The Year Ahead: Annual Market...
2007 is upon us, and though the “in with the new” sentiment of the new calendar year does not necessarily portend the onset of new trends in the markets, it is nonetheless a good time to take stock of what may lie in store ahead. Taking into account as we always do that the short term is unknowable, here following are the issues weighing on our minds as January gets underway. In brief:
The US economy should slow down, though not to the point of recession. We are comfortable with 1.7 – 2.0% of real GDP growth, somewhat on the lower side of the consensus range. We think consumer spending, housing and corporate earnings may disappoint by the second quarter while exports could benefit from a weaker dollar.
We believe risks are skewed to the negative with more likelihood for a confluence of weakness than a show of strength. The US dollar has the potential to cause real problems although we think an orderly decline is more likely with central banks in Asia and elsewhere gradually allowing artificially undervalued currencies to appreciate. ? Global capitalization – or economic decoupling – will be on the radar screen this year as present data are conflicting about the extent to which a US slowdown will spill over into other markets and regions and the extent to which regional capital formation will speed up the decoupling process.
Geopolitical X-factors may include energy problems related neither to oil nor the Middle East as Europe, Russia and ex-Soviet border states tussle over natural gas supplies. There is no shortage of potential crisis spots in the world, any one of which could bring us to an unpleasant tipping point.
In US equity markets we look for another winning year for value over growth and a readjustment from small cap to large cap. On a risk-adjusted basis we would expect large cap to be more attractive than small cap this year while we think growth will lose to value in both absolute and risk-adjusted terms.
We expect another strong year for international developed and emerging equity markets fueled in part by the dollar’s continued decline. Emerging market economies are likely to outperform the G3 (US, Eurozone and Japan). Globalization has affected different countries in different ways and we think this requires a more sophisticated segmentation of international exposure across all asset classes.
In fixed income as in equities we think it is a good year to concentrate on quality with a bias towards downside protection rather than leveraging our upside. There is a good case to make for non-US and emerging market debt. Average duration in a 3-4 year range can offer potential value capture from declining interest rates with fewer risks in our opinion than further out on the curve.
Alternative asset classes are increasingly important both for diversification and as a potential source of true excess returns (alpha). We will look to obtain risk tolerance- appropriate levels of exposure to, for example, hedge funds, private equity and structured products in addition to commodities and real estate.
The Economy
“…a dreary, desolate, and indeed abject and quite distressing one; what we might call…the dismal science.” – Thomas Carlyle, Fraser’s Magazine, 1849
Those who believe Thomas Carlyle summed up the science of economics better than any commentator before or since will be happy with this past year’s reinforcement of the sentiment. If the 2006 economy could be personified as a graduating high school senior then her yearbook would read: Most Likely to Never Make Up Her Mind. Inflation was a real threat, except when it was not. The property sector was heading for a Thelma and Louise-style plunge off the cliff, except when it didn’t do any such thing. Consumer sentiment was bleak, except when it was as effervescent as a Taittinger cork popping on New Year’s Eve. The Fed was sure to start reducing interest rates any time to head off recession, except when it was more concerned about growth or stagflation.
You get the picture. Amidst all of this inconclusive data it seemed that at some point in the middle of July the stock market threw up its hands and said “Well, no-one seems to know what on earth is going on, but it doesn’t really look all that bad, so let’s party!” And party it did, giving the S&P 500 a tailwind to sail into a 15.79% total return for the year, its best performance for the decade thus far with the exception of 2003, when it was coming off a post-recession trough. Generally Wall Street hates nothing more than economic uncertainty. This time, though, the gloomy Cassandras were shrugged off and the cheerful Pollyannas had their day in the sun.
In the wake of this cheery second half run a consensus view seems to have gelled around a presumed fait accompli “soft landing” engineered by the Fed whereby neither runaway inflation nor a recession nor anything else awful are likely to transpire. GDP growth estimates tend to fall somewhere around 2%. The OECD and Consensus Economics forecast 2.4% and 2.3% respectively, while the Wall Street Journal’s panel of 60 economists polled in mid-December arrived at a 2.2% average for 1Q07 real year on year GDP trending up to 2.9% yoy by the 4th quarter. That same WSJ panel sees generally tame inflation decreasing from the upper end of the Fed’s comfort zone of 1-2%. High single-digit corporate earnings growth, unemployment just below 5%, and a bottomed-out but still-weak housing market complete the story. The happy talk calls this a “Goldilocks” economy – not too hot, not too cold, but just right.
