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"Reflect upon your present blessing of which every man has many
... not on your past misfortunes, of which all men have some."
Charles Dickens, 1812-1870, A Christmas Dinner.
Editors Note: This periodic commentary has been produced for almost 20 years and its purposes and goals are important for readers to know and understand. In order of their importance the objectives are: 1] to record our outlook and forecasts; 2] to provide our analyses and explanations for our economic and financial-markets’ conclusions; 3] to determine the various risk-reward relationships that emanate from our macro-economic work; and 4] to produce, chronicle and rationalize value-adding investment strategies with regards to the financial markets… primarily equities. These four goals dovetail one another and are usually expressed in opinionated analyses that conform to the laws of supply and demand. Using available data and these economic principles, we determine and prioritize the most likely outcomes (as we see them) of the many factors that will shape future GDP, profits, jobs, interest rates, currency values, etc. While never easy, this was a much simpler task when the laissez-faire (free-market) principles dominated the Authorities’ behavior. Within the last two years, all this has changed making our task more difficult and less certain. As one pundit put it, “The US embraced the free markets’ philosophy until they no longer liked the results and then changed their beliefs.” Since human interaction as well as its expanse and depth are unknowable, forecasts can be errant …but, these are not the shortcomings of the laws of economics. In today’s extremely uncertain world, all of us must be flexible and willing to revaluate our ability to achieve our investments goals as well as gauge the risks and rewards tethered to our expected outcomes as well as the means being utilized to achieve them. The most important message we have been championing is: “Be, and remain, flexible!”
So many external data and assumptions combine with human emotions and the “follow the crowd” mentality to determine asset values, that forecasting stock prices, much less market movements, are impossible. Doing so anchors one’s psyche to a defense of their outlook. This stance prevents objective analysis as it quickly dismisses new or conflicting data. Besides, predicting financial asset-valuations fall outside of the science of economics. Hence, Knott Capital prefers to avoid any forecast of future stock market prices. This doesn’t imply we won’t discuss over- or under-valuations (P-E ratios) since these can be compared to historical assessments along with the resulting outcomes. Those who ignore history are doomed to repeat it… or so they say. We utilize our macro-economic work to determine the sectors and industry groups that have assisting tailwinds and those that face forceful headwinds. While our studies lead to sector-selections, they are not based solely on unsupportable opinion… rather they are based on both our top-down and bottom-up research. In all instances, we approach the above goals with objective analyses, reliable data, logical and impartial judgments and attempt to reach intermediate (18-36 months) and long-term (2-5 years) conclusions. In a few instances, large and uncontrollable (by the Authorities) factors (the direction of currency movements, meaningful reduction in ongoing budget deficits, etc.) will produce forecasts that stretch as far as 10 or 15 years. Finally, for more than 15 years, your editor has utilized an “opening quotation” to frame a theme or the focal point of each month’s content. We believe it adds a “recall phrase” or a short but well worded thematic conclusion. We’ll continue this practice.
We searched for two quotations which would describe the current situation. The first part of the initial phrase aptly summarizes the recent sustained rally in the stock market…while the latter portion details some of the warnings that many noted economists are voicing about our nation’s (longer-term) economic future. There have always been two sides to every market -- that’s why buyers can relieve worrisome sellers of their equities and why sellers seek them out. Each, in their own way --but at opposite ends of the spectrum -- find what they’re looking for. The second quotation is not a perfect fit. Our interpretation of Dickens’ words is: all men endure some hardships… but mankind is far better off pondering and focusing on their good fortunes …perhaps to be not only a source of solace but also concentrating on negative factors inhibits one’s ability to seek a better outcome. Today, we could all benefit from better times.
January’s Focus -Long-term challenges + short-term problems = many uncertainties, slower growth and “this time it’s different” outcomes -This year’s annual forecast will be like no other for a number of reasons. First, the Authorities are constantly interfering with the laws of supply and demand. This meddling is designed to favorably (in their viewpoint) change the economic outcomes from what it otherwise would have been. However, their efforts can create large, ongoing and unknowable effects on this year’s GDP. Second, long-term negative forces are providing huge, severe and complex headwinds that are battling the shorter-term stimulus as well as the Fed’s asset acquisitions, guarantee programs and their easy-money policies… tailwinds, so to speak. These endeavors also muddy the waters of forecasting. Finally, we believe the lack of job creation, home price depreciation, financial deleveraging and the inability to
return to typical GDP growth patterns will inhibit the economic recovery. Having said that, let’s get started. To guide our readers through our analysis, we like to revert to our question-answer layout. We find it useful to “play the devil’s advocate,” asking “tough” and critical questions of ourselves! It also lends itself to reviews of past editions and quick shifts in subject matter. Thus, we embolden the content being discussed above the query. The questions are in italics and a smaller font while the replies are in normal type.
