Below is my updated thesis as of the beginning of 2011. The main points are in order of importance (ie the factors that lead the development of my thesis). For example, I believe that at the present time, the most important factor for the US economy currently stands in what direction our government is taking to address important economic issues, therefore this topic is first. The global economy is the second most important factor towards shaping the trajectory of the US economy (hence it’s second on the list)… and so on.
For comparative purposes here’s the link to my previous outlook.
US Government Policy:
—Main Thesis—: Current plans to cut government spending at the federal, state, and local level are very alarming. The private sector is still very vulnerable to any exogenous shock and is not in a position to take the economic baton from the government sector. Furthermore, I believe that there won’t be enough political will within Congress to pass additional stimulus, should we be faced with increasing signs of another fall in economic activity. There is a high probability that there will be deadlock between Republicans and Democrats. Republicans are hungry for more political control and in an effort to blame future economic malaise on the failed economic policies of president Obama, will make things very difficult for the Democrats when they propose new stimulus measures . However, It will all be in the name of “fiscal prudence”. It will also become more accepted that the effects of the massive stimulus package passed in February ’09 and Quantitative Easing, which lasted throughout 2009 and 2010, were nothing more than a sugar high and did not address the structural imbalances that remain in the economy; in other words it will be deemed as a failure. Voters have begun to realize that bailouts, consumption-based stimulus and quantitative easing are a long-term negative for our nation. Overall, I believe that this new mentality of fiscal prudence will solidify my double-dip recession thesis. I expect this trend of “political frugality” to take place over the course of several quarters.
—What’s Happened?—: So far, what’s been occurring in regards to this topic has been spot on with my Q2 ’10 outlook as I explained here and here. November was an ugly month for Democrats as Republicans swept the House and nearly took the Senate. More importantly, the reason why Republicans did so well was because of the Tea Party. These cohort of freshman politicians have been put into power by an extremely frustrated electorate. After approving a temporary Bush-Tax extension along with other stimulus-rated goodies (that one last stimulus I wrote about in my previous outlook), policy makers are now in a “cut-spending” attitude. We are beginning to see the development of a different fiscal path for our country, one which does not involve failed consumption-based gimmicks. State and Local governments, who must balance their budgets, have been cutting spending at a furious rate. They have also resorted to increasing taxes (thanks Quinn) and firing state workers.
—Keeping An Eye Out—: I’ll be checking political stories to keep tabs on this longer-term “Political Frugality” theme which seems to be firmly established for the time being. While the issue has taken a back seat since the election, I’ll also be checking for articles detailing protectionist sentiment between the US and China. The threat of senators proposing protectionist legislation due to China not “having done enough” on the Yuan’s appreciation continues to loom.
Global Economy/Global Trade:
—Main Thesis—: Overall I expect the global economy/trade to slow and possibly double-dip as we undergo a second phase in the global economy’s restructuring process. Most countries outside of the US remain very reliant on exports. In the past few decades the global economy was shaped on fueling the American Consumer. This long-standing economic structure can still be seen as US attempts to weaken the dollar have been met with capital controls and interest rate increases (while holding their currency mostly steady) in exporting nations. They do not wish to see their currencies strengthen against the dollar as it would make their economies uncompetitive in the global marketplace. Specifically, I do not believe that China is prepared to lead the global economy into a sustainable recovery. Their economic model is still too dependent on exports; the transformation into a consumer-based economy is not yet complete. Currently the communist nation has shown disturbing signs of runaway inflation. In battling these inflation issues, officials have applied the bulk of the therapy via interest-rate hikes, the Yuan has risen in value only a little and thus reinforces officials’ worries on the imbalances that remain inherent in their export-centric model. To complicate matters, there’s the possibility of a property bubble. Raising rates is akin to rubbing the point of a needle against the thin rubber of a blown up balloon. Finally, we need not forget that protectionism is still alive and well (this is another issue that has taken a back seat, surprisingly — See US Gov’t Policy section above). Overall China finds itself in a very tight spot with not a lot of room to maneuver. I don’t believe that China will come out unscathed. The country will experience a hard-landing in the short to medium-term. Regarding the Eurozone, I don’t believe that her individual countries are prepared to cede political control. This is what it would take for the Euro to survive in my view. Will it be politically acceptable for Germany to continually sign their name on the dotted line to bailout deficit-ridden countries without having some control over that country’s financial affairs? Will citizens of these countries allow German control of their government’s financial affairs? I don’t believe so. The Eurozone has a structural problem and I don’t believe we’ve seen the last of the sovereign debt problems in the region. In the longer-term, the future of the global economy lies in China. The country is in the slow process of entering a period of sustainable expansion. In contrast to the US, I believe that China’s stock market has bottomed and it is currently in the retesting phase.
