I thought the economy would continue to experience a “sub-par” recovery, burdened by numerous headwinds (e.g., excessive government spending, great monetary policy uncertainty, increased regulatory burdens, fears of a Eurozone sovereign debt crisis), and grow by only 3-4%. It now looks like it managed to grow by about 2.5%. That’s not a grievous miss, however, since I thought that the market was priced for even weaker growth. Importantly, I thought the downside risks of Eurozone defaults were greatly exaggerated, and that proved to be correct.
I predicted that CPI inflation would be about 3%, but instead it will probably turn out to be a bit less than 2%. I didn’t think the Fed would need to resort to another round of Quantitative Easing, but they did. Treasury yields failed to rise as I expected, but they were roughly unchanged for the year, despite additional Fed bond purchases.
I predicted a stronger housing market, and it improved significantly by almost any measure. Mortgage spreads tightened instead of widening as I expected, because the Fed opted to expand its purchases of MBS. Commodity prices failed to rise as I thought, but on balance they were roughly unchanged. I expected gold prices to be very volatile and probably down for the year, but they ended up with a gain of 7%—a clear miss. The dollar didn’t rise as I thought, but it was essentially unchanged.
My worst mistake: a belief that the electorate would vote in favor of less government, lower and flatter taxes, and a simpler tax code. Thanks to the results of the November elections and the recent fiscal cliff deal, we are now burdened by the prospect of more government, higher and more progressive taxes, and a more complex tax code. Regulatory burdens will increase.
Arguably, the misses and near-misses noted above were trumped by my investment recommendations. I thought equity returns would be 10-15%, and the S&P 500 enjoyed a 16% total return for the year, even though the growth in corporate profits slowed as I expected. Emerging market debt (+22%), investment grade debt (+11%), junk bonds (+12%), and REITs (+17%) all did very well, as predicted. Throughout the year I reiterated my view that cash should be avoided at all costs, and that was indeed a good call. Anyone who avoided cash, no matter what they chose to invest in, was rewarded. In the end, risky assets did well because the economy did better than expected.
Now let’s turn to the future.
This year I will eschew point forecasts, since the real purpose of forecasting is to put oneself on the correct side of what the market is expecting. If the market expects no growth or a recession, then any forecast that calls for growth greater than zero is likely to be rewarded if the economy fails to stagnate or decline. That was the case last year, and I think it will be the case again this year.
For the 5th year in a row, I think the economy is likely to do better than the market is expecting, even though growth is likely to be less than what it would be if this were a normal recovery following a deep recession. I think the market is quite fearful that growth this year will be either zero or negative, and I base that on my observation that yields on safe-haven, risk-free assets (e.g., T-bills, Treasuries) are extremely low, yields on inflation-indexed, risk-free assets (e.g., TIPS) are negative, forward interest rates are priced to the expectation that the Fed will not raise short-term rates meaningfully for at least 2-3 years, equity PE ratios are below average even though corporate profits are at record highs, and high-yield spreads are still quite elevated.
A quick glance at key indicators—e.g., very low swap spreads, a positively sloped yield curve, negative real yields, relatively low levels of unemployment claims, flat industrial production but decent ISM readings, strong auto sales, strong residential construction gains, and continued growth in jobs—rules out an imminent recession. Going forward, monetary policy is almost certain to be non-threatening this year. Although fiscal policy has tightened—in the worst way, through higher taxes instead of reduced spending—on the margin it’s not a huge problem (things could have turned out a lot worse), and the negative impact is likely to be absorbed by the economy’s inherent dynamism, the continued growth of jobs, and ongoing gains—albeit modest—in productivity. On balance I think the economy can generate some modest growth this year despite the ongoing headwinds.
If there is a silver lining to the cloud of big government that darkens the outlook for the economy, it is that we will have a divided government for at least the next two years. The House can effectively block any big new spending initiatives, and if spending can continue to shrink relative to GDP, then this will give the private sector some badly needed breathing room.
