2010 Market Outlook

Offsetting fOrcestOp ten themes fOr 2010 and BeyOnd

Gene D. Balas, [email protected]

January 2010

Executive Summary1. Dollar: Neutral in early 2010, but renewed economic weakness in US relative to other

economies after (temporary) boost from inventory build and fading effects of stimulus in second half of 2010 cause dollar to resume fall, particularly against certain emerging economies.

2. Potential for rising interest rates by Treasury’s borrowing needs offset by increasing consumer savings and shift of household assets into fixed income securities, given new retail investor focus on income and safety. Wild card is Fed exit strategy, particularly in MBS purchases, which flow through to other asset classes.

3. Need for US to increase taxes and cut spending offset by potential for US simply to “print” money to avoid difficult political choices. Cities and states cutting services and raising taxes will crimp economic growth and offset federal fiscal stimulus.

4. Will exports (11% of US GDP) offset weakness in domestic consumer demand (70% of US GDP)? As to the China theme, I note that exports to China are only 0.5% of US GDP but Chinese exports to US are 7% of China’s GDP .

5. If the dollar falls, higher import prices due to falling dollar will be offset by output gap and weak pricing power, eroding margins of exporters to the US. Deflation is a more likely theme than inflation, though not “severe” in nature. Note that falling velocity of money indicates increase in amount of cash in system less likely to be inflationary.

6. Are commodities and gold safe havens for dollar debasement? Baltic Dry shipping rates fail to confirm real-economy demand for commodities, indicating speculative activity; contango issues limit commodity ETF use; gold helpful hedge against currency debasement but is a crowded trade, which may limit gains, but may be offset by central banks reallocating into gold as “currency” of choice.

7. US consumers pay down debt and save more. Third quarter GDP report showed (temporary) consumer spending spurt was funded entirely by an unsustainable drawdown in savings triggered by government stimulus programs that encouraged purchases of houses (and furnishings, electronics, appliances, etc.) and cars.

8. Inventory build could boost GDP in short run, or will limited financing available to fund inventories curtail build (i.e., CIT bankruptcy) or be offset by retailers’ desire to avoid need for clearance sales? What is role of technology in lean inventories?

9. Global spending on infrastructure: who will or can it actually employ? How much does federal spending offset cuts by states and cities?

10. Rising emerging market prosperity: societies building domestic consumption are more attractive than those dependent on exports of finished or crude goods.


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Imagine that you are an ordinary individual, making $50,000 a year. Say you already have $40,000 in credit card debt,

but since you’re spending $55,000 a year, you rack up another $5,000 in debt this year, partly to pay off principal and interest on your other loans coming due and part of it to give away to friends so they can buy a new car or house. Even though you’ve always paid your bills on time and in the full amount due (you’ve been demanding your neighbors loan you the money or you won’t buy their items at their garage sale), who would lend more money to this person?

Suppose this “person” is the US government. The proportions of debt and deficit spending of the US federal government and GDP of the US are roughly similar to the debt, excess spending and income numbers of the “person” in the example stated above. The “neighbors” in this case are our trade partners, who have been financing our deficit spending because we send them more dollars than we earn to buy goods and services from them. (The “cash for clunkers” program seems to have helped our trading partners quite a bit, given the surge in imports in the recent trade balance figures.) Even the above example is being generous, as GDP is, of course, a much broader measure than federal government receipts, and I have not even included the potential unfunded obligations of Social Security and Medicare. While government fiscal stimulus and deficit spending can, if done correctly, stimulate the economy so that the government can later recoup some of its spending costs through taxes on an economy that would then post greater growth, some stimulus measures add little to long run growth, and thus tax revenue. Some good examples of government spending that have paid dividends for decades include the interstate highway system, the space program and even the military buildup during the Cold War.

Giving money to overly leveraged consumers to encourage them to take on more debt to buy a new car or house does not add anything to long run growth, as cars and houses are not productive assets that can lead to long-term economic growth potential. Moreover, giving a homebuyer tax credit to existing homeowners does not stimulate the same new household formation as it did with the new homebuyers tax credit, which was consistent with the uptick in sales of furniture, appliances and electronics that we have seen in the last quarter (apparel sales fell, indicating that consumer spending in other areas is still weak). Instead, the government is now giving away $6500 to an existing homeowner to move to a vacant house and create a newly vacant house (the previously occupied home) in its place. Additionally, by stimulating residential construction spending, as we have seen in the latest GDP report, we are only adding to the housing glut inventory, not reducing it.

Inserting a parenthetical thought related to the homebuyer’s tax credit, I see in the third quarter GDP report that residential construction increased by 23% from the last quarter, at a seasonally adjusted annual rate (SAAR). The total dollar amount spent on residential construction at $363 billion at an annual rate would correspond, in a rough estimate, to building 1.3 million homes (including rentals) annually at the average price of $282,000 in the Commerce Department’s new home sales report. There are already 4.4 million vacant homes for rent and 1.9 million vacant homes for sale. In addition, at the end of the third quarter, as many as 1.7 million homes are in some stage in or near foreclosure that might not yet be listed for sale or rent, an increase of 54% from a year ago. With this “shadow inventory,” a total of 5.5 million homes are available for sale as of the end of the third quarter.

Given that new home sales fell by 3.6% to a SAAR of only 402,000 in September and it is already taking builders 13 months to sell their inventory, adding such a large amount of new homes to the glut of unsold homes already on the market

certainly does not bode well for the direction of future home prices. Home prices will likely continue to decline by the simple nature of supply and demand, especially with a near record of 2.5% of all non-rental homes sitting vacant and for sale. Overall, there are 18.7 million vacant homes in the US, or 14% of the total. Add in the fact that effective rents have deflated by 3% YoY according to Reis, a real estate information service, and the price-to-rent metric further argues for continued price deflation; as it is, price-to-rents suggest a further 10% to 15% contraction to return to longer term norms even without declining rental rates.