—What Happened?—: The Shanghai index has continued to fall on the back of growth concerns and a deflating property bubble. After the April/May fireworks that brought the Euro down to approx 1.19, the Euro has staged a comeback as the German economy shined in the back half of 2010 (due to a weaker Euro). Recently however, it has been under renewed selling pressure. Overall global trade continues to expand but at a decreasing rate.
—Keeping An Eye Out—: Regarding China over the shorter-term, I’ll be looking out for news on the effects of recent interest-rate hikes as well as the introduction of property taxes. I’ll be looking at property-developer equities in the Chinese markets to see if they begin to swoon (which would be another confirmation that a possible property bubble may be popping). Additionally, checking how the Aussie Dollar is doing wouldn’t hurt (AUD/USD) as the Australian economy has been feeding the great Chinese machine. Protectionist actions are also something I’ll look out for. It seems that US Senators continue to not be satisfied with the steps China has taken in correcting the “perceived” currency imbalance. Rash decisions based on political gain may spark a trade war and would obviously be a very negative catalyst for global trade. For the Eurozone, it’s all about government bond yields –especially in Spain. If they begin to rise quickly, the Eurozone may be in big big (like too big to bailout) trouble. In the longer-term, I’ll be looking at China’s transformation from an export-oriented to a consumer-based economy (social-safety net, credit card legislation, etc). The potential demand emanating from China as millions of farmers/peasants move up the consumption ladder is enormous and will be a main source of a secular bull market in that country in the years to come.
—Main Thesis—: In the US, a very important factor in the creation of a self-sustaining recovery lies in the labor market. Substantial and consistent job creation is needed so that we have a healthy, organic, and strong trend in wage growth. If this occurs, then consumption growth will have more staying power (sustainability). However, we currently are in a “chicken-or-egg first” scenario. In times past, the use of credit, and/or rising home values served as the match that lite consumption growth, this lead to job creation and the positive feed-back loop was in motion. This is no more. High structural unemployment from drastic losses in the construction and financial sectors will persist. These types of jobs will not be coming back anytime soon. Furthermore, the credit bubble over the past decade created fake additional demand, which was pulled in from the future. The bill is in the process of being repaid. Jobs that existed to feed this pulled demand won’t be coming back for a long time as we now have a semi-permanent reduction in demand. A housing double-dip won’t help matters either as it will suppress growth in confidence among consumers. All these factors will act as considerable headwinds towards job creation, which I expect to continue being very tepid. The probability of additional job losses is elevated due to the large imbalances upon which this recovery has been built. In the longer term, there must be a re-balancing of the global economy (think Chinese consumption), some new life-changing technology developed, or a “New Deal” type of legislation for there to be an increase in aggregate demand leading towards consistent job creation. I don’t see any of these things coming in the short or medium-term.
—What’s Happened?—: As expected the unemployment rate kept above 9% for all of 2010 as I had forecast in my previous outlook. Recently it has fallen and has opened discussion on whether the labor market is indeed improving. Another bullish sign has been the large drop in jobless claims to much healthier levels and points to a completion in firings. Job growth as per the BLS payrolls report has still remained very lumpy and has not performed well compared to historical performance at this stage in the recovery. Temp workers have increased by a significant amount, however, this usually dependable leading indicator has not resulted in substantial job growth as expected.