Why will this double edition be more extended than your previous years?
The principal explanation is: there’s so much that’s unknowable, it will require some lengthy discussion to fully appreciate our viewpoint. Just knowing what we think will unfold isn’t as important as understanding why and how we reached our conclusions. Here are some major points: there will be continuing interference from “the Authorities,” i.e., the Fed, US Treasury, the Obama teams, etc. The extent and timing of these intrusions will probably include some unintended consequences, as well as costs to provide more assistance to the economy. Other likelihoods include unknowable global events (such as Dubai’s financial plight or the inability of Greece to fund its debt obligations) that will either affect the world’s economy and/or investors sentiments. In the US, we see the likelihood of weak and inconsistent job creation as well as a workforce that has been dubbed “the permanent temp-position.” Then, there are the waning effects of the stimulus, as well as the need to either raise taxes or cut spending to deal with the frightfully large budget deficit and the unfunded government, but legislated, social programs.
Monetary policy and interest rates pose an all-important consideration. We think the Fed will (purposely) overstay their quantitative easing and 0% monetary policies. If so, (at least in theory) the “bond vigilantes” will react by selling the longer-end of the Treasury yield curve and longer-dated bonds will fall in price as mortgage rates and the cost of borrowing rises. Theoretically, these events would cause the US Dollar to decline. However, the major trading blocs are “playing a competitive devaluation game.” All things being equal, these efforts are aimed at generating greater demand for the winners’ goods and services which in turn, creates jobs. The losers opt for protectionism to deal with the threat of higher unemployment. Currency moves will probably play a big part in stability (or the lack of it). The “Euro-bloc” has (at least) five members whose finances are in poor shape and may face deflationary pressures and/or default on their debt. They are Portugal, Ireland, Italy, Greece and Spain, the so called the PIIGS. Japan has never recovered from its “lost-decade” (or two) following the ’89 stock market bubble.
We could list more serious and widespread hurdles. But, the key to understanding what investors must try to cope with is whether all governing bodies have decided they will get involved and interfere whenever they think the outcome is not to their liking. While we all have come to realize this, the huge questions are: what, when, where??? This modus operandi creates large and lasting uncertainties… something the market and investors abhor. We no longer live in the free-market environment that existed for decades! And, we’re unlikely to see those days for quite some time. Today’s inability to foresee enough to allow for a reasonable assessment of risks and rewards forces investors into one of two unfavorable choices. Either sit on the sidelines in riskless securities whose returns are minute and negative after the effects of inflation or invest with little ability to quantify the prospects for long-term returns, much less understand what that profit will yield in benefits (on an after-tax basis). Thus, we counsel again and again: Be flexible and remain so!
I know there are some readers who would like to hear your bottom line forecast now. They can read the details and reasoning later when they have more time. So why not provide your economic, interest rate and investment tactics now so everyone will have a preview of what you think 2010 holds for these critical factors?
We do not ascribe to the normal recovery scenario. This time it’s different for many reasons, but principally because this recession bordered on the edge of realizing some elements of our systemic risks. Large amounts of wealth were lost. Our difficulties require more time and money to heal the damage. We foresee a labored, weak and uneven recovery that materially impacts four areas: job creation and the type of future employment our economy will experience; real GDP - it will average 2% to 3% for the next
two years or so; administrated (Fed controlled or influenced) interest rates will remain near historically low levels for at least two years; and bubble-affected assets (housing, private equity funds, etc.) will have a difficult and incomplete recovery. Consumer spending will be weak for four reasons: poor job creation, lethargic income growth, restrained consumer credit, and the need to rebuild personal savings. Higher taxes and lower returns on savings will also affect consumer outlays.
