Predicting the future back in
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
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
180º 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
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
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
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
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-month T-bill yields
at 0.85% by the end of next year, with 2-year T-notes at 1.6% and
10-year T-note yields at 3.9%. Betting that 10-year yields will
rise from their current level of 3.4% is not enough, however;
shorting the 10-year incurs a carry cost that must be made up by
falling prices. 10-year yields need to be at least 3.9% for a short
position in the 10-year 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
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
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
Equity prices are likely to register gains of 10-15% next
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
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
These economies tend to thrive in an environment of easy money,
rising commodity prices, fiscal policy reform, and ongoing
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
The dollar is likely to move higher against most major
currencies, and hold relatively steady against emerging market and
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
I am long equities, short Treasury bonds, and long high-yield debt
at the time of this writing.
Despite Cyclical Momentum, U.S. Consuming Its