—Keeping An Eye Out—: Is the the recent decrease in the unemployment rate a indication of real improvement in the labor market? Payroll reports in the upcoming months may shed light on this question. I’ll be keeping my eye on the government to see if they begin discussing the possibility of legislation being passed to battle chronic unemployment as well. On this front, we are currently in an environment where we are seeing government pare back spending, which is not positive. Additionally I’ll be keeping an eye on the JOLT survey as well as consumer confidence and real-time polls (Gallup.com, ABC, University of Michigan, etc.) for signs of accelerating job growth. On this front, we have seen some improvement but it has been painfully slow.
US Dollar/US Monetary Policy:
—Main Thesis—: The future of US Monetary policy is very clouded, however, I am starting to tilt to the view that Quantitative Easing as a viable tool for combating future economic weakness is losing its allure. This may result in the Fed’s hands being tied if equity performance begins to disappoint. Emerging market economies are experiencing perilous inflation problems and some are beginning to wonder if the Fed is behind it all. Furthermore, it seems to me that this policy is only leading to higher commodity prices despite a worsening US economic backdrop. I believe that 2011 may be the year that Bernanke will not be able to turn on the monetary spigot if equity markets begin to suffer, at least not immediately. In this new year, the 4 NEW voting members of the FOMC from the regional Federal Reserve banks are:
- Charles L Evans from Chicago Bank (replacing James Bullard from St. Louis)
- Richard W. Fisher from Dallas Bank (replacing Thomas M. Hoeing from Kansas City)
- Narayana Kocherlakota from Minneapolis Bank (replacing Sandra Pianalto from Cleveland)
- Charles I. Plosser from Philly Bank (replacing Eric S. Rosengren from Boston)
Contrary to last year when we had one inflation hawk, Hoeing, repeatedly dissenting in US monetary policy decisions, this year we have two confirmed hawks (Fisher and Plosser). It will become much more difficult for Bernanke to initiate what would be QE3 in time to avoid risk aversion from taking over. I DO believe that we’ll eventually get a QE3, but it may occur behind schedule. Another factor that may tie the Fed’s hands is the creeping politicization of monetary policy. Given our extremely high rate of unemployment, consumption power is becoming more vulnerable to increases in food and gas prices. Bernanke will be under more pressure from politicians if economic activity slumps because it will further solidify that QE didn’t do anything to structurally fix the economy, it was only a sugar high that caused massive speculation in commodity and equity markets. With respect to the US dollar (DXY), I am bullish. If quantitative easing is not initiated, equity markets will suffer. Couple this with a potentially souring global economy (China hard-landing coupled with Eurozone woes) and you’ll have a large flight to safety supporting the dollar. Longer-term, I’m not really sure what will happen, but I have been pondering the mother of all contrarian plays. I still haven’t made up my mind though.
—What Happened?—: As expected in my previous outlook, the dollar began to underperform as economic weakness prompted talk of QE2. However, it has been seeing support lately and I have turned bullish once again as a result.
—Keeping An Eye Out—: I’ll be keeping an eye on the Fed bank presidents to see what steps they would take should the economy begin to weaken substantially. Will they see QE as a failure and not support QE3, or will they make life easy for Ben Bernanke? I’ll also be looking at the Eurozone and whether it can contain its own list of problems as well as the UK and Japan for flare-ups in those countries. Finally I’ll be looking at possible protectionist acts as this would reduce global trade and cause another strong headwind for the global recovery. If the global recovery becomes derailed, the US dollar will be bid as a safe haven play.
—Main Thesis—: Housing will remain in a deep funk for the next few years. We are still faced with a very large supply of homes and very little demand from households. We also can’t ignore continued foreclosures or the overhanging shadow inventory hiding in the marketplace. These factors further reinforce the large supply situation. Political will for another homebuyer tax-credit is very low and there is a high probability that we will not see another credit for a while. The simple fact is that we have a large structural imbalance coupled with high unemployment and meager job growth, all factors that will keep demand muted in the years to come.