The Fed policy will keep their asset acquiring programs in place; they will not raise the Fed funds rate before September; and they will retain their asset “backstopping” arrangements. Thus, investment grade and Treasuries (of less than 5-year durations) will remain near (within ½% - ¾%) today’s levels. Longer dated issues and junk or deteriorating quality issues will decline producing rising yields. Led by the big banks -- the top 4 control 50% of lending and deposits, while the foremost 50 manage 75% (of same) -- credit will continue restrained as banks play the yield-curve (can’t lose) money-making opportunity courtesy of the Fed’s 0% lending policy. Why this strategy rather than lending? They need additional capital, and will be nursing their residential and commercial-mortgage losses as well as their credit-card impairments. Besides, bankers want to see what the new reforms and regulatory environment will be. For the next few years, price inflation for goods and services are unlikely to present problems. Most of the huge amounts of liquidity are finding its way into the financial asset arena (especially equities) with some of it boosting real estate prices. These factors are verified by the Fed’s data …charts of money supply growth and velocity as well as credit expansion. However, inflation is one of our future’s greatest threats! Since (we believe) the Fed will over-stay their easing efforts, the ultimate costs of excessive debt creation on top of our nations already high debt levels will be sizable and their eventual costs inescapable. Besides, it’s beginning to look as if we may need more stimuli for a “jobs program” as well as one to boost economic growth. Any attempt to fund our huge budget deficit will reduce either consumer spending and-or corporate profits and both affect GDP and hiring prospects. Returning to the inflation threat, worldwide capacity is much underutilized. In addition, not only our labor markets but those on a global scale are so weak that inflation can’t get a foothold! And without rising wages, inflation is a relatively small and futile risk. Inflation can’t gain traction in a weak labor market with large amounts of over-capacity. Today’s concerns are for another place and time. The real dilemma is: how will the Fed deal with its threat when it appears…raising rates may not be their response.
While we don’t forecast stock market movements, we will provide our take on the major factors that affect equity values. Due to extremely draconian measures by Corporate America, earnings should continue to produce strong bottom-line returns, given our weak-recovery forecast. Capital expenditures will be almost exclusively utilized to increase productivity and shed labor as “permanent” temps become the norm. The “improve-the-bottom-line” attitude worked extremely well during the ’01 recession and those firms who followed this formula saw their stocks outperform their peers and the S&P 500. 2010’s operating earnings (for the S&P) will probably fall in the $67 to $76 range with our single-number forecast at $71.50. 2009’s robust equity market was due to five factors: the principle one was, (and due to tiny yields on bonds), and still is, the lack of viable investment alternatives. Money market funds are a parking lot while fixed-income securities have three strikes against them…historically low rates, the future inflation threat from the Fed’s quantitative-easings and record budget deficits. While stock certainly have risks, they are perceived, rightly-so, in our opinion, as “the only game in town” that can (not will) produce meaningful appreciation. The remaining four (stock-market props) are momentum investing as the “follow-the-crowd mentality is alive and well; the Fed’s huge liquidity injection, as well as Obama’s stimulus package. Finally, there’s the Obama “put”…if anything goes wrong with the economy, banks, etc., the authorities will ride to the rescue. While some say stocks are cheap, or at least reasonable on a P/E basis. This is debatable when one accounts for the overhanging economic risks, the suspension of mark-to-the market accounting and suppressed interest rates. Today’s markets can’t and shouldn’t be compared to past values that don’t reflect present risks. Remember, all stock valuations emanate from the assumption that there will be sustained profit growth…not just a recovery rebound. Thus, without robust, self-sustaining GDP growth, the economy isn’t likely to maintain its equilibrium. Where’s the source of self-sustaining economic growth? We don’t see it.
I realize you don’t forecast stock prices but can you offer a flavor or opinion as to how 2010 might play out?
Yes, but it’s based on our economic and interest rate outlook, not anything tied to today’s equity market. While we believe the downside risks truly outweigh the upside potential, the huge creation of excessive liquidity has to go somewhere and equities are the most likely target. But, that’s only if the risks we foresee are ignored. Since ’09 was so strong and the US problems are many, we think it’s more likely this year will be one of consolidation with a widening trading range developing. There will be opportunities to sell and to buy. We believe this year will favor astute sector selection as well as stock picking as opposed to last year’s broad rally where the rising tide raised all boats. Today, we are overweighed in technology, materials, healthcare, and underweighted in consumer discretionary, financials, industrials and utilities. We’re about equal weight the remaining four sectors. This should provide you a reasonably decent view of what type of volatility we expect and the groups we like and dislike. But, much will depend on corporate profits. Our key strategy will be to remain flexible and take what the markets give us.
Now that you’ve outlined your “down and dirty” conclusions, how about a brief review of how we got where we are?
