Tuesday, January 8, 2013

Predictions for 2013

First, a review of last year’s forecast.

I thought the economy would continue to experience a “sub-par” recovery, burdened by numerous headwinds (e.g., excessive government spending, great monetary policy uncertainty, increased regulatory burdens, fears of a Eurozone sovereign debt crisis), and grow by only 3-4%. It now looks like it managed to grow by about 2.5%. That’s not a grievous miss, however, since I thought that the market was priced for even weaker growth. Importantly, I thought the downside risks of Eurozone defaults were greatly exaggerated, and that proved to be correct.

I predicted that CPI inflation would be about 3%, but instead it will probably turn out to be a bit less than 2%. I didn’t think the Fed would need to resort to another round of Quantitative Easing, but they did. Treasury yields failed to rise as I expected, but they were roughly unchanged for the year, despite additional Fed bond purchases.

I predicted a stronger housing market, and it improved significantly by almost any measure. Mortgage spreads tightened instead of widening as I expected, because the Fed opted to expand its purchases of MBS. Commodity prices failed to rise as I thought, but on balance they were roughly unchanged. I expected gold prices to be very volatile and probably down for the year, but they ended up with a gain of 7%—a clear miss. The dollar didn’t rise as I thought, but it was essentially unchanged.

My worst mistake: a belief that the electorate would vote in favor of less government, lower and flatter taxes, and a simpler tax code. Thanks to the results of the November elections and the recent fiscal cliff deal, we are now burdened by the prospect of more government, higher and more progressive taxes, and a more complex tax code. Regulatory burdens will increase.

Arguably, the misses and near-misses noted above were trumped by my investment recommendations. I thought equity returns would be 10-15%, and the S&P 500 enjoyed a 16% total return for the year, even though the growth in corporate profits slowed as I expected. Emerging market debt (+22%), investment grade debt (+11%), junk bonds (+12%), and REITs (+17%) all did very well, as predicted. Throughout the year I reiterated my view that cash should be avoided at all costs, and that was indeed a good call. Anyone who avoided cash, no matter what they chose to invest in, was rewarded. In the end, risky assets did well because the economy did better than expected.

Now let’s turn to the future.

This year I will eschew point forecasts, since the real purpose of forecasting is to put oneself on the correct side of what the market is expecting. If the market expects no growth or a recession, then any forecast that calls for growth greater than zero is likely to be rewarded if the economy fails to stagnate or decline. That was the case last year, and I think it will be the case again this year.

For the 5th year in a row, I think the economy is likely to do better than the market is expecting, even though growth is likely to be less than what it would be if this were a normal recovery following a deep recession. I think the market is quite fearful that growth this year will be either zero or negative, and I base that on my observation that yields on safe-haven, risk-free assets (e.g., T-bills, Treasuries) are extremely low, yields on inflation-indexed, risk-free assets (e.g., TIPS) are negative, forward interest rates are priced to the expectation that the Fed will not raise short-term rates meaningfully for at least 2-3 years, equity PE ratios are below average even though corporate profits are at record highs, and high-yield spreads are still quite elevated.

A quick glance at key indicators—e.g., very low swap spreads, a positively sloped yield curve, negative real yields, relatively low levels of unemployment claims, flat industrial production but decent ISM readings, strong auto sales, strong residential construction gains, and continued growth in jobs—rules out an imminent recession. Going forward, monetary policy is almost certain to be non-threatening this year. Although fiscal policy has tightened—in the worst way, through higher taxes instead of reduced spending—on the margin it’s not a huge problem (things could have turned out a lot worse), and the negative impact is likely to be absorbed by the economy’s inherent dynamism, the continued growth of jobs, and ongoing gains—albeit modest—in productivity. On balance I think the economy can generate some modest growth this year despite the ongoing headwinds.

If there is a silver lining to the cloud of big government that darkens the outlook for the economy, it is that we will have a divided government for at least the next two years. The House can effectively block any big new spending initiatives, and if spending can continue to shrink relative to GDP, then this will give the private sector some badly needed breathing room.

The Fed’s aggressively accommodative monetary policy has pushed up inflation expectations over the past year or so, but I note that current inflation remains relatively subdued. Regardless, I continue to think the odds favor inflation that is higher than expected. Since Treasury yields are still extremely low, they offer a very unattractive risk/reward profile, with downside risk greatly exceeding upside potential. Although the yield on TIPS would rise in line with inflation, higher inflation would likely push Treasury and TIPS real yields higher, thus depressing TIPS prices and damping total returns; in short, TIPS are expensive inflation hedges given the very low level of real yields. Treasuries just don’t have much appeal in this climate.

