Always watch where you are going. Otherwise, you may step on a piece of the Forest that was left out by mistake.
~Pooh’s Little Instruction Book, inspired by A.A. Milne
On Monday we reviewed our thoughts on 2010. Today we’ll look at a general outlook for 2011. It’s difficult to predict the direction of the economy and next to impossible to foresee the twists and turns of the stock market over the course of a year, so I won’t attempt it. Still, it’s good to at least be aware of some of the key themes that could affect your money and your life in the coming 12 months.
There will be two parts to this article as there was too much information to fit it all into one. The first part will present a general overview while Part II will get into more specifics. I’ve tried to put together a comprehensive sample of the views out there as we begin another calendar year.
By far, the current consensus is more bullish than bearish. Sentiment readings, volatility as measured by the VIX, and many of the 2011 prediction articles out there are overwhelmingly positive. That feels pretty good after the tumultuous period we’ve just been through, but it also makes a lot people want to fade that sentiment and take the other side of the trade – at least in the near term.
Bulls vs. Bears
Richard Bernstein is bullish on the markets for 2011, feeling that stocks will outperform bonds, and that energy and materials will remain strong while gold will likely correct. On the other hand, the Economist’s Buttonwood blog has a bearish view on the markets in 2011:
Indeed, for all the efforts of governments and central banks, many of the global economy’s long-term problems have yet to be solved. The banks are weak, the American housing market is still in the doldrums and the global imbalances have not gone away.
Like all great debates, there is probably some truth to both sides of the argument. All of the facts cited in the bear case are true. But they were also true in 2010, which was pretty bullish for the markets.
Bifurcation & Biflation
Last year I thought debt would be the primary theme. This year, I think we will continue to see divergences that have been building over the past couple of years grow wider, but not necessarily resolve themselves. For me, the dominant theme of 2011 will be bifurcation: a growing divide between the haves and the have-nots in the following areas:
- Biflation: Inflation continues to be an issue in the commodities markets as food and energy costs rise. On the other hand, deflation is still very much an issue in the U.S. housing market, and the persistently high unemployment rate is not helping. Biflation will persist in 2011.
- Consumers: We are still seeing a big divergence between the spending habits of high income vs. low income consumers. (The middle class continues to melt away.) So high end jewellers are doing well, but dollar stores are expanding as well. The bounce in the stock market over the past two years is decidedly more favorable for the well-off, as they are much more likely to participate in the markets.
- Countries: The biflation battle is being fought at the sovereign level as well, with surplus countries like China and Germany trying to quell inflation while highly indebted sovereigns like the rest of the euro zone, the U.S., and the U.K. are working hard to stave off a deflationary debt spiral.
While these divergences are unlikely to carry on indefinitely, I’m not so sure any of them will come into balance in 2011 unless some sort of crisis forces the issue. That’s certainly possible, but the market’s recent resilience shows that it can ignore serious issues for quite some time. Hopefully, these imbalances will be addressed gradually over the long term instead.
Quantitative easing has magnified these cross-currents by helping to boost commodity inflation. Unfortunately, it has so far only served to heat up economies that are already too hot while imposing an additional tax on struggling economies in the form of higher food and energy prices. Those price increases are now starting to move into the real economy and it will be interesting to see how this will affect consumption in 2011.
A hasty guess would be that rising food and energy costs will hurt the lower part of the income spectrum a lot more, but that the upper end would be more affected if higher commodity prices led to a correction in the stock market. Up to this point, markets have risen with commodities. But at some point, higher gas and grocery prices become a drag on the economy and the markets.
Knight Research put out a note in November that took this a step further, calling Game Over on the emerging market and commodities trade that took off again in 2009. They view the resurgence as an “echo bubble”, observing the following:
We believe that the end of the Great Consumer Credit Cycle and the vast structural differences in the terms of trade between the United States, the EU, and China, have finally caught up with the secular bull thesis on Emerging Market and Commodities. Quite ironically, the Fed’s aggressive policies will likely prove to be the catalyst which breaks China’s unbridled expansion of credit and non-economic growth, ushering in a wholesale rebalancing of risk assets.
This type of dynamic could play out eventually, but it remains to be seen whether 2011 is the year that it becomes a reality. On the other hand, I’m sure there are plenty of investors out there who hope that China experiences a serious short-term setback as they are extremely bullish on the long-term prospects for the emerging markets/commodity trade.
If you want a quick look at 10 Things to Watch for in 2011, I can recommend John Nyaradi’s list. He acknowledges the current bullish sentiment, but offers a few items to watch out for in order to avoid getting too caught up in the New Year euphoria.