Once again it's time for me to demonstrate the foolhardy part of my nature by putting to electronic pen my forecast for 2005. I spend more research time on this one letter than on any four or five combined, simply reading hundreds of pages of research, looking at mountains of data all in an effort to try and catch the gist of the markets. It is a daunting task, but one to which I actually look forward, as it challenges the mind like few other endeavors.
If I go into as much detail as I usually do on each topic, there is the potential for this e-letter to be much too long. Therefore I will try and take the larger picture, make specific and shorter predictions and save the details and the arguments for later issues. Let's begin by quickly reviewing how we did last year.
Each year as I sit down for my forecasts, I try to focus on what the main macro- economic forces are and how they will affect the markets and our investments. In 2001 it was the coming recession; in 2002 it was a weak recovery and the beginning of the Muddle Through Economy; in 2003 it was Surprise and Transition. When I looked back last January on my 2003 predictions, I decided that "All in all, not bad. For masochists and those with lots of time, you can go to the archives at www.2000wave.com and read the 2003 (and now the 2004) forecast issue. But in general, given the vagaries of prediction, I would be glad to do as well this year."
I can echo that again this year. All in all, not bad, with just one major miss.
I called last year "The Silver Lining Economy" as my outlook was fairly upbeat. I called for above trend economic growth, a flat stock market, a falling dollar, rising gold and oil prices and a Bush victory by a small margin. I even thought longer term interest rates would not rise, although I was right for the wrong reason, so that one doesn't count (more on that below).
Where I really missed it was my prediction that the Fed would not start to raise rates until after the election, and then would do so swiftly. I wrongly guessed that Greenspan and Co. would not want to be seen as interfering in the election. Clearly, they showed the usual Fed independence and have since started to raise rates at a slow and steady tempo - what they term as "a measured pace."
The See-Saw Economy
We are all familiar with the see-saw. Who among us did not play upon one as a kid? See-saws work as long as both partners work together. Indeed, with the proper cooperation, they are quite fun. However, there are more than few of you who let your partner get to the top of his ride and then jump off, allowing him to drop to the ground. I, of course, never did that to my younger brother.
The world is in a kind of see-saw economy, precariously balanced between a US trade deficit and foreign central bank buying of US treasuries. In general, I think the game continues though 2005. It is in no one's best interest to stop the game. It should be another good year for the economy, but we are getting closer to the endgame, when one partner decides they are doing all the heavy lifting and the other partner is just along for the ride. And as I explain at the end, it may not be our foreign partners who bail out of the game first.
As is my usual style in the forecast issue, we will look at the macro environment which drives the various markets, make predictions about those forces and from that model will see if we can opine upon the effect those macro- economic forces will have upon the various investment markets.
On the global economic front, first and foremost, the US trade deficit looms large upon my mind. There are those who say deficits no longer matter. We do not care that Oklahoma has a trade deficit with Texas, so why in a global economy should we care if the US has a trade deficit with Asia? Clearly, the US has been running an ever increasing trade deficit for years and our growth is just fine, thank you. Arthur Laffer maintains in this week's Wall Street Journal that a trade deficit is a sign of strength, not weakness, as it means that people are lining up to invest in the US.
Well, not exactly, Art. First, there is no currency risk between Oklahoma and Texas, so doing business is merely an issue of solving credit risks. Doing business in another currency (and with another government) poses major additional risk to the lender and the borrower. The US has so far gotten away with a trade deficit that is almost (and unprecedented) 6% of GDP, but that is primarily because we are the world's reserve currency.
But that may be slowly changing. Roughly half of China's growth in foreign exchange since 2001 was placed into dollars. However, last year China saw its reserves grow by $112 billion, but the dollar portion was only $25 billion. (Source: Bank Credit Analyst)
China has made it clear they are spreading out their reserves and putting less emphasis on the dollar. It is reasonable to suspect that this move to diversify out of the dollar is also putting upward pressure on the euro and other "floating currencies."
Secondly, the level of private investment in US securities has plunged dramatically in the past four years. The difference has been made up by (mostly Asian) central bank's buying of US treasuries. Roughly half of that buying has been by Japan in an effort to keep the yen from rising too much against the dollar and the Renminbi, with other Asian countries doing their part.