We are not Cassandras but we do see several developments that could throw a wet blanket over Goldilocks. Let’s start with consumer spending. Whenever the legendary American Consumer finally collapses on Heartbreak Hill the four culprits will likely be: household income, consumer debt, national savings and housing prices. Unfortunately none of these indicators looks particularly healthy these days. Household debt is at a record level while the savings rate is negative. Not to worry, says the crowd, because household wealth comes from other sources today and anyway the savings rate is an anachronism. From what sources, may we ask? Housing equity, first and foremost, but wait, aren’t housing prices lower now than they were when we took out all those interest-only mortgages and the like just a couple years back?
Oh, and speaking of paying off mortgages and all of that other consumer debt, how is growth in household income doing? That’s a bit of a tricky question. In the manufacturing and construction sectors it’s pretty dismal and getting worse if the latest figures from the likes of GM, Ford and others are to be believed. Yes, replies the Goldilocks Pep Squad, but that’s about 1/6th of the economy versus the 5/6th share occupied by the services economy, which is humming right along. The ISM Non-Manufacturing Report shows 45 consecutive months of uptrend for services, coming in at a healthy 57.5 for December (above 50 meaning expansion).
True enough – but household income is not perking along in equal proportions throughout a swathe of the US economy that includes Wall Street and Wal-Mart. Bankers in downtown Manhattan are pocketing record bonuses meaning seven figures just for showing up on the deal team, while bedraggled workers at the fabled big-box store are seeing in the New Year with news that their new customer traffic-driven work schedules will leave them in the dark as to whether they need to be picking up in Aisle 4 at the same time as their kids need picking up from school or childcare. The services sector may look rosy on the surface but there’s plenty of dislocation afoot and real economic worries…by those same folks we expect to be doing their patriotic duty by shopping, shopping, shopping.
Just as credit card companies and home equity providers enable Uncle Frank to purchase that must-have Deluxe Chrome Titanium Twin-Cam Turbo Grill and Oven Combo, so too do the People’s Bank of China and the Bank of Japan enable Uncle Sam to run up that must-have current account deficit that at last glance was about $829.1 billion. Except that central banks don’t enforce a credit limit on Uncle Sam the way NationsBank does on Uncle Frank. These central banks have been taking on upwards of $450 billion every year to fund our domestic consumption and foreign policy adventures. In practical terms this state of affairs can last as long as the financing required to sustain US trade deficits is matched by the willingness of central banks to build up dollar denominated reserves.
But the dollar is declining, not cyclically but over a longer secular horizon, and central banks can’t prop up the dollar with their own purchases. The bulk of foreign exchange trading is in private, not central bank transactions. Holding assets that are diminishing in value has an economic cost, and the longer the trend continues the higher the cost. This may sound familiar to anyone who was around in 1971 – it’s what led to the collapse of the Bretton Woods agreements and heralded a decade of economic stagnation. In fact the current relationship between Asian central banks and the US is known among a number of observers as “Bretton Woods 2” – and that is not meant to be a compliment.
Bretton Woods 2 and downward pressure on consumer spending could materialize as a perfect storm of a worst-case scenario. We should stress worst case, not our base case, because we have no hard, indisputable evidence that either the US consumer or the world’s central banks will reach their tipping points in 2007. However it seems to us that the bias is skewed towards the negative because we see even less evidence of one or more variables that will replenish household and national debt, buttress the dollar, turbo-charge productivity and perk up income growth across the swathe of the middle class. We ascribe about a 65% probability to a base case a bit more modest than the consensus – GDP growth of 1.7-2.0% rather than 2.2-2.5%, continued woes in housing, construction and manufacturing, mixed results in service sectors and on the bright side a currency-driven pickup in exports relative to imports (which of course adds to GDP). From the remaining 35% we ascribe perhaps 22.5% downside and 12.5% upside of that.
How we see this playing into Fed policy and market trends will be the subject for discussion in later sections of this report.