At Mid-Recovery: What Does Our Economy Look Like?

2010 proved to be a continuation of the recovery that began in 2009.  For the year, the Dow Jones Industrial Average finished up 11% with the S&P 500 up 12.8%, and NASDAQ up 16.9%.  Concerns over rapidly rising interest rates proved false with rates actually dropping.  When rates fall, bonds do well as just about every category of bonds had positive returns.  The second year of equity gains can be attributed to five consecutive quarters of strong corporate profits.  Businesses continued the trend of reducing costs, holding steady on payroll and holding greater than normal cash.  Strong corporate performance and business spending remains the best hope for a stubbornly high 9.4% unemployment rate.

Now that talk of a double-dip recession has faded, what will the next few quarters look like? 

The Republican-controlled Congress will attempt to bring more fiscal discipline to new legislation and the budget ceiling.  Concerns over both Federal and state budget deficits will grab headlines causing investors and businesses alike to remain more cautious than normal.  Investors caught a temporary break with the extension of many tax cuts from 2010 but new health care mandates will draw employers' attention to spiraling costs.  While 2010 was a speculator's market in commodities and foreign currencies, look for a reversal particularly in gold and silver.  We expect commodities pricing to revert back to the rules of supply and demand with China and other emerging economies increasing their demand for such raw materials.  Money will continue to flow to the higher interest-rates in foreign currencies until either inflation or a stronger US economy draws money back to less speculative investments.
Result: Take diversified approach to both US and foreign equities; clear winner is undetermined.

We will probably will not see higher inflation, municipal bond defaults nor higher interest rates in 2011.  The Fed is scheduled to buy $600 billion of additional Treasuries this Spring to help keep rates low.  With companies still below capacity, businesses will unlikely raise prices for either products or wages. Due to the new makeup of Congress, government spending and investment will add less to overall growth.

Still hampering the economy are record high personal bankruptcies and commercial real estate delinquencies.  Look for only gradual improvement in 2011.

What are some of the wild-cards in 2011? 

• Federal Stimulus: Quantitative easing (or, the Government pumping an additional $600 billion into the markets) favors investors who buy riskier assets such as high-yield bonds, commodities and foreign securities.  The Fed feels this stimulus is necessary to ensure stability in the markets.  A change in tenor by the Fed could prove destabilizing. 

• New Jobs: 2010 non-farm job growth was 1 million new jobs.  The problem is that we had seven million more jobs at the market peak in December 2007.  There is a direct correlation to the number of new 2011 jobs and overall growth in the economy. Will the new long-term unemployment rate be 6% instead of 5%?  What are the social and economic implications of such a change?
• China:  Increasingly, US policies are determined by events in Asia with China at the center.  What impact will China's military buildup (and political response) have when confronted with an untested, new leadership in an increasingly unstable, nuclear North Korea?  China's double-digit growth rates and larger world role will continue to draw Wall Street firms and institutional investors. Closer ties to the West will bring new pressures on a China that may be unable or unwilling to meet the traditional responsibilities of a world power.  China's thirst for resources and the constant inflationary pressures on food, housing and fuel will challenge Chinese leadership in dealing with an increasingly demanding  Chinese work force.