As was the case last year, if the economy simply avoids a recession and manages to grow, I think those who avoid cash will be rewarded. The yield on just about any risky asset is substantially higher than the almost-zero yield on cash, and this becomes compelling as long as disaster fails to strike. Equity yields at 7% simply tower over the yield on cash. If there is any obvious caveat it would be for investment grade corporate debt, since spreads are relatively tight and the sector is thus exposed to the risk of rising Treasury yields. High yield debt, in contrast, still offers attractive spreads, and any pressure from higher Treasury yields (which would only come if the economy strengthens) would likely be absorbed by declining default risk.

Households have almost $7 trillion in bank savings deposits as a hedge against another recession. But since savings deposits yield almost nothing, then as more time passes without a disaster, at least some may feel that their savings could be put to better use in other asset classes or simply spent. Any attempt by households to redeploy their savings would put upward pressure on other asset prices, and possibly fuel an increase in the growth of nominal GDP. This is the wild card to watch.

The dollar remains very weak, so it’s more likely to strengthen, especially if the economy does better than expected. Gold remains a very risky asset at these lofty levels, and I think it is priced to a lot of very bad things (e.g., very high inflation, geopolitical risks) that have yet to happen, so again I’m not a fan of gold. Commodity prices, however, do have some upside potential after consolidating over the past year, and they have tailwinds such as easy money and ongoing growth in the global economy. Real estate stands out as the cheapest and most attractive inflation hedge, and commercial real estate offers some decent yields to boot. Equities are a decent inflation hedge as well.

11 comments:

Benjamin said...

Nice wrap-up.

Inflation is dead, fuggetabutit.

The problem is getting out of zero bound.

The Fed will have to get a lot more aggressive. The WSJ recently ran an op-ed by Woodford and Mishkin calling for nominal GDP targeting, which, of course, I have been blabbering about for a couple years here at Calafia Beach.

At long last, the monetarists are paying attention to Milton Friedman.

I have yet to come across a case in which Milton Friedman was wrong.

And he told Japan to print money to the moon.





mmanagedaccounts said...

Here's my prediction: Benjamin is going to get his wish, a much smaller military. That is what the president wants and that is why he has nominated Hagel for the post. I agree that we could cut back on some of our defense spending but I worry how this president will cut.

theyenguy said...

You relate Commodity prices, however, do have some upside potential after consolidating over the past year, and they have tailwinds such as easy money and ongoing growth in the global economy. Real estate stands out as the cheapest and most attractive inflation hedge, and commercial real estate offers some decent yields to boot. Equities are a decent inflation hedge as well.

I respond, Gold, GLD, rose 0.7%, for the first time in what is likely a double bottom low, stimulating the mid cap gold mining stocks, AEM, EGO, GOLD, ANV, RGLD, FNV, NGD, AUY, KGC, seen in their Finviz Screener, to rise 0.4%; their combined Yahoo Finance chart suggests that they have bottomed out. In the Age of Fiat Asset Deflation, with Credit, AGG, Stocks, VT, Major World Currencies, DBV, and Emerging Market Currencies, CEW, trading lower, an investment demand for gold will arise taking gold to fantastic levels. Physical possession of gold, in bullion form, or in Internet trading vaults, such as Bullion Gold, is now the safe and sane way to preserve wealth.

Jeff said...

My predictions for 2013:

1) Benjiman will continue to rant about Japan

2) Dr. McKibbin will not change his profile picture

3) Public Library will go private

4) Marcus will continue criticizing Scott on obscure points

5) Scott will post 17 pictures from his iPhone 5 in 2013 but not mention AAPL again until it is above 600...with a bullish recommendation.

6) Jeff will buy an iPhone 5 even though he has a year to go on his 4S

7) Oil will be cheaper

8) Gold will be cheaper (so buy, see #10)

9) The deficit will be over $1 trillion (again)

10) Government size, spending, power, et al will continue to increase. Republicans will loose the house in 2014. We will continue to spend our way to prosperity. Market forces will finally win out over the Fed and interest rates will start to go up; along with inflation expectations. Deficits will go up as interest expense rises. Total government spending will exceed 50% of GDP. But we cannot "cut our way to prosperity", so government spending will not be cut; taxes will rise on the wealthy. 75% marginal rates will be the norm across the globe. The US will institute a wealth tax for the first time. And a VAT. And a milage-driven tax. And a carbon tax.

As more people are suffering, the call for government to "do more" will only increase. Entitlements, assistance, unemployement insurance, earned income tax credits will all increase. As the deficit hits $3 trillion, and debt exceeds 150% of GDP, the dollar will start falling hard. Gold will hit $5,000.

