Tuesday, December 28, 2010

Predictions for 2011

Predicting the future back in late 2008 wasn't too difficult, because the market was priced to Armageddon; I thought we would survive, and I turned out to be right. Last year it was more difficult to predict the future, and while I got most things right I made some critical mistakes, mostly concerning the Fed and inflation. This year is going to be even more difficult, because the difference between what the market expects and what I expect to see isn't nearly as great as it was one or two years ago.

From an investor's perspective, the important thing about forecasts is not whether you get the exact number right (e.g., whether economic growth is going to be 3.5% or 3.8%), it's whether you get the direction right relative to what the market is expecting (e.g., whether growth is going to be stronger or weaker than the market expects). If the market expects 3% growth and you correctly forecast 3% growth, that isn't worth much since you are unlikely to make much money by betting with the market.

With those caveats in mind, my outlook for 2011 is shaped by a belief that the economy will do somewhat better than the market expects, that the Fed will be less easy than the market expects, and that inflation will be somewhat more than the market expects. I held the same general view a year ago and turned out to be wrong on the Fed and inflation, but I don't see any reason to change now. Monetary policy is notorious for acting with long and unpredictable lags, and policy has moved much further in the direction of stimulus in the past year, so at some point we could see the fruits of monetary ease come true with a vengeance. This is no time to get wobbly on the Fed's ability to get what it wants (i.e., higher inflation).

So here we go:

The economy will grow by 4% or more in 2011. I think the market is priced to the expectation that growth will be around 2.5-3%, slightly better than the "new normal" economy scenario that has been all the rage in the past year or so. I'm more optimistic, for a number of reasons. Most important is the 180ยบ shift in the direction of fiscal policy that started with the November '10 elections—that's very good news for the economy. Washington is now much more friendly to capital and to the private sector, and those are the folks who create real jobs and real growth. Going forward, fiscal policy is likely to promote the growth of the private sector at the expense of the public sector. Taxes are not going to rise as so many had feared, and we may even see some cuts along with a simplification of the tax code. Many worry that cutbacks in federal, state and local government spending will prove very painful for the economy as a whole, but I disagree. One reason the economy has experienced a very sluggish recovery is precisely because there has been way too much growth in the public sector in recent years. Feeding resources to the public sector is a recipe for disappointing growth, and the experience of the past two years is proof of that proposition. So it only stands to reason that reversing the tendency to fiscal profligacy should be stimulative: fiscal austerity is bad for the public sector but good for the private sector. Given the improvement in unemployment claims of late, I expect to see an increasing number of new jobs over the course of the year. And the improvements already evident in autos, exports, mining and manufacturing can generate a positive feedback that lifts most other sectors. The forces of recovery are alive and well, and growth can trump a lot of the lingering problems we still have (e.g., underwater mortgages, state and local insolvency, high unemployment).

Inflation will trend slowly higher. Inflation is already a mixed bag, with the CPI and the PCE deflator having trended lower in the past year and the GDP deflator having trended higher. I would expect to see more uniformity this coming year, with all inflation measures showing a rising trend, albeit only a moderate one. Nevertheless, inflation is likely to be more of a problem than the market currently expects. TIPS currently are priced to the expectation that the CPI will be about 1.3% next year, compared to 1.1% over the past year. I see lots of signs that money is in abundant supply, and that is a good indicator that inflation pressures are on the rise: gold and commodity prices are soaring, the dollar is very weak, and inflation in China—a canary in the coal mine since China is tied to the dollar and thus is experiencing the same monetary policy as we have—is on the rise.

The Fed will raise rates sooner than the market expects. Fed funds futures currently are priced to the expectation that the Fed will raise the funds rate to 0.5% next December. I think it will happen sooner. The combination of a stronger-than-expected economy and signs of rising inflation will motivate the Fed to reverse its quantitative easing program sooner than most expect. Ending and/or reversing quantitative easing does not, however, equate to monetary policy that is a threat to growth; it will be a long time before the Fed raises rates enough to choke off growth.

The housing market will be showing signs of life by the end of the year. Housing still looks weak, and the weakness will probably last a bit longer (e.g., a modest further decline in prices, and flat construction activity). But with the economy picking up speed, money in abundant supply, and ongoing growth in the population and household formations, I think the housing market could be on the mend by the end of the year.

Interest rates on Treasury bills, notes and bonds should be higher than they are today, and higher than the market currently expects. Treasury yields out to 10 years are driven by expectations of future Fed policy, so if I'm right about the Fed raising rates sooner than the market currently expects, this should result in higher rates across the yield curve. Currently, according to implied forwards, the market expects to see 3-mo T-bill yields at 0.85% by the end of next year, with 2-yr T-notes at 1.6% and 10-yr T-note yields at 3.9%. Betting that 10-yr yields will rise from their current level of 3.4% is not enough, however; shorting the 10-yr incurs a carry cost that must be made up by falling prices. 10-yr yields need to be at least 3.9% for a short position in the 10-yr to be profitable. Higher yields on risk-free Treasuries will not threaten the economy, since they will be the result of a stronger economy. Higher yields on cash will be a net benefit to the household sector, since it holds more floating rate assets than floating rate liabilities.