—What’s Happened?—: Housing prices have begun their double-dip as I had forecast. Mortgage applications have remained anemic in growth.
—Keeping An Eye Out—: Real Estate is a very slow market and trends take years to complete so at this point I would be focusing on longer-term economic metrics (such as the homeownership rate and household debt/income ratios). I’ll be looking at the owners equivalent rent metric as a gauge on whether prices have come down to more normal levels. The job market will also be an important factor to watch. Keeping an eye on mortgage applications would also be prudent as it is one of the best short-term leading indicators in the industry.
—Main Thesis—: Consistently high unemployment and poor job prospects will continue to semi-anchor consumer confidence. Housing my contribute to declining confidence as prices continue to fall, but I don’t believe that it will have as much of an effect as it did in 2006. Regarding the shorter-term, a dip in consumer confidence is an increasing probability due to seemingly never-ending increases in commodity prices (food/gas). I still expect confidence to come back but very slowly. A setback is certainly possible if we have the double dip recession or commodity prices continue to rise.
—What’s Happened?—: Events have been transpiring according to plan (my Q2 ’10 outlook). Consumer confidence has been rising, but at a very low pace. The job market continues to be mentioned as one of the primary reasons for subdued confidence.
—Keeping An Eye Out—: …the labor market. At this point all people care about is job creation. Psyche has been beaten down so much that any considerable improvement on the job front may result in a significant boost to confidence. I think housing will have less of an effect as people already know that home prices are low and will stay low for a long time. Finally I’ll be keeping an eye on the “Expectations” sub-component of the consumer confidence surveys. We have recently seen a divergence between “Current Conditions” and “Expectations”…is this due to increasing commodity costs?
Consumption (Domestic End-Demand) and Borrowing:
—Main Thesis—: Consumption in the US will be weak for sometime to come due to a myriad of reasons (Let us count the ways):
- Continued meager job growth and high unemployment along with a double-dipping housing market will equate to a heavy medium to long-term headwind as organic growth in consumption due to rising incomes will be negligible.
- Federal and State/Local governments will grapple with high debt and severely unbalanced budgets. These factors will lead them to reduce spending, administer additional job cuts, and even raise taxes.
- This reason is longer-term and psychological in nature. The seeds of “Ricardian Equivalence” are being sown. Higher expected tax rates will lead to more saving by consumers in the medium-term to eventually pay for them. This phenomenon will act as a weight on consumption growth. The higher US debt levels go, the more pain there will be in balancing the budget.
- Most baby boomers are still caught flat-footed as their retirement plans have been turned upside down by two giant bubbles in the past decade. They cannot count on the automatic housing ATM to deliver spending power anymore. Furthermore, their retirement portfolios don’t sport the balances that they did in late 2007…a giant do over for Monte Carlo simulations. Most Retirees will not be spending what they had planned in the past.
- With regards to credit, you have the budding psychology of living a healthier financial lifestyle by paying down debt = De-leveraging. This will result in continued weakness in demand for credit over the medium to long-term. While we have recently seen an increase in credit for the first time in many moons, I believe the psychological secular trend of saving more is still intact. The most common sense reason why this would change, is if job creation staged a furious comeback.
- The straw that may break the camel’s back and actually cause consumption to contract again (a high probability) are higher commodity costs. As liquidity reigns supreme (Courtesy of the US Fed), commodity prices will march higher if the global economy continues to show signs of strength. The question will then become: “at what point are prices so high that they suppress confidence and consumers hide their wallets again? (think summer 2008). This is a question that will be answered eventually imho. From a longer-term perspective the policies of our Federal Reserve coupled with ongoing secular growth phase in the emerging markets is really beginning to get me worried (read more here). This last point is a developing long-term thesis point, it won’t happen in the coming year or even 2 years, but it may be an issue 3-10 years down the road.