This buying spree by primarily Asian Central Banks, and not the lack of Fed action, is what has kept longer term US rates low. It has allowed US consumers to accumulate even more debt at low costs and spend it on Asian goods.
In the 90's, private foreign investors lined up around the corner to buy our stocks and invest in America. Today, the private foreign flow is inconsequential. There is little or no foreign investor confidence in the US. Indeed, look at the very astute Bill Gross's latest column from Pimco. (www.pimco.com) He is not exactly a raging bull on US securities, suggesting foreign bonds as among his favorite investments. This is from a conservative US bond guy!
Foreign central bank purchases of US Treasuries in order to maintain a competitive currency valuation to attract the US consumer is not a sign of strength. It is a sign of desperate foreign central banks trying to maintain their economies which are dependent upon US consumers. They KNOW they are going to get hosed on their dollar holdings, but feel they have no choice.
This is a trend that cannot continue indefinitely, but it can (and probably will) go on longer than we think. The world must re-balance from US-centric growth to a more balanced growth, with Japan and Europe, as well as the rest of Asia, becoming their own consumer engines. But this will not happen overnight, or even in a few years. This is a longer, more drawn out process. When it starts, it will not be fun.
This next part of the process will start in earnest when the Chinese let the Renminbi float. "Ah," you ask, "but when is that?" It will be when we least expect it, or at least when the market does not expect it.
The Chinese agreed to let their currency float by 2007 when they joined the World Trade Organization, so we have an "end date" in the process. They would be foolish to wait until then, as the pressure would become too big, with no way to gauge the response. The longer they put it off, the more the market knows they must move.
So it is likely to be done before then. My guess is that it is done gradually, starting sometime no earlier than the last half of this year (and of course, since I do not expect it until the last half, that means it will almost certainly be at some other time). There are two likely ways for them to go. They could simply set a limit or a "band," say 5%-10% of the current peg, and over time increase that limit. That would allow for gradual change.
Let me point out that it is not altogether clear that the Renminbi would immediately rise if the currency were allowed to float and the Chinese people were allowed to hold non-Chinese currencies. There might be a lot of Chinese companies and individuals who would like to diversify their holdings. Over time, the Renminbi almost surely rises, and perhaps significantly, but the initial moves could be a surprise. Since the Chinese Central Bank and government do not like surprises, they are likely to approach things on a gradual basis. And they will also do it when it benefits them the most.
Or, they might announce that instead of having a dollar peg as they do now, they are going to peg the Renminbi against a fixed basket of currencies (perhaps trade-weighted, perhaps not). That would allow the Renminbi to rise against the dollar but stay relative to their neighbors. It would also allow Asian currencies to stop the competitive devaluation contest they have been in for a decade. They could all allow their currencies to rise, more or less in tandem, against the dollar.
The Asian organization SEATO, composed of ten major Southeast Asian countries, basically announced such a basket of currency reserves policy when they declared last quarter that they would work toward a free trade zone including China. It would be the largest such zone in the world. Part of the deal would be to value their reserves in a basket of currencies of their trading partners, lessening their dependence on the dollar.
(So, how does the US respond to the growth of free trade everywhere? Maybe asking to join? No, we slap a huge multi-billion dollar tariff on foreign shrimp today. Now, there's a threat to the US economy. Coming to a restaurant near you: jumbo shrimp at much higher prices. Your government at work protecting you. Maddening.)
The Dollar: Same Song, Fourth Verse
Before we move on, let's make our more or less annual (since 2002) prediction about the dollar. It will go down in 2005. The dollar went sideways for much of 2004, and then started to fall. It went too far, too fast. Last year I though it might touch $1.40 against the euro. It got to 1.36 before it began to correct last week.
I think the dollar is likely to get stronger for some time, just like it did in the first part of last year. There are just too many dollar bears, and they need to be flushed out of the trade. It will happen. The dollar will rise for some time, and then once again begin its long climb down. This year we could scare $1.50. We are less than half way, in percentage terms of the last dollar bear market, through this dollar bear market. The last dollar bear took ten years, with much of the damage in the first part of the bear.
