2011 in Preview: A Year of Transition (or Worse)

If 2010 was a positive year for most asset classes, then what does 2011 hold in store for our capital markets? I certainly don’t know, but this year should start out in transition. As economic growth quickens, stocks should try to rally, bonds should fall, and commodities should continue to grind higher. The dollar will try to explore higher ground in this environment, but it likely will be held hostage by events in Europe (sovereign debt issues) and Asia (central bank monetary tightening). Last year may have ended with a six week stretch where investors embraced risk of all types, but 2011 could see risk appetites shift more often than in 2010. Finally, 2011 should see another transition, one where market participants worry less about deflation and more about inflation. Looming in the background is a growing pile of unpaid bills at the state and federal level in the U.S. and throughout the developed world. Will 2011 be the year they come due?

Perhaps some background is in order. After the largest credit bubble in history exploded in 2008, the policy response both in Europe and the U.S. could best be described as ones that worked very hard to paper over the resulting mess. The solvency issues facing many homeowners, businesses, and banks in 2007/2008 never really “cleared” the markets. Instead, many obligations were essentially shifted from private hands to public ones. Trying to avoid systemic collapse, the U.S., U.K., and many European nations offered up various rounds of guarantees, credit facilities, direct bailouts, and fiscal stimulus packages. Eschewing the type of restructuring that swaps debt for equity, Western politicians have embarked upon a huge experiment in trying to solve a debt crisis with more debt.

Not content to sit on the sidelines while their elected leaders attempted this high-wire act, central bankers have been busily fashioning a monetary net beneath this process of socializing credit risk. The Fed, ECB, and BOJ have all purchased bonds issued by their respective governments. Fed Chairman Bernanke calls these asset purchases “monetary policy” and others call them “Quantitative Easing”. What they should rightly be called is debt monetization and money-printing. The world is awash in fiat currency paper as 2011 begins, and just where prices receive a boost going forward may be problematic. Global equity prices have benefited thus far, but also rising are the prices for food, energy and other necessities. Money-printing has helped inflate financial assets since 2009, but one of the more interesting themes of 2011 should be a shift toward higher prices for not just raw commodities but finished products as well. This transition will affect equities only with a lag; bonds will suffer first. Here are my views about what might happen in 2011:

2011 Outlook:
Economy: QE II and extension of Bush era tax cuts create backdrop for faster growth in 2011. Rising interest rates will matter, but not until later in year or 2012.
Stocks: With bonds not attractive and cash still yielding zero, stocks become the repository of the Fed’s attempt to force-feed risk appetites. As the securities at the bottom of corporate capital structure food chain, equities will be a battleground of competing forces all year. Rising earnings and continued money-printing will be the positives, while rising interest rates and event risk (think: Europe) will be the negatives. In the absence of either exogenous shocks or much higher interest rates, stocks could post a surprisingly strong rally, but unresolved problems in Europe, potential geopolitical catalysts abroad (Iran, North Korea, etc.), and rising interest rates at home will give us at least one white-knuckle sell off — perhaps even another “flash crash”. Low end of the range for S&P 500 is 1100, while top end is 1400. Low end of the range is at risk if funding problems materialize in U.S.
Bonds: Treasurys remain unattractive, with the middle and long end of the curve vulnerable to upside surprises in either growth or inflation. Moments of turmoil that create flights to quality should be sold.
Dollar: Will benefit from perception of stronger U.S. growth and/or until Europe’s issues play out. Rallies in greenback should be sold and used to buy Canadian dollar and Brazilian Real. The days of the dollar-centric global reserve currency system (Bretton Woods II) are numbered.
Commodities: Demand still exceeds supply (obviously a positive) in most markets, but prices will be volatile because most commodities remain above their marginal cost of production. Markets will be buffeted by alternating perceptions of growth or cooling in China and U.S. Biggest tailwind is money-printing; biggest risk is overly aggressive tightening of monetary policy in China and emerging markets. Favorite agricultural commodities are wheat and rice, while favorite energy commodity is heating oil.
Precious Metals: Start to decouple from other commodities as they become increasingly viewed as currencies. Despite the occasional setback, gold sets another all time high at $1500/oz or more. Precious metals stocks, however, outperform their underlying metals from today’s levels (1/20/11).
U.S. Housing Market: No recovery worthy of the name and there is a decent risk of further price declines if long term rates rise substantially.
The Fed: Stays the course and completes QE II. Chance of QE III is higher than chance fed funds rate heads north of 50 basis points. Mr. Bernanke is trapped, and FOMC actions in 2011 could either speed or slow the arrival of the type of funding crisis that has wracked peripheral Europe.
Volatility: Low will be sub 15 and could see a high of 40 once or twice when “events” pop up, but will mostly behave until funding crisis hits.
Credit Spreads: Stay relatively narrow as fixed income crowd fights over higher yielding alternatives to Treasurys. The occasional “event” causes spreads to widen but they will be bought until funding crisis is upon us.
Inflation: Inflation is a growing problem overseas (China and emerging markets), and even the central banks that are tightening are still behind the curve, i.e. real rates are still negative. There is a good chance inflation starts to literally be imported by developed nations from emerging ones. In the U.S., food and energy prices are already advancing, but Fed will ignore (even welcome) rising prices. FOMC focuses on initially quiescent core inflation until it’s too late.

