Crescenzi: Top-10, Top-Down Themes for 2011
When formulating an investment strategy and constructing a portfolio, investors should at all times use as a major input the major macro influences deemed likely to shape the direction of both the economy and the financial markets.
Having a macro perspective is vital because macro influences tend to be both strong and lasting. A sense for the big-picture can help investors to avoid the trappings of short-termitis and be more confident in the underlying fundamentals at the root of their investments, giving them the patience to wait for the best sources of value to be realized as well as to ride winning strategies to their full potential.
Here now is my list of top-10, top-down themes for 2011:
1. The waning of the 30-year "duration tailwind" will compel bond investors to seek out other sources of value in the bond market:
This means focusing away from duration, or the length of maturities, and toward other major contributors to returns, including positioning along the yield curve, volatility, credit selection, and country selection. At $90 trillion in size, the global bond market is a virtual supermarket offering many opportunities for investors to boost returns. These other sources of value did not exist at the start of the journey to the extent that they do now.
Investors in 2011 will see the bond market as a market of bonds, in a vast $90 trillion supermarket where there's a spill in aisle one, so to speak, and it's U.S. Treasuries. There's a spill in aisle two as well, where European bonds are. Investors are likely to tread carefully in both of these slippery aisles and walk down other aisles where they will find numerous other sources of value.
2. The U.S. reserve-currency status will be held intact:
This theme is important because it answers the question of our age: If the U.S. is backing its financial system, who is backing the U.S.? The question is critically important because the U.S. continues to need massive amounts of money to finance its expenditures as well as its efforts to restore stability to its economy and financial system. Thus far, support has been superfluous, as evidenced by both the relatively low level of market interest rates and the broad level of participation in the Treasury's regular auctions of Treasury securities.
The U.S. will preserve its reserve status primarily because it remains the world's preeminent power economically, politically, and militarily. Moreover, the currencies of rising powers such as China are not yet ready to absorb the $9 trillion in reserve assets the world holds, particularly because their bond markets are immature and can't house reserve assets as U.S. markets can.
Moreover, Europe , amid all of its financial woes, isn't even close to ready to take the mantle. The implication of this is that the U.S. will remain a “going concern” and preserve investments in dollar assets, albeit at lower rates of return than in other countries, notably those in the emerging markets.
3. The overhang of unsold homes stay on a downward path, lowering the vacancy rate, and eventually stabilizing prices:
Unbeknownst to many, the supply of unsold new homes is at a 42-year low. How? Home builders have substantially curtailed the construction of homes whilst the population continues to grow. The inventory theme is a bankable one because it relates to a basic necessity in life: shelter. It's simple math. The U.S. population is growing by close to 3 million per year, resulting in about 1 million new households. If builders construct just 600k or so new homes, the net increase in the housing stock is actually much less than that because perhaps 100k or 200k of these are replacement homes, representing the reconstruction of homes from storm damage and such, and as a result of teardowns.
Given the basic need for shelter, people-including those whose homes were foreclosed upon, have to go somewhere. People are born short a roof over their heads and eventually they have to cover, whether by renting or owning. The vacancy rate is already declining and further declines are likely.
This all said, the housing market remains precarious, with about 20 percent of homeowners underwater because of negative equity in their homes and another 30 percent or so within 10 percentage points from being underwater. This will leave a cloud over housing until the demographic influences I mentioned work their magic. Housing therefore is at best set to muddle through its secular problems and it needs a stable economy to do so. This is the base case for now.
4. Seven “C's” will keep the tech sector afloat:
There are many big-pictures forces that will keep technology spending on a sturdy upward path, not the least of which is the tax deduction that Washington has provided for the expensing of new equipment.
Here are the seven “C's” that will add to the momentum already in place: Cost reduction initiatives (the purchase of equipment and software can boost productivity); Competitive forces (in order to maintain competitive advantages, companies can't risk falling behind investing in the best equipment and software); Capital depreciation (the depreciation rate for information-processing equipment is much faster than for other types of machinery, which will tend to sustain investment in technology equipment); Controlling inventory (businesses recognize that having the best technology in place helps them to keep inventories from increasing undesirably, a risk during uncertain times); Capital deepening (businesses recognize that their return on capital is generally good on spending on equipment and software); Cyclical forces (the technology boom that began in the mid-1990s is secular, which means it will rebound when the economy does; Cultural fabric (consumers and businesses simply love new technology: have you walked into an Apple store lately?).
