Fourth Quarter 2010

The fourth quarter gave a number of positive economic surprises which boosted the stock market and investor sentiment. Manufacturing grew in December for the 17th consecutive month, expanding faster than any month since last May. Small business optimism is improving, as is consumer sentiment. While unemployment remains high at 9.8%, first-time unemployment claims are dropping sharply, which may soon have a favorable impact on the overall jobless rate. The private sector added a surprising number of new jobs in December, the 11th straight month of expnsion. These improving trends should continue well into 2011, as analysts begin the year by revising upward their GDP forecasts.

The surge in commodity prices continues to gather momentum, and those commodities most important to the global economy (cereals, oil, and iron ore) are hitting two year highs. Copper, gold, and cotton are hitting all-time highs. If commodity prices continue their rise in 2011, some analysts worry that an inflationary surge will ensue, forcing central banks to begin raising interest rates in order to slow consumption. The Chinese central bank did precisely this on December 25th in order to combat higher food and commodity prices. According to the U.N., the global food price index is at its high since the measurement began in 1990. While the debate rages between inflation and deflation, many ordinary expenditures to U.S. consumers are also hitting new highs (ground meat, turkey, college tuition,prescription drugs, domestic package and freight shipping). These are signs of incipient inflation, which will likely drive interest rates higher sometime in late 2011.

Stocks are positioned to benefit from:

  • Investors moving out of bonds and cash instruments seeking higher returns in riskier assets.

  • Corporate cash levels, at an all time high, being used for share repurchases, acquisitions and dividend hikes.

  • Pension funds need to chase higher returns to meet future obligations.

  • The perception of risky assets improving due to better economic conditions.

  • Stock valuations being relatively cheap to history and having a better earnings yield than corporate or government bonds.

It’s useful to consider the difference between the Federal Reserve’s first stimulus package in late 2008 (“Quantitative Easing 1”) versus the recent announcement of further stimulus in October (“QE2”). The first was a response to a huge increase in the demand for money as investors sold risky assets during the financial crisis of 2008 and banks increased reserves against risky loans, and even reserves against plain old deposits. (The deposit-reserve ratio plummetted from 9 to 1, lower even than after the Great Depression.) The Fed’s actions were a necessary response to provide liquidity in the face of this need for money. Now, however, there is no particular increase in the demand for money, but a potentially huge increase in the supply of money. The Fed will be buying some $850 to $900 billion of U.S. treasuries with printed money. To put this in perspective, it amounts to the entirety of China’s U.S. treasury holdings. The potential outcome of this is inflationary, and should continue to drive up prices of real assets. Stocks and commidities are likely to continue benefitting from such a scenario.

As yet, there is still no credible budget deficit reduction plan in the United States. In fact, the Congressional Budget Office is forecasting an important rise in the debt-to-GDP ratio from 61.6% in 2010 to nearly 70% by 2020, despite a forecast rise in GDP. This estimate was made before the extension of the Bush era tax cuts and unemployment benefits, so in reality it may be even worse.

In Europe, fiscal austerity plans are being put into place in Ireland, Greece, Spain, Portugal and the U.K. As one would expect, the peripheral economies are underperforming the manufacturing and export heavy ones such as Germany and Sweden. It is likely that with an improving U.S. economy, the U.S. dollar will further strengthen against the Euro throughout 2011, particularly because Europe is still grappling with its sovereign debt issues. Emerging markets may be due for a pullback and are likely to underperform the U.S. market on a risk adjusted basis, because of inflationary pressures facing these economies for raw materials.

Grant Rogers

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