Tuesday, December 29, 2009

Predictions for 2010

Following the tradition I started one year ago, in which my predictions for 2009 proved amazingly accurate, here’s what I think will happen to the economy and the markets in 2010. Caveat: last year’s accuracy provides no assurance whatsoever that this year’s predictions will be accurate or profitable.

Inflation: Inflation hit a low ebb one year ago, and has been trending slowly higher since. I think inflation will continue to trend slowly higher, because all of the key leading indicators of inflation are still saying that monetary policy is accommodative: the dollar is weak, gold is strong, the yield curve is very steep, commodities are strong, breakeven inflation rates on TIPS are rising, and credit spreads are declining. I don’t see significant inflation on the horizon, but I do believe that inflation will exceed the breakeven expectations implied in the pricing of TIPS, which are currently in the neighborhood of 2-2.5%.

Growth: Thanks to a return to more normal financial market conditions, an abundance of signs that economic fundamentals are improving on the margin, and the growing pushback that is emerging against Obama’s hard-left agenda (an important development that has helped the market for most of this year), I believe the economy will grow 3-4% over the course of the year. While this represents an above-average growth rate from an historical perspective, it will be a distinctly sub-par recovery given the depth of the recession which ended about six months ago. I think the main reason for sub-par performance will be the misguided and bloated Keynesian stimulus policies enacted earlier this year, coupled with a significant increase in government regulatory burdens and government spending (mostly in the form of transfer payments), and huge federal borrowing requirements. (Not surprisingly, this puts me at odds with most Keynesian forecasters, who generally believe that the winding down of stimulus spending will cause the economy to slump in the second half of the year. Where they see slower stimulus spending hurting the economy, I see stimulus spending acting all along as a obstacle to recovery.) If the economy manages to exceed 3-4% growth, it will likely be due to the fact that corporations and individuals have a strong incentive to accelerate the receipt of income this coming year, in order to avoid the higher tax rates that are slated to take effect at the beginning of 2011.

Fed: The market currently expects the Fed to begin raising short-term interest rates in June, and the current year-end expected Fed Funds rate is approximately 1.0%. Given my relatively optimistic outlook for the economy, and my belief that inflation is likely to trend higher, I think the Fed will end up raising rates sooner and/or somewhat more aggressively than the market currently expects.

Housing: Residential construction activity is likely to slowly but gradually improve over the course of the year. Housing prices on average are likely to post modest gains as well, thanks to improving economic activity, rising incomes, relatively low interest rates, and accommodative monetary policy. Prices could dip briefly as a result of increased foreclosure activity in the first half, but this should prove to be only a temporary setback. Rising mortgage rates, since they will still be relatively low from an historical perspective, should do more to encourage a "buy it now" mentality than to discourage would-be buyers who will see that in many areas homes are more affordable than ever.

Interest rates: Interest rates on Treasury bills, notes and bonds should rise significantly over the course of the year, with 10-yr T-bond yields exceeding 4.5%. The impetus for higher rates will be a stronger-than-expected economy, and higher-than-expected inflation. Higher rates will not threaten the recovery, however, since they will occur largely as a result of the recovery. Moreover, even though I see the Fed tightening sooner than expected, I nevertheless expect them to be “behind the curve” throughout the year, much as occurred with monetary policy in the 1970s (i.e., the Fed will wait too long to raise rates and is unlikely to raise them by enough to quickly dampen inflation pressures). There is very little risk that Fed policy will be anywhere near tight enough next year to threaten the economy.

MBS spreads: Since the Fed plans to cease its purchases of MBS by March, this could push MBS spreads wider over the next few months. Regardless, MBS spreads are likely to widen over the course of the year. The main impetus for wider MBS spreads next year is likely to come from an across-the-board increase in the extension risk of MBS as Treasury yields rise.

Credit spreads: Credit spreads are likely to decline gradually over the course of the year. Easy money and a strengthening economy add up to a perfect environment for spread tightening. Easy money that leads to higher inflation and improved cash flows is a boon to borrowers, especially the most indebted ones, and that means lenders will be rewarded by lower than expected default rates. High-yield bonds and emerging market debt should be the biggest beneficiaries of tighter spreads.

Equities: Equity prices are likely to experience a few dips along the way, but they should be at least 10-20% higher by the end of the year. The onset of Fed tightening may provoke a temporary selloff, but in the end a Fed tightening is just what the economy and the markets really need to build confidence in the dollar and in the future of the economy. The main impetus to higher equity prices will be an improving economy and improving corporate profits.

Commodities: Commodity prices will continue to work their way higher over the course of the year, buoyed by an ongoing improvement in global growth conditions and accommodative monetary policy.

Gold: Gold prices are likely to spike one more time to a new high this coming year. Gold speculators will be encouraged to see that the Fed is “behind the curve” and reluctant to tighten boldly and aggressively. However, gold is a highly speculative investment at these levels, and not for the faint of heart. In the long run, gold's downside potential now greatly exceeds its upside potential.