The economy has seen its worse and most prolonged downturn since the 1930s. If one annualizes the period between ’08’s Q3 and ’09’s Q1, world trade fell 50%! And, global industrial production declined at a 24% pace. In the ’08-’09 time span, the equity markets have had a wild and woolly ride, first with severe drops and then with an exhilarating rocket ride. The economy’s plight and revival propelled and paralleled these actions…although many will argue to a much greater degree than the data would have one believe. But, that’s usually the case when emotional decisions create momentum in one direction, then another. The major damage was caused by four factors: falling home prices, job losses, the threat of big bank failures, and severe losses in stocks. Four factors also (eventually) stabilized the situation: The Fed’s extremely accommodative monetary policy; TARP and other rescue funding or guarantees by the Treasury (et ali); extended consumer safety nets and extended unemployment benefits; and lastly massive stimuli that spawned GDP regeneration. The result is a slower recovery than the “old normal” advocates expected, but a better one than most dour forecasts predicted. Today, GDP and corporate profits seem on the road to recovery. However, the critical job situation looks much better when you evaluate the BLS report (that surveys large companies) but very suspect when you examine and analyze the household-survey’s results. We believe the underlying environment for small business is rather poor.
Almost everyone believes employment is critical to our longer-term recovery prospects. It’s an extremely controversial subject, as you noted, with the optimists exhorting the BLS data while others cite the very disturbing figures from the phone-generated household surveys. What do you think the situation is?
Each one has a different source of statistics. Large firms have seen layoffs subside although hiring is spotty. Data is suspect. The “birth-death” model improperly (many argue) added (net) new and phantom jobs all during the past three years. It allocated additions to the payroll during the entire economic downturn. Seasonally adjusted new unemployment claims also received a fair amount of criticism. (It shouldn’t come as a surprise that economic and especially job and inflation numbers have been manipulated by those in charge for many decades.) Then there’s the underemployment numbers. Newly hired temps count as job creation. Corporate America is embracing temporary workers…and for good reasons: no company-funded retirement or medical benefits and no paid vacations or sick-days. These folks are easy to lay-off without any severance pay. In fact, about 26% of all workers are considered part of the “permanent” temporary workforce. Good for profits, bad for income generation and safety net infrastructure. It’s how Corporate America is competing with the cheaper and growing efficient (global) workforce. While the “job-report” improvement during the past five months has been almost miraculous, the discouraged worker and underemployment data indicate another story. December’s unemployment rate remains at 10%, but this was entirely due to the loss of 661,000 people who indicated they no longer remained part of the workforce because they stopped looking for work. This was confirmed by the lowest participation rate (64.6%) in 24 years. This has to be considered a large and perplexing negative.
Over the last two years, the decline in payrolls has been the sharpest since the end of WWII. And, the so-called underemployment rate (comprised of discouraged and part-time workers who want full-time
employment) rose to 17.3%. Another consistent and telltale sign of our nation’s industrialized woes has been the steady deterioration of manufacturing jobs in the US. Over the past 10 years, this key sector has seldom provided any net permanent new jobs on a sustained basis. However, this type of job is key to the health of our nation’s job market. Why? …because manufacturing creates so much additional work when one realizes all the incremental materials, components and services are required to build large numbers of mechanized products. Thus, the loss of these workers reflects poor GDP prospects. This can also be measured by the average-workweek number. It has remained within a very narrow range for years.
We believe “quality” job-creation will remain a sticky problem for years to come, not that job creation (including many temp positions) won’t emerge…it will! To remain competitive, the US must and will seek cheaper labor costs, either here or abroad. Income generation will suffer, and it’s the basis for consumer spending which, in turn, is 65%-70% of GDP. We are not going to replicate your father’s (or grandfather’s) employment opportunity. Cheaper labor, lower taxes, less litigation and regulation promote outsourcing to foreign lands. Corporate America is merely reacting to the resulting loss of market share to (cheaper and some say stronger) global competition. Since all technology can be quickly transferred to foreign lands, profits are maintained or enhanced, can you blame them?
Don’t those moves boost corporate earnings and profit margins?