Pragmatic Investor said...

In summary, you got most things wrong and a couple of things right last year. To avoid furthur embarrassment, you've decided to stop doing forecasts and just use vague languages this year.

Benjamin said...

Jeff-

I think yoga re right about the first of your predictions...the rest I am not so sure about.

Really, a dollar dump?

I have been hearing about that since about 1967.....

William said...
This comment has been removed by the author.
William said...

OEDC Composite Leading Indicators, December 2012

10/12/2012 - Composite leading indicators (CLIs), designed to anticipate turning-points in economic activity relative to trend, show diverging patterns across major economies. The CLIS for Canada, Japan, Russia, Germany, France and the Euro Area as a whole continue to point to weak growth.

In Brazil tentative signs have emerged that the positive growth momentum predicted in recent months is dissipating.

In China and Italy, on the other hand, signs of turning points in the cycle are beginning to emerge. Tentative signs of a stabilisation in growth have also emerged in India.

In the United States and the United Kingdom, where consumer confidence picked up strongly last month, the CLI continues to point to economic growth firming.

Jeff said...

The WSJ editoral board agrees with my prediction #10!

Team of Liberal Loyalists

...
It's notable how Mr. Lew's reputation has changed during the Obama years. As White House budget director in the Clinton era, he was viewed by Republicans as a reasonable liberal they could do business with. But as budget director and chief of staff in the Obama White House, Mr. Lew has been the President's most partisan and implacable negotiator.

Our sources who have been in the room with the 57-year-old say he is now a fierce defender of entitlements in their current form, resists all but token spending restraint, and favors higher tax rates. In taking these positions he no doubt reflects Mr. Obama, but no one should think he'll emerge as his own man at Treasury.

It's also worth noting how different Mr. Lew's selection is from most modern Treasury secretaries, of either party. Democrats have tended to select men with credibility in the business or financial worlds. JFK chose Republican financier Douglas Dillon, while Bill Clinton chose moderate Texas Senator Lloyd Bentsen and then Mr. Rubin of Goldman Sachs GS +1.67%. George W. Bush picked former or current CEOs, though until Hank Paulson economic policy was run out of the White House.

Mr. Lew's selection signals similar White House dominance, as well as a degrading of Treasury's traditional role as the voice for pro-growth policies. Mr. Lew is not the economic general you choose if you're looking for tax reform or a bold growth agenda.

He's the man you pick if you expect months of political trench warfare over taxes and spending. He's the partisan you nominate if your overriding political goal is to destroy House Republicans in the midterm elections, not strike a deal with them.

Mr. Lew's nomination would continue the post-election trend of Obama Unfettered. There's no more restraining his progressive agenda, as during the last two years. Chuck Hagel will be unleashed to shrink the Pentagon and reduce America's global military footprint. John Kerry will be dispatched to give engagement with Iran and other U.S. adversaries another try, whether or not they're interested.

But Mr. Obama's main project is to reorder the relationship of Americans to their government. His goal is to extend and entrench entitlements into the daily expectations of the middle class—from cradle to college to health care during the working years to retirement and then the grave. The productive engines of the private U.S. economy are to be reoriented to finance this income redistribution.

His first four years, at least before House Republicans rudely interrupted, were about extending and entrenching the entitlements. His next four years will be about protecting every inch of that expansion while trying to find the means to pay for it.

Mr. Lew's main job will be to cajole or pound that money out of Republicans. And if he can't do that, he'll try to position Democrats to retake the House in 2014. Then in Mr. Obama's final two years, the President and Nancy Pelosi could finish what they started and impose the new energy tax or value-added tax they know is essential to finance their dreams because it taps the middle class.

Mr. Lew only makes sense as a Treasury secretary if this is the agenda. Policies to grow the economy will be an afterthought. The GOP should calibrate its expectations and strategy accordingly.

NormanB said...

"..equity PE ratios are below average even though corporate profits are at record highs.."

This is exactly what happens in markets: Profits high, P/E's low. When profits are in the tank, P/E's are high.

Charles said...

The economy has almost finished adjusting to the slow growth, high unemployment Obama trajectory. The piece that remains is residential construction which will eventually recover to 1.2 million units per year and there will be some multiplier effects from the housing recovery.

There is nothing on the horizon that is likely to throw the economy off course so we should expect a year similar to 2012.

Interest rates are unlikely to change because boomers have a desperate need to save and there are few investment opportunities. There are no signs of the flight from US govt debt that will surely come but later rather than sooner.