But, after digressing, I return to the budget deficit. The point is, it is unsustainable, and what is unsustainable always ends, and often ends badly. Since the capital account must equal the current account, our trade deficits will at least partially fund our budget deficits, but the factors that balance the equation are the price of the dollar and interest rates. Several themes emerge from this, including:

Home prices will likely continue to decline by the simple

nature of supply and demand, especially with a near record of

2.5% of all non-rental homes sitting vacant and for sale.


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1. Neutral View on Dollar in Early 2010, Potential Weakness LaterThere are some differences of opinion as to whether and how far the dollar may continue to fall, given its depreciation in 2009. Some people are now bullish on the dollar, after some better-than-expected economic data boosted optimism that a Fed rate hike might not be far off and US investments may have attractive return potential. Meanwhile, many developed economies have a number of problems, and their currencies may not have much room to appreciate against the dollar, but many emerging markets, on the other hand, are in much better shape than the US or other developed economies. Of course, there are always those people who are perpetual bears on the dollar and warn that the US will lose its status as the world’s premier world currency. I am not making the argument here regarding the dollar’s reserve currency status; there are no viable alternatives as most of the developed world has problems of some sort or other. Instead, I am focusing on aspects that are more mundane, such as risk appetite, investment return potential and supply and demand.

During 2008 and early 2009, we had seen the dollar strengthening and Treasury yields falling as fear-based trades caused investors to flock to the safe-haven investments of US Treasurys. After March of 2009, when risk appetite returned (sending global stocks and commodities higher), the dollar resumed its long term decline against a trade-weighted basket of currencies from a nearby peak earlier this decade (after the last bear market) and Treasury yields rose (as I forecast in my 2009 Outlook). Then, with the release of November payroll data in early December, optimism about US economic growth and Fed rate hikes took hold, with the dollar rebounding.

As we enter 2010, we are at a juncture where the strength of the global economy and financial markets are flashing mixed signals. On one hand, we see concerns with sovereign debt issues in some smaller economies (e.g., Greece, Dubai, etc.), while at the same time US economic growth appears to be gaining some traction in a few areas, stabilizing in others or, in the case of unemployment, continuing to disappoint. These mixed signals make it difficult to discern an accurate near term direction for the dollar in early 2010.

During the first half of 2010, with some consolidation in equity markets as investors’ optimism gives way to a

perhaps more realistic assessment of opportunities and risks, we may need to wait until the effects of the stimulus program fade and the US economy is left to stand on its own before the dollar begins another downtrend. Economic data has presented some perhaps encouraging, but still mixed, signals. Currencies are a relative game, however, and nuances of inflation, potential returns (including economic growth and interest rates) of many economies around the globe play a factor in determining currency rates between the US and overseas economies. I should note that currency forecasting is fraught with risk, given the intricacies of the many variables involved.

However, a simplistic, yet easy, way of assessing different economies would be to think of where investors would like to invest, due to return prospects, inflation potential and interest rates coupled with flow of funds linked to trade. These considerations argue for a weaker dollar later in 2010 against some Asia-Pacific and certain Latin American currencies as fear of sovereign credits recedes while the US economy languishes. Much of the developed world has problems, the US included. In my view, the prospects of rising short term US interest rates before similar rates gain in other economies is a bit misplaced. As discussed in related segments, US economic growth is likely to be anemic; high unemployment is likely to be a greater concern of the Fed than inflation

might be, and other central banks are more likely to hike rates before the Fed does. Goldman Sachs estimates that the stimulus spending will add two percentage points (annualized) to GDP in the first half of 2010, and then nothing after that, leaving the economy to rely on private demand.

Given the prospect of a softer economy in the second half, investors may focus on opportunities elsewhere later in 2010, at the same time that the US is busy trying to raise funds to fix its economic woes.

Now that the Treasury is continuing to borrow to finance record budget deficits and investors may no longer feel a need to focus on safety globally later in the year, the mechanism for a price that will clear the market is through some combination of a falling dollar (similar to cutting prices on clearance merchandise) and/or rising interest rates. This is if there are no lurking sovereign debt problems discovered as the year progresses. (The question of whether interest rates might rise is discussed below.) A primary component of my views is that economic growth, particularly consumers’ incomes and spending, will be weaker than official forecasts and

Goldman Sachs estimates that the stimulus spending will add two

percentage points (annualized) to GDP in the first half of 2010, and

then nothing after that.


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result in lower tax revenues and therefore higher budget deficits than predicted.

However, improving economies abroad, including both select developed and many emerging markets, along with their higher potential investment returns and rising short term interest rates in some countries should result in pressure on the dollar as investors seek better return potential and distaste for our profligate spending and borrowing needs. Add in the carry trade of borrowing in US dollars to buy risk assets globally and further pressure builds, although a sudden reversal to repay those dollar-based loans for whatever reason, such as a rise in US interest rates, could trigger a snap back in the price of the dollar. Importantly, a significant case for the dollar’s continued weakness is that the US government, loathe to either increase taxes or cut spending, may choose instead to “reflate” its way out of its fiscal mess by simply printing more money.

2. The potential for rising interest rates is offset by rising consumer savings and shift in household asset allocationIt is easy to make the argument that the US Treasury’s borrowing needs will push up interest rates, but is that really the correct answer? Above, I suggest that the price mechanism will be a falling dollar. Here, I must consider the argument that the forces of supply and demand will result in higher interest rates, but instead I propose that interest rates will likely not rise significantly. The operating word is “significantly,” as I am not necessarily forecasting that rates would actually decline either. Many pundits make the case that the $3.4 trillion of cash on the sidelines will push equity markets higher. Stocks are not the only investment in town! Investors have been badly burnt by two bear markets this decade, and while it has risen from notable lows, consumer confidence in the economy is still consistent with a recessionary backdrop. These two psychological hurdles must be overcome before retail investors return in droves to stocks. Any corrections in the equity markets may further reinforce a trend of reallocation toward fixed income assets.

