2011 Global Financial Market Predictions

I. U.S. Markets

2011 should be another good year for U.S. stocks, with S&P 500 returns in the range of 10%. This will occur in spite of enormous challenges, including still high-debt loads for consumers and governments (federal, state, and local), high unemployment, a moribund housing market, and rising long-term interest rates. Corporations are in good shape: debt loads are manageable, profits have bounced back from the nadir (after 7 consecutive quarters of declining profits through the third quarter of 2009, we have now had 5 consecutive quarters of increasing profits through 2010), and strong growth overseas is offsetting slow domestic growth. U.S. GDP will grow in the 3% range. This represents anemic growth for this stage of an economic recovery, where GDP should be growing in the 5% range. This shortfall is the direct result of the over-leveraging hangover of the past decade. Sub-par economic and employment growth will be the result for many years to come.
The tax compromise reached during the lame-duck Congress in December, 2010 provided some juice to the stock market and will aid economic growth slightly over the next two years, at the expense of the federal budget deficit. This compromise bill was the correct course of action based purely on economics, regardless of the politics involved. Sound economic policy necessitates that a federal government run deficits during recessions and surpluses during economic booms. This provides a counter-cyclical stabilizing force (along with Federal Reserve interest rate policy) on the economy. A good blueprint for this happened in the late 1990’s, which provided the first U.S. federal budget surplus since the early 1960’s. Reduced tax rates enacted in 2001 were also appropriate since that was a period of weak growth. The breakdown in federal tax policy happened during the economic boom years of 2004-2007, where the U.S. budget deficit never got above 3% of GDP at its peak. If we had run a surplus during these boom years our nation would be in a much stronger fiscal and economic situation today. Subsequent to the economic boom, the deficit eroded to ~10% of GDP along with the economic depression of 2008-2009, leaving the U.S. economy in a severely weakened state with few options.
The third year of the presidential cycle has historically been the best year for stock returns, and has generated only one negative return since WWII. The reason for this pattern is that the party in power wants to put policies in place in the third year so that those policies have time to work so they can retain power in the fourth year. Although I predict U.S. stock markets will increase in 2011, it will be accompanied by significant volatility. The Federal Reserve’s $600B quantitative easing program #2 is scheduled to end in June, 2011.
The best U.S. investment category in 2011 will be in the microcap area (stock market capitalization under $1.0B) and large-cap (>$10B) areas. Mid-cap ($2.5B-$10B) and small-cap ($1.0B-$2.5B) categories dominated in 2010. Microcap companies could not easily obtain credit from risk-averse bankers in 2009 and 2010, so they may be ready to finally have their day in the sun. Also, large-cap stocks have been held back the past two years by the banks. Banks returns have been miserable due to their exposure to bad loans emanating from residential mortgages and commercial real-estate. That is slowly beginning to turn around to the point that large-cap company returns should at least equal that of mid and small-caps in 2011. It’s the micro-cap area that provides the best potential in 2011 as unappealingly low interest rates more investor tolerance for risk, coupled with better access to credit make these tiny companies attractive.
The long-term outlook for U.S. stocks is not good. Growth in the U.S. should be anemic for the next decade as emerging economies become integrated with the rest of the world. The world economic pie is growing nicely, it’s just that our slice of it percentage-wise is getting smaller, causing painful adjustment in Japan, Europe, and the U.S., including falling real wages, de-leveraging, and GDP growth averaging 2.0% (instead of the post-WWII average of 3.0%). U.S. stocks look good in 2011, fueled by Federal Reserve liquidity and some bounce-back from the 2008-09 depression, but after that stocks start to look a bit dicey. Higher inflation in the out years coupled with slower growth will almost certainly lead to a contraction in P/E ratios. The current S&P 500 P/E ratio of 14 represent the post-WWII average. However, profit margins are close to a peak. Higher business input costs from rising commodities and hiring (good for the unemployed) will shrink profit margins soon. Single digit P/E ratios are historically not uncommon at all
Stock market cycles generally last approximately 20 years, and a secular bear market started with the internet bubble bursting in 2000. I believe we have about 7-9 more years of generally side-ways action in U.S. stocks between the 2007 S&P 500 high of 1550 and the 2009 low of 700 (1285 currently). So enjoy it while it lasts!
Bond markets in the U.S. had a volatile year in 2010 as anemic economic growth and Federal Reserve policy clashed with fears of incipient inflation. Junk bonds outperformed Treasury bonds slightly as fears of corporate default subsided. Fears of municipal default increased however, causing the municipal bond market to be the most volatile. Interest rates should slowly rise for the next few years, but not in a straight line, which translates to bouts of volatility. This means that bonds will return slightly less than their coupons in 2011: Low single-digit returns for the Treasury market, 5% for the municipal market and high-grade corporate market, and high single-digit returns for junk bonds.

