It’s that time again. January will be over by the time you read this which means we are out of holiday excuses or “just ramping up for the new year” reasons for not getting back to work. Having said that, I’d like to offer my excuse for the Annual Forecast getting to you in February instead of the first week of the year. Hand over my heart, we started early this go-round. We’ve spent the last few months committed to gathering data, then analyzing the incredibly complex interaction of markets, economies, and government policies around the globe. This process happens year-round, but the Annual Forecast is an especially important chance to that extra step back to see the big, big picture. Come late December I began pulling it all together into this forecast. When I was finished it was about 4 times longer than what you are about to read . It didn’t take long for Chris to set me straight.
Chris: “I don’t care how brilliant this is, nobody is going to read 16 pages without some incredibly provocative photos.”
Clyde: “But I worked really hard on this!”
Chris: “Well, then I imagine you’d want people to read it.”
Sooo…the Executive Summary.
Not quite bullet points. Not quite novella. For those of you who wish to understand how I arrived at these conclusions or can’t stand to let a red-hot page-turner on economics go to waste, we’ll have the entire forecast on our website within a week. We also plan to publish it in digestible pieces over the next few weeks. If this one turns out to be half as prescient as last year’s forecast it will be well worth your time. For some behind-the-scenes action, check out last yea r’s Annual Forecast here.
Here’s what the 2013 outlook boils down to:
The world has changed a lot in the last decade. US, Europe, China, and Japan, the four largest economic zones, all share a common demographic fate of an aging population. Changes in relative wage costs, automation, and exchange rates are driving some companies to close manufacturing operations in China and expand them in the US. Japan has recently adopted very aggressive economic policies, which like Europe and the US now reflect a commitment to deliberate debasing of their currency in a desperate attempt to manage excessive government debt. Widespread competitive devaluations among major economic powers have not been commonplace since the 1930s. These policies have long-term economic implications, all of which are designed to reduce an unmanageable burden on debtors by lightening the wallets of creditors and savers through inflation.
Japanese economic growth has been virtually non-existent for over two decades. The Nikkei (Japan’s major stock market index) is trading at less than a third of its peak 23 years ago. Government debt, an aging population and a shrinking workforce remain problematic. On the other hand, unemployment has remained relatively low (around 5%) and per capita incomes (inflation adjusted) have largely been constant.
The success is absolutely amazing when we consider that Japan is an export-dependent economy and the easy-money policies of the Fed and ECB raised the value of the yen to only 75 per dollar. Remember that a strong currency is bad for exports and vice versa. Anticipation of Japan’s recently announced monetary and fiscal polices have already reduced the yen by more than 15%. This means they can either cut prices or the profit doubles on every Lexus they ship. Furthermore, they have businesses around the world whose profits will soar when translated into yen at the new exchange rates. US investors will suffer from currency translation when investing in Japan, but the gains from rising profits will be more than double the currency losses. I consider Japanese stocks this year’s best equity bet.
In 2012 global financial markets were focused on the fiscal crisis in the weakest European Nations: Greece, Italy, and Spain. One year ago we said, “The European Union as a whole is actually more solvent than the US…growth in 2013 will be back close to zero and the Euro will survive.” Our script continues to play out. Creditors (mostly German) have written off substantial portions of bad loans. Actions by the European Central Bank have assured creditors that sovereign debts will be repaid and interest rates on bonds are back down to levels that countries can afford. European debtors have been forced to renounce their socialist policies and expand free markets in exchange for debt forgiveness. The bottom line is the recession continues on the continent, but as we expected, growth is possible in 2013.
Greece is too small to matter while Italy and Spain have made great progress. The weak link is now France. France may not have problems on the scale of Greece, but it is too big to fail. Unlike Bernanke’s egomaniacs at the Fed who act as if everything will be OK if they just print enough money, Mario Draghi is acting like a central banker. The ECB became the lender of last resort in the crisis. The problems continue, but the crisis has past. The banks of Europe are repaying their loans and the balance sheet of the ECB is shrinking. For investors like us, this means the Euro will be the strong major currency of 2013. This will suppress exports, corporate profits, and inflation. A huge portion of European profits is earned on the continent. European stocks are cheap. Therefore we like this sector. Profits will rem ain soft, but for US dollar investors, the gains on the currency translation will make European stocks a viable option.
