1. Interest rates on Treasuries rise.
Interest rates on longer-dated Treasuries begin to rise as 1) deficits remain high due to tax cut extensions; 2) investors lose confidence in the government's ability to address structural deficits (entitlement spending); and 3) commodity prices continue to rise. Central banks across the developing world will increasingly tighten to avoid runaway inflation. The Fed may attempt QE3 but will find that it has lost control of the Treasury market. In response, the Fed will seek new tools to stimulate investment, borrowing and spending.
2. Home prices will fall again.Housing prices will fall an additional 5-15 percent as mortgage rates rise moderately and foreclosure backlogs work through the system. Further home price declines will trigger more defaults and foreclosures as the percentage of underwater mortgages rises from the current level of about 25 percent. The government will be forced to address the deteriorating housing market through initiatives designed to support prices. The resolution of Freddie Mac and Fannie Mae must be included as part of any program to address the housing market.
3. The banking system undergoes renewed stress.
Housing prices will fall and loan losses reaccelerate. Another round of capital raises may be in the offing as more and more banks find themselves undercapitalized based on new Fed and Basel standards. Bank failures may also accelerate, and industry consolidation will result in an even higher concentration of assets held at a handful of huge banks. Investors will seek out the strongest, best capitalized banks and avoid the others.
4. Major rotation in the stock market.
Faced with rising rates and losses on bond positions, investors will rotate into high-quality, high-yielding blue-chip stocks. The "risk trade" in the equity markets will be off as money flows into companies with strong balance sheets and stable, highly visible and transparent earnings.
The largest companies will outperform the smaller and more speculative companies. With regard to industry sector, the non-cyclical industries (health care, consumer staples, technology) will outperform the more cyclical industries (industrials, financials, energy, materials) as investors begin to better appreciate the continued economic challenges. In general, higher stock prices will be supported by resilient corporate earnings, thanks to lean and efficient operating structures.
5. Pain and gain for the E.U.
Germany will succumb to pressure and agree to massive support for the suffering fringe European economies. Painful austerity measures will be implemented across the continent, and some semblance of order will be restored to the bond markets. Economic growth in Europe will suffer, and the loss of investment dollars in Europe may benefit U.S. equity prices.