With 2011 already speeding by I thought it would be a good idea to get my annual outlook to you. There are so many things going on in the world and in particular here in the US that it has been difficult to narrow down exactly what we wanted to focus on. However, I feel that really there are four key themes that we will be watching play out this year which will have the greatest impact on the direction the economy and the market take: Politics, Debt, China, and Inflation.
Politics
I find it a little funny that over the last year people have become downright furious about the deficits. The topic itself isn’t funny at all, but what is funny to me is that these deficits are not new. We have spent in excess for quite a while. It is the result of asking for more and more “handouts” from our federal government and even getting some for which we didn’t even ask. Now, rather suddenly it seems, we have become enraged by this excess spending and have demanded it stop.
The problem of course comes when what we think is a misuse of federal funds happens to be the bread and butter (quite literally sometimes) of someone else who isn’t willing to part with that money. Who are we to say that funds sent to states for higher education is more important than the subsidies a farmer receives for continuing to farm?
Obviously there are the “easy” ones. Some were even outlined in the State of the Union recently (can we say too many federal government departments?). Unfortunately cuts to these programs is not really going to knock down the annual deficit in a meaningful way. What really has to be cut are the entitlements. We can’t keep increasing what and who we pay for social security. We also have to reign in Medicare and Medicaid. If you mention cuts to these of course you’ll get the massive push back from those about to or already receiving these benefits. It would almost be political suicide to disrupt those outflows. I don’t personally have the answers to the problem, but what the Social Security trustees have proposed seems fairly reasonable and necessary (i.e., push out full retirement age, raise tax slightly, and/or reduce payments).
Entitlement programs and the other necessary spending cuts aside, the real problem to be discussed right now is how much of these cuts can be done without severely hurting the system. Let’s face it, whether we agree with it or not the government has wormed its way rather deeply into the economy right now. If they were to rip themselves out now there would be some pain and perhaps so much pain we would relapse into another severe recession. It is an exceptionally difficult balance that those in Washington are trying to keep between supporting job growth (currently the focus of the Fed despite their dual mandate) and reducing spending.
While I’d like to tell you I am confident that the right long-term decisions will be made, I am concerned that the short-sighted mindset in Washington doesn’t appear to be going away quickly. It will be important to watch throughout the year as the election gets closer what we hear from Washington. Will tackling the deficit continue to take precedent over job creation or will they somehow be able to find the balance necessary to keep the economy moving while reducing spending? I have found it somewhat confidence boosting to hear that discussions are in the works to lower the corporate tax rate and more pressure has been placed on China. It will be interesting to watch those discussions continue and see what, if anything, comes by way of change to corporate tax laws after the President’s speech.
The good news is that job growth is expected to improve this year. However, even with job growth we will not likely see the unemployment numbers drop by much. This will likely keep the consumer on a slower spending rate than where we were at the peak (though the consumer spending numbers as measured by GDP for the 4th quarter of 2010 were impressive), but consumer spending will be one of the most important numbers to watch throughout the year.
China
Before we dive right into the issue of China, I want to review a few concepts which are directly related to the relationship between China and the United States. The current economical relationship between the majority of developed counties and developing countries is that developed countries are increasing their debt levels to fund their spending habits. This contributed to developed countries importing more goods than exporting. This relationship is known as ‘vendor financing’ and occurs when vendor countries (i.e., China, Germany, Brazil, etc.) buy bonds sold by major importing countries (i.e., the US and UK) and the money received by the importing countries for their bonds is then spent on purchasing goods from the vendor countries.
Over the years, this type of relationship between the US and China has been frustrated due to China’s currency devaluation policy of having the renminbi tied to the US dollar. This devaluation policy has the objective of holding the renminbi at a consistent price level below the US dollar. Basically this means that China is manipulating their currency so Chinese goods are cheaper than US goods and consumers are more inclined to purchase Chinese goods than more expensive US goods – of course there is the discussion of quality but that has yet to deter consumers to a large degree.
Of course, the Chinese are able to maintain their currency peg to the US dollar by either printing or selling bonds to control the amount of cash in the market. In the current situation of the US-Chinese currency relationship, the US is increasing the money supply (aka Quantitative Easing and QE2) in hopes of helping the recovery process. Keep in mind they have the dual mandate of keeping inflation in check and supporting the economy primarily through low unemployment; they have prioritized the latter mandate as the more important lately. With an ever increasing money supply in the US, China, has had to “print” large amounts of their own currency so it will stay below the deflated US dollar value. The Chinese currency which is now flooding the market due to the governments’ policy has the potential to cause inflation and move asset prices skyward. If the Chinese government does not stop pegging the renminbi to the US dollar or at least let their currency appreciate a greater amount than they have conceded of late, we could see more severe Chinese inflation.
