Time to re-think 2011.
The news of the last three weeks plus the market reaction to that news demands a rethink of investment strategy for 2011.
2011is going to be a lot less linear, a lot more volatile—if not necessary more or less profitable– than I thought it would be just a few scant weeks ago.
Let me begin by contrasting what I thought then with what I think now and what those changes mean for how to approach 2011.
Here’s what I had thought a few weeks ago: A slow-growth U.S. economy had entered a temporary slump in the second quarter. The U.S. economy that quarter grew by just 1.7% and that low growth rate was enough to set off fears of a slip toward even slower growth. We even got talk of a double-dip recession. That slump yielded to higher 2% growth in the third quarter, but 2% growth was still way below the 2.5% to 3.5% needed to take a serious bite out of unemployment or to reverse a trend that was leading to 0% inflation—or worse, actual deflation. All that was enough to force the Federal Reserve to implement another round of monetary stimulus. (Known as QE2 for quantitative easing 2 and possibly for the program’s resemblance to a big ocean liner that can’t change direction quickly.)
That stimulus would be enough to power a stock market rally, especially when combined with signs in the early fourth quarter of better than expected U.S. growth lead to an improvement in consumer spending that would first show up in improved retail sales. So investors would get a solid, if not spectacular fourth quarter rally as fears of a slump yielded to optimism about holiday spending.
The real growth slump would set in during the first half of 2011 as the effects of the 2008 stimulus in China and the 2009 stimulus in the U.S. faded. That slump would be worsened by efforts in the European Union to reign in government spending and in China to fight inflation by tightening the money supply. The U.S. would be almost alone in the world in continuing a program of monetary stimulus designed to lower unemployment rather than pursuing a reduction in the national deficit.
I did expect the U.S. and global economy to pick up in the second half of the year. Growth in the world’s developed economies wouldn’t be red hot but the second half would see a pickup of 0.5 percentage points or more in growth in European economies and a gradual push in U.S. growth above 2%. Pressure on developing economies would diminish as the supply of hot money from the Federal Reserve’s $600 billion in quantitative easing ended in June. That would result in fewer interest rate increases as developing economies tried to fight inflation and that in turn would remove one brake on economic growth in that part of the global economy in the second half of the year.
The recipe in that scenario was relatively orderly with economic growth and my expectations for the stock markets of the world divided into three stages: a fourth quarter rally, an economic slump in the first half of 2011that would take back some of the gains of 2010, and then renewed growth and stock market gains in the second half of 2011.
As the events of the last few weeks have amply demonstrated, it’s going to be a lot messier than that.
Because the twin crises in China and the Euro Zone don’t have simple do-this-and-it’s-over solutions. Instead they resemble oscillating pendulums that reach equilibrium only after alternating swings to extremes.
And because leaders in both China and European nations seem determined to pursue policies that both stretch out the length of the each crisis and that indeed push the swings of the pendulum to greater extremes.
And because the U.S. economy looks like a real wild card in 2011.
Let’s start with the easiest of the three stories of the last few weeks, the European Union.
The current euro crisis is really two, two, two crises in one. There’s the Irish debt crisis, which has turned into a replay of April’s Greek debt crisis because of a terrible decision, in hindsight, by the Irish government to nationalize the bad debts of the country’s banks. Anybody who does the math now realizes that the Irish government doesn’t have the resources to salvage these banks on its own. Which, of course, has led the financial markets to completely stop lending money to Irish banks. Which has left them propped up only by loans from an extremely reluctant European Central Bank. Which has led to fears that there is no real lender of last resort and that the whole rickety structure will collapse.
I think this specific Irish crisis is working its way to a conclusion in the next week or so that will involve Irish agreement to some kind of bailout of the Irish banking system that is dressed up as a bailout of the Irish government since the European Union and the European Central Bank don’t want to be seen as bailing out these banks.
That agreement will temporarily put an end to the slide in the euro, removing one factor propping up the U.S. dollar, and restore stability to European financial markets.
But that’s only part of the crisis. It’s now clear to all, I trust, that the solution to the Greek debt crisis cobbled together by the European Central Bank and the International Monetary Fund in June 2010 was a temporary fix and not a real solution. The Greek government is not going to be able to deliver the budget deficit reduction goals set out in that agreement and the burden imposed on the country by that agreement isn’t sustainable. As soon as Ireland edges its way out of the headlines, Greece will start edging its way back in.