5. The emerging markets will continue to outperform those in the developed world:
Economic growth in the developed world is likely to be constrained by the large amount of indebtedness that exists in the U.S., Europe, and Japan. Much of the developed world has reached the Keynesian Endpoint, a point where the last balance sheet has been tapped and highly indebted nations can no longer borrow from the world to finance fiscal profligacy, resulting in fiscal austerity and slower economic growth in the developed world—particularly relative to countries in the developing world, where favorable initial conditions include demographics, high savings rates, low or zero current-account deficits, and relatively large international foreign exchange reserves, all of which are bolstering economic growth.
6. Consumer confidence will rebound:
Better economic data, cumulative employment gains, further progress in repairing household balance sheets, and a general sense that Washington has moved toward the middle of the political spectrum will likely fuel gains in consumer confidence. The gains will help revitalize consumer spending and increase the odds that the U.S. economy will achieve so-called escape velocity, a condition where the economy is less dependent upon government stimulus and can make it on its own.
Sentiment may improve initially on hope, or expectations for better conditions. What will be more important for the economy and the financial markets is the extent to which forward looking gains are realized, specifically with respect to employment gains. If they are, then the confidence report to watch will be the Conference Board's, because it is the only confidence report with direct questions about the labor market-two of the survey's five questions are about the job market. In contrast, none of the University of Michigan 's survey speaks directly to the job market.
7. Capital spending will grow relatively strongly:
There were already positive forces building up for the capital goods sector of the U.S. economy before Washington enacted the Tax Relief and Job Creation Act of 2010, which, among other things, in 2011 enables businesses to expense 100 percent of their purchases, an incentive that the White House estimates in 2011 could result in more than $50 billion of additional investments. Combined with strong growth in corporate profits, high levels of corporate-held cash, and high levels of returns on capital relative to the cost of capital, capital spending seems likely to grow at a strong clip in 2011.
8. “Torque” in the economy will lead to continued, and probably better, employment statistics in 2011:
Increases in final demand will put pressure on businesses to boost output in order to avoid the loss of market share. “Torque,” or tension, has built up in the U.S. economy over the past year, reflected in high levels of productivity growth, slowing delivery times, and a decrease in inventories relative to sales. No company wants to lose market share, especially in a rising sales environment, such as the current one is.
Businesses respond by boosting output, resulting in an increase in worker hours, boosting incomes and thus personal spending. Round and round it then goes—a virtuous cycle of self-reinforcing increases in production, income, and spending, which is the very definition of what lies at the root of economic expansions. Importantly, torque is also building up in the service sector, where 85 percent of U.S. jobs are. This is evidenced by recent gains in personal spending on services-the best in about four years.
9. Addition by the elimination of subtraction will bolster economic data:
Substantial adjustments to production and employment have already occurred in the U.S. economy that are very unlikely to repeat and if anything could move in the opposite direction, boosting economic activity. Two industries stand out: the construction and automotive industries. In the construction industry, a substantial decline in the construction of new homes, from a peak of about 2 million in 2005 to about 600k recently, left construction workers completing projects with scant jobs to roll into, resulting in a loss of 2 million construction jobs.
Today, the number of housing completions is running about equal to the number of starts, meaning that there no longer is an excess in the number of construction workers still working on projects relative to what is needed for new projects. Hence, there will no longer be any subtraction to the monthly payroll numbers from the construction trade, at least on the magnitude already seen. The situation is similar in the automobile industry. Nearly 500k workers were cut while the industry adjusted to its new normal for sales: a 12 million annual sales rate instead of about 16 million. Adjustments to production are set to move in the opposite direction, with output scheduled to increase significantly in the first quarter of 2011, boosting GDP by about a percentage point on an annualized basis during the quarter.
Another likely contributor to the notion of addition by the elimination in 2011 will be bank lending, where a slower pace of deleveraging would boost GDP. Here's how. Suppose a household in 2010 had $100 of income and used $10 of the income to pay down debt. That leaves $90 for spending. Suppose in 2011 the income level is the same but that households decide to instead pare $8 of debt. That leaves $92 for spending, boosting GDP by $2 compared to 2010.
There are many other ways in which previous drags on the economy will either be eliminated or reduced, resulting in better looking economic data overall.
10. The reflexivity for 2011 will be positivity:
No matter the facts, reality in the economy and in the financial markets is often what people make it. The process by which this happens is what George Soros called “reflexivity.” The reflexivity of the moment is positivity, and it looks certain to prevail in 2011.
It is what will lead the U.S. economy to a self-reinforcing virtuous cycle of increases in production, income, and spending, and it is what will enable risk assets to continue to outperform less risky assets. This condition will prevail for a while. The path to successful investing is to ride these trends and get off before they are discredited.
__________Tony Crescenzi is Executive VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."