With an aging population and baby boomers entering or nearing retirement and with allocations to Treasury notes and bonds as a percentage of household assets sitting at very low amounts relative to their historical levels, it is more likely that this cash on the sidelines will be invested in fixed income securities. Recent mutual fund flows demonstrate that point, with bond funds taking in more assets, while equity funds have seen outflows in recent weeks (which is especially significant given retail

investors’ propensity to chase returns, given the huge rally we have seen recently). If this cash on the sidelines were used to reallocate (e.g., increase) investors’ assets back toward longer term norms of fixed income assets as a percentage of household balance sheets, much of the Treasury’s supply of note and bonds can be absorbed without a rise in interest rates.

Then there are the banks. The Obama administration is exhorting banks to lend money…but isn’t that what got us into this mess in the first place? We still have another banking calamity looming on the horizon: Goldman Sachs recently estimated that losses on commercial real estate accruing to banks would be about $180 billion. Goldman also noted that banks are carrying their approximate $2 trillion in commercial real estate loans at 96 cents on the dollar. Ever notice how many empty store fronts you see, or “For Lease” signs on office buildings, not to mention hotels and apartments?

Given this backdrop of a mountain of bad debts looming on the horizon, would a bank really prefer to take another gamble of loaning money, when it could just as well invest in Treasurys? Given the steepness of the yield curve, the net interest margin provides a decent profit with no credit risk. As an aside, doesn’t Uncle Sam need quite a big loan these days? Banks buying Treasurys has also driven equity and commodity markets higher. How? Well, they have to buy the bonds somewhere! If banks do not buy Treasurys at the auction, other investors selling Treasurys (e.g., hedge funds, long-only portfolio managers, etc.) take the proceeds and invest them in risk assets. Continued Treasury buying by banks can boost prices of not only bonds, but stocks as well.

There is a huge caveat to this argument. As I point out above that banks buying Treasurys can send other markets higher, so too can the Fed’s purchase of mortgage backed securities to bolster the housing market. Where do investors selling mortgage-backed bonds into demand supported by the Fed’s purchases invest the proceeds? Stocks? Treasurys? As the Fed curtails its MBS purchases in 2010, that flow of funds through the MBS market into other asset classes can undermine a crucial area of support, which may send Treasury yields higher, given the US’ continued issuance of bonds. Of course, the timing of the Fed’s exit from MBS purchases will roughly coincide with the time that the homebuyer’s tax credit will expire, and demand for mortgages from homebuyers will likely plunge, along with issuance of MBS securities. All the homebuyer tax credit likely did was pull demand forward from people who would likely


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have bought homes anyway; now that they did, demand for homes (and mortgages) will likely fade.

3. Rising taxes and cuts in government spending choke off economic growth at some point…or will the US just “print more money”?This is a point that is probably at least in the back of everyone’s mind...not the least of whom are consumers. As economics textbooks suggest, the potential for rising taxes in the future can limit spending in the present as consumers’ spending is tied to their expectations for the future (which is why consumer spending is correlated only to the “Expectations” component of the Conference Board’s consumer confidence survey and not to the headline figure). As to the point I made previously that what is unsustainable always ends, and usually ends badly, eventually, federal government receipts have to rise, spending is cut, or the US government tries to “reflate” the economy by printing more money. To the latter point, higher inflation will make it easier for the government to pay back borrowed money in the future with dollars that are essentially worth less.

From an econometric point of view, cutting taxes could actually boost economic growth to increase overall tax revenues in some cases, but tax rates have already been cut from levels from years ago and the government is still running deficits. In an extreme example, one can see that cutting tax rates to say, 1%, would likely not result in higher tax receipts, nor would increasing tax rates to 99% result in higher tax revenue, as economic activity would be suffocated. The complicated area is determining tax rates somewhere in the middle. Higher taxes are politically unpalatable, but so too are spending cuts. Neither higher taxes nor cutting spending will help economic growth, but some combination of the two will eventually have to be done. Aside from cutting spending or raising taxes, the government can simply print more money, which argues for a falling dollar: the more there is of something, the less it is worth.

Then there are the cities and states to consider. Even after the help to cities and states from the fiscal stimulus, states still face budget shortfalls. States filled about 30% to 40% of their budget shortfalls with the approximate $250 billion that was part of the federal stimulus bill, most of which will have been distributed by the end

of 2010. The remaining shortfalls must be covered by spending cuts and/or tax hikes.

According to the National Governors Association, states have cut over $55 billion from budgets from the current fiscal year (most of which began July 1), still leaving deficits of nearly $15 billion and after instituting tax hikes of nearly $24 billion. This $94 billion in enacted or pending spending cuts and tax increases offsets about half the federal stimulus spent this year. State general fund spending dropped 5.4% in the past year, the largest drop since records began in 1979. Further budgets cuts are coming: the Center for Budget and Policy Priorities estimates that states face a budget shortfall of $180 billion for the coming fiscal year.

That money must come from somewhere: either cutting spending or raising taxes, as states cannot just “print money”, unlike the federal government. The result is that either states must raise taxes, and hurt consumer spending, or cut services and institute more layoffs and furloughs, which would hurt consumer incomes. Putting these spending cuts in context, it may be more helpful to think in terms of how many potential layoffs would

be needed to close budget gaps this size (the average municipal salary is about $46,000 according to PayScale.com, across several categories of employees), rather than comparing the size of the cuts to broad US GDP. If half of the 2011 state budget shortfall of $180 billion comes from

cutting salaries, hypothetically, that is nearly two million jobs, for the purposes of this illustration.

