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Chadwick: A Look at 2011

The U.S. Economy

The dichotomy during the last two years between the private and the public sectors of the U.S. economy will continue because the private sector has become lean and mean and is increasing profitability while the public sector has become bloated and inefficient and is running deficits.

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While the private sector is poised to increase both its capital spending and its hiring, the public sector will be forced to make operational cuts, to shed businesses, most likely through privatization and to lay off employees.

The result will be a shrinking of the public sector piece of the economic pie which is good in the long run for economic growth and for profits and thus for the stock market. However, in the short run it will only prolong the major economic and social problem in this country, namely unemployment.

The downsizing by many towns, cities and states over the next several years will have a negative impact on the rate of GDP improvement in the country. I expect that the economy will average only modest growth in 2011—on the order of 2 – 3 percent. This is well below its potential.

Unemployment

Last year at this time I predicted that year-end unemployment in December 2010 would be over 9 percent. I make the same prediction for December 2011, and I hope that somehow I will be wrong.

The cause of the sustained and unacceptably high level of unemployment will be from the required cuts in public sector spending, as cities and states are forced to deal with budget deficits and runaway pension costs. Increases in fees and local tax rates will not be sufficient to close the gap between income and spending.

Inflation

Despite the rising price of oil and a number of industrial and agricultural commodities, inflation will not materialize in 2011. Rising material prices will not have a spillover effect on either total production costs or on pass-through pricing. As a little aside, it is interesting to note that the actual cost of the agricultural commodities in food is only 5 percent of the price of the final product.

Labor costs (in the private sector at least) are not rising in a meaningful way. Home prices are continuing to fall overall, and while there are cities in the country where housing is stable and improving, it is apparent that there is still massive oversupply of housing stock, significant foreclosure activity ahead in the coming year and no incentive for new construction.

Energy prices will likely continue to rise and that will act more as a deterrent to economic growth than as a stimulant to inflation.

The Markets

I believe that 2011 will be a good year for the U.S. stock market, reflecting another year of solid growth in profits. The path of the stock market will likely be volatile as it was this year, but stocks in general are not expensive and growth in earnings will be reflected in rising prices.

Volatility will likely result from headline events that sound scary but ultimately will not bring the market down. Included in the ‘scary headline’ category will be the fears of insolvency on the part of some states and cities. Bankruptcy and bailouts will be debated and opined upon, but I do not foresee any rush by the U.S. Government, i.e. the taxpayers, to resolve the financial problems facing the public sector of the economy. Nor do I envision their problems to cause a repeat of the financial crisis that hit the world in 2008.

Outside the U.S., the challenges facing many members of the European Union will continue to be headline news that will add volatility to the market, but in the long run, the strong countries will bail out the weak countries, and Europe will remain a slow growth sector of the world with an increased layer of debt.

It must shrink its public sector share of the economy, but that process will be much more laborious and painful that in the U.S.

Global economic growth will continue as countries with large populations—formerly known as ‘third world economies’ and now referred to with far greater reverence—become the engine for demand that will benefit more mature economies, the U.S. and Western Europe. That will be good for markets around the world.

The bond market will face greater challenges. The inflation/deflation argument will continue to pull in both directions. Low yields actually have a deleterious impact on consumer incomes and therefore spending, and a rise in yields might actually be advantageous to consumer spending and the economy. In an expanding economy with rising profits, high yield bonds may do very well, while low yielding long term government debt is likely to be an underperformer.

Without inflation as a serious problem, it is hard for me to see interest rates rising sharply enough to impact economic activity in a negative way.

Gold

Two of the smartest people I know have diametrically opposite points of view on gold. I suffer from having witnessed the meteoric rise in the price of gold during the 1970’s, followed by its collapse over the next twenty years, and followed once again by a second decade of meteoric rise.

I think the gold bulls are right, but it scares me when I hear the plethora of radio and television ads luring unsophisticated investors into putting their life savings into gold. All commodities peak out at some time. So will gold this time around.

Summary

The fallout from the global crisis of 2008 will continue to impact economies around the world, but the amplitude will be lower, allowing for a return to a more normalized environment for growth and profits. As health returns to economies, so will investment returns.

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Patricia W. Chadwick has had more than 35 years of investment experience. She is the founder and president of Ravengate Partners LLC, a consulting firm that provides advice on financial markets and global economics.

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