That will emphasize the long way the European Union has to go to fix the basic imbalances at its core between its surplus economies and its deficit economies. Those imbalances will continue to push Greece and other deficit economies in the Euro Zone toward an actual debt restructuring in 2012 or 2013. As we’ve seen in the Irish crisis, the countries of the European Union have significant differences over how to handle sovereign debt and rescue packages. I’d guess that an actual restructuring will raise tensions in the union even higher, European leaders have already increased anxiety about the long-run viability of the European Union by arguing in the Irish crisis that a failure to rescue Ireland could damage the union. The difficult negotiations about an actual restructuring by Greece or another member will just add to those worries.
What I’ll call the China crisis—the country’s need to slow inflation, deflate an asset bubble in real estate, and get run-away money supply growth under control– shows a similar pattern. Patch work fixes swing the pendulum toward confidence that the situation is under control while, in their inadequacy setting up the swing back to fear when these steps don’t fix the problem.
So for example, China’s leaders have decided to launch a program of price controls on food, subsidies for the poorest Chinese, and increases in fuel supplies in order to control the effects of inflation. Politically that makes sense. The government will be seen to be doing something and for a while the prices for things like cooking oil and cucumbers will stop rising.
But economically price controls don’t do anything to attack the causes of inflation and they can actually derail efforts to increase supply. If you cap the price of garlic at the wrong level, for example, garlic farmers won’t have enough incentive to increase supply. (Unless they can divert part of their garlic to a black market, which pays higher prices, and that, of course, defeats the whole purpose of price controls. There is, already, evidence of speculators at work in the garlic market.)
The problem is that each stop gap measure not only delays the day when the government takes effective measures but also makes it more likely that those measures, when instituted, will have drastic effects. For example, price controls, by diverting attention from real estate speculation just encourage more real estate speculation. And then when limits on loans are actually enforced and big increases in the interest rate paid on savings actually are instituted by the People’s Bank, the odds of a chaotic collapse in the real estate market have grown. (For my take on how serious Beijing is about a real fix right now see my post http://jubakpicks.com/2010/11/17/so-exactly-how-serious-is-beijing-about-slowing-chinas-economy/ )
In China the swings of the pendulum can be especially wild because the Shanghai and Shenzhen stock markets work as giant amplifiers of each rumor about a change in government policy. With so many traders trying on make a yuan by guessing which way Beijing will move, swings from fear to hope are extremely frequent and potentially violent.
Each time Beijing does introduce a new policy the markets react with rally on the hope that this is the last measure that will be necessary to control inflation, to tighten the money supply, or to reduce loan volume. And every time the recently-introduced measure turns out to be inadequate, the markets react with fear of new policies.
What I’m describing is a 2011 that’s dominated by the kind of oscillations that investors have experienced in the last week or two when a rally in anticipation of the Fed’s QE2 program quickly turned into a week or losses and then a really punishing couple of days on a big swing toward fear in China and Europe.
Oscillations of this kind are hard or easy to navigate depending on how extreme they are. And here it’s the performance of the U.S. economy that will determine how far the pendulum swings.
If the Fed’s quantitative easing program works as intended (or if the U.S. economy picks up despite the Fed because it was on the road to faster growth anyway), the swings of the pendulum will be smaller. Rising growth in the U.S. will lead to hopes of the higher growth in Europe that’s needed to help Greece, Ireland, etc. dig out from under a mountain of debt. Faster growth in the U.S. will keep more dollars at home, easing some of the hot money pressure on China, Brazil, and the rest of the gang. And faster U.S. growth will ease some (not much, I admit) of the worry about the U.S. budget deficit.
If the U.S. economy slows in 2011, especially in the second half of the year when all the forecasts are looking for growth, then the swings of the pendulum in 2011 will get more violent because the global economy as whole will be less supportive and countries in the developing world and in Europe’s deficit block will be looking at less palatable policy choices. (For more on how the trend is fighting the Fed, see my post http://jubakpicks.com/2010/11/17/core-consumer-price-inflation-is-still-on-track-for-0/
What does that suggest as an investment strategy for 2011?
You’d still like to be invested for the second half of the year when the odds, to my way of thinking, still point toward a pickup in economic growth.
You’d still like to keep my advice on investing when you fear the zombies are about walk in mind and keep risk under control. http://jubakpicks.com/2010/10/26/how-to-profit-today-when-you-think-the-financial-zombies-will-walk-tomorrow/
And you’d like to make sure you use the swings of the pendulum to buy low and sell high to the highest degree possible within your investment framework.
By low and sell high is, of course, easier to say than do. In my Tuesday pre-Turkey Day post, I’ll write about what it actually means in a market like what I see for 2011.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of the most recent quarter see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/