2010 was a year of uneven economic progress.  While there have been gains in some areas, such as consumer spending and corporate profits, there are still headwinds in others, such as housing and unemployment.  In addition, uncertainty on the part of both consumers and business leaders has been exacerbated by actions (and in some cases, the lack of action) of policy makers in Washington.  We are hopeful that in 2011 we will see some of the headwinds subside, allowing economic growth to continue apace.

 

On the plus side, in November, consumers increased overall spending for the fifth consecutive month.  Further surprising the skeptics, MasterCard Advisors’ SpendingPulse estimated a 5.5% gain in retail sales this past holiday season.  Many consumers are slowly coming out of their shells, despite high overall unemployment and lackluster wage growth. Notably, there was a shift in what people bought this year.  Electronic retailers, which had been stalwarts of growth in past years, saw lackluster demand, while value providers saw stronger results.  Consumers seem to be spending more on basic goods, like apparel which saw an 11% increase, than on personal electronics which saw a paltry 1% increase.  It also appears that consumers are not increasing their debt to make these purchases, as outstanding consumer revolving credit continues to fall.  The money appears to be coming from savings, as evidenced by a declining savings rate.  While we posit that spending savings is more responsible than adding to debt, we would much rather see new job creation drive consumer spending.

 

Corporations also increased their demand, as orders for capital goods saw continued, yet sporadic, improvement throughout 2010.  This increase was buoyed by a rise in demand for U.S. manufactured goods abroad, thanks to the weak dollar, and by increased stability in domestic demand.  The latest Chicago Purchasing Managers Index jumped six points on December 30^th to 68.6.  (A reading above 50 means firms reporting improved business outnumber those reporting weaker conditions.)  One possible fly in the ointment is the increase in business inventories.  If real final demand does not continue its recovery, it could create a temporary headwind for the economy as manufacturers reduce production to work off the overhang.

 

On the negative side, the unemployment rate remains stubbornly elevated.  In fact, the problem may be worse than current statistics imply.  Over the next four months, the Bureau of Labor Statistics (BLS) will phase in the ability for respondents to its unemployment survey to report being unemployed for longer than they currently can.  Previously limited to two years, respondents will now be able to report that they have been out of work for up to five years.  Although this will not change the number of unemployed, nor the unemployment rate, it will have an impact on the average duration of unemployment.  Given the phase in, the full impact of the change should be observed this April.  The change will most likely show that the jobless are, on average, remaining jobless for much longer than previously shown in the official statistics.  While this alone is not good news, it may spur policy makers to act to stimulate job growth, rather than continue to simply dump cheap money into the system, which in our view has had no discernable impact on employment.  Although a single statistic is not a trend, we did see a “positive” initial jobless claims report of “only” 388,000 at year-end.  This is the first reading below 400,000 since July 2008.  However, continuing claims jumped by 57,000 to 4.128 million.  We hope the positive year-end initial jobless claim numbers are the beginning of a trend that will continue throughout 2011.

 

In addition to stubborn unemployment rates, housing has yet to start a durable recovery.  Home sales are still very depressed and inventories of unsold homes continue to be very large.  The foreclosure debacles at major banks, and the expiration of the first time home buyer’s credit, have not helped.  The overhang (or shadow inventory) of future foreclosures also looms as an additional headwind for housing in 2011.  A large percentage of recent home sales has been of foreclosed properties, as buyers perceived these to be better values.  In the third quarter 2010 government release, newly initiated foreclosures increased by 31.2% over the previous quarter and 3.7% over the same period a year ago.  Parenthetically, the second phase of quantitative easing (QE2) has not been successful in bringing down long-term interest rates, and by association, mortgage rates.  In fact, since implementing QE2 in November, interest rates on long-term bonds and, in turn, mortgages have risen.  As a result of these factors, mortgage applications dropped 18.6% in the December 17^th report from one week earlier, the worst such weekly reading in 2010.  It seems the Fed has not achieved its objective of keeping long-term interest rates low through quantitative easing.  As a result, the financing cost of buying a home has risen and fewer homebuyers may qualify for mortgages while the inventory of unsold and foreclosed homes continues to rise.  It is possible, given a continuation of these trends, to see housing prices fall further this year.

 

 The Fed has unfortunately become a one-trick pony.  Apparently Fed leaders feel that more cheap money is the panacea for all that ails us.  In the process of creating this wash of liquidity, our currency has weakened but interest rates have actually risen.  This may reflect fears of a future inflation bubble in the U.S.  Inflation is already showing up in China and some emerging economies that experienced robust growth.  More worrisome is that inflation is also making an appearance in economies that have not yet recovered, like the U.K.  Although this may be a commodity price driven blip, it poses a serious challenge for policy makers.  The risk is that rising price expectations become entrenched.  We hope Mr. Bernanke can safely land his helicopter before we hit an inflationary air pocket.

 

Our elected officials in Washington passed some major legislation in 2010.  Some of the new bills created general unease and greater uncertainty in the business community (health care and financial reform, in particular), while some made planning a bit easier (the tax rate extension and the unemployment benefit continuance).  We hope that 2011 sees a respite from additional mega-legislation, allowing consumers and businesses the time to digest these new laws and be better able to plan for a more prosperous future.

 

As for our strategy, we continue on a steady course of balancing major risk aversion while opportunistically seeking returns.  Although there are no longer any soft pitches like there were in late 2008 and early 2009, we feel that there are still enough bond issues from well-run companies that offer reasonable returns without going too far out on the risk or duration curves.  We do not believe it is prudent to lower quality standards or to take excessive duration exposure at this time in order to increase returns.  We believe there will be better opportunities for that in the future.

 

The economy, although weak, seems to be slowly moving in the right direction.  As policy makers, consumers and business leaders gain confidence that these improvements are more durable, hopefully we will see further investments in productive capacity and, by inference, more job creation.  The nascent recovery is built on a fragile foundation of cheap money and a weak currency.  Once we are truly out of the woods, we would expect the Fed to step aside and let market forces determine the correct level for interest rates.  We would also expect our currency to strengthen.

 

As always, we appreciate your support and welcome your questions.  Here’s to a better 2011!

 

 

 

 

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Past performance is no guarantee of future results.  This commentary contains the current opinions of the authors as of the date above which are subject to change at any time.  This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product.  Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.

 

No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.

 

The Chicago Purchasing Managers Index is read on a monthly basis to gauge how manufacturing activity is performing.  This index is a true snapshot of how manufacturing and corresponding businesses are performing for a given month. 

 

Duration is a commonly used measure of the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity.  Securities with a longer duration generally have more volatile prices than securities of comparable quality with shorter duration.

 

 

 

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