The longer-term effects of cutbacks to education can be profound, as it could threaten the competitiveness of the US when our children reach the labor force. Moreover, the stresses to the social fabric and personal health of citizens is difficult to quantify, as health care programs are cut and prisoners released early from jail with little employment prospects and fewer social services to help them integrate successfully into society. Will increased crime be the result of early releases of prisoners occurring at a very challenging period in the labor markets?

If half of the 2011 state budget shortfall of $180 billion comes from

cutting salaries, hypothetically, that is nearly two million jobs.


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4. Will Exports Drive the Economy?First, let’s examine one popular theme: China. Everyone talks about Chinese economic growth. How will that affect US exports? Consider a few facts: US exports to China in 2008 were about $70 billion (data from the US Census Bureau) out of a US economy of roughly $14 trillion with about 300 million people, or about half a percent of US GDP. Chinese exports to the US were about $300 billion, out of a Chinese economy of about $4.5 trillion, with a population of about 1.1 billion. It took nearly a decade for exports to China to increase by 300%, so it seems unlikely for exports to China to boost US GDP by a significant amount in the short term. A one percent fall in US consumer spending would swamp the economic effects of a doubling in exports to China. Instead, given that Chinese exports to the US are a much bigger part of the Chinese economy, and since we depend on cheap goods imported from China, it is unlikely that either party really wants the yuan to appreciate significantly, regardless of what US officials may say publicly.

That said, exports, which comprise about 11% of the US economy (versus about 70% for consumer spending) will be a bright spot, though not a savior, to the US economy. Both goods and services will benefit if a cheaper dollar makes our exports more competitive abroad. US- based multinational companies are an obvious beneficiary, but so are their suppliers, which may include smaller firms as well. Industrials, materials, healthcare and consumer goods, including food and beverage companies, are all likely beneficiaries. This theme of domestic-based exporters has been prominent in my 2009 and 2007 Outlooks, and may likely continue to benefit.

5. Risinginflationduetobothhigherimportprices caused by a falling US dollar and increasedmoneysupplyisoffsetbydeflationdue to weak domestic demand and excess capacity of capital and laborLet’s consider inflation for a minute. Many people say that the cash injected into the system will cause higher prices for goods and services. I point out that the velocity

of money has fallen significantly recently, which makes the increased amount of cash in the system less inflationary. While the cash in the system certainly seems to be boosting the prices of stocks and commodities (the prices of the latter have also been boosted by the falling US dollar, discussed below), the government’s printing press does not seem to be causing prices of goods and services to rise. This is not surprising given the output gap. The excess capacity of capital (capacity utilization is a very low 71% versus a more-normal 80% + rate) and labor

(high unemployment points to decreased labor costs, which comprise about two-thirds of the costs of goods and services in this country) argue for lower cost structures.

Weak pricing power due to a deleveraging consumer sector makes it more difficult to pass through higher end prices to the customer. Instead, I would argue that inflation is not, in fact, a theme we will see, as firms’ pricing power is significantly eroded given weak consumer sector and the significant output gap. I believe deflation, though not of a substantial degree, will be a more prevalent theme. (See the quote from the National Federation of Independent Business in #9 for further amplification.) Anecdotally, the discounts offered by retailers even in advance of and in addition to the traditional “Black Friday” event would argue for the necessity of price discounts to lure frugal shoppers to spend.

The velocity of money has fallen significantly recently, which makes the increased amount of cash in the

system less inflationary.

US exports to China in 2008 were about $70 billion out of a US

economy of roughly $14 trillion with about 300 million people, or about

half a percent of US GDP.


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As to import prices, consider that the trade-weighted dollar has fallen by about 12% or so from its nearby peak in March of this year (though it has been in a secular downtrend since 2002), and it would seem like import prices should rise in tandem. Yet, import prices have risen by only by 1.6% during this period, based on the non-fuel imports price measure published by the Bureau of Labor Statistics. What does this mean? Since the dollar has fallen by a much larger amount than non-fuel import prices (in dollars) has risen, foreign exporters to the US likely have taken a hit to margins. Since pricing power in the US is weak, given the high unemployment rate and difficult access by consumers to credit, foreign-based exporters have resorted to what amounts to price cutting. As such, even though a falling dollar makes investments in foreign stocks more attractive, all other factors equal, the fact that their margins are probably being hit makes me a bit wary of foreign firms that depend on exports to the US for a big chunk of their sales.

6. Are Commodities and Gold Havens for Dollar Debasement?Having just discussed non-fuel import prices, it is worth noting that fuel import prices increased by 43% from April 1 to October 31 (also courtesy of the BLS). (Speaking of oil imports, I see that gas prices are at a 12-month high, costing the average driver $50 more per month. Without even considering trucking or mass transit, this threatens to drain over $120 billion a year from the economy, offsetting much of the benefits of the fiscal stimulus program.) As such, the hike in gas and other energy prices on household finances, in aggregate, is analogous to offsetting the entire incomes of 2.4 million households! Oil prices, of course have been very volatile recently, peaking a couple years back at very high levels, then falling precipitously, and then rising again this year. Many commodities are priced in dollars,

so a falling dollar often means rising commodity prices, although that is not the only explanation.

The prospects for rising demand, limited supply, and geopolitical concerns also weigh in on the direction of price movements. Importantly, using the catchall term of

“liquidity” (whatever that may mean) sloshing around in the system is often used to explain price movements. Indeed, it would seem as though the printing presses of governments around the globe seem to result in at least some of that money chasing commodity prices higher, at least in US dollar terms. Note, however, that price increases of commodities when expressed in euros, yen or many other currencies are much less than price increases in the declining dollar, and countries producing any of the affected commodities are not

always enjoying a proportional increase in revenues in local currency terms.