The revaluation (not demise!) of the dollar is part of the global re-balancing process, and part of the answer to the US trade deficit. So far, the process has been fairly stable. Hopefully it will take several more years. We don't want to live in a time when it happens all at once.
Because the only major currencies which really float are the euro, the Canadian and Australian dollars and the British pound, they have born the brunt of the revaluation process so far. They will bear more of it this year, sadly for them. When I was talking about a euro ultimately in the range of $1.50-$1.60 back in 2002, readers wrote to ask me what I was smoking? Now I get few such letters.
But this, too, shall pass. I think the euro may again trade at parity with the dollar in the next decade. But not before overshooting way too far to the upside in this one. I have written about why this swing is coming in the past, and may do so again. It is an important topic.
(As an aside, we spent New Year's at the Red Eye Grill in New York, watching the ball drop for the first time in my life. I thought dinner was excellent, if rather pricey. But the couple sitting next to us from London thought they were getting the bargain of the year. New York was filled with Europeans looking for a bargain. Meals in London and Paris last year cost me twice what they do in Dallas, and maybe it is just my taste for home cuisine, but I thought the food was not as good. And forget the cost of hotels. And Geneva is even worse!)
Once the Chinese start the ball rolling the pressure on the currencies mentioned above will ease. But until then, they are the true outlet for a falling dollar. Yes, the Asian currencies will slowly let their currencies rise, but not much until they see the Chinese willing to play ball.
And speaking of China, I do not see any real problems for the country this year. Just the usual emerging market, fast growth type of issues that we have seen for the past few years. The country seems to have a handle on inflation. Growth is still very high. Their own consumer market is developing. I will do a series of letters on China in the next few months, but I am still bullish on the country, despite all the problems.
And speaking of international growth, the world economy will slow down from the very robust pace of 2004, but it is not headed for recession and should do quite well, mainly due to Asia. Europe will struggle to post a positive GDP, and sometime later this year, even the incompetent European Central Bank will actually lower rates, though do not hold your breath. Though the ECB is only a few years old, they are making a run at Japan's title for the Most Incompetent Central Bank.
I've Got a Secret - Fed Style
Some of us are old enough to remember the old TV game show called "I've Got a Secret" where panelists tried to guess what a guest's secret was. They would get clues, and could ask questions, and sometimes they would guess the secret and sometimes not.
The Fed is trying to be as clear as they can about current policy, but I am pretty sure they do not know when they will stop the tightening cycle. They are trying to guess the "secret" of when to stop by getting clues from the economy and the market.
The Fed has raised the Fed fund rate by 25 basis points for each of their last five meetings. I think they have made it pretty clear they are going to raise for the next 3-4 meetings. But what do they do after that? Let's look at some recent events.
First, Alan Greenspan gave us the following warning last November (after the election) in Frankfurt: "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged this position by now obviously is desirous of losing money." I think that is pretty clear. His intention is to keep raising rates. The carry trade is in danger.
Secondly, the Fed has started to release the minutes of its meetings on a faster pace, so now we have the minutes from the December 14 meeting. From the minutes:
"...Some participants [meaning Fed governors] believed that the prolonged period of policy accommodation had generated a significant degree of liquidity that might be contributing to signs of potentially excessive risk-taking in financial markets evidenced by quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity, and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums."
How could you take this as anything but a warning that rates would continue to rise? So, the question is not whether rates will rise, but when will they stop raising rates?
The Fed started raising rates in June. Looking at the St. Louis Fed database, the ten year note was bouncing around 4.74 %. They have raised short term rates by 1.25% since then. Normally (like almost always), when the Fed starts raising rates, long term rates rise as well. Maybe not in perfect tandem, but there is a high degree of correlation.
Yet today ten year rates are at 4.28%. Admittedly, they have risen somewhat in the past few weeks, but last June, who would have thought long term rates would go down while short terms rates would rise?
In fact, let me pose you this question. Let's say I told you on Jan.1, 2004, that in the coming year inflation would almost double, short term rates rise by 1.25%, gold goes to $450, the dollar falls to $1.36 against the euro, the economy grows 3.5%, Bush gets re-elected, corporate profits grow by 25%, bank consumer loan delinquency rates fall to multi-year lows, the savings rate drops to 1% (!), the government deficit swells to well over $300 billion and the trade deficit grows to $600 billion. Who, besides Gary Shilling (who always and everywhere expects rates to drop), would have predicted that the ten-year rate would essentially be flat for the year?