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. Mortgages, which currently behave like intermediate-maturity bonds, are at risk of becoming long-term bonds as interest rates rise and refinancing dries up.  It's possible, however, that MBS could still provide a reasonable rate of return, and/or beat the returns on comparable Treasuries if spreads fail to widen significantly.

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 borrowers. Easy money adds fuel to corporate pricing power, and improved cash flows are a boon to borrowers, especially the most indebted ones, and that in turn means lenders will be rewarded by today's still-relatively-high yields and lower-than-expected default rates. High-yield bonds should be the biggest beneficiaries of tighter spreads. If Treasury yields rise enough, however, spreads on higher quality bonds are not likely to be able to absorb the full brunt of rising market rates, meaning there is the risk of mark-to-market losses on corporate bond prices. 

Equity prices are likely to register gains of 10-15% next year. I see no signs that the equity market currently is overvalued. Corporate profits have been very strong, and PE ratios remain relatively subdued. A stronger economy should continue to boost profits, and enhance investors' confidence in the outlook for future earnings, resulting in at least a moderate rise in equity prices.

Commodity prices will continue to work their way higher over the course of the year, buoyed by ongoing improvement in global economic growth and accommodative monetary policy. In real terms, commodity prices are still far below the highs they reached in the inflationary 1970s. Oil prices are likely to drift higher as well, and at these levels still do not present a serious threat to economic recovery. Commodity investing, however, is fraught with perils, particularly the fact that commodity speculation can result in backwardated futures prices, and those act to limit the speculative returns to commodity investing.

Emerging market economies are likely to do somewhat better than industrialized economies. 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, mainly since monetary policy is very likely to remain accommodative. But the potential for a significant decline—should, for example, the Fed surprise everyone and tighten early—is enough to keep me out of the gold market. Gold is a highly speculative investment at this point and should be approached with extreme caution.

The dollar is likely to move higher against most major currencies, and hold relatively steady against emerging market and commodity currencies. Currently, the dollar is so weak against most major currencies, both nominally and in inflation-adjusted terms, that even modest upside surprises such as higher-than-expected U.S. growth and/or an earlier-than-expected reversal of quantitative could prove very bullish for the dollar. Put another way, so much bad news is already priced into the dollar that I think its downside potential is limited.

Full disclosure: I am long equities, short Treasury bonds, and long high-yield debt at the time of this writing.


Benjamin Cole said...

Another terrific post by Scott Grannis.

I sense we will actually see lower inflation next year, possiblyy mild deflation. Bush econ adviser Marc Sumerlin said today that some Fed officials are basically expecting zero inflation for next year, while the PCE for third quarter 2010 was at 0.5 percent.

Add to that, that when an economy first expands, many costs for businesses start going down. You get overhead spread over more units, lowering per unit costs. And we are still witnessing deflating unit labor costs (going down at nearly a 2 percent annual rate).

With all that, we could see inflation flatline in 2011, or mild deflation.

For longtime students (I am always learning, never seem to master) of the economy, this sets up a situation our econ profs never taught us to expect: Inflation at zero or deflation, interest rates near zero bound, but the economy enjoying strong growth based on monetary stimulus.

Who'da thunk it?

I agree with Scott that we see 4 percent growth next year, although I think the Fed should target 5 percent or 6 percent.

We are now operating in an economic environment we have never seen before. Capital is abundant, interest rates at zero. It ain't supposed to be this way, but it is.

Unknown said...

This was kind of a bizarre year for the mortgage market. In the first half of the year, you had a decent number of home sales keeping mortgages for purchases stable, thanks to the home buyer credit. In the second half of the year, that changed as demand crumbled when the credit was withdrawn. At the same time, you had very low mortgage interest rates throughout much of the year cause a mini-refinancing boom. 2011 will look very different, as the housing demand continues to struggle and mortgage interest rates have begun rising.

honestcreditguy said...

what about the inventory drag..
the inventory component push this year will never be replicated...


that should drag gdp lower and people will not be able to afford to purchase that new toy....

The Lantern said...

Looking forward to seeing how your predictions play out...you did very well in 2010

Interesting that you did not forecast an employment outlook. Employment is my #1 concern with the economy and I am not optimistic. A 4% growth assumption and prediction of higher rates probably implies some improvement in employment (perhaps exit 2011 at sub-8%?).

brodero said...

To me and this is my bond background (and not really that noticed by the retail incevtor crowd) is the tightening of credit spreads...this is very important...
a lot of press will be given to rising treasury yields but as long
as corporate bonds yields are relatively behaved we can have
a reasonable growing economy.

Jim said...

I hope you are right, but sadly, I think the debt that we have here is too overwhelming. I think we are closer to Japan's situation than we think.

Pragmatic Investor said...

It's ok to be confident. But you have to be honest. If the 4th quarter GDP prints below 4%, you will only be getting 5 of 11 predictions right in 2009. How can you say you got most things right?

Scott Grannis said...

Re: unemployment. 4% growth sounds really strong, but it would not yield a huge reduction in the unemployment rate. A drop to 7-8% is all you could expect, unless we get even faster growth.

Paul said...


What about oil? Faster growth is going to push the price up to well over $100 a barrel.