Commodity prices are difficult to forecast in the shorter term, given vagaries such as geopolitical tensions and the discovery of new supplies as but two examples, but the longer-term relation of supply and demand should continue to send commodity prices higher. Note, however, that the recent plunge in Baltic Dry shipping rates would correspond to diminished demand for non-petroleum commodities, leading me to believe the recent price increases have been largely the result of investors and speculators. An important point on commodities and precious metals is that they are hard to value: there is no cash flow to consider as is the case with stocks or

bonds, so commodity prices must be taken with a grain of salt.

Now, as to investing in commodities…investing in ETF’s that invest in futures contracts may not at all deliver returns anywhere close to the changes in spot prices. Many commodities futures are often

in contango: prices for future delivery may be higher than prices today, and holding the futures bought at the higher prices has often resulted in gains substantially less than the rise in the spot prices for the same commodity (assuming spot prices increase). The remaining options

The hike in gas and other energy prices on household

finances, in aggregate, is analogous to offsetting the

entire incomes of 2.4 million households!


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to invest in the space are somewhat indirect: specific companies (miners, manufacturers and drillers, etc.), as well as countries or regions that are commodity producers. Remember that the effects of currency changes may

complicate things when investing in companies abroad, both as to the currency translation of the commodity and the underlying stock. Given the complexities of the space, I would suggest more research on a company- and country-specific level before investing. While more thought would be required, I see price increases for commodities over the long run. I would also venture to say some commodity prices might be based on near-term economic growth prospects that are overestimated by investors, and as such, I might wait for a pullback in commodity prices before investing in the space.

Gold, on the other hand, often marches to the beat of a different drummer than commodities, but I am discussing it here due to its role as an investment apart from financial assets. It can be a commodity, as it has a use in jewelry, but it also is seen as a store of wealth. It is not necessarily a perfect hedge for inflation (but has done well when inflation had been combined with weak economic growth, such as the 1970’s). Instead, it may be best used right now as a hedge against currency debasement. Fiat currencies are little based on the gold standard now,

and governments are free to print money at will. As I made a point of a falling US dollar above, here I suggest that foreign central banks may want to increase their gold holdings versus depreciating dollars as the reserve “currency” of choice. Gold is a crowded trade, however, given that Consensus, Inc. (a survey firm) reports that 78% of investors are bulls on gold. When something is expected to occur, something else often occurs instead.

That said, even though a high bullish figure can be a contrary indicator, gold can continue to move higher for some time. As such, even though it is likely that the price already reflects investor sentiment to some degree, the actions by central banks, while unpredictable, might send gold prices higher still. I recently see that India is increasing its share of gold in its central bank reserves by 200 metric tons, or $6.7 billion, absorbing half the supply the IMF put on sale.

While the US government is going on a borrowing binge, the over-indebted US consumer, faced with looming retirement and shrunken assets, needs to pay down debt to a sustainable level and save for retirement. (While the need for repairing consumers’ balance sheets should seem fairly obvious, and recent indicators such as consumer credit showing a remarkable contraction recently [due both to banks cutting credit limits on the supply side and consumers cutting borrowing on the demand side], consumers are not always a rational bunch and, as such, their behavior cannot be quantifiably predictable.) This leads to one very important theme:

7. US consumer spending remains weak as consumers pay down debt and save moreOverall, this theme will limit corporate revenue growth, and thus corporate profit growth, over the next several years, resulting in limited gains in US equities. As I point out above, consumer credit has fallen remarkably recently, as seen in the nearby graph. Meanwhile, consumers’ incomes (as measured by real disposable incomes in chained 2005 dollars as reported by the Bureau of Economic Analysis from the Commerce Department) have fallen in each of the past four months through September. With flat

Gold is a crowded trade given that Consensus, Inc.

(a survey firm) reports that 78% of investors are

bulls on gold.

Investing in ETF’s that invest in futures contracts

may not at all deliver returns anywhere close to the

changes in spot prices.


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or falling real incomes and consumers paying down debt, it is hard to envision a scenario in which US consumers significantly increase spending in light of the headwinds of rising unemployment. It can go without saying high unemployment bodes ill for real wage increases, either measured in aggregate or in an individual worker’s paycheck, nor does rising unemployment enhance the mood to spend.

While we did see a (perhaps temporary) increase in consumer spending in the third quarter GDP report, I note that the increase in GDP was coincident with an unsustainable drawdown in savings (also buried in the GDP report) during the period. In fact, the drawdown of savings funded all of the increase in GDP in the third quarter…not the makings of a sustainable trend, yet this fact escapes the public’s attention. (As an aside, to throw some water on another economic statistic, some people have been encouraged by some reports on improving same store sales in the retail sector. Remember, same store sales, by definition, do not include stores that have closed! Given the fact that tens of thousands of stores have closed [including many that are not part of chain stores], focusing only on stores that are still open is a bit misleading.)

Let’s explore the issue of the consumer’s financial health further, with a particular focus on consumer debt levels. This is an important topic, because the rise in consumer debt levels, which funded consumer spending growth beyond consumer income growth, largely propelled the massive growth in corporate profits over the past couple decades that fueled the markets from 1982-2007 (with other factors such as increasing multiples boosting share prices, of course). Without this debt accelerant, how far can the economy go, considering

that in recent years each dollar in GDP growth required three dollars in credit growth?

In fact, consumer debt relative to consumer income rose from about 64% in the 1960’s to 100% in 2000. It then skyrocketed to nearly 140% a couple years ago in the midst of the housing and mortgage bubble. Since then, we have seen a massive undertaking to reduce household debt (mortgages, credit card, auto loans, etc.), but in

fact household debt relative to household incomes has only decreased to 131% for the most recent data. I will preface this discussion by highlighting that the painful recession we recently endured was coincident with this nine-percentage point reduction in debt-to-income levels, and note that we still have about 31 percentage points more to go to get to a “normal” state of about 100%, where it was earlier this decade. Doing a little math, considering that there is about $13 trillion of household debt outstanding, we need to see that reduced to about $10 trillion, a

reduction of at least $3 trillion to return to a serviceable level.

