Feb 04, 2011

It Could Be a Very Good Year

If there is a theme in this year’s surprises, it is that more than half of them are in the direction of the consensus but go further.  Understandably, investors tend to extrapolate current trends.  Before September last year the United States market moved back and forth 165 times over its starting point of the Standard & Poor’s 500 at 1115, but stocks did very well in the fourth quarter.  Historically forecasters usually expect the market to rise 10% in the following year almost regardless of what it had done in the previous period and that was also the case this year.  The same was true for the economy, where observers were looking for a continuation of the modest growth we experienced in 2010. 

My first surprise is that the economy will be stronger than the consensus expects.  Most forecasts for real gross domestic product growth are around 3% with 4% the high on the positive side.  I think the U.S. economy can grow at 5%.  In the interest of full disclosure I have to admit I was looking for 5% last year also and I was wrong, but at the end of the year business conditions improved and the economy began to build up some momentum, driven by the consumer, exports and capital spending.  Last year I also thought the unemployment rate would drop below 9% and it ended the year at 9.4%.  I believe we will see unemployment drop into the 8%–9% range during 2011.  Initial unemployment claims are in a clear downtrend and this should mean that more jobs will be created soon.  There are jobs out there, but many of them have been filled by temporary workers or have gone unfilled because companies have been unable to find employees with the requisite skills.  I don’t expect the unemployment rate to drop to the low levels of earlier cycles, but I do see an improvement of one-half to one percentage point from current levels. 

Most observers were expecting U.S. Treasury yields to rise last year but the yield on the 10-year note dropped more than 100 basis points.  I thought that the yield might reach 5% during the year; instead it dropped to below half of that.  How did that happen?  First, the economy was weaker than expected, reducing the demand for riskier assets.  Second, inflation remained low because there was no pressure from workers for higher wages and real estate remained weak.  Third, the European financial crisis sent investors looking for safe places to invest and this favored U.S. Treasurys.  Fourth, the Federal Reserve engaged in a quantitative easing program putting downward pressure on rates.  My view is that several of the conditions will be reversed in 2011.  The economy will do better and investors will become more comfortable investing in equities.  Most important, however, the United States will be borrowing more than ever before and will continue to be dependent on foreign investors to provide these funds.  I believe those investors may demand higher yields because of the inability of the U.S. to balance its budget any time soon and the sheer volume of the securities being sold.  Many investors agree with me on this one, but they expect the 10-year yield to rise to 4% and I think we will see it at 100 basis points higher than that.  I believe spreads with other fixed income securities will narrow; there will not be a parallel rise in interest rates across the board. 

I am more optimistic about the U.S. equity market than most observers.  The consensus sees the S&P 500 at about 1400 and I think it could reach 1500.  Operating earnings are expected to reach $92–$95 next year and the market generally sells at 15 times that earnings level sometime during the year.  But markets often overshoot and it would only take an increase in multiple of one unit (to 16) to bring the S&P 500 to 1500, in striking distance of its old high.  It is unlikely that this move to higher levels will take place early in the year.  The market started 2011 with optimism among investors at extreme levels and we may need a correction of some importance to create a more conservative or cautious mood.  The rise last fall began when there was considerable concern about the economy, the election outcome and its implications, and the resolution of the credit problems in Europe.  Good things in the market rarely happen when everyone expects them.  Moreover, if interest rates rise later in the year stocks could react negatively, so while I believe there is a better than 50% probability that the S&P 500 will reach 1500, I do not necessarily think it will end the year at that level.

My fourth surprise is that the price of gold will reach $1600 an ounce.  By the end of last year the number of investors positive on the outlook for gold had increased, primarily because the metal had performed well during the year.  The fundamental background had improved, however.  Rapid monetary expansion in the developed world, the sovereign debt problems in Europe and the fear that paper currencies of mature countries would be debased over time to make it easier to pay down the debt accumulated over decades made owning something proven to be “real” over centuries attractive.  The consensus is that gold could rise to $1500 and I’m at $1600.  The inveterate gold bugs are at $2000 or higher and that is certainly possible over time, but I think my target is reasonable for this year.  Hedge funds were active in the gold market in 2010 but they basically traded positions, selling and even going short at any sign of trouble and then buying again when the uptrend resumed.  The big long-term buyers are likely to be in the developing world, which is suspicious of financial assets and which holds large dollar reserves.

While the first four surprises are in the direction of the consensus but more extreme, the fifth one is not being discussed anywhere to my knowledge.  The Chinese finance policy makers have two important problems.  The economy is growing too fast (more than 10%) and inflation is too high (more than 5%).  They could control both by aggressively revaluing their currency upward.  No single policy change would accomplish the two goals as quickly and easily as a currency revaluation.  Since the currency is tied to the dollar, the decline in the U.S. currency has made their renminbi cheaper and exacerbated both the growth and inflation problems.  For this reason an upward revaluation would only bring the renminbi back to where it was earlier in 2010.  In addition the Chinese are beginning to think about moving away from pegging their currency to the dollar and perhaps embracing as the world’s reserve currency some sort of basket including the dollar and the renminbi.  Revaluation could be a step in that direction.  The principal benefit of a cheap currency is that it makes the country’s goods attractive to overseas buyers and puts people to work.  That has been a major factor influencing China’s past currency policy, but bringing inflation and growth down to reasonable levels may make a shift in direction more appealing. 

