Feb 01, 2010

The Market is Ahead of the Economy

Deciding on this year’s Ten Surprises was not easy.  While I had developed a list of many alternatives, coming up with the final ten proved to be difficult.  It was harder to identify the consensus on some of the issues and I thought other potential entries, while of great interest to investors, were not really surprises.  The final ten are generally positive on the economic outlook but reflect my thinking that the market itself may already discount the favorable fundamentals.  Last year was the best ever in the twenty-five year history of The Ten Surprises in terms of accuracy.  As I have often said the goal is to step back and stretch your thinking about what could happen.  Doing that can help you invest more creatively.  I try not to worry about how many will be right.  I listed the Ten Surprises last month.  Now let’s take a look at them in more detail.

The United States economy appears to be in a tender state.  During the first week of the new year there was a very favorable report from the influential Institute of Supply Management, but the employment report for December issued by the Labor Department was somewhat disappointing.  The first surprise is that the economy does much better than the consensus expects and grows at a 5% real rate during the year.  If I’m right about this I think the unemployment rate will drop below 9%.  The consensus view is that the economy will grow at about 3% and the unemployment rate will hover near 10% as we experience a jobless recovery.  My optimistic view is based on the observation that deep recessions are usually followed by strong recoveries.  The recession that ended in the second quarter of 2009 had a peak to trough decline of 3.9% and, based on historical precedent, the recovery should be in the 6-8% range.  Because of structural problems in the U.S. economy and intense competition from abroad I don’t believe growth will be that strong, but I do think a 5% real growth rate is likely.  During the recession inventories were slashed, the workforce was cut severely and capital spending came to a halt.  Rebuilding inventories, restoring the workforce to normal in relation to production and services provided (productivity is unsustainably high now) and a reasonable amount of spending on technology could bring growth in the economy toward my target. 

The second surprise is that the Federal Reserve finally begins to move interest rates higher.  I do not believe this will be in response to a troubling increase in inflation.  As long as rents and wages stay stable or soft, I think inflation will remain subdued.  Commodities alone cannot drive the overall inflation rate higher.  The Fed will start to raise rates because the zero interest rate policy will have done its job and started the economy growing again.  Zero interest rates have also given the banking system an opportunity to rebuild balance sheets by loaning money and buying Treasuries at a favorable spread.  During the course of the year I expect the Federal funds rate to reach 2% and this should diminish the so-called “carry trade” where financial institutions borrow at virtually no cost and invest in riskless securities paying a reasonable yield.

In my view intermediate and longer term U.S. Treasury yields are artificially low.  Fear and a flight to safety have drawn many investors into Treasuries as they await more certainty in the outlook.  The carry trade has also depressed yields.  As the economy strengthens investors will be more willing to take on risk and will move away from the safety of Treasuries forcing yields higher and this is the third surprise.  I have the 10-year Treasury yield rising to 5.5% from its present level below 4%.  While many observers anticipate some increase in yields, few expect them to go that high.  Those who think the economy will weaken again (the “double dippers”) believe interest rates could actually decline from present levels but I do not think that is likely.

The fourth surprise anticipates a very volatile U.S. market with the Standard and Poor’s 500 rising to 1300 in the first half of the year but then declining to 1000, finally ending the year where it started at 1115.  Sentiment data shows investors are already optimistic about the about the prospects for equities.  This does not mean the index cannot go higher; it only suggests that a major move from here is unlikely.  The best time to buy stocks, as we all know, is when investors are pessimistic as they were last March.  In addition valuations are reasonably full.  The price earnings ratio for the S&P 500 is one standard deviation above the historical median.  If I am right about interest rates rising, the bond market may give the stock market some competition.  Finally I think investors have come to realize that the U.S. economy is mature and likely to grow slowly in the future.  With consumers reducing leverage, government deficits (both national and local) high, taxes likely to be raised, dramatic improvements in earnings beyond this recovery year are less likely.  With interest rates rising investors should not count on the expansion of price earnings ratios. 

The decline in the dollar last year was a clear positive for U.S. exports.  The dollar actually became cheap on a purchasing power parity basis compared with other major currencies.   Most observers believe the rally in the dollar is likely to end soon.  In the fifth surprise I expect the dollar to be strong against the euro, reaching $1.30 and the yen, exceeding 100.  This surprise is also related to the expectation that the U.S. economy will be strong and that overseas investors will want to commit capital here.  Rising short and long term interest rates will also help the dollar.  Two important reasons for the dollar’s decline are our large trade and budget deficits.  While the trade deficit has declined, the Federal budget deficit has reached 10% of gross domestic product, a level not seen since The Second World War.  As a result the long term outlook for the dollar remains unfavorable, but for now, with the prospect of a strong economy and rising yields, the strength in the dollar should continue.