—What’s Happened?—: Consumption growth accelerated in Q4 and gave the bulls a lot to chew on. Consumption growth rates have maintained their strength, but this has come at the expense of a falling savings rate due to tepid income growth (high unemployment). Recently we saw that consumer credit has finally turned positive a positive for growth. Auto sales have also been climbing, however, they remain very low by historical standards. The Bush-tax cuts were extended and this provided a boost for consumption psychology. How long will positive sentiment last? On the other hand, unemployment benefits have been allowed to run out (is this morally correct?). Retail Sales show that growth has continued though it ran into a rough patch recently (though this has been blamed on the recent snow storms).
—Keeping An Eye Out—: I’ll be looking at the job market and wage growth for signs of a longer-term sustainable tailwind for consumption. Substantial job gains must become a regularity (leading to stronger wage growth) for consumption growth to have staying power, plain and simple. As long as the job market does not recover, uncertainty will be present. As long as uncertainty persists, wallets will be held close. In the past one could rely on credit as a way to jump start consumption, however, with credit growth hard to come by, we cannot depend on this factor anymore. In my prior outlook in Q2 ’10, I signaled the housing market as one of the factors to watch. Lo and Behold, we now are seeing a developing double-dip in prices. While consumption has not slowed markedly as of yet, I believe that a double-dipping housing market will pose as a developing negative headwind over the course of the rest of 2011. Will extending the Bush-Tax cuts cause a more permanent psychological boost to consumption? Will unemployment insurance be extended for the 99ers? From a deleveraging standpoint I’ll be looking at the Household Debt to Disposable Income Ratio and the Savings Rate. Any additional stimulus targeted towards increasing consumption (an extremely low probability at the current time) may cause a pop in consumption trends and is something I’ll be looking at as well.
Industrial Production (Manufacturing):
—Main Thesis—: After providing most of the growth for the US economy, lack of end aggregate demand will lead to a slowing business climate, which could potentially end in contraction if we enter a double dip recession, a high probability in my view. Overall I have a bearish view in the short-medium term. Longer-term though, company cash levels are very high, and emerging markets may provide the secular growth that is needed for manufacturing to stage a big comeback in the years ahead. While I don’t believe that this scenario is knocking at our door, it’s progressively getting closer.
—What’s Happened?—: Consistently high ISM manufacturing numbers have characterized what has been a vastly improved industrial sector compared to early 2009 and most of 2010. Rail activity has also remained strong. ISM Ratios are pointing to expansion and leading indicators such as the Ceridian-UCLA Pulse of Commerce report have shown continued expansion on the horizon. Durable goods orders, another leading indicator of industrial activity have been positive as well, but the trend has been weakening of late. Overall, manufacturing has been THE beacon of the recovery and has outperformed my expectations.
—Keeping An Eye Out—: First and foremost, I’ll be looking at end-demand in the US, China, and Europe. If China or Europe experience any negative surprises (an increasing probability), demand from those countries will drop and will have a negative effect on manufacturing activity. Given that we are currently experiencing a recovery in the US at this point (a very weak one in my view), industrial activity may be buoyed by continued demand at home, however, if consumers continue to be cautious, we may see depressed growth rates and a vulnerable manufacturing sector. Finally, I’ll continue to focus on the development of consumption-based policies coming from China. As Chinese officials put these policies into place, the outlook for Chinese consumption will improve. This in turn will improve my outlook for Industrial Production.
Service Industry (Non-Manufacturing):
—Main Thesis—: This sector makes up 80 to 90% of the economy. Weakness here will no doubt have an overall negative effect. I believe that this sector’s growth is self sustaining (contrary to my tone in my Q2 ’10 outlook) if held in a vacuum, however, a negative shock to the US economy may tip this sector back into contraction territory (an increasing probability). Lack of substantive end-demand growth will keep hiring activity at a low level, and low job creation will keep end-demand growth insignificant; all in all, this sector will be hard-pressed to find any impetus for strong growth, contraction is very possible. In the longer-run, the story is similar to manufacturing (secular expansion), although to a lesser degree.