Yes, they sure do! All these factors help the P&L statement and investors have already recognized these facts. That is one reason why stocks have rallied so much! It hasn’t been revenue recovery; its been margin expansion that has provided better than expected results. But, these “moves” as you call them, don’t expand US GDP …in fact, they lessen it. Given our ‘less-than-consensus’ GDP forecast, we think outsourcing and permanent temps are part of a long-term trend. Remember, 2010’s stimulus will be about one-half of last year’s dose, and the sporadic job creation is both a tailwind to profits and a headwind to the economy. We expect the trend of making “temps” permanent workers one that has just begun. The goal is to keep earnings expanding from margin improvement - especially in the cyclical sectors where work schedules are flexible. Technology and capital goods firms should do well but consumer discretionary ones won’t. Since the consumer makes up 70% of GDP, these firms’ revenues are affected by three factors: the aforementioned job scenario, the need to rebuild personal savings and the need for higher taxes to fund federal, state and local deficits. Our estimate for ’09’s Q4 GDP is about 4¾%-5¼%. This compares very favorably with the latest data from Q3 of 2.2%. However, more than one-half will be the result of one-time inventory rebuilding.
In effect, we’re optimistic on this year’s profit recovery possibilities. However, we believe the next few years (’11-’13) will be constrained by a over-indebted consumer and the need to invoke fiscal discipline on state and federal levels as the now out-of-control budgets clash with huge unfunded but promised benefit payments. These include Social Security, defined pensions, as well as the health care programs that our government is obligated to provide. Then there are the costs for the FHA, Fannie and Freddie as well as other bailouts. In effect, taxes will have to rise materially…most likely on the well-to-do, the top 25% of the income-wealth population. While this constituent makes up only 20% of our population, their disbursements account for 40% of discretionary spending. Any reduction in Uncle Sam’s outlays or increase in taxes reduces GDP growth.
Inflation has two definitions
Isn’t lower wage levels and slower personal income growth good news from an inflation threat?
Yes, it is… all things being equal. But, inflation has two definitions…the popular one that describes an increase in prices; and, the technical one that monetarists use to describe the increase in the supply of money whenever the printing presses are activated by the central bankers. While the latter can often lead to the former, it’s not always the case. As we’ve indicated in past editions, inflation (in the latter sense) is due to the Fed’s increase of the money supply -- sometimes through quantitative easing and injections of liquidity and sometimes though credit expansion. All these can boost stock prices, depress bond yields and prop-up asset values. Few would call those instances of inflation a negative event. It’s when the economy finds demand heating up that capacity utilization is tightened and rising demand crimps our resources, our sources of labor and our credit availability. Prices of all three rise and that’s when the
punch bowl needs to be quickly removed. Barring any unforeseen circumstances or negative incidents, we don’t think the US will experience any menacing or runaway bouts of inflation in the near future.
Longer-term inflationary (price) pressures will depend on the combination of four factors: US GDP growth vs. our major trading partners; the amounts of “quantitative easing” and liquidity injections; the size of the federal deficit as well as the cost of borrowing those sums; and the success of our government’s ability to cut outlays and increase taxes. There are so many moving parts that this is something that needs to be monitored. We just don’t know all the answers to this complex puzzle and we can’t know. One of the big problems we think the US won’t avoid is the Fed’s inability to escape the need for “quantitative easing.” We can’t see how the US will be able to accomplish three things at the same time: First, pay out its unfunded “obligations” without either reducing the (promised) amounts or printing the payments. Reducing the heretofore promised benefits is politically unacceptable. The states have similar problems but without the benefit of printing script. Second, maintain acceptable levels of GDP growth while they attempt to implement fiscal discipline. Finally, discover a means to reduce our debt burdens that have mushroomed since we supplemented borrowing from the future to fund our (now) present spending. While your inflation concerns are rightly a distressful apprehension, they should not be a looming worry until late 2011 0r 2012, at the earliest.
This brings me to the matter you raised above. What are the probabilities of a balanced budget?
That’s a political question, not an economic based query. However, the laws of supply and demand can shed light on the likely answer to your question. As we see it, real reforming fiscal discipline -- one that truly lowers the debt load over the long-term --requires either too much of a tax increase -- in a fragile economy -- and-or spending cuts that are too deep to keep GDP and employment on a growth path. GDP must remain on a rising trajectory for the US to grow itself out of the debt dilemma we’ve created for ourselves. In our opinion, growing out of this difficulty is the only workable solution! Two other (linked) factors play into this assessment: the level of interest rates and the rate of inflation. The higher the latter means the greater the former. If either is rising, the costs are a burden to both borrowers and-or investors who seek real (after inflation) return on capital. We might see partial success with new cuts in outlays or an innovative tax measure. In short, they will be well-intentioned attempts, but ultimately unsuccessful.
