Outlook for 2011

Disclaimer: I am not a professional investor, and not authorized to give advice. As you read the following, remember that the phrase ‘caveat utilitor’ has never been more applicable.
Accuracy and completeness of information is not guaranteed.


“U.S. Is Running Out of Time to Fix Deficit, Budget Woes”

“China Tightening Monetary Policy to Damp its Over-charged Recovery”

“Commodities Soar while Global Economy Hobbles”

“Sovereign defaults, as a whole, should jockey for mind-share”

If someone went asleep in the first week of 2010, and woke up an year later to read the headlines, he can be forgiven to think that not more than a day has passed. These headlines from the first few days of 2010 are even more true today. Most likely, 2011 will see a resolution to most of the above issues, and the resolution path will drive returns for majority of the asset classes. In the following four pages, we will first look at the current status of some of the key players in the global economy, and derive our outlook for 2011 from there.

US Federal Government: With the midterm elections over, we now have a Republican Congress, a Democrat president seeking a re-election, and Ron Paul, a vocal critic of the Federal Reserve and author of the book ‘End the Fed’, voted as the chair of the House sub-committee that has jurisdiction on matters related to the Federal Reserve. President Barack Obama is certain to go for economic growth, as elections are heavily dependent on state of the economy and gas prices. The Republican Party, which now has the gavel of the House, now has equal responsibility of the legislation and is unlikely to oppose all policies coming from the White House. A stalemate, like the one brought by Newt Gingrich in the 90s is also unlikely, as inaction is blamed on the Congress and has been proven to pay little political dividends. All in all, we can expect Washington to shoot together for growth. It is hard to predict the measures that will be taken, but we can be certain that further large-scale fiscal stimulus is unlikely, as that would run contrary to the biggest plank of the Republican Party. Federal government’s $14.3 trillion debt limit will be reached in March or April, and though extension is certain, the amount of extension will signal willingness to tackle the ballooning debt.

On the other hand, we can expect heavy politicization of the Federal Reserve’s policies. Though core inflation has remained less than 2%, if the gas prices approach $4 per gallon, it will put further pressure on Ben Bernanke to prove that the Fed is sticking to the ‘stable prices’ part of its dual mandate. We can expect the Fed to continue playing a big role, especially in light of the unfolding debt crisis in Europe, but further monetary stimulus is unlikely.

US State and Local Governments: The recession has also turned focus on poor fiscal health of US state governments and municipalities, though the severe cost-cutting undertaken has often gone unnoticed. Local governments reduced spending for the first time in the last fiscal year, and are showing resolve. 2010 default rates of municipal bonds outstanding is only 0.15%, and the last state to default remains Arkansas in 1933. Interest payments constitute only 5% of overall municipal spending, hence default remains unlikely. The new governors will likely highlight poor condition in their states to attract federal money, but we can expect that after April, once taxes have been counted, a better picture will emerge. Though long-term problems will remain, outright imminent default will not be the most talked-about option.

US Corporations: The US corporations had a historically profitable last year by cutting costs to the bone. The EPS estimates by analysts continue to rise, but it is worth noting that the ascent is not driven by revenue growth but further cost cutting assumptions. Further efficiency gains will be difficult, and may put a ceiling on total earnings in the near term. The street is also abuzz with the $1.9 trillion cash that the corporations have on their balance sheet, and investment of this ‘cash on the sidelines’ is expected to spur growth. But, the cash is held in form of bonds, which means that the liquidity has already been invested in the economy by other companies or by the government. Liquid assets held as a %age of total credit market debt owed by non-farm non-financial firms is in fact near historic lows of about 20%. Overall, we can expect further profits to come from topline growth, not further efficiency gains or deployment of cash by other firms.

US Consumer: This is the most familiar story of all—despite marked improvements in consumer sentiment and PMI, unemployment is still close to 10% and structural unemployment theories abound. US lost close to 8m jobs in the recession, has clawed back 1m, while 2m jobs have been consumed by efficiency improvements and employees working longer. Retail sales looked especially up on in December, but only because of earlier than ever sales in November, and the final picture is less optimistic that before, but still cautiously optimistic. Housing prices are expected to fall some more, and housing starts are expected to climb to 1m by 2013 from the current level of 500,000 and may take another 2 years to reach 40-yr historical average of 1.5m.