I can tell you, I would have missed that one, and I bet you would, too. So what happened? Asian Central banks, and especially Japan, is what happened. Normal foreign investments by private individuals and companies are spread across a wide range of investments. Foreign central banks buy US Treasuries and government obligations. They have bought enough that the price of the longer term obligations has remained fairly stable in the face of a Fed tightening mode.
And now we come to the conundrum. It is quite likely they will continue to buy massive amounts of US government debt. It is also quite likely that short term rates go to 3.25% by this summer. Can ten year rates stay flat with a spread of only 1% between the short term rate and ten year bonds?
Let me jump ahead. I expect the economy to once again grow above my Muddle Through Decade trend of 2-2.5%. We should do about 3%. The trade deficit will grow. The savings rate will stay abysmal. The dollar will drop. Inflation will rise. Government deficits will still top $300 billion. Gold will rise.
What's different about this year and last year if the central banks of the world keep plowing into our bonds at an even bigger pace in 2005? Could it be that long term rates stay flat?
If that were the case, the yield curve would be quite flat by this summer. Would the Fed continue to raise rates, and risk an inverted yield curve? Why would anyone buy a ten year bond for a lousy extra 1% and the risk that goes with it? Unless, of course, you thought the US was going into recession. A long term bond might make sense at that point.
But the flip side of that coin is that long term rates do start to rise. A 5% to 5.5% ten year means a plus 6% mortgage rate, and that will put a serious damper on mortgage refinancing, which has been a major source for consumer spending. Not to mention putting a crimp in the growth of housing prices.
But this is a forecast issue, and I am not supposed to waffle, even if this was the one major area I missed last year (after multiple years of getting it right) and I should be more cautious. Let's see if we can start another multi-year string.
I think longer term rates rise gradually, but not as fast as the Fed funds rate does. I am aware I am disagreeing with Paul McCulley and a host of people smarter than me, but I think the Fed keeps on raising rates, with perhaps a pause or two, until it gets to at least 4%. Their history is that once they get started, they do not stop until there is some pain. Since the signals of "pain" tend to lag, it is quite possible the Fed tightens too much before it stops.
(By signals I mean that most economic data is a few months old before we get it, or can establish an actual trend.)
That is not good for bonds, and it is not a good environment for credit spreads. (A credit spread is the difference between a type of bond, like a corporate or high yield bond, and the corresponding government bond.) Credit spreads are "tight" now, which means the difference between a government bond and other bonds is historically very low. And by tight, I mean REALLY tight. There is no room, or very little, to get any tighter.
How did we get here? Because interest rates are so low, investors looked for any place to get higher yields. And as they poured into high yield bonds, corporate bonds, and emerging market debt, the yield on those bonds relative to government debt has come down, making it a fairly risky proposition if you are playing the spread game.
The Fed is going to continue to raise rates until the economy shows signs of trouble. While the Fed in the past has been willing to cause a recession, I do not think this Fed will do so. They are on the See-Saw between worrying about inflation and creating another speculative economy with interest rates too low and the concern that raising rates too much will squeeze the growth out of an economy that has grown addicted to, if not fat upon, - maybe even dependent upon - low interest rates.
One Caveat: if long term rates do not rise, the Fed will stop sooner than 4%. They will not create an inverted yield curve on their own.
Stocks: A Year of Disappointment
Stocks have "issues," as my kids would say, in the coming year. Right now, they are priced for perfection. We have low interest rates, low inflation, we are coming off a 25% annual rate of increase in earnings and corporate balance sheets are the best we have seen in years. But...
Consensus forecast for earnings are 10% or more. Yet corporate earnings as a percentage of GDP are at an all-time high. There is very little room for above long term average growth. Average corporate earnings rise 6% or so a year over the long term. While I think earnings do grow this year, they do not grow as much as the consensus forecast. Small disappointments will be the norm. And in a market with high valuations, small disappointments are not good. It puts a lid on overall stock market growth.