The ideal surprise is one where very few people share the idea.  When this is the case, the likelihood of losing money if you are wrong is relatively small because almost everyone who could sell probably already has done so.  My view that Japan could be the best performing major industrialized market this year is an example of this and it is the sixth surprise.  The common view is that Japan’s prolonged recession will continue.  The country is a high labor cost producer in a low labor cost region and its government debt as a percentage of gross domestic product is among the highest in the world.  Its savings rate used to be high enough to finance the debt internally, but that is no longer the case and, finally, its aging population is going to be more of a burden for the country.  On the other hand Japan appears to have reached an inflection point.  Real GDP declined at a 10% rate in the first quarter of 2009, but was close to positive at the end of the year and, as a result of the declining yen, exports are improving.  Japan is a clear beneficiary of China’s growth and the economic recovery in the rest of the world.  For investor interest to refocus on Japan business conditions do not have to get robust; they just have to stop being so bad.  I believe that is happening and if I am right, the equity market there should reflect that improvement.  I have the Nikkei 225 reaching 12,000 by year-end.  I can tell you from talking to clients that this is one of the two most controversial of this year’s Ten Surprises, especially since the new government there is not off to a great start.

The other controversial surprise is my belief that the Obama administration will promote nuclear power over coal for the generation of electricity as a way to show its leadership in improving the environment.  Currently coal accounts for 50% of electrical power generation in the United States, and is widely recognized as a major contributor to the country’s pollution problems.  Many think that natural gas is a better, cheaper option and there may be some movement in that direction also, particularly because of the political problems associated with nuclear facilities and nuclear waste disposal.  The issues I am concerned with here are climate control and the environment.  Obama committed to taking action to reduce pollution during his campaign and little progress has been made.  I see him making a major effort to establish himself as the President determined to restore “the greening of America” during the coming year.  This is the seventh surprise.

For both supporters and critics Obama’s first year as President has been disappointing.  The unemployment rate remains high, the pace of the recovery so far remains slow, progress in both Iraq and Afghanistan is uncertain and the Administration’s relationship with business is sour.  The President’s popularity is at a low and a majority of people think the country is headed in the wrong direction.  The election of a Republican to replace Edward M. (Ted) Kennedy in Massachusetts, perhaps the bluest of all states, demonstrates declining support for the Administration and its agenda.  My belief is that we are close to a bottom in terms of the President’s popularity and that support for his initiatives will be rising by the time of the November Congressional elections.  If I am right, that would certainly be a surprise based on where we are today.  If the economy is as strong as I expect it to be and the unemployment rate drops below 9%, that will help a lot to improve support for the President.  Peggy Noonan, writing in the Wall Street Journal, argues that Obama has failed to “connect” with the American people.  It is not uncommon for a newly-elected president to have a troubled first year in office.  The economy and Middle East intransigence are an important cause of that.  If a turnaround is imminent, then the Democrats should lose only 20 seats in the House of Representatives and still maintain a comfortable majority.  While the incumbent party usually loses seats in its first mid-term election, this loss is much less than currently projected, especially since Scott Brown won in Massachusetts.

The financial service industry is not only a victim of populist rage, but also the hostility of elected officials.  Wall Street executives are paraded in front of Congressional committees as the people who caused the country’s economic problems and the profit recovery at banks and investment banks is being viewed as exploiting the system rather than skillfully taking advantage of opportunities.  As a result many fear that highly restrictive regulatory changes will be passed by Congress.  There is no question in my mind that steps should be taken to restrain the leverage taken on by financial institutions and to improve significantly the transparency of derivative transactions.  I also think that measures to protect consumers from oppressive credit card fees and interest costs and from unfair mortgage lending practices will be passed.  Over the years I have observed how hard it is to write financial service legislation and I think that will be the case this year.  Having seen how difficult it has been to pass the health care bill, which had widespread support at the start, I think getting a financial service reform bill through Congress will face similar problems and, in the end, banks and investment banks will be able to conduct their business without onerous restrictions.

