Mid-year forecast review

My predictions for 2011 are experiencing mixed results so far, but I think I've been more right than wrong.

The economy will grow by 4% or more in 2011. Wrong. First quarter growth was only 1.9%, and while I expect that second quarter growth will be in the 3-4% range, growth in the first half of the year will likely be only 3% or so. One reason for the growth slowdown was the supply-chain disruptions that followed in the wake of the Japanese tsunami, but those disruptions are already easing and paving the way for a pickup in growth in the second half. I expect growth will be in the range of 3-4% for the year as a whole, only slightly less than I expected late last year. Importantly, although my growth expectation amounts to only a modest recovery, I think I am more optimistic than the market. To judge by the very low levels of Treasury yields, I believe the market is expecting growth of 2-3% at best.

Inflation will trend slowly higher. Correct. All measures of inflation have turned up this year. On a six-month annualized basis, the CPI has moved up from 3.1% to 5.1%; the core CPI from 0.8% to 2.1%; the PPI from 5.9% to 10.8%; the core PPI from 0.9% to 3.5%; the PCE deflator from 1.9% to 3.9%; the core PCE deflator from 0.4% to 2.0%. On a year-over-year basis, the GDP deflator has moved up from 1.2% to 1.6%. I think it is worth noting here that even though the economy was weaker than I thought, and disappointingly weak even from the market's rather gloomy expectations, there has been a very clear trend towards higher inflation. This runs directly counter to the Phillips Curve theory, which predicts that a very weak economy and a large output gap generates deflationary pressures. I continue to think we'll see somewhat higher inflation over the next year.

The Fed will raise rates sooner than the market expects. Too early to call, but probably wrong. I called for the Fed to raise rates before the end of the year, but currently the market is assigning almost a zero probability of that happening. Unless the economy stages a very impressive recovery in the next several months, I doubt the Fed will hike rates before the end of the year.

The housing market will be showing signs of life by the end of the year. Too early to call. As I have noted in recent posts, there are some signs that housing is bottoming, but it is too early to point to anything concrete. I still think we will see some signs of improvement in housing before the year is out.

Interest rates on Treasuries should be higher. Wrong. T-bill yields have fallen from 0.1% to 0.03%; 5-yr Treasury yields have fallen from 2.0% to 1.6%; 10-yr Treasury yields fallen from 3.3% to 3.0%. However, 30-yr yields are unchanged at 4.3%. I continue to believe that Treasury yields will move higher this year, and that they offer very unattractive valuations.

MBS spreads are likely to widen. Correct. Spreads on current coupon Fannie Mae collateral have widened by about 10 bps so far this year. I continue to believe that mortgage spreads will widen as investors worry about extension risk in a rising interest rate environment.

Credit spreads are likely to decline gradually. Correct. Investment grade spreads have narrowed by about 15 bps, and high-yield spreads have tightened by about 50 bps. Even though growth has been disappointingly slow, corporate profits have been strong, and easy money and rising inflation have improved the outlook for corporate cash flows and reduced the risk of default. I continue to believe that corporate bonds offer attractive valuations.

Equity prices are likely to register gains of 10-15%. Correct. The total return on the S&P 500 year to date is 4%, and on the Dow 6.5%. Importantly, despite lots of volatility along the way, the return on equities has been substantially higher than the miniscule return on cash. I continue to believe that equities offer attractive valuations.

Commodity prices will continue to work their way higher. Correct. Despite a sharp selloff in the past two months, the CRB Spot Commodity Index is up over 5% so far this year, the JOC Index is up 1%, and Arab light crude is up 20%. I continue to believe that commodity prices will move higher with time, as the economy is likely to pick up and monetary policy remains very accommodative.

Emerging market economies are likely to do somewhat better than industrialized economies. Correct. Most emerging market economies are enjoying stronger growth than most industrialized economies. However, most emerging market equities are underperforming those of industrialized economies, as global growth has slowed somewhat. Emerging market debt has generally performed quite well, however. I continue to believe that emerging market equities and debt offer attractive valuations, since these economies tend to thrive in an environment of easy money, rising commodity prices, fiscal policy reform, and ongoing globalization.

Gold will probably move higher. Correct. Gold is up 5.5% so far this year. I continue to believe that gold can move higher, given the likelihood that monetary policy will remain very accommodative, but the potential for extreme volatility (especially on the downside) makes gold an unattractive investment for all but the most ardent speculators.

The dollar is likely to move higher against most major currencies, and hold relatively steady against emerging market and commodity currencies. Wrong. The dollar is down about 5% relative to major currencies so far this year, and it is also down against most emerging and commodity currencies. I continue to believe, however, that the dollar has significant upside potential, given that it has never been weaker and I think the outlook for the U.S. is likely to improve.