II. Foreign Stock Markets

The three categories of foreign stock markets are: Developed (Europe, Taiwan, South Korea, and Japan), Emerging (China, India, Brazil, Russia, Indonesia, Mexico, Chile, Thailand, South Africa, etc.), and Frontier (tiniest markets in Africa, Middle East, Eastern Europe, South America, and Asia, such as Vietnam, Qatar, UAE, Nigeria, Columbia). The liquidity binge propagated by developed country central bankers is slowly migrating toward riskier assets due to unrewarding domestic interest rates and increased confidence in the world economy and banking system. Frontier market stocks were the place to be in 2010, and will repeat that feat in 2011. These markets returned ~35% in 2010 (tickers FFD and FRN). While these returns probably won’t be repeated in 2011, I expect returns in the 25% range. Emerging markets returned ~16% (tickers EEM and VWO) generally in 2010, but this value is comprised of a wide range of individual country returns. The weakest emerging market in 2010 believe it or not was China, with a return of ~3%. I expect China to do better in 2011, with returns in the 10-15% range. The strongest emerging stock markets in 2010 were in Indonesia (+40%, ticker IDX), Thailand (+50%, ticker THD), and Malaysia (+35%, ticker EWM). These returns will not be repeated in 2011 because inflation is starting to become a problem in these rapidly growing countries. Their governments are raising interest rates to combat rising prices. They are also putting restrictions on a destabilizing flood of foreign investment inflow from around the world.
One European market I like in 2011 is the Irish market. It was labeled as one of the PIIGS (over-indebted countries of Portugal, Ireland, Italy, Greece, and Spain) in 2010 and performed like a pig (down 3% when most countries experienced ebullient stock markets). The Irish have taken pretty tough austerity medicine in their federal budget and borrowed money from the EU for their banks. The market is extremely unloved, which is music to a contrarian’s ears.

III. Commodities

In general, 2010 was a good year for commodities. The broad-based commodities ETF basket (ticker DBC) was up 12% in 2010. As always with commodities, though, this overall return is comprised of a wide range of individual returns, such as palladium (ticker PALL, +79%), silver (ticker SLV, +82), gold (ticker GLD, +29%), agricultural products (ticker JJA, +38%), oil (ticker USO, -1%), and natural gas (ticker UNL, -36%). I believe these returns are part of a long-term secular trend that is based on the desires of the world’s 4 billion poor people to join the middle-class, and therefore should continue for many years, though not at the same torrid pace. In 2010 a decline in the value of the U.S. dollar juiced returns for commodities because most of them are priced in dollars (so you need more dollars to buy the same amount of commodity). I don’t expect this same tailwind in 2011 (see part IV). As is always the case with commodities, there will be huge divergences in returns. I believe the most likely winners in 2011 will be in the agricultural complex because better food is one of the first things that poor folks want when they have disposable income, and these products are much more vulnerable to unpredictable weather patterns. Most other commodities should rise in 2011, though not at the rate of 2010. I expect a volatile year for precious and semi-precious metals, including gold, silver, platinum, and palladium, with final returns up ~15%, after some huge swings and with possibly a blow-off high during the first half of the year.
The energy complex should be higher in 2011 by ~10%, with higher global economic growth outweighing abundant oil and natural gas supplies and a generally higher dollar. Oil prices should exceed $110/barrel in 2011.
The rare-earth metals complex (lanthanum, neodymium, yttrium, etc.) is a very interesting area. China mines most of the world’s rare-earths. They have made noise about restricting exports to make sure domestic demand is met. This sent the world rare earth markets (ticker REMX) into a tizzy and sent some of the western rare-earth miners stocks’ soaring. Expect more volatility in 2011, with announcements from western miners and the Chinese alternately roiling rare-earth markets.

IV. Currencies

Currency movements are driven primarily by perceived sovereign economic management, relative interest rates, and balance of trade. The U.S. dollar was abused in 2010 by the Japanese yen, Canadian and Australian dollars, and the Swiss franc, due to their perceived economic and banking stability. The U.S. dollar held its own against the euro and the British pound in a race to the bottom in 2010, as all three economies had major problems with excessive sovereign debt and anemic economic growth. The Chinese finally started to allow the yuan to appreciate at mid-year, albeit at a slow pace of ~5% per year. This should continue into the foreseeable future. This rate of yuan appreciation is not enough to make a significant impact on China’s huge trade surplus. The Chinese may increase the rate of yuan appreciation to tame domestic inflation (which is currently running at ~5%), not to appease foreign pressure on the trade front. If this happens it will be in the second half of the year.
I believe the U.S. dollar will appreciate against the euro, pound, and yen in 2011 by 5-10% due to rising interest rates and relatively better economic growth in the U.S. The U.S dollar should stay flat against the Canadian and Australian dollars in 2011 because these currencies appreciated in 2010 and are now at or near parity with the U.S. dollar, which is a level that will start to pinch their economies if it continues.

V. Final Tally on 2010 Predictions

I predicted last year that the U.S. unemployment rate would stay above 9%. It ended 2010 at 9.4%. I predicted U.S. stocks would return “high single digits” in 2010, which was low. The S&P 500 returned ~15%. I predicted junk bonds would return 9% in 2010, and they returned 12%. I predicted that natural gas prices would stabilize in 2010, but the increased supply from shale drilling has continued to weigh on natural gas in spite of good demand. I was a year early, as this same prediction should hold in 2011.
I predicted at the beginning of 2010 that gold and gold-mining stocks were a “good buying opportunity.” Gold was up 29% in 2010 and gold-mining stocks increased by 33%. Finally I predicted that the U.S. dollar would appreciate against the euro, pound, and yen in 2010 and depreciate against the Canadian and Australian dollars. I got three of five correct, as the dollar fell against euro and yen.