Eurozone: What a year has it been for Europe. The fiscal union that its leaders have worked for decades suddenly seemed untenable and ECB had to intervene repeatedly to support countries’ yields. Europe’s leaders have worked too long for a union, and will not abandon the concept. But, the problem is far from over, even for countries that ECB has intervened on behalf for.

Yields of government debts have risen back to levels see at the peak of Greece and Ireland bailout. This effectively means that the European leaders need to send a stronger signal, such as E-bonds or an economic accord, to the market that they will stand behind the currency. But, political considerations will continue to make agreements difficult. I believe that it may take an even larger crisis for all the political and monetary leaders to come together, and propose a more comprehensive plan, hopefully including long-term loans by the governments. My wild speculation is is that ECB will let one of the PIGS (sans Spain) fail to drive home the trouble that EU has on their doorsteps. Spain cannot fail; the day that happens, Rubicon will be crossed, and all rules will be unmoored. I am fairly certain that G8 will be engaged before Spain falls, if it ever comes to that.

China: World’s growth engine continues to deliver close to 10% growth, but there are signs that a brief hiatus may be needed, as inflation has crossed the 5% line. Money supply has grown by more than half since January 2009. PBOC has already raised rates and increased reserve ratios, and is focusing in more efficient allocation of capital to fund growth in Chinese interior. Delays in the diverting more capital to the interior may mean more rate tightening to combat inflation, but the traditional drivers of the Chinese economy—infrastructure development, migration to cities, and rise of Chinese consumer remain in place.

On a slightly different note, Chinese military developments like the stealth aircraft and anti-ship missiles will keep other nations on toes, and defense contractors worldwide happy.

Commodities: Industrial metals should see continued demand from ongoing infrastructure investments in CIRB (readjusted for growth) countries, even while it takes time to bring more supply online. Popularity of commodity index funds, which take possession of metal supplies, instead of traditional bets on futures, may cause additional volatility. Backwardation seems to be returning to these markets, which may invite further more investors. Precious metals, cousins of VIX, will track developments in US debt market and the Eurozone debt crisis, and exhibit significant volatility. Food inflation may turn out to be one of the biggest drivers of 2011, tempering growth in EMs. Agricultural prices have already reached the peak last seen during the 2007-08 food crisis. The rise in rice and wheat prices has not been as meteoric as the Food and Agriculture Organisation food price index, but if staples see further price increases (through continued inflation or supply disruption), a new crisis will come to fore.

India: Barring unprecedented political upheaval in neighboring AfPak region that might require military intervention by Delhi, India’s growth story would have continued at the recent rate of 8-9%. Except, spiraling inflation has chosen to intervene; inflation, food inflation in particular is in double digits. Recently we have seen India’s Prime Minister Manmohan Singh stepping in to address high onion prices. I expect aggressive rate tightening to address social (and political) discontent, but the fundamental drivers of growth remain in place.

Investment Recommendations:

Overall, macro-economic concerns on several fronts leave us with a lot of uncertainty. But, we can still tease out actions that should help us preserve capital and hopefully earn some gains.

Asset classes to avoid –

Bonds: World’s risk-free rate should begin increasing by the end of 2011, if not before. Growth in the US economy will naturally lead to higher interest rates, but if by the end of the year, growth is nowhere to be found, US government, out of both fiscal and monetary stimulus firepower, will begin focusing on tackling the sovereign debt/GDP ratio. In absence of growth, United States’s only way to repay the debt will be to manipulate the coinage, outside of outright refusal to pay–highly unlikely. Thus, even in case of anemic growth, engineered inflation will push up the interest rates. Hence, bonds with maturities longer than 2011 should be avoided. Bonds with maturities of less than a year are not a great place to invest either, as interest rates are unlikely to go below where roughly $5 trillion of combined stimulus has pushed them.