The thesis underlying these forecasts is that the downside risks of the bailout cum money-printing policies since 2009 become ever more apparent as 2011 progresses. Continued monetary accommodation by the G-3 central banks — in spite of the accumulating inflationary risks — also underpins these predictions. The final assumption inherent in these views is that the EU, ECB, IMF, and outside investors (think: China) find a way to help Europe muddle through for at least another year. These prognostications are unlikely to prove useful if Europe comes unglued, if there is an outbreak of fiscal sanity in the U.S. or if G-3 central banks tighten monetary policy. These outcomes are unlikely but must be monitored – especially the situation in Europe.

If, as I believe, the policies we’ve seen since 2009 eventually lead to some sort of funding problem in the U.S. , then why do my 2011 predictions lack the fire and brimstone attendant to a run on the dollar or much higher interest rates? The answer lies in timing. Given the calendar constraints of a twelve month forecast, I think the most troubling aspects of paying the bill for all the bailouts and easy money may lie beyond 2011. If a crisis does occur this year, the above guesses will look foolishly benign. I do think the Fed is well and truly trapped by the circumstances I describe below, but it may take time for market participants to appreciate this threat to wealth preservation. Investors may even choose to believe our Fed Chairman and various economists who claim that rising interest rates are actually good in that they signal a return to economic health.

Certainly stock market participants have shown a willingness throughout history to overlook rising interest rates for a spell while focusing on rising earnings. The same could be true in 2011 — up until a certain, unknowable point. Stocks will probably struggle if 10 year Treasury notes yield more than 4% (currently 3.45%), but the S&P 500 could still manage to rally. Equities will truly be vulnerable if that bellwether yield breaches 5%, though. Such an event would indicate creditors are starting to view the U.S. in the same light as financially troubled nations, perhaps triggering the type of downward spiral which leads to funding problems for the U.S. government.

If the U.S. starts to be viewed with the same suspicion as peripheral Europe, who will bail us out — the Fed? Leaving aside the Fed’s role in contributing to our current problems, our central bank can only buy some time by continuing to buy up bonds via Quantitative Easing. Dallas Fed president Fisher has described QE’s I & II as “bridge financing” until the economy recovers and fiscal policy can normalize. He would be right if our debt and deficit issues were cyclical, but they are increasingly structural. PIMCO’s Bill Gross shares some of these same worries in his latest Investment Outlook (see below).

We now have so much debt outstanding that the interest costs alone will start to crowd out the rest of our budget if long term rates rise too much. And if the Fed institutes QE III, IV, or V to pin long rates down, then the dollar will likely crack wide open. Our Treasury could try to shift more debt issuance to the front end of the yield curve (where rates are lower), and the Fed could try to keep the funds rate at zero to keep the interest costs manageable, but the outcome would still be the same — our currency would collapse. The perception of rising inflation will only exacerbate these challenges facing our Fed in 2011 and beyond.

In other words, it’s “checkmate” for the U.S. in the years ahead until it deals with its structural deficit issues. If those who claim to care about the well-being of our planet are looking for something to protest that is truly unsustainable, then the aforementioned process of bailout/stimulate and issue debt/monetize debt is it. It’s monetary pollution and it’s toxic to a nation’s health. I just don’t know whether these potential funding issues hit in 2011, 2012, or later. Whatever the timing, gold will increasingly be seen as the currency of choice until these problems are resolved.

We have to find a way to bring what we spend in balance with the revenues we take in. Acting now will hurt, but the cost of waiting is even more painful. And it doesn’t have to happen all at once, either. Global capital markets would welcome any visible and viable path back toward responsible fiscal behavior. As an optimistic individual, I think we can do it. As a realistic investor, I think matters will have to get worse before Washington finds the will to act.

— Jack McHugh

January 2011 Investment Outlook: “Off With Our Heads”, by Bill Gross, PIMCO

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