Is there anything else you’d like to add before we shift our discussions?
While the Fed can influence each of the following factors …they cannot control either the Dollar’s exchange rate or the yields on long-term Treasury bonds. The financial markets determine both of these critical factors. Banks and other sizable financial institutions will under go massive regulatory reform. Banks -- and other highly leveraged entities -- will probably need to unwind as well as curtail their former collateralizing efforts. Reforms will require additional capital, reduce profits and restrict risky activities including the creation of CDOs. Most think any future MBS will require the originator to keep a sizable amount of “skin-in-the-game.” As some astute pundits have stated, deleveraging will be a minus to GDP growth because it will have the opposite effect of adding more and more debt to fund spending. This is also true when one repays his outstanding debts as opposed to savings funds as an asset against these liabilities. The former reduces profits, inhibits lending and requires less of managements’ resources. We foresee a large amount of hurdles for the banks and other similar entities. This sector’s woes include overcapacity, growing competition, large loan losses on housing, credit cards, corporate loans, and commercial buildings. If it is to serve any worthwhile purpose, regulatory reform will be confining, expensive and capital intensive. FDIC funding will be needed for years to come. Low interest rates means limited credit spreads while a difficult economic environment means higher loan losses. To paraphrase Churchill: “Never have so many sought profits from so few so often!” We don’t see why so many flock to the bank stocks…the future is very uncertain, the competition fierce and the risks high. That’s why we are underweighted in this sector.
February’s Focus - 2010‘s forecast and a review of ’09’s predictions. As we wrote earlier, this year’s annual forecast will be like no other for a number of reasons. We’ll continue with the same format... the questions are in italics and a smaller font while the replies are in normal type. We will also embolden the content being discussed above the query.
What are the long-term headwinds you noted above?
Cost-effective environmental legislation, that is beneficial to the entire nation.
In effect, we believe the US is falling behind other nations, not in all areas, but in enough of the less highly-skilled professions that many firms are resorting to foreign outsourcing and/or cutting domestic production. We need to create more better-paying jobs and fund productivity-enhancing capital spending. The US is too dependent on high levels of consumer spending many of which are foreign made. One other issue to remember is that a number of factors only relate to our nation’s balance sheet and do not affect GDP. While these elements are inter-connected, it’s important to separate those components that relate to our nation’s balance sheet, its P&L statement (i.e., its GDP), the economic outlook (both global and domestic) and finally, the current investment scene as well as its
future outlook. All these factors form the basis of the risk-reward evaluations that shape our investment strategies.
In past issues you’ve categorized a number of our hurdles or headwinds with the letter “D.” Could you recite them again to remind readers of your concern?
We like to group these factors into words that begin with the letter “D.” We’ll start with the most key item, the huge US and global Debt loads. Then, we’ll add: Deflation, Deleveraging of the financial system, our Deficits (trade and budget), the Decline in job creation, the Dollar’s stability, Derivatives (namely Credit Default Swaps {CDS}), loan Defaults, and the Credit Default Swaps, the Fed’s Decision to print more money. Finally, without Deficient regulation, we wouldn’t be in such a mess. If only the regulators had just done their job! Four areas were ignored: sub-prime loan ratings and securitization (SEC), excessive bank leverage (the Fed, FDIC, and the Comptroller of the Currency), CDS derivatives (Insurance Commissioners and the Fed) and the off-balance sheet use of SIVs to speculate on what is now classified as toxic-waste securities (the Fed, FDIC, and the Comptroller of the Currency).
All these and the other factors above have current as well as future consequences.
Let’s move on to 2010’s economic scenario.
First, here’s the less uplifting news. This year, we’re less optimistic than most on the pace of corporate revenue and GDP growth. We also have concerns about the US’s willingness to invoke fiscal disciplines. As we see it, it will require sizable spending cuts and large tax increases to balance the budget. The economy may be too fragile to withstand these tactics. Except in the temp-worker arena, job creation will be slow, spotty and focused on lower paying employment. Increases in pay will be few and far between. Thus, personal income and spending will lag expectations but profits will be strong as Corporate America keeps its focus on the bottom line.
Politically, we don’t see much in the way of progress. It will be difficult to pass worthwhile legislation. Today, there are two rival camps that oppose one another because their ideology and political allegiance prevent such agreements. To the victor belong the spoils. This assessment is based on our appraisal of the political winds -- not economics.