US Equities with exposure to US Federal government: US federal spending is likely to be curbed, and healthcare is likely to bear the biggest brunt, barring a serious effort at the repeal of Affordable Healthcare Act. Pentagon has begun looking at $75 billion spending cuts over the next five years, though further surprise military spending by China may lead to reconsideration.

Japan: Japan has a shrinking population with stagnant productivity, and is heavily dependent on exports to China. Slowdown in China is certain to impact Japan negatively, ETF buying by the BoJ notwithstanding.

Marquee Emerging Markets: Amid the excitement about BRICs, it is worth considering that S&P has outperformed EMs for the last 3 years. With relatively limited participation in the capital markets by the firms in BRICs, firms to invest in are limited, and valuation is rich. For example, India equities are valued at 23 times September 2010 earnings.

Asset classes to invest in –

Even though emerging markets look richly priced, there are two ways to reap dividends from the rapid growth in the economies.

US Equities with exposure to emerging market infrastructure: US equities on the whole do not offer the best valuation at the moment. Shares are cheap based on estimated 2011 earnings, but they are extrapolations based on further cost cutting or a sharp rebound in the economy, based on 4-5% growth seen in previous recoveries. But, as Prof. Rogoff and Reinhart show in their book ‘This Time is Different’, recoveries are 1-1.5% slower in wake of financial crises. Given the recent rebound in equities, and exhausted stimulus, a wide bet on US securities may be imprudent. But firms that can tap into the infrastructure development in emerging markets still look cheap, though an even stronger dollar can limit the upside. Firms dependent on emerging market middle-class consumers should be avoided, as inflation is expected to subdue spending.

Staple food commodities: This is another great way to tap into the growth in emerging markets. Rice and wheat have not tacked the overall food price index growth, and being staples, are susceptible to swift export restrictions. Inventories have been depleted because of crop failures in 2010, notably soybean and wheat. Inflation combined by disruption in even one of the staple-producing countries can lead to a swift rise in prices.

Base metal commodities: Construction metals such as aluminum, steel and copper should continue to rise, as estimates of metal needed over the next 5 years continue to rise. Alcoa expects the 2020 aluminum demand to double from the current levels. Copper has been rising at a torrid base by the new construction in China—at the rate of 90 pounds per new home. This should accelerate as development moves inland, where per-capita GDP is less than half of that on the coast, according to China’s National Bureau of Statistics. China’s consumption of Copper has tripled in the last decade, and similar trends in the emerging economies will drive the metal even higher. This is not the only driver—the metal is heavily used in the new greener cars, and their mass acceptance will push another lever of demand. It takes a couple of years for supply to come online, especially since starting smelters is a big investment. During 2001-2010, only 4 mines with more than 200 kiloton (per annum) capacity were developed. To meet Chinese demand growth of 5 million tons, more than 20 mines of such capacity need to be developed. For the next 18 months, not a single mine of this capacity will come online.



  1. Is the fed trying to stimulate a demand which does not exist? In other words, won’t the demand be for different kinds of goods post the crisis.

    Also, with the two political parties quarreling, will the deficit be arrested, which is necessary before the bond market starts trembling?

    Good stimulating post

  2. My short answer to the first question: yes, Fed tried to stimulate demand that didn’t exist.

    Long answer:
    Some theory first –
    Fed stimulates by lowering cost of capital. So, if no inherent demand exists, it doesn’t matter what the interest rates are. Also, interest rates almost never influence short-term demand, as it makes little difference. To sum, long-term interest-rate sensitive investments are what Fed aims to influence / can influence.

    Now, let’s look at what are some typical long-term investments by consumers and corporations–housing, and long-term Capex respectively. None of this were likely to be spent post such a large crisis, as every needed to de-leverage. This is why banks are holding close to $1T in reserves and not lending it out / cannot lend it out.

    As for the second question, both parties will engage in saber-rattling, but no one wants to be blamed for govt. shutdown. For now, looks like they’ll figure out a way by doing these 15-days deals.

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