Back in the vein of in the direction of the consensus but more extreme, the sixth surprise is that “soft” or agricultural commodities will rise in price more than the consensus expects.  I have corn at $8.00, wheat at $10.00 and soybeans at $16.00.  In each case I am about $1.00 above the consensus.  My reasoning is that the standard of living is rising around the world and this will be reflected in the improvement in diets.  More meat will be eaten and more grain will be fed to the livestock that provide it.  Perhaps because of the effects of global warming creating excessive rain in some places and droughts in others, crop failures seem to be more prevalent, so we have a combination of rising demand for the commodities and diminishing supply, resulting in higher prices.  Industrial metals (e.g., copper) have already risen as a result of demand in the developing world.  We are now going to see that happen in agricultural commodities.
There is a great deal of controversy about the housing outlook.  Some observers, including Peter Schiff, who was early in seeing the problems in sub-prime mortgages, believe house prices could fall another 30%, and the Case-Shiller index of house prices in twenty major markets has been weak lately.  Last year there was no change in the substantial inventory of unsold homes, but this year homes for sale, and those with mortgages in trouble, are likely to be reduced by more than 800,000 units, about 10% of the total.  That still leaves a lot of homes waiting for buyers, but I believe we will see a pick-up in single-family housing starts from the current level of about 475,000 to 600,000.  Some argue that an inflection point in housing starts is unlikely to be reached if interest rates are rising, but the housing market has done well historically when mortgage rates were much higher than current levels.  Also, if it becomes harder to evict tenants in default on their mortgages as a result of recent court decisions, the inventory of homes for sale will be reduced.  An improvement in housing, however, is dependent on the economy getting better and jobs being created, which I expect will happen, but which has been slow in coming. 
In the eighth surprise I believe the price of oil will rise to $115 a barrel.  Those who anticipate higher prices are mostly looking for $100.  I have been a bull on oil for some time because demand from the developing world is expanding rapidly and the ability of the oil producing nations to increase supply has been modest at best since new discoveries basically have only offset the decline in production of existing wells.  The developed world is using less oil but the low level of consumption in the developing world has been steadily rising as standards of living have improved.
President Obama has clearly moved to the center since his “shellacking” in last November’s congressional election.  In spite of fears (or hopes) of “gridlock” in Congress a compromise was reached extending the Bush tax cuts and continuing unemployment benefits.  There is already a plan in place to remove American combat troops from Iraq by the end of this year.  I believe Afghanistan will be included in the troop withdrawal plans for 2011, and that is the ninth surprise.  It is not clear that our military is making real progress there.  The country is basically tribal and is likely to again be ruled by warlords once American troops leave, whenever that day comes.  Those who believe terrorist camps will be built if there is no military force to prevent their construction should recognize that terrorist training continues along the Pakistan/Afghanistan border and in Yemen, Somalia and other places.  We cannot create a democracy in Afghanistan which will prevent terrorism on its own.  The war in the Middle East is extremely unpopular and the President will want to get American troops out of there before he begins to campaign for re-election in 2012.

Finally the tenth surprise is that there is no second act in the European financial crisis.  The stronger countries, France, the Netherlands and Germany, have considerable loans outstanding to financial institutions in the weaker countries and have a lot to lose if the Eurozone financial crisis deepens.  I believe the banks in the stronger countries will try to reduce their exposure over the next three years.  In the meantime the European Union, the International Monetary Fund and Germany will try to provide transitional aid as the southern tier implements austerity measures, selectively raises taxes and hopefully enjoys some modest growth.  A lot has been invested in the European Union and considerable benefits have been realized, primarily in trade.  I don’t think any of the major participants are ready to give up yet and they have the means to ensure survival over the near term.

Because so many of the Ten Surprises were in the direction of the consensus I included ten “also rans” in the list this year rather than the three or four I have had in the past.  I will not discuss them in detail.  They include Pakistan and North Korea becoming serious trouble spots shifting attention away from the Middle East.  Iran becomes less hostile and moves away from its nuclear weapons development program to relieve itself of sanctions and provide more opportunity for its younger people by attracting aid and investment from the West.  The dollar strengthens against the yen and the euro as a result of faster growth in America.  Confusion in the Republican party and dissension over Sarah Palin improve Obama’s election chances.  Russia implements a program to attract more foreign investment with the rule of law as a centerpiece.  Marijuana laws are liberalized in several more states.  Infrastructure problems snarl New York subways and Los Angeles freeways and there is no federal help to solve the problem.  A state fails to pay its interest on a bond issue, creating havoc in the municipal market.  There is no terrorist event in the United States in conjunction with the tenth anniversary of the World Trade Center attack.  And worry about climate change recedes in the United States as the winter is milder and the summer is less oppressive, but natural gas usage increases and the price rises to $6.00 per mcf.

The “also rans” either have less than a 50% probability in my opinion, or are less important than the basic Ten Surprises.  They are worth thinking about, nonetheless.  I look forward to reporting to you early next year on how this year’s surprises have worked out, and to coming up with another list for 2012.

Contact Information:

The Blackstone Group L.P.
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Byron Wien
The Blackstone Group
345 Park Avenue
New York, NY 10154
Tel: 212.583.5055