You also need to factor in the effect of foreign investors heavily investing in developing markets because they currently offer the highest returns in the global market. This massive inflow of money is causing developing countries to experience a large amount of inflation which has begun to erode their production edge of cheap labor and raw materials. You will need to keep this in mind with your international investments this year.
China has recognized this potential issue and has implemented domestic policies with the objective of controlling inflation and drastic asset price increases. These policies have been somewhat successful and the rise in Chinese asset prices has not been explosive, but has been creeping upwards. I believe that the current Chinese policies are just a band-aid for the problem and need to be addressed in the near future lest we see severe inflation which has begun to erode their production edge of cheap labor and raw materials.
Our politicians have started to chime in on China’s policies and have even threatened stiffer trade regulations. I’ve talked about our focus on exporting our way out of this mess and China’s policies are making it hard to do that. Ben Bernanke has also joined in on highlighting this problem when he explained:
“Current policies of export dependent growth countries [China] have led to an unnatural balance of import/borrowing countries and export/savings countries. There should be a continuous balancing act between importing/borrowing powers and exporting/savings powers which is dependent upon the natural changes of currency prices. This means that countries with weaker currencies should be in the exporting/savings seat while those with stronger currencies should be in the importing/borrowing seat. Over time the export/savings countries accumulate wealth and their currency begins to rise in price while the importing/borrowing country’s currency begins to weaken and the countries switch places. It should be a continuous cycle of switching places, but China is purposefully keeping their currency price artificially low to stay in the export/savers position so they can fuel their growth through exports”
Bernanke believes that for the world to recover at a faster rate, China needs to relinquish control of the export/saving position and let their currency price rise. He does not want China to drastically decrease their GDP, but to focus on GDP growth through internal investing rather than relying on exporting goods.
U.S. Deficit
The main topic on everyone’s mind of late, it seems, has been the skyrocketing deficit, however, it seems that it is rare to find the reasoning written out as to why it is such a big deal (other than the rather ubiquitous statement of we are burdening our children). What it comes down to is: What is the lending rate we are paying on our debt?
As we add to our debt each year through excess spending (i.e., the deficit) the interest we are paying on the debt we owe becomes larger. For now we have a fairly low lending rate on our debt, however, should that rate rise even a small amount, we would begin paying more to interest payments than most other government programs. It is the excess spending that must be stopped. As mentioned before however, the government is in a little bit of a bind. How much can they cut spending while not sending unemployment shooting up again? What programs should be cut and what programs should remain?
There is also the much discussed predictions of state and municipal governments defaulting on billions of dollars of their debt in the coming year. The current situation facing most states and municipal governments are high debt levels and underfunded obligations. At the start of the crisis the federal government swooped in on their white horse and gave the states lots of funding and helped states raise or refinance their debt. Now, however, the federal government is not going to be able to do as much for individual states or municipals. As a result non-federal level governments will have to cut their deficits the old fashioned way by decreasing spending and increasing their revenue through budget cuts and taxes respectively. There is the chance that some will go bankrupt, but I do not believe that the problem will be as wide spread as many are predicting. States and municipalities will get their budgets back in line, albeit with a good amount of pain, and as we have seen plenty lately, refinancing the debt is possible and at reasonable rates.
These federal, state, and municipal issues will mean that throughout the year more research will have to be done for your fixed income investments. We will continue to keep an eye on the state and municipal levels to monitor the risks and plan accordingly.
Europe
News out of Europe has played a major factor in economic and market movements of late, and I believe that with some decisions that must be made we might see that role diminish. The critical decision point for Europe that I believe must be made within the upcoming year must be made by the European Central Bank (ECB). They are currently faced with a situation where a relatively small portion of European Union (EU) countries (i.e., Germany) are prospering due to their well established economies and manageable debt levels while the rest of the EU (i.e., Spain, Portugal, Greece, etc.) are experiencing high levels of debt and unemployment because of excess spending and the inability to export their way out of their problems due to the relatively high currency value. This situation will force the ECB to make one of two decisions:
1 – Maintain a strong currency and high interest rate thus keeping inflation stable in Germany and helping Germany attract new investment. For the southern European economies, this will result in increased competition with different export dependent countries with lower valued currencies and possible deflation resulting in a much slower recovery rate from their current recessionary states.
2 – The ECB will provide some form of stimulus by increasing the money supply and/or lowering interest rates. This will weaken the euro and cause Southern European goods to become more competitive in the export market. It will cause high inflation levels in Germany and the country will begin to shift from an exporting/saver model to an importer/borrower model.
I believe the ECB will eventually change to following a policy that is catered to the larger number of member states thereby following the second option, but no one should discount the power of Germany’s position.
So, what do you think? What are your thoughts on these four areas and is there some other critical area we should be watching for the year?
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