Consumers could default on debt, of course, which will cause further pain in the banking system and credit markets and lead to continued economic weakness, given that every dollar a bank loses is about ten dollars in loans it cannot then make, given capital requirements. As noted before, the US economy has in recent years required three dollars in new credit to fund every one dollar in GDP growth. Alternatively, households could immediately save nearly 30% of their incomes to get debt in line with a manageable amount (reducing debt servicing ratios from over 14% of disposable household

income to the long range norm of 10% to 11%), which is unlikely, or they could boost savings/debt repayment

The increase in third quarter GDP was coincident with an unsustainable

drawdown in savings that funded all of the increase in GDP in the third quarter.

The painful recession we recently endured was coincident with a nine-percentage

point reduction in debt-to-income levels, and I note that we still have about 31

percentage points more to go to get to a “normal” state.


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more gradually. If households were to boost savings gradually to 10% of disposable income (roughly, where it had been for many years) over the course of the next five years, they could reduce household debt to a level about equal to household income, viewed by some economists

as a sustainable amount. This would also bring debt service to about 10% of income and the savings rate to long-term norms of about 10% of income. Reducing the debt in this fashion would result, of course, in lower consumer spending in the near term.

In fact, by repaying consumer debt in this manner, consumers would cut their spending by over $700 billion over five years versus the status quo rate of debt reduction (which assumes a 14.5% debt service ratio). Increased savings and repaying debt would be a hit to GDP, versus what it would be otherwise, of over 5 percentage points over the course of the next five years, beyond cutbacks in spending so far since the start of the recession and assuming that real incomes increase annually by 1% to 2% over this five-year period. I note that real household incomes since the start of the decade have essentially been stagnant, so a 1% to 2% annual growth rate in real incomes over the next five years could be optimistic, given that the high unemployment projected over the next several years could keep real wages from posting significant gains. Another comment to put the savings rate into perspective is the shift over the past few decades from (employer funded) defined benefit pension plans to (employee funded) defined contribution plans may actually require the savings rate to be much higher than that of a couple decades ago in order for workers to have a secure requirement.

This forecast would argue against consumer discretionary stocks but in favor of discounters, such as Wal-Mart, Costco and BJ’s. I might also favor defensive plays, such as healthcare and consumer staples stocks, which may include companies with a global presence and a strong brand with pricing power, and many of these stocks have seen relatively muted gains relative

to riskier names during the recent stock market rally. This theme might also favor those beneficiaries of higher savings rates, such as some banks, although care must be taken to consider the likelihood of aggressive accounting techniques given the subjective nature of bad-debt writedowns and the potential for future losses, especially

given the propensity for further consumer defaults. Importantly, the pending disaster in commercial real estate, trillions of dollars of which must be refinanced in the next two years, is cause for fear of many banks. Asset managers, though, may also benefit, especially those that have an emphasis on more conservative strategies (given that households may have been badly burnt by the recent stock market rout), and companies that serve as third-party retirement plan administrators and other operational backbones of mutual fund complexes as consumers increase 401(k) contributions and participation rates.

UnemploymentTo offer a few thoughts on unemployment, consider

first that the US economy needs to produce 100,000 to 150,000 new jobs every month just to keep up with the growth of the labor force. We must also need to consider that the workweek is near a record low number of hours: before companies actually hire new bodies to meet increased demand, they will likely give their existing workers more hours. Moreover, any continued strong gains in productivity may lessen the need for substantial hiring. Considering that, how many jobs does the economy produce during “boom” times? Well, in 1999, at the height of the tech boom, the economy added an average of 250,000 jobs per month, according to the BLS. We now have over 15 million people who are unemployed and looking for work, and 11.5 million more who are either working part time but want full time work or who are unemployed and would like a job but have, more or less, given up on the job search for the time being (the “marginally attached”).

For the sake of this argument, we will focus on the 15.4 million “officially” unemployed. To get to a state of full employment, we would need to see 8 million of these potential workers get jobs. Adding in the 2.3 million in the “marginally attached” category and the analysis

Every dollar a bank loses is about ten dollars in loans it

cannot then make, given capital requirements. The US economy

has in recent years required three dollars in new credit to fund

every one dollar in GDP growth.

Increased savings and repaying debt would be a hit to GDP, versus what

it would be otherwise, of over 5 percentage points over the course of

the next five years.


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becomes even more daunting. Assuming we have an (unprecedented) string of boom years in which the economy creates, say, 250,000 jobs each and every month for the foreseeable future and there are only 100,000 new entrants to the labor force, that leaves us with net reduction in the number of the unemployed of 150,000 per month. Conveniently ignoring the fact that older workers may stay on the job longer to replenish badly-needed retirement savings, we then see that it would take over four years of above-average job creation to get back to full employment (here, we will say that full employment is 5%). And that’s being optimistic. From January 2003 to December 2007, an average of only 133,000 jobs was created each month. At that pace, it would take 15 years to get back to full employment. (A reduction in immigration may reduce the number of jobs needed to be created each month to keep up with labor force growth, but at the same time will heighten the issue of an aging population.)

Whether one uses an optimistic or pessimistic view of potential job creation, the reality is that high unemployment will be with us for at least several years. The economics of this situation becomes difficult to quantify, as it relies on the unpredictable nature of human behavior and the resources available to the unemployed. Some questions one might ask could be: How much will a household cut its budget if a family member is unemployed? That in turn depends on the household’s ability and willingness to use savings to fund its expenses and how much of its budget unemployment insurance covers. Can the household raise funds from other sources (borrowing from friends and relatives and/or selling non-financial assets)? How much will everyone

who personally knows someone who has lost his or her job boost precautionary savings?

