Our Economic Outlook for 2011

by: James Byrne

The New Year is kicking off with a bang. Economic data continues to suggest the US and global economy remain on a positive trajectory. Be it the downward trend in weekly unemployment claims, the ongoing strength reflected in the Purchasing Managers Index, or weekly Leading Economic Indicators, all point to a sustainable economic revival while chances of a double dip seem remote.

The oft written-off consumer refused to succumb to pressures to conserve and nest. Hikes in personal incomes and spending lead to robust fourth quarter retail sales from dollar discounters to high end bag producer Coach (NYSE:COH). New and existing homes sales received a bump in the recently released November numbers. Granted, there is still much work to be done on this front, but analysts are pointing to this just past year as being the trough. As has been noted in this space many times, the deleveraging US consumer simply cannot do all the heavy lifting this go around.

The good news has arrived. Importantly, emerging markets consumption is gaining traction. History shows between 1998 and 2008 Emerging Market consumer spending rose 66%. That figure represents twice the rate of developed nations. Average per capita spending was 48% higher in 2008 vs. 1998. In 2008, Emerging Market consumer spending represented 27% of worldwide totals. Industry forecasts middle class consumers will grow from 2.5 billion to 4.5 billion by 2025, the majority of which should come from Emerging Markets. The hard work and huge capital investments of the US these last fifty years are finally producing a positive return.

A last fun fact. Since 1947, the ratio of S&P 500 Index to US national Income and product accounts has averaged .86%. It now stands closer to .74%. If profits were to remain constant and the ratios were to revert to the mean, the S&P500 would rise above 1400. GSA’s projection for 2011 is slightly higher for the year. Now to the risks - there just may be a few which we’ll now flag.

1. Political. Domestically, our newly elected Democrat and Republican Tea-Party-ers need to take a cue from Rocker Prince and “party like it’s 1999”. Federal pay freezes and social security benefits age extensions won’t do it alone. We need to roll back budgets and spending to levels not seen this decade to make meaningful progress on our ballooning deficits and maintain our AAA debt ratings.

2. Sovereign Debt default. When looking for potential landmines abroad, Greece still lurks as potentially the first domino (think Lehman Brothers) to fall and potentially ignite a contagion. The trial balloon has already been set afloat into the market. On a quiet Friday afternoon some weeks back in December, Greece officials whispered the idea of restructuring their debt. Under this scenario, bond holders would take a 15-20% haircut to principal along with restructured bonds with lower more favorable interest rates. It was like no one heard or was paying attention and focused too much on the holiday season. Should this restructuring come to fruition - look out. First, it sets precedence and opens the door for Ireland, Portugal and who knows else to follow suit. Banks are major holders of these sovereign bonds and if forced to write down these investments by 20%, it once again would result in recapitalization in the hundreds of billions of dollars or Euros. The effect would be another choking off of lending. Austerity needs to reign here.

3. Inflation. Since core inflation is benign, we have no worries here. That is, if you don’t eat, heat your house drive a car etc. The proliferation of ETFs, coupled with the debasing of the US greenback, has sent some commodities parabolic. These spikes push higher prices into the pipeline that eventually may/should work their way to the general economy and pricing of goods. A super spike in oil needs to be monitored as this would surely have a profound impact on consumer spending and sand up the gears of our domestic economic engine.

4. Real Wildcard. The US Treasury has a near failed bond auction, meaning, the Treasury attempts to raise cash via a usual bond auction. A near failure would be if the bid to cover ratio is less than 2-1. Our typical auctions reflect 2.5 -2.6 dollars in bids for every 1 dollar in bonds being offered. An auction with 1.9 to 1 would be terrific for most any other country, but not the US. This would send shock waves throughout all markets globally.


Monetary policy remains highly accommodative, and due to continued housing market weakness, should remain so throughout 2011. The Federal Reserve's current QEII purchase plan may not be fully executed due to the quickening pace of recovery which would/will cause market disruptions and a resumption of volatile market swings. S&P 500 earnings are anticipated to come in close to $94 a share. Residing in a low interest rate, low inflation rate deficit cutting environment should allow for P/E expansion closer to 15-15 1/2. This brings us to our target range of 1410-1450, or roughly 12% higher. This also assumes US GDP expansion of 3-3.5%. Should earnings momentum accelerate to the upside, we would look to upgrade our targets. GSA believes the challenge, aside from any near term round of profit taking, is in handicapping Chairman Bernanke’s ability to identify when and how aggressively to remove any excess liquidity sloshing around the markets in late 2011.

We maintain our aggressive investment posture entering 2011, but remain focused on the progress already made by the markets exiting 2010. Should the market enter into a round of profit taking that appears to be morphing into something more, we will act accordingly.

While I've been a fan of AIG in the past, the problems brought on by one small division that nearly crippled this company had me question the risk management policies, or lack thereof, at this industry titan. New management and better oversight allows me to introduce AVF - exchange traded debt into discussion for income investors. Sporting a 7.7% coupon, yielding 7.9, two years of call protection and CEO Benmosche at the helm, investors can feel a lot more confident bringing AIG back into the fold.

Yours in pursuit of the Kwan.

Disclosure: I am long AVF, AIG.