2010
-- THE YEAR AHEAD
Wow,
what a ride, this year just past. Now we look ahead, but in
order to divine the future, we must first attempt to understand
how we got to where we are today. The U.S. economy was already
in recession, even before the now infamous collapse of Lehman
Brothers in September of 2008. The nation's orgy of debt and
consumption, along with the substantial over-investment in housing,
was taking a serious toll. The residential real estate bubble
had burst. Banks were tightening credit, unemployment was rising,
and the consumer was retrenching. While we had been expecting
a protracted period of deleveraging, we had also hoped the process
would be orderly. But, that was not to be.
The
demise of Lehman unleashed a near freefall in U.S. spending
and production. And given the highly leveraged, globally intertwined
banking system, the fallout spread rapidly. Stock markets plunged
worldwide. Banks stopped lending, and consumers and businesses
stopped spending. The global economy was shutting down. In response,
central banks and governments around the world undertook massive
rescue operations, flooding their economies with money and sponsoring
huge stimulus programs. In hindsight, they had little choice.
And
so it was that, amidst widespread fear of financial Armageddon,
the world's stock markets bottomed in March of 2009, in what
can only be viewed as a classic selling climax. Following that,
investors began to refocus on the prospect of future growth,
and stock markets rallied once again. Fortunately, the massive
stimulus efforts took effect and most of the world's economies
started to recover, including our own. The huge central bank
reflation efforts also resulted in a substantial reservoir of
excess liquidity - over and above what their economies were
able to deploy. Thus, in an environment of very low interest
rates and few practical investment alternatives, stocks continued
their rise, eventually ending the year with substantial net
gains.
So,
what now? The U.S. economic outlook is positive, but the expected
rate of growth is mediocre. And with the huge rally in U.S.
equity prices, stocks can no longer be considered "too
cheap." Also, while the private sector is continuing to
deleverage, one cost of the financial rescue was an enormous
increase in public-sector debt. Government stimulus efforts
were justifiably huge, but now, the key policy challenge going
forward will be how central banks and governments, particularly
our own, manage their exit strategies. When, and how quickly,
the liquidity punch bowl is removed, will likely be the key
to U.S. financial market performance in the year ahead.
With
that in mind, what follows is our outlook for 2010. We remind
you, however, that while we are attempting to forecast the future,
our continued investment success in these volatile times will
depend much more on our ability to interpret and adjust to trends
and events, as new information becomes available.
The Economy
Economists'
forecasts for 2010 are primarily clustered into two camps. Those
in the smaller but more visible camp believe that while there
has been enough stimulus to bring the system back to life, the
boost has not been sufficient to ignite a self-sustaining economic
expansion. In this camp, they contend that the underlying damage
to consumers and businesses has been so deep that once the effects
of successful stimulus programs, such as "cash for clunkers,"
have worked through the system, the economy will fall right
back into recession mode - the so-called "double dip."
Economists
in the larger camp (the one to which we find ourselves most
drawn) suggest that, while a double-dip recession is unlikely,
there are major structural impediments to the rate of future
growth. Thus, following a couple of relatively strong quarters
resulting from the restocking of inventories and some pent-up
consumer demand, the economy is likely to settle into a prolonged
period of subpar growth. The rationale for this position is
that in the aftermath of such a huge credit overshoot, lenders
and borrowers will have little choice but to continue repairing
their balance sheets, thereby spending and investing at less-than-normal
levels. They also note that, going forward, the economy will
be constrained by increased regulation and the tax hikes scheduled
in 2011.
There
is, of course, a third possibility, that of an anti-consensus
positive growth surprise. For one thing, given the depth of
the inventory correction, restocking could be significant. For
another, companies have been especially aggressive in paring
labor costs and pulling back from capital spending. The result
is that, even with the modest economic rebound experienced to
date, U.S. corporate productivity has been outstanding. Corporate
balance sheets are in excellent condition, as well. The weaker
dollar and strengthening global economy should combine to provide
a boost to U.S. manufacturing activity, as should the very probable
rebound in global capital spending. In this scenario, an improved
manufacturing environment should eventually lead to a noticeable
pickup in hiring and serve to buoy consumer confidence and spending.
Readers should note that economic growth does not need to be
exceptional to have positive implications for the stock market.
It just has to be better-than-expected.
The
U.S. Federal Reserve Board and central banks around the world
had little choice but to aggressively reflate. But as a result,
most now find themselves balanced on a policy tightrope, with
the risks of economic stagnation on one side, and future inflation
and another asset bubble on the other. Most central bankers
have stated their intentions to pull back from their highly
stimulative policies as developments allow. Those decisions
will be crucial to the economic and investment outcomes.
Inflation and Interest Rates
Many
clients have expressed concern about the outlook for inflation
and interest rates. Their worries are understandable. The Federal
Reserve Board has injected a huge amount of liquidity into the
system. Furthermore, the combination of reduced revenue and
the enormous total funding of public-sector stimulus programs
has led to burgeoning government debt, with little evidence
of any credible deficit-reduction strategy.
And
yet, we consider it unlikely that inflation will become a meaningful
problem over the next year or two. With high unemployment and
plentiful unused manufacturing capacity, there is little direct
cost pressure. Also, the fact that China and other recently
emerged nations are continuing the march of industrialization
almost ensures a further intensification of global competition.