Moreover, since the ranks of the unemployed included a different set of people over time, many more households than just the 10% currently unemployed

have been, at some point during this recession, been without a paycheck. If we say that, hypothetically, 20% of households have seen at least one member being unemployed during the entire recession, and we factor in all of those people close to the situation, this could engender a sea change in American attitudes towards savings versus consumption that could last many years.

To explore the issue further, let’s just make up a few numbers for arguments sake, using a simplistic calculation. First, there’s always going to be some unemployment in any economy, so we’ll focus on the long-term unemployed (over 26 weeks), who number 5.9 million according to the BLS for the November 2009 data. This is about 4% of the labor force, and would likely be expected to grow until the economy creates jobs in a meaningful sort of way. How much will they cut their spending? That’s a difficult question to answer, of course, as it depends on the items I raise above. We also don’t know how much each of them made while working. However, assuming these households cut their spending by, say, 20%, and earned the median income of $50,233 (according to 2007 data from the US Census Bureau), that would cut consumer spending by nearly $57 billion on an annual basis (with the assumption that savings rates

began at roughly 4% while employed). On a back-of-the-envelope basis, then, spending cutbacks by the long term unemployed alone, over the next four years, can offset nearly 40% of the remaining fiscal stimulus money not yet spent. This is distinct from any trends towards increasing savings/paying down debt by other households.

From January 2003 to December 2007, an average of only 133,000 jobs was created each month. At that pace, it

would take 15 years to get back to full employment.

Spending cutbacks by the long term unemployed alone, over the next four years, can offset

nearly 40% of the remaining fiscal stimulus money not yet spent.


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According to the National Energy Assistance Directors Association, 4.3 million utilities customers had their utilities disconnected due to non-payment during the past fiscal year, a 5.1% increase from the prior year. This is despite increased federal assistance for utility payments. If more households are having trouble paying their utilities, then it stands to reason that cuts in spending, defaults on debt (credit cards, auto loans, mortgages), and rent (which brings to mind, yet again, the problems in commercial real estate – doubling up on space to save on rent will increase vacancies and decrease rents), cannot be far behind. Tishman Speyer Properties, LP and Blackrock, Inc. missing a payment on debt on Stuyvesant Town and Peter Cooper Village in New York is the latest in this saga; it is on track to become the second largest commercial real estate default in history. (The property is the largest residential housing complex in New York and has over 11,000 units. It was purchased in 2006 for $5.4 billion with $3 billion in debt and is now estimated to be worth only $1.6 billion by Fitch.)

Another difficult question to answer is that pertaining to defaults by the unemployed: how long will a household go before possibly defaulting on credit cards, auto loans, and the mortgage? Some may never default, others may do so immediately, but as the duration of unemployment lengthens for many Americans, we will likely see further losses accruing to banks as the savings of the unemployed become depleted and/or they exhaust their unemployment benefits. Since accounting rules now allow banks to continue accruing interest on loans as many as 180 days past due, it may be well into 2010 before banks recognize losses on these (and other) loans.

Once the unemployed are working again, it may be a while before a formerly unemployed person has repaired his or her credit and/or re-established his or her work history to the point of being able to take on new household debt. (Given the likelihood of defaults occurring much later than the surge in actual job losses, it is no wonder that banks, wary of their perhaps questionable loan portfolios, are not willing to bet their balance sheets on making further loans.) This credit availability factor will serve to curtail consumer spending in years to come, at least at the margins.

The remaining three themes include two that are temporary and one that is structural. They include:

8. Inventory build boosts US economic growth over the short termAt first glance, the graph below would appear to say it all about the need for companies to boost inventories, which would increase economic output at least for a little while, given that the inventory-to-sales ratio is at such a low level.

The current improvement in the manufacturing sector is likely at least partly the result of an inventory boost. I will be one of the first to admit that building inventories, possibly to meet pent-up demand by consumers, who have previously curtailed spending significantly, would be an integral part of increasing economic activity, possibly resulting in hiring and reducing spare capacity. I do, however, want to consider a few alternative issues. First, to what extent has a lack of credit, especially vendor financing of inventories performed by such firms as CIT, which declared bankruptcy, curtailed inventory builds on retailers’ shelves and will this continue? How much do retailers (and by extension, wholesalers and manufacturers) want to keep inventories lean because they are unsure about sales prospects and want to keep inventory costs down and reduce the potential for the need of expensive clearance sales to bring in new seasonal merchandise with better sales prospects? What is the role of technology in keeping inventories lean?

To answer these questions, at least from the perspective of small businesses (which comprise about 17% of the US economy and are a good barometer of domestic demand since relatively few are exporters), consider the following excerpt from the recent press release of the National Federation of Independent


13


Businesses (which also addresses some of my other themes):

Overall, the small business job machine is still in reverse, due to continued declines in reported sales, rising labor costs, and a need to cut costs. Reported capital spending is at historic low levels, owners are still, on balance, reducing inventory stocks (only seven percent reported increases, 32 percent reported reductions) so orders to wholesale and manufacturing firms for new inventory are weak. Price cutting is rampant (though slowing) which combined with lower real sales continues to produce record reports of earnings declines, one reason capital spending remains low. Few firms report credit availability as a problem, though those who are borrowing report more difficulty and tougher terms than during the expansion. Events in Washington are not supportive of more optimism about the future – another reason not to spend or hire.

9. Global spending on infrastructureIt seems that many countries around the globe are targeting infrastructure as a way to boost their economies. This is a particularly valuable way to enhance economic activity in both the short and long term, as in the short term it creates needed jobs in construction, engineering, state and local governments, and of course, all of their suppliers. In the long term, infrastructure can boost productivity (think of the interstate highway system as a prime example).

