So are we...
Here’s the good news – 2009 is over. Here’s some more good news – 2010 will be better for the economy. Here’s the bad news – 2011 might not be and that implies that 2010 could be a volatile year for stock prices, which appear to lead the economy by six months or so. Bottom line: you should be prepared for a roller coaster ride this year as investors experience mood swings in the face of rapidly shifting economic forecasts and a world replete with geo-political uncertainty.
One might be tempted to dismiss this gloomy chatter. After all, the gloom and doomers have been talking about foreclosures, weak bank balance sheets, high unemployment, etc., for months only to watch the market surge ahead, creating significant wealth for believers in the process. In other words, since March of last year, it hasn’t paid to be a contrarian. After a January/February 2009 market swoon that left markets tapping against lows not felt for a decade, U.S. equities presided over a massive rally that began on March 9th and lasted virtually through the balance of the year with almost no interruption and reduced volatility. The S&P 500 rose nearly 24 percent for the year, while the more heavily cyclical and economically sensitive tech-laden Nasdaq was up a whopping 44 percent.
Investors in certain global markets fared even better. After a miserable 2008, the Shanghai Composite expanded 77 percent last year. Both the Borsa Italiana and Hong Kong’s Hang Seng Index were up more than 50 percent and many other global markets enjoyed returns between 20 and 30 percent.
While some observers may attribute these rallies to the liquidity-enhancing actions of policymakers across the world, the fact of the matter is that one of the primary drivers of equity performance last year was the return of corporate earnings. According to Morgan Stanley, operating earnings per share among S&P 500 companies were down 40 percent in 2008. But last year, they were up approximately 15 percent and are expected to be up 36 percent this year. It is for this reason that there are many who believe that the rally that began in March of last year can only continue.
The Case for Stepped-Up Volatility
As investors know, what makes a market is disagreement. Every exchange of assets, whether stocks, bonds or real estate is a reminder of the differential expectations and valuations between us. In our view, the gap in beliefs is growing as emerging optimism is countered by a growing sense that the good times simply cannot last forever and that reversals of momentum in corporate and economic performance may occur sometime later this year.
For now, economic momentum remains firmly in place. GDP expanded at an annual rate of 2.2 percent during the third quarter of 2009 and as of this writing the consensus forecast for the fourth quarter is north of 3 percent. Job loss has slowed to a crawl, with the Bureau of Labor Statistic’s initial estimate for December standing at -85,000, a far cry from January 2009 when the nation shed more than 700,000 jobs. In November, the nation actually added 4,000 jobs according to the standing estimate.
Reinforcing emerging domestic economic momentum is a synchronized global recovery. Economists from the IMF and other prominent institutions expect big growth years from China, India, South Korea, Brazil, South Africa among others. This creates more global wealth available to pour into equities and other assets as well as an environment conducive to expanding U.S. exports. Morgan Stanley Smith Barney economists expect that the global economy will expand more than 3 percent in 2010. Developing economies are expected to expand 6 percent while developed ones will expand about 2 percent. The U.S. is expected to outperform the collective performance of the balance of the developed world.
Based on this, how can anyone craft a case for enhanced volatility and perhaps even a reversal in market fortunes? The answer is that there are so many gray clouds out there that the likelihood of rain remains elevated. Take the inflation debate as an example – one that promises to intensify in 2010. As has been said before, inflation is everywhere and always a monetary phenomenon. Well, we got money. Both the Federal Reserve and the Federal Open Markets Committee have undertaken a set of unprecedented actions over the past 18 months as they moved the Fed Funds rate to virtually nothing and the balance sheet swelled to more than twice its pre-crisis measurement.
But what can be given can be taken back. The treasury debt purchase program that began during the spring of last year ended in October. The Fed has also announced a tentative cessation of its purchases of mortgage-backed securities at the end of the first quarter of 2010 with an aggregate purchase target of roughly $1.425 trillion. It was the commitment to the purchase of these assets that helped drive down mortgage rates. If the purchases stop, mortgage rates could rise by 1 percent or more in very short order.
Monetary policy will generally become tighter over the course of the year and increasingly the economic impact of the American Recovery and Reinvestment Act of 2009 will begin to wane as we approach 2010. Add it all up and the economy remains at risk of another recession or at a minimum an economic slowdown that batters corporate earnings growth; perhaps in 2011 or 2012 if monetary accommodation is pulled back too quickly. As theories of our collective economic future begin to diverge more forcefully over the months ahead, investors can anticipate a heightening of volatility.
Anirban Basu is Chairman & CEO of Sage Policy Group, Inc., an economic and policy consulting firm in Baltimore, Maryland. Mr. Basu is one of the Mid-Atlantic region’s most recognizable economists, in part because of his consulting work on behalf of numerous clients, including prominent developers, bankers, brokerage houses, energy suppliers and law firms. On behalf of government agencies and non-profit organizations, Mr. Basu has written several high-profile economic development strategies, including co-authoring Baltimore City’s economic growth strategy.