—What’s Happened?—: Similar to the manufacturing sector, the service industry has been on the mend. This sector seems to lag its manufacturing brethren, which makes sense because it represents 80-90% of the economy. It is now in expansion mode. The ISM Services indicator has been showing an acceleration in expansion in the service industry.
—Keeping An Eye Out—: …once again, end-demand in the US and China. Consumption needs to continue to show growth and that growth would feed into improved business conditions. Once again it’s all about the positive feedback loops. I’ll be keeping an eye on the US dollar compared to the Euro and the Yuan. Weakness on the part of the dollar would increase export demand if the global economy remains healthy.
—Main Thesis—: Despite all the brouhaha regarding the impending inflationary spiral hitting the US and eventually leading to hyperinflation, I believe from a secular standpoint that we are still in a deflationary environment. This recent alarm (back up in bond yields, rising oil prices) is merely a hiccup. The reason for my seemingly contrarian view stems from a few factors:
- High levels of household debt, coupled with tepid job growth and low consumer demand for credit (de-leveraging), will produce an environment where firms are unable to pass higher raw material costs to consumers. Consumers do not have the buying power to oblige firms raising prices. To be more clear, food and gas prices are indeed on the rise, however, all this serves to do is sap purchasing power from more discretionary (not life important) industries. As I point out here and here, we are seeing inflation in commodities, food, and raw materials. However, on a larger national scale, margin squeezes for companies will be the result, not inflation.
- IF we were to begin seeing inflation on a wider scale, bond markets would react with a vengeance. Rates would begin to rise as fears of investor’s fixed income payments would deteriorate in real value. Higher rates would become a significant headwind on an already weak housing market. Aside from declining housing values, consumer demand would also suffer as the cost of credit would rise as well. Also, at what point do higher Treasury yields begin to compete with stock market returns? All these factors would result in risk aversion. What I’m getting at is that if we have any sign of persistent increases in inflation, the bond market will do its part in stopping this trend, it will in effect undermine further development of the recovery.
- Emerging Markets are displaying some disturbing signs. Inflation is indeed a problem there, no doubt about it. The reason for this I covered here. Central banks in emerging market economies are raising rates in order to cool their overheating economies. The probability of a negative surprise from China is high and increasing. China is the engine of global growth. If China experiences a hard landing, something I believe is very probable, it will translate to falling commodity, raw material, and equity prices around the world.
Longer-term, I am becoming very concerned with what our Federal Reserve is doing. Constant application of quantitative easing is a very myopic strategy and leaves us at the mercy of unexpected future market forces. See here more detail.
—What’s happened?—: Consumer inflation over the second half of 2010 remained very low. Core Inflation metrics continue to show a slowing in price increases. However CPI including food and energy rose a decent bit from November to December on a YoY basis, underscoring the increases in raw material prices. PPI metrics show that inflation at the producer level continues to rise, particularly at the raw material level (Crude Goods). Inflation expectations on the part of consumers have ticked up as of late, but haven’t shown signs of becoming un-anchored. Average hourly earnings have continued to show very little growth, though they did pop in the latest month. Capacity utilization has increased, but remains low when compared to the historical norm. Bank credit of all commercial banks was flattish most of 2010, but has been showing weakness to start 2011. Excess NSA has been mostly flat and signals that credit is still not freely flowing on Main Street.
—Keeping An Eye Out—: First and foremost, will the Job market improve? If it does, then consumption will go up and consumers will be able to dish out more cash if firms raise prices. Is the Fed able to rekindle the buy buy buy mentality with the use of credit? Is the recent rise in consumer inflation expectations just a blip? I’ll be watching this indicator as well.