Now, here’s the more favorable side of the ledger. Inflation should remain very tame for all of 2010. This is due to three factors: weak global demand, large amounts of overcapacity in big ticket items and the lack of pricing power. Thus, the Fed will be able to maintain a 0%-¼% Fed funds rate. With an extremely weak housing market, large numbers of foreclosures and the lack of a workable solution for homeowners who are upside-down, we believe the Fed will resist (or completely ignore) any and all calls to tighten credit unless inflation or rising long-term yields on the 10-year exceed 4½% to 5%... and, we don’t think inflation is a threat. It’s possible the Dollar could do a swan-dive freefall, but we doubt it! Hence, interest rates should remain low for most, if not all of 2010.
You’ve already set the scene and scenarios that you believe are dominating today’s economic world and the financial markets, so let see the barebones numbers.
The recovery will be weaker than today’s consensus number by about 1% to 1½%. Interest rates tied to Government guaranteed bonds will remain low both from an historical and an absolute basis. While CPI inflation won’t be as tame as last year, it will rise about the same as a typical year. The printing-press variety (through the Fed’s quantitative easing) will remain in practice for the foreseeable future. The dollar will lead a “double-life:” a robust and strong one due to its reserve stature, the eventual recovery of interest rates, its role as a flight to quality investment and the huge pool of liquidity. On the other hand, its unending deficits, towering debt levels, constant quantitative easing and inability to operate under a balanced budget argue for a weakening trend. Our forecast is for a lot of volatility! Our forecasts are yearend levels.
| We see year-end yield at: | Today’s level | Year End Forecase | Range |
| 10-year Treasury | 3.65% | 4¼ % | 4% - 4¾% |
| 5-year Treasury | 2.38% | 2 5/8 % | 2.40 - 3% |
| 2-year Treasury | 0.92% | 1 3/8 % | 1 1/8% - 1¾% |
| 90 day-T-Bills | 0.08% | 5/8 % | 3/8 %- 7/8% |
| Fed Funds | 0% - ¼% | 0% -¼% | 0% - 1¾% |
Other data points include:
Some of the more key or critical factors include:
Here was 2009’s forecast: in their exact words:
The recovery will not be a V-shaped rebound. Interest rates tied to Government guaranteed bonds will remain low for years to come…unless runaway inflation takes hold. We see year-end yield at:
Other data points include:
Some of the more key or critical factors include:
How accurate were your calls?
Considering all the cross-currents and unknowns, we did quite well. The interest-rate calls were right-on except for the 90-day bills which came in at 0.05% vs. our Ǫ%. Fed funds, the 2 and 5 year calls were within the range of ¼% of the actual numbers and the 10 year was 3.84% vs. our 3¼% projection.
Home prices were within 1%-2% of the bottom and today’s prices for the “average” home. We were not close on oil which closed the year at $80.02 vs. our $57 estimate… but, on the other hand the second half of 2009 was stronger than we had anticipated. The Dollar calls were respectable as the Euro was 1.43 (vs. our 1.28) and the Yen was 93 (vs. our 96). Unemployment of 9.8% vs. an actual 10% and we won’t know cap-spending for another 40 or 50 days. The S&P earnings, a rather challenging prediction came in at $50 vs. our $46.25 estimate. Again, the strength in the second half boosted that figure. The 1st half GDP number was -6.4% and -0.7% for the 2 quarters for a combined -7.1% and the second half was a +2.2% and a +5.7% for a combined +7.9%. In effect, the economy sank about 1.6% further than we predicted and rose about 5½% better than we thought. The gain in the latest quarter was almost ¾ accounted for by inventory rebuilding. Ex-those numbers, we almost nailed it.
As 2010 unfolds, we will find out whether the initial steps taken to reverse the “vicious circle” of home price deprecation, bank contraction, rising unemployment and consumer retrenchment will lead to a sustainable economic recovery. The chart below highlights how far we have come, and the critical steps which must follow if the recovery is to continue:
We'll see how our 2010 calls will fare in about 12 months. I think we have provided the important factors that will shape our 2010 forecast and those conclusions that are critical to understand our viewpoint on the economy, interest rates, inflation and equity strategies. We want to wish all of our readers and their families a happy, healthy and prosperous 2010 and thank you for your participation and comments in our periodic writings.
Charles A. Knott, Co-CIO Editor January 27, 2010