Further, we are facing one of two scenarios. Either inflation goes up further, or rates go up enough to kill the rise in inflation. Either one, higher inflation or higher interest rates, is not good for stocks.
The economy is going to be good, so I don't think we see the start (yet) of the next major bear leg, although this year will mark the high for what I think will be many years. This will be a frustrating year for stock market investors. You can always do well if you are a good individual stock picker, but broad indexes and mutual funds are not the place to be. The market is a sideways to down market, with the risk to the downside as we get toward the end of the year and a possible recession on the horizon in 2006.
And not to put too fine a point on it, I still think we are in a long term secular bear market. In a few years, we will look back and realize this was a bear trap - another sucker rally.
Gold and Commodities
It goes without saying that if I think the dollar is going down then I think gold will rise. Gold is a neutral currency. As the dollar rallies from its oversold condition over the next few months (or maybe longer), gold will languish. Maybe we even get a chance to buy some more at $400 or less, but at the end of the day, we will see new highs.
The risk to oil is on the upside. OPEC has seen the light. As an example, Saudi revenues are up 90%. Think they want a return to $30 oil? Ditto every oil producing nation. There is a floor in the mid-30's on oil, unless the world falls into a major recession. But as Asian demand (especially China) increases, the pressure on oil is on the upside. Ditto most industrial commodities.
So there you have it. The dollar continues is slide after a rally; the economy grows above trend; short term interest rates rise until there is a sign of problems, long term rates rise a swell, but not as much; the stock market is sideways to down for the year; gold is up and oil is in a trading range with the pressure on the upside; Europe and Japan look to continue to slow; and the Chinese start the floating process later in the year.
One Last Thought on the Trade Deficit
A falling dollar will not be enough to cure the trade deficit. It will also take a rising savings rate from the consumer. What will bring that about? When the next recession comes in 2006 or 2007, the stock market will drop. Average drops during a recession are 43%. The Baby Boomer generation will realize that the stock market is not going to bail out their retirement hopes. They will stop spending and start saving with a vengeance. Problem solved, only it creates more problems. The world will not like it when the American consumer retrenches.
Since the bond market usually anticipates the actual recession, which means that long term bond rates will fall, we should see an inverted yield curve prior to a recession. Major caveat: with Fed manipulation and foreign central bank buying, we are in new territory. The old rules may no longer apply, or be applied differently. Pay attention, gentle reader. This is one we will watch closely.
As far as the end game, the short version is that once the recession starts, the Fed moves aggressively to stimulate the economy, brings back inflation and we get high rates and inflation. Over time, we end up in stagflation. Of course, we will hit the reset button, work our way through that and start the next big bull move. But all that is in our future. For 2005, we can enjoy the see-saw, and hope our partners don't jump off.
My Personal 2005 Forecast
A few months ago, I decided to travel less in 2005. What an optimist. My travel schedule is just as hectic as it was this time last year, although I have hopes it slows down. I am not speaking in the next three months, except in Tampa in early March and possibly London later that month (details coming), but I already have about 12 cities booked for the first four months of the year, plus the usual quick trips which I am sure will develop. Business is good and getting better, but it demands more and more travel. You can't evaluate a manager or a fund over the phone. But these are all good problems.
Yet travel does give me time to read (as well as meet friends), and this year I am going to read more books and essays and less market commentary. I want to think more about change; about changes in the past and what we can learn from them to give us insights about change in the future; what the world will look like in the face of change in the coming decade; and how we as a society adapt to an increasing pace of change. It should make for some interesting, and hopefully thought-provoking, diversions in the weekly letter. Feel free to suggest reading material.
So I see more travel, lots of good times with friends and family, a business that continues to grow, an even more thought-provoking letter. Not a bad forecast.
Last week I finished the letter in New York, with all the staff having the day off. Thus, a major mistake slipped through. I told you the wrong link for my own web site. Not one of my better marketing ploys.
So, repeating from last week, (sans mistake) "... if you think about it, feel free to forward my 2005 forecast to your friends and suggest they go to www.2000wave.com and subscribe for free for themselves." I would be happy if they could join you as one of my one million closest friends.
Here's to our best year ever,
Your dreaming big and thinking large analyst,