2010 Economic Outlook
With 2010 now officially upon us, we turn our attention to what the rest of the year has in store for us. The investment world has been full of surprises over the past 12 months and it will be interesting to see how things unfold over the remainder of the year. One thing can be certain, this will be no ordinary year, and it is our bet that we will see the making of some dramatic economic shifts that will require very careful planning to avoid significant portfolio shocks. Here is the rundown of some of the key areas we will be watching closely.
Interest rate hike:
While there is still a lot of debate (and outright arguing) by the deflation vs inflation camps, it seems that we are seeing more of a swing toward at least one interest rate raise coming during 2010. The overzealous stock market recovery, a likely (though small) improvement in unemployment numbers, commodity appreciation and a very real need for the government to inflate its way out of the enormous debt burden will all be drivers.
For reference, here is a chart that shows the historical Fed Funds rate since the 1950s and how infrequent the periods of ultra low effective rates are.
Higher Inflation, particularly Stealth Inflation:
There is an interesting push/pull going on with inflationary forces right now that is likely to swing backwards and forward for some time. With commodity prices on a strong run in 2009 and showing no sign of weakness, we are inevitably going to see the trickle down of price increases into the broader economic landscape. Supporting this has been an improving stock market, a weakening dollar and gains in corporate credit fundamentals . The drag is on the demand side with high unemployment numbers, foreclosure rates and consumer spending still being very sluggish overall. Balancing both sides appears to give the nod toward higher inflation over the short term, and significantly higher inflation over the 5-7yr range. The spread on the yield curve in the US between long term issues and short term is also growing and is often a sign of inflation to come. If the government sees consumers put under additional pain through retail price increases, a raise in rates will bring some of this back into check and managing consumer sentiment will be a key priority to keeping things as economically healthy as possible.
Stock Market Increase Followed by Slide:
Perhaps the greatest surprise of 2009 was the scale of the recovery we saw in the stock market. With no real, fundamental or strong economic news underlying any prospects of a sustainable recovery it is hard to identify the areas of support that will allow this to continue. This is also not to say that the stock market and economy have to trend together, as there have been many periods when this has not been the case. It seems likely that we are in a period of multi-year ups and downs that could feasibly continue for another decade and will follow a similar pattern to what we have already seen since the start of the century.
This secular bear market type of activity is extremely difficult for investors to manage due to the rapid (relatively), changes in market performance that make entry and exit points difficult to determine for an active management approach. Buy and hold strategies also suffer as you risk no appreciation (just look at the last decade) while enduring the gut wrenching roller coaster ride we saw in 2000-01 and 2008 where many converted their paper losses and fled to cash. Our expectations are for the broader market both domestically and internationally to continue it’s late 2009 trend through the first couple of quarters of 2010. What then happens may be largely dependent on how bonds react in the first half of the year. Ironically, the biggest risk to the stock market could be the bond market, as it is likely that the Fed will not hesitate to pull liquidity and crash the stock market if the US continues to have difficulties in selling treasuries.
Long Term Bonds Get Hurt:
If you talk to bond traders right now, the conversation often comes back to the possibility of a bond collapse, particularly on longer duration Treasuries. With the US Government needing to issue more debt, and also now printing even more money to buy Treasuries (the Fed bought $289million in 2009), the Treasury market is in a very unstable position. Foreign purchasers have already scaled back their acquisitions greatly as they diversify into other holdings, and this will continue into 2010 and beyond unless we see a rate increase that will make the yields more attractive than they are now to outside investors. The issue here is that with any type of rate hike (good for long term yields), there will be some significant declines in bond prices. In fact, shorting long term Treasuries in 2010 and beyond may be the play of this decade. Many hedge fund managers are already making dramatic changes to their bond portfolios and selling longer duration holdings out of their funds, resulting in an increasing yield and lower prices particularly at the 10year level and longer. As the world starts to question the ability of US to pay back the money on its debt issuance, interest rates on Treasuries could dramatically increase not to mention the potential threat of the AAA rating the US currently enjoys on its government bonds.
Commodities Continue to Rally:
As mentioned above, there is something of an inextricable link between commodity price appreciation and the inevitable appearance of inflation, particularly when the growth curve has been as steep as we have seen in 2009. Commodities may also prove to be the stealth inflation factor the government overlooks when it views its CPI figures. We see the biggest gains to continue in energy, agriculture as well as industrial and to some extent precious metals. Gold is forever the wild card and while we feel it has a large speculative component to its appreciation, that increases its risk dramatically, it is very possible that we will continue to see new highs. Assessing whether recent commodity prices have been ‘real’, or largely attributed to currency depreciation is a key component that needs to be factored in when considering the 2010 commodity landscape. Even while we expect to see some strengthening of the greenback later in the year, slowing investment gains, commodities should continue to trend upward in 2010.
There you have it. In very broad brushstrokes an outline of what we see for the rest of 2010. Please contact us with any questions on the above commentary and to find out more about the services we offer at Caledonia Wealth Management.