The final surprise concerns Iran.  Many investors believe that an air strike on that country’s nuclear development facilities by the United States or Israel is likely this year.  I do not think that will happen.  As we now know the facilities themselves are spread throughout the country, some in subterranean hideaways and an extensive bombing effort supported by elaborate intelligence would be necessary in order to be effective.  I also think the United States does not want to become embroiled in a third war in the region or be seen as supporting an air strike by Israel.  Even though a nuclear Iran is viewed as intolerable by many in the West and feared by Iran’s neighbors, I think the bombing of a Muslim country by a non-Muslim power would add to geopolitical instability.  Moreover I think there will be a regime change in Iran during the coming year.  While the clerics are sure to remain in control of the country.  I think they have come to view Mahmoud Ahmadinejad as a liability.  The tenth surprise is that he resigns and is replaced by an official whose rhetoric is less hostile to Israel and the West and who seems more willing to enter into constructive negotiations on the country’s nuclear effort.  I don’t expect much progress there, but I do believe Iran will recede as an imminent threat.  The major problem in the country is its lack of economic progress and opportunity for young people.  If Western countries can provide meaningful economic assistance, I think Iran may be willing to back away from its weapons-oriented nuclear program and provide for sufficient surveillance to make sure its promises are kept.  Perhaps this is wishful thinking, but I believe the odds are better than even that something like this will come about.

So there they are.  As usual The Ten Surprises are not starting out well, but that’s to be expected.  They are “surprises” after all and they should appear unlikely (perhaps even hopeless) early in the year.  Some of them, perhaps even more than a few, won’t work out.  I usually only have six or so get to or close to the target.  The tone of the surprises is constructive and if I’m right about that, there is a lot of money to be made in the volatile markets I anticipate.  But I think we all have to recognize that the coming year won’t be an easy one, nor will any of the years going forward.

The Blackstone Group L.P.
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Notice: Change of address
Byron Wien
The Blackstone Group
345 Park Avenue
New York, NY 10154
Tel: 212 583 5055
wien@blackstone.com

The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Partners L.P. (together with its affiliates, “Blackstone”) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein.

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Investment concepts mentioned in this commentary may be unsuitable for investors depending on their specific investment objectives and financial position. Where a referenced investment is denominated in a currency other than the investor’s currency, changes in rates of exchange may have an adverse effect on the value, price of or income derived from the investment.

Tax considerations, margin requirements, commissions and other transaction costs may significantly affect the economic consequences of any transaction concepts referenced in this commentary and should be reviewed carefully with one’s investment and tax advisors. Certain assumptions may have been made in this commentary as a basis for any indicated returns. No representation is made that any indicated returns will be achieved. Differing facts from the assumptions may have a material impact on any indicated returns. Past performance is not necessarily indicative of future performance. The price or value of investments to which this commentary relates, directly or indirectly, may rise or fall. This commentary does not constitute an offer to sell any security or the solicitation of an offer to purchase any security.

To recipients in the United Kingdom: this commentary has been issued by Blackstone Advisory Partners L.P. and approved by The Blackstone Group International Partners LLP, which is authorized and regulated by the Financial Services Authority. The Blackstone Group International Partners LLP and/or its affiliates may be providing or may have provided significant advice or investment services, including investment banking services, for any company mentioned or indirectly referenced in this commentary. The investment concepts referenced in this commentary may be unsuitable for investors depending on their specific investment objectives and financial position.

This commentary is disseminated in Japan by The Blackstone Group Japan KK and in Hong Kong by The Blackstone Group (HK) Limited.

The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Partners L.P. (together with its affiliates, “Blackstone”) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein.

This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities. Such offer may only be made by means of an Offering Memorandum, which would contain, among other things, a description of the applicable risks.

Blackstone and others associated with it may have positions in and effect transactions in securities of companies mentioned or indirectly referenced in this commentary and may also perform or seek to perform investment banking services for those companies. Blackstone and/or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments of those companies.

Investment concepts mentioned in this commentary may be unsuitable for investors depending on their specific investment objectives and financial position. Where a referenced investment is denominated in a currency other than the investor’s currency, changes in rates of exchange may have an adverse effect on the value, price of or income derived from the investment.

Tax considerations, margin requirements, commissions and other transaction costs may significantly affect the economic consequences of any transaction concepts referenced in this commentary and should be reviewed carefully with one’s investment and tax advisors. Certain assumptions may have been made in this commentary as a basis for any indicated returns. No representation is made that any indicated returns will be achieved. Differing facts from the assumptions may have a material impact on any indicated returns. Past performance is not necessarily indicative of future performance. The price or value of investments to which this commentary relates, directly or indirectly, may rise or fall. This commentary does not constitute an offer to sell any security or the solicitation of an offer to purchase any security.

To recipients in the United Kingdom: this commentary has been issued by Blackstone Advisory Partners L.P. and approved by The Blackstone Group International Partners LLP, which is authorized and regulated by the Financial Services Authority. The Blackstone Group International Partners LLP and/or its affiliates may be providing or may have provided significant advice or investment services, including investment banking services, for any company mentioned or indirectly referenced in this commentary. The investment concepts referenced in this commentary may be unsuitable for investors depending on their specific investment objectives and financial position.

This commentary is disseminated in Japan by The Blackstone Group Japan KK and in Hong Kong by The Blackstone Group (HK) Limited.