The working-age population in China is shrinking. Wages have been rising at a double digit pace for more than a decade. Despite the recent slowdown, the Chinese skilled labor pool is fully employed. Although Chinese labor remains cheaper than US labor, it is now very expensive compared to labor in less developed economies like Vietnam, Burma, and Latin America. Like the US, the Chinese can no longer compete in labor-intensive industries. High volume automated production uses very little labor so the Chinese cost advantage relative to the US is evaporating.
Wage inflation and a housing bubble preclude aggressive monetary action by the People’s Bank Of China. The Chinese economy should grow a bit faster in 2013 and Chinese stocks should continue to rally from the lows reached last year. That rally is only a bounce. The economic growth rate is on a long-term secular decline. Chinese stocks may be a good trade, but they don’t look like much of an investment in spite of expected continued strength in the Yuan.
Latin America and Southeast Asia
Like China a decade ago, emerging markets in Asia and Latin America continue to enjoy labor costs that are inexpensive relative to the developed world (as well as China and Korea). Like agriculture, some manufacturing is still labor intensive. These jobs will continue to shift to these emerging economies for the foreseeable future.
Although manufacturing wages in emerging economies are low by our standards, they are high relative to wages currently earned by the majority of their population. Income equality is increasing in places like Latin America. This is allowing a growing portion of the population to enter the middle class. Look for these economies (despite socialist agendas in places like Brazil) to outgrow the rest of the world. Lots of issues remain but we see serious opportunities in Latin American and Southeast Asia. This will be a bumpy ride, wait for a correction before investing heavily.
Unlike 2012 I am bullish on commodities in 2013. Both metals and energy prices are poised to rise. Gold may or may not continue its recent decline to the levels I forecast last year, but gold prices will bottom this year then begin to head higher eventually (not in 2013) reaching $2100/oz.
The United States
The most important single driver of the US economy over the next two decades is changing demographics. Each day, approximately 10,000 baby boomers turn 65. A second demographic factor is that their children (the echo boomers) have postponed creating households and have some catching up to do. To a large extent they are a “peter pan” generation. This generation has refused to grow up, postponing marriage and parenting much longer than their predecessors. Now with biological clocks running down they feel the need to have their own place and cement their careers. Over the next decade, much of my generation will retire, sell our homes to raise cash for retirement, and even pass on. The next generation will begin to take our places, our jobs, and our homes. But most importantly, they will pay our Social Security and Medicare Bills.& nbsp; These demographic changes will drive every aspect of the US economy. Ignore them at your peril. Yes, Alfred E. Neuman, it might just be time for you to start worrying. Start with the Federal Budget.
The Fed is still providing excess liquidity, the housing recovery is accelerating, state and local government cutbacks will be smaller this year, while growing US competitiveness means exports will rise faster than imports. A key factor is that US labor costs are rapidly becoming competitive with China. Those gains will be limited by the payroll tax hike, sequester-related Federal Budget cuts as well as an end to quantitative easing later in the year when inflation approaches 3% and unemployment falls below 7%. Look for home prices to rise 5-10%, unemployment to drop below 7%, real GDP to grow closer to 1% than 2%, and consumer prices to rise around 3%.
S&P 500 as reported corporate profits managed to flat-line in 2012. Thanks in no small part to stock buybacks and the deferred tax effect of holding foreign earnings offshore. Buybacks will continue in 2013, but foreign profits will become a smaller piece of the pie this year. With money earned in the US taxed at 35%, a lot less of it will drop to the bottom line. Add in rising labor, energy, and material costs and you get lower profits despite higher US output.
In the fall of 2012 the S&P 500 came close to our forecast high (S&P-1500) and has pierced that level this week. Last year we suggested that not only was the S&P likely to reach 1500, but renewed bullish sentiment could take us back to the old highs of 1565. It’s still a coin flip whether that will happen. Now with valuations stretched, profits under pressure, and investor sentiment extremely bullish (a contrary indicator), we are looking for the stock rally to be followed by a major correction of at least 15%. The only reason to buy stocks at these prices is because bonds are terrifying. Unlike stocks, bonds have no upside from these levels and are also poised for a double digit decline as 10 year TBond yields rise to 3% before year end on their way to even higher yields (lower prices). This means that bond ownership poses a serious hazard to your wealth. If things go wrong, the short-term risk may not be any greater than the risk in stