue to compress, but taking profits was the wrong strategy unless one reinvested during the European tumult.

Inflation: CPI is not a worry during the early months of 2010, but it could become one later this year or in 2011 if the near zero fed funds rate overstays its welcome. Cost-push inflation (i.e. rising food and energy prices) is much more likely than demand-pull (i.e. rising wages) inflation.
Measured inflation (CPI) still largely a no-show, but cost-push inflation is gathering strength.

Given that 2010 was a good year for most investors, what lessons can be learned from the year just passed? Some will say we learned that deficit spending and money-printing “work”. After all, the economy grew, stocks rose at a double digit pace, and long term interest rates fell while the dollar and inflation were quiescent. 2010 was a policy maker’s dream year, and no doubt our politicians and central bankers are pretty happy with themselves. They probably think that the aforementioned results are ends that justify the profligate means by which they were achieved. Let us hope they don’t. Let’s hope they don’t think fiscal stimulus and money-printing can cure all economic ills. Like dogs that chase cars, overly indebted nations that pursue policies of the type we saw in 2010 don’t have long lifespans. The costs can be pushed down the road, but for only so long. Short-sighted solutions have a nasty way of making long term problems worse.

What happened to Greece and Ireland in 2010 should also be a lesson for policy makers. Because those nations lack a printing press, however, they are not the best analogy for what faces the U.S. going forward. Argentina has pursued reckless fiscal policies many times during the past four decades, and its central bank has tried printing money to help. Markets eventually took away the printing press by crushing the Argentine peso each time. It would be a mistake for our elected officials and unelected central bankers to think they can indefinitely keep buying time with the policies of 2009 and 2010. Worse still, their policy interventions may mask important price signals that properly functioning markets need in order to best allocate capital. It won’t be popular, but we should act now before the markets impose an even tougher solution in the future.

Our leaders need to find the courage and political will to act. As we celebrate Martin Luther King day here in the U.S., let’s remember the courage Dr. King so often displayed. It may be a misplaced hope, but wouldn’t it be nice if our newly elected Congress honored Dr. King’s legacy by having the courage to face our long term fiscal problems in 2011? Certainly the last Congress displayed all too little of it in 2010.

— Jack McHugh

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