So until the economy begins to pick up steam, the Fed will not
feel pressured to raise interest rates. That, and the fact that
there is little household demand for funds, should serve to
keep interest rates low for many months to come.
Still,
we do not favor long-duration fixed income investments at this
time. With very low current interest rates, there does not seem
to be much potential for bond market capital appreciation. Yet
at the same time, there is a substantial risk of higher interest
rates longer term that would be associated with a lack of political
will to trim our rising deficit.
We
anticipate that the Federal Reserve Board will gradually raise
short-term interest rates and slowly remove excess liquidity
from the system, perhaps beginning during the second half of
2010. But this nation must also take action to put its fiscal
house in order. The U.S. government has emerged as the major
borrower in the world. It is crucial that we develop a credible
strategy for reducing the deficit, or the financial markets
will eventually rebel. Failure to undertake corrective action
would likely have the consequence of higher inflation, and perhaps
lead to an all-out dollar rout and an eventual decline in U.S.
living standards. Unfortunately, with high unemployment, an
aggressive social-spending agenda, and mid-term elections scheduled
for late 2010, it is difficult to be optimistic on this front.
The Stock Market
2009
turned out to be an unexpectedly positive year for the stock
market. The risk of a total financial meltdown had passed by
late spring, and the avalanche of rescue liquidity had to go
somewhere, so stock prices surged. But as we enter the new year,
stocks are no longer undervalued. So again, the question is,
where do we go from here?
Our
opinion is that the stock market is somewhere in the transition
period between the liquidity-driven portion of the bull market
and the next phase, which should be more a function of earnings
growth and fundamental improvement. While we continue to expect
stock prices to grind their way higher over the coming months,
the next leg of the advance will likely be more selective, more
volatile, and consequently, more challenging.
These
are tough times for America and it is easy to get bearish on
the outlook. There are myriad risks, and we cannot help but
worry, as well. However, we also recognize that doubts and concerns
are common emotions following a recession. If anything, the
risks are very well publicized by the financial press and, therefore,
are probably largely discounted in current valuations. The combination
of low inflation and accelerating growth is very positive for
stocks, and we suspect that large numbers of individual and
institutional investors remain underweight equities relative
to their benchmarks. In addition, with returns on cash near
zero, stocks continue to look attractive relative to the alternatives.
So for now, our continuing strategy is to buy on dips.
The
bottom line is that we think the stock market should continue
to perform well during the early portion of 2010. When the world's
policy makers embark on the next tightening cycle, reduced liquidity
may serve to limit further stock market progress. But, we think
that event is at least two or three quarters away.
Longer
term, visibility is fairly low. We suspect that we are in a
multi-year environment for stocks which may turn out to be much
like the second half of the 1970s. A very big decline in 1973-74
was followed by a significant rebound in 1975. Then began a
several year period of alternating cyclical bull and bear market
fluctuations, with little net progress overall. During the 1970s,
the Dow Jones Industrial Average seemed stuck at the 1,000 level.
Now we are in a period of consolidation around Dow 10,000, setting
up the base for the next secular advance. But, the start of
that advance is probably still a few years away. On a positive
note, while the general indices made little progress during
the latter '70s, it turned out to be an excellent period for
well-considered sector and stock selection strategies. Astute
investors profited handsomely.
Conclusion
Financial
innovation, deregulation, and the greatest credit overshoot
in modern times all combined to boost economic activity during
the last two decades. But, as a nation we lost control, and
the very things that served to foster growth severely broke
down. Necessarily and appropriately, policy makers took drastic
measures. The system was rescued, and most of the world's major
economies started to grow again during the second and third
quarters of 2009. Nonetheless, the deleveraging process and
its resulting consequences will be ongoing. Domestic credit
growth will be considerably slower going forward, and thus,
so too will be economic growth. Increased regulation and higher
taxation will place further impediments on future growth.
Still,
the U.S. economy is healing, and we anticipate modest growth
in 2010. The global economy will expand as well, and Corporate
America is in fine shape to benefit from that. As such, we expect
reasonable earnings growth this year, particularly from those
firms with meaningful international exposure. Furthermore, liquidity
remains abundant, and U.S. stocks, if no longer cheap, are also
not excessively valued. While volatility is likely to increase,
there are still few practical alternatives to stocks. Our expectation
is for moderately positive equities returns for the year as
a whole, but we believe they will exceed the returns produced
by cash, bonds, or real estate.
Our
world is changing, the emerging markets have emerged and the
U.S. is no longer the primary driver of the global economy.
With the rapid industrialization of China, India, and other
nations comes great opportunity. Hundreds of millions of people
around the world are rising into the middle class and consuming
accordingly. In order to prosper during this evolution, we must
embrace free trade and globalization. We must also bolster our
educational standards and foster the creativity and entrepreneurial
spirit that has made this nation so great. And, we must not
overtax or over-regulate. Within reasonable bounds, the chaos
of competitive markets can still be a beautiful thing.
As
a final note, we wish all of our friends and clients peace,
joy, health, and prosperity in the new year and for many years
to come. 
