Things appear to be heading in the right direction as we prepare to welcome a new year. GDP growth estimates are being revised upward, corporate profits are up sharply, and stocks are about to log their second consecutive year of impressive gains. Accordingly, bullish predictions about both stocks and the economic recovery are becoming more and more commonplace. Yesterday, Jim O'Neil, Chairman of Goldman Sachs Asset Management, insinuated that 2011 will be the "Year of the USA", with economic growth of up to 4% and stocks up 20% for the year. How did everything suddenly become so rosy?
It is true; there are many reasons for optimism right now. Monetary and fiscal policy is very supportive of economic growth and stock prices. The job market appears to be picking up a bit. Corporate balance sheets are in great shape, profit margins are very strong, and earnings (as measured by S&P 500 operating earnings) are expected to exceed all-time highs. Inflation and interest rates remain low by historical standards. Stock prices, as measured by price-to-earnings ratios, are reasonable by historical standards. Emerging markets continue to grow at fabulous rates. The savings rate has rebounded, leaving consumers in (slightly) better financial condition. Fund flows have favored bonds all year long, and the retail stock investor is still, by and large, on the sidelines.
For our part, we can understand the sentiment shift. However, we still have our share of well-documented concerns about the US economy, foremost of which is the effect of higher rates on the economic recovery. In our December 8 market commentary, we discussed the possible reasons for the recent sell-off in Treasury bonds. To quickly summarize, we suggested that the sell-off could be related to 1) a fear of inflation, given the massive amount of monetary stimulus; 2) the expectation for stronger economic growth ahead; or 3) worries that the US government has become a greater credit risk, given the effect of continued monetary and fiscal stimulus on budget deficits. But regardless of the cause of higher interest rates, a continued rise in rates represents an underappreciated risk in an environment of near-unanimous optimism.