Dollar:
The dollar is near enough to its all-time lows, both in nominal and in real terms, that it is likely to rise at least modestly against most major currencies, and it should be able to hold near its current levels against most emerging market and commodity currencies. The dollar will find support from Fed tightening, and from the growing realization that the economy is getting stronger despite all the concerns about the disturbing trends in fiscal policy and the ongoing defaults in the residential and commercial real estate markets.

17 comments:

W.E. Heasley said...

If Jimmy the Greek was alive he would likely bet with you regarding your predictions.

From your predictions, one would assume you see high persistent unemployment. One would need 20 or more continuous uninterrupted quarters of 5% growth to reduce the published unemployment rate to approximately 6%. That has never occurred in US economic history. At a 3 to 4% growth rate, one is going to experience largely a jobless recovery.

One thing overlooked in the Macro sense is: simultaneously deploying Keynesian deficit spending and Quantitative Easing in a current environment of government hyper-debt creates uncharted economic waters. Both the theories were developed in low or no current government debt. If you deploy the two theories simultaneously in an environment of hyper-debt, cascading unintended consequences occur (Japan 2002-2006).

alstry said...

In fairness to Scott, I doubted his powers last year only to be humbled and develop a new found appreciation for analyzing on the margin.

Who coulda thunk that he would prove so accurate despite the S&P trading at a reported PE of over 140(now only accessible to subscribers), commercial real estate collapsing, residential foreclosures continuing into record territory, U6 unemployment approaching 20%, annualized deficit approaching $2 Trillion, transportation revenues contracting, bankruptcies skyrocketing, tax receipts evaporating, and now we are expanding military engagements on multiple fronts???

Scott has an insight that few can even come close......at least that is what the past year confirms and we should all appreciate his amazing calls....I am looking forward to a repeat.

fboness said...

Someone has hacked your RSS feed (or less likely, your site) to display a phony and malicious green card lottery popup.

Bob said...

Scott,

Can you tell me which of these predictions you are the least confident about. Just curious. Thanks again, been looking forward to this.

Bob

brodero said...

Excellent observations....I feel your extensive background in the fixed income markets gives you special insights into other markets...that is your edge....thank you....

Benjamin said...

I would like to take issue with one of your predictions, but I can't.
Maybe inflation will be lower than you think.

REW said...

I stopped midway just to comment on this portion:
"If the economy manages to exceed 3-4% growth, it will likely be due to the fact that corporations and individuals have a strong incentive to accelerate the receipt of income this coming year, in order to avoid the higher tax rates that are slated to take effect at the beginning of 2011."

Very important point, one that is not mentioned nearly enough. Great job.

Scott Grannis said...

Bob: The predictions I'm least confident about would be the Fed. In the past I'm often assumed the Fed would opt for the responsible course of action--which in this case would be an earlier than expected tightening--but I have been wrong most times.

Rob said...

Thanks so much Scott for this blog, which quickly became the only economics / investing blog I read regularly. As a UK resident, any predictions for Sterling ?

Bill in NC said...

"10-yr T-bond yields exceeding 4.5%"

Doesn't that mean 30 year mortgages @ 7%?

Not much help to the residential real estate market.

Scott Grannis said...

Bill: A 4.5% 10-yr Treasury yield plus a wider MBS spread would give you a 30-yr fixed rate conforming mortgage of about 6% to 6.25%. I would argue that this is not a very scary figure. In the past 13 years the average conforming rate has been 6.6%, and during the housing boom years of 2002-2006, it averaged 6.0%.

This is the process that is underway: since the end of last year we have been steadily moving from an environment of exceptionally (absurdly?) low interest rates to an environment of relatively low rates (from a long term historical perspective). I don't see the cause for alarm.

Jay Norman said...

Scott:
A question from the unitiated, understanding your caveat, but what could be where to position oneself if your predictions come true.

Thank you for your blogs, they have been extremeley helpful.
Jay

Scott Grannis said...

The investment implications are fairly straightforward. Long equities, long high yield and EM debt, and short Treasuries (and/or long a 30-year mortgage) as a core position. If you want to speculate, buy commodities and gold, but be very careful with gold. Avoid taking on exposure to major nondollar currencies. Using some leverage is probably not a bad idea if that suits you. When the crowd wants to deleverage and interest rates are very low, then it can make sense to swim upstream.

Family Man said...

Other investment implication is already visible.
Lower correlation (in place now)should strenghten in 2010, in equities means more stock picking effort must be done. Crisis means contagion, expansion means differentiation.

Katrina Rose Dunkley said...

Thank you so much for your predictions this year. I really enjoy your blog. All the best in 2010.
Katrina
The Energy Diaries

Rob said...

Scott, you said "Avoid taking on exposure to major nondollar currencies" .. would that include £ sterling ? Thank you.

Scott Grannis said...

Rob: I've been trying to come up with a view on Sterling but haven't reached a conclusion yet. Holiday festivities have been intervening.