Financial Market Forecasts
Stock Market & Commodities:
—Main Thesis—: Many headwinds are in store for US markets in 2011. In the US, the housing market has once again rolled over and is in the process of double-dipping (this may negatively affect domestic consumption trends). Meanwhile, Emerging Markets are experiencing their inflation-related issues and have been raising interest rates as a result. Looking at how Emerging Market indices have lagged in the latest run-up in the US equity markets portrays tougher times ahead for those economies. Let’s not forget how important these countries have been for US corporate profits lately. The Eurozone issues don’t seem to be getting resolved (it’s surprising how nothing’s really said on this front anymore). Lack of clarity or solution on these fronts have yielded some unsightly cracks in the bull market’s armor as of late. Furthermore, there’s a large sense of complacency among investors as the VIX is at levels last seen April ’10 (when the markets promptly sank 10+%) or mid-2008 (I don’t need to delve into what happened in subsequent months). These signs are cause for concern in my view. I believe that US equity markets will rollover at some point this year and the secular bear market that has been in place since the mid-2000s will resume once again. In the end, I don’t feel like we’ve experienced a market low that would be characterized by a sense of indifference and hopelessness towards US stocks. That would be called a secular market low. With the large imbalances that exist in the US economy I believe we will see one in the years ahead.
—What Happened?—: Stocks and Commodities staged brilliant comebacks (much to my chagrin–though I did see the rally at the back end of 2010) to finish 2010 in positive territory. The magic began after the Jackson Hole summit where Bernanke began openly discussing QE2. Analysts believe 2011 will bring more equity gains as the recovery strengthens.
—Keeping An Eye Out—: I’ll be keeping on eye on the Fed presidents (see US monetary policy section) to see when QE3 will make its appearance (too late in my view). At this point, the economy is in a secular restructuring process as de-leveraging takes place and unemployment remains high. As far as I can see, the highest probability of an impetus in growth leading to a sizable rally in US stocks would have to come from a fiscal or monetary source (as it did in the back half of 2010) or a miraculous bullish sequence of events in China. I’ll also be keeping a close eye on the developing divergence between equity prices and breadth to see if it corrects or not. Regarding commodities, I’ll be checking out how the China story progresses. If things sound like they are getting worse, commodities may have downside risk.
Treasury Market/Interest Rates:
—Main Thesis—: Over the medium term, I am still bullish on US Treasuries and have more conviction now than I had a few months ago. Fears of higher inflation leading to hyperinflation are overblown in my view. This is still a detested asset class, so the wall of worry remains high. From my point of view, the US consumer is tapped out because of too much debt. As long as you have that factor and a tepid recovery in the job market, companies won’t have the necessary pricing power to create an inflationary spiral. Issues in Europe have not gone away and emerging markets are actively suppressing economic growth for fear of inflation eroding rural savings (think Egypt and Middle East riots). The risks facing investors are daunting and I don’t believe that they are accounted for in current US equity prices. As equity markets begin to realize the magnitude and gravity of the situation at hand, Treasury yields will begin perhaps the final leg in the secular bull market that has existed since 1981. Sources of demand for Treasuries will continue to come from retirees, banks, and pension-funds. While we may see the pricing in of a credit quality premium (US = AAA?), it should be offset by an overall deflationary outcome for a time. Regarding the longer-term, something very worrying occurred when the markets rose in the second half of 2010. Quantitative easing did NOT achieve the goals Bernanke said the policy would achieve. Rates did NOT go down. They’ve moved higher since then. In the years ahead, I’m beginning to see a situation where we may see a sustainable recovery in China producing some very unexpected consequences in the US. Continued QE may be laying the groundwork for a period of significant increases in commodity prices, which would bring about the downside from the Treasury market top. Is the 30-yr yield starting to smell this? It’s about to break through a declining trend in yields in place since 1996.
—What Happened?—: Bernanke started chatting about QE2 and since then Treasury bond prices have declined sending yields higher. I became cautious during this time. Fears of inflation eating away at bond investors’ coupons have caused yields spike recently.
—Keeping An Eye Out—: China China China. Once China embarks on a sustainable recovery driven by consumption, the secular bull in Treasuries will be done in my view. On a more granular level, I’ll be looking at consumer inflation expectations as well as the job market and consumption.
This completes my overall thesis. My next update will occur around mid-June/early-July.