The Fed’s aggressively accommodative monetary policy has pushed up inflation expectations over the past year or so, but I note that current inflation remains relatively subdued. Regardless, I continue to think the odds favor inflation that is higher than expected. Since Treasury yields are still extremely low, they offer a very unattractive risk/reward profile, with downside risk greatly exceeding upside potential. Although the yield on TIPS would rise in line with inflation, higher inflation would likely push Treasury and TIPS real yields higher, thus depressing TIPS prices and damping total returns; in short, TIPS are expensive inflation hedges given the very low level of real yields. Treasuries just don’t have much appeal in this climate.
As was the case last year, if the economy simply avoids a recession and manages to grow, I think those who avoid cash will be rewarded. The yield on just about any risky asset is substantially higher than the almost-zero yield on cash, and this becomes compelling as long as disaster fails to strike. Equity yields at 7% simply tower over the yield on cash. If there is any obvious caveat it would be for investment grade corporate debt, since spreads are relatively tight and the sector is thus exposed to the risk of rising Treasury yields. High yield debt, in contrast, still offers attractive spreads, and any pressure from higher Treasury yields (which would only come if the economy strengthens) would likely be absorbed by declining default risk.
Households have almost $7 trillion in bank savings deposits as a hedge against another recession. But since savings deposits yield almost nothing, then as more time passes without a disaster, at least some may feel that their savings could be put to better use in other asset classes or simply spent. Any attempt by households to redeploy their savings would put upward pressure on other asset prices, and possibly fuel an increase in the growth of nominal GDP. This is the wild card to watch.
The dollar remains very weak, so it’s more likely to strengthen, especially if the economy does better than expected. Gold remains a very risky asset at these lofty levels, and I think it is priced to a lot of very bad things (e.g., very high inflation, geopolitical risks) that have yet to happen, so again I’m not a fan of gold. Commodity prices, however, do have some upside potential after consolidating over the past year, and they have tailwinds such as easy money and ongoing growth in the global economy. Real estate stands out as the cheapest and most attractive inflation hedge, and commercial real estate offers some decent yields to boot. Equities are a decent inflation hedge as well.
The Fed’s aggressively accommodative monetary policy has pushed up inflation expectations over the past year or so, but I note that current inflation remains relatively subdued. Regardless, I continue to think the odds favor inflation that is higher than expected. Since Treasury yields are still extremely low, they offer a very unattractive risk/reward profile, with downside risk greatly exceeding upside potential. Although the yield on TIPS would rise in line with inflation, higher inflation would likely push Treasury and TIPS real yields higher, thus depressing TIPS prices and damping total returns; in short, TIPS are expensive inflation hedges given the very low level of real yields. Treasuries just don’t have much appeal in this climate.
As was the case last year, if the economy simply avoids a recession and manages to grow, I think those who avoid cash will be rewarded. The yield on just about any risky asset is substantially higher than the almost-zero yield on cash, and this becomes compelling as long as disaster fails to strike. Equity yields at 7% simply tower over the yield on cash. If there is any obvious caveat it would be for investment grade corporate debt, since spreads are relatively tight and the sector is thus exposed to the risk of rising Treasury yields. High yield debt, in contrast, still offers attractive spreads, and any pressure from higher Treasury yields (which would only come if the economy strengthens) would likely be absorbed by declining default risk.
Households have almost $7 trillion in bank savings deposits as a hedge against another recession. But since savings deposits yield almost nothing, then as more time passes without a disaster, at least some may feel that their savings could be put to better use in other asset classes or simply spent. Any attempt by households to redeploy their savings would put upward pressure on other asset prices, and possibly fuel an increase in the growth of nominal GDP. This is the wild card to watch.
The dollar remains very weak, so it’s more likely to strengthen, especially if the economy does better than expected. Gold remains a very risky asset at these lofty levels, and I think it is priced to a lot of very bad things (e.g., very high inflation, geopolitical risks) that have yet to happen, so again I’m not a fan of gold. Commodity prices, however, do have some upside potential after consolidating over the past year, and they have tailwinds such as easy money and ongoing growth in the global economy. Real estate stands out as the cheapest and most attractive inflation hedge, and commercial real estate offers some decent yields to boot. Equities are a decent inflation hedge as well.
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