Now, let me provide some caveats. One must consider the timing and the ability to implement these projects. It takes quite a while for a large project to be debated before it goes to the planning stage, let alone implemented. That said, here in the US, indeed quite a few unemployed people might be put to work in infrastructure projects. The question is, how many of them would be both willing and qualified to be employed for such projects? Would an out-of-work investment banker be suitable for building a road or bridge? Could a former retail clerk design a wind turbine? If an opportunity arose in South Carolina, could an unemployed auto worker sell his house in Michigan to relocate? The infrastructure theme is likely to bear fruit at the level of individual companies that can benefit, but given the questions posed above, it may not be sufficient in itself to have a significant and immediate economic impact but will likely have societal benefits in the future. Construction and engineering firms would likely benefit, as well as those in the industrial and materials sectors.

10. Rising emerging market prosperity over the long term, especially those with developing consumer demandWe can think of demand coming from two sources: internal, or domestic consumption, and external, or exports. We can then divide exports into commodities and finished goods. Now, we have seen that the falling dollar has likely brought pain in the form of crimped margins to exporters of finished goods to the US, and we can also see that the falling dollar has meant that commodity prices in dollar terms does not translate into price gains in local currency terms. In fact, the currency gains of some commodities exporting countries negate much of certain commodities’ dollar-price gains. Moreover, as I point out above, the drop in Baltic Dry shipping rates suggests that volumes of non-petroleum commodity and finished good shipments are soft, suggesting price moves may be the result of speculators. I note that Australia, a commodity exporter, recently reported a drop in exports in its trade figures. That leads me to want to focus on emerging economies that are focused on growing internal demand, although I must point out that nearly all countries engage in activities that would be a combination of domestic consumption as well as exports of finished goods and/or commodities.

First, many consumers in emerging economies save much more as a percentage of their incomes than do their counterparts in the developed world. Much of their savings is precautionary, so in order to get them to consume more, their governments need to provide safety nets for things such as health insurance, unemployment benefits and disability benefits, things that we in the developed world take for granted. Once these safety nets are put into place, they allow consumers to direct

more of their incomes toward consumption, and some of their precautionary savings can be then directed towards spending. As such, countries instituting these policies can see an outsized consumption gains quickly, relative

The drop in Baltic Dry shipping rates suggests

that volumes of non-petroleum commodity

shipments are soft, suggesting price moves

may be the result of speculators.


14


to incomes, simply by alleviating the need for households to have such a large cash cushion against calamity.

Second, the financial crisis emanating from the developed world highlighted very saliently the need for emerging countries to attempt to insulate their economies from the vagaries of demand from the rest of the world; in other words, to develop more robust and diversified economies. It seems that this point was especially taken to heart in Asian economies, which seem to have rebounded relatively well. These economies, and certain others, appear poised to revert toward longer-term growth trends more quickly than many economies in the developed world might, presenting opportunities for investors, notwithstanding the recent surge in share prices. Of course, this theme will play out for many years and is not just a 2010 play.

Following that, given the global economy, companies with international brands with strong export distribution chains would be a favored way of playing emerging market domestic demand. These companies could be located in any country. There would also be local companies that might benefit, especially in the consumer discretionary area, along with their suppliers. As I noted previously, I might tend to underweight companies and countries that are reliant on exports of either crude or finished goods to the developed world. Plenty of opportunities exist to invest in local companies that serve the local market, but finding and researching these companies will take on-the-ground research.

ConClusionThe financial crisis that arguably started in 2006 with the deflation of the housing bubble and the first hints of looming subprime defaults and then cascaded into the worst global recession since the Great Depression has perhaps left an indelible mark on consumers and policymakers everywhere. In a sense, things may never be quite the same, or at least not for a while. Consumers in the US, and indeed, much of the developed world, are learning that discretionary items are not, in fact, essential to their well being, and are making do with a newfound frugality. Meanwhile, certain developing economies, especially in Asia and certain other economies, are learning that the developed world is not, in fact, essential to their well being and are preparing for a new world order, perhaps not immediately, but at least in the not-too-distant future.

The investment themes are profound. Investors will likely eventually conclude when deconstructing equity returns that, over the very long term, stock returns are dependent on profit growth. Profit growth over the very long run cannot exceed nominal GDP growth (otherwise, corporate profits would eventually theoretically consume all of GDP), and nominal GDP growth cannot deviate markedly from nominal income growth: lower wages eventually will equal lower profits. The era from 1982 through 2007, during which massive amounts of borrowed money drove growth in consumer spending well

in excess of growth in consumer incomes, finding its way into corporate profits and fueling a tremendous bull market, is now over. A realistic number for US nominal GDP growth over the long term is, perhaps, 5% to 6%, and thus underpins likely US equity performance over time. The important exception to this formula is profits from global trade.

The opportunities outside the developed world are tremendous. In the preceding discussion, I compare a few facts about China’s economy to that of the US. While China itself may not be quite as open to either US investors or US exporters, it may serve as an example of the potential of the emerging world. China’s per capita GDP is less than one-tenth of that of the US. Given the right catalyst of appropriate policy measures and global free trade, there is considerable potential for the emerging world to catch up to the developed world, providing investors with abundant profit prospects.

The beneficiaries would likely include firms that can adapt to rising prosperity in new locales, companies with global brands and distribution, strong pricing power and good corporate citizenship. Companies that will benefit are those that supply the world’s growing need for “things:” commodities of all types, including food; infrastructure; pharmaceuticals, (including serving an aging developed world population); and finished goods, both consumer goods and those related to capex alike. Services are also increasingly global, and demand from the emerging world is important here as well. Many of the companies providing these goods and services are located in the US and the rest of the developed world. Despite consistently falling employment in manufacturing, we may see that sector increase in importance in our economy as the falling dollar boosts our competitiveness.

Due to the seismic shifts of the global financial markets and the Great Recession, the speed with which the world realigns may be sooner than we once had anticipated. Active management is essential.

A realistic number for US nominal GDP growth over the long term is, perhaps,

5% to 6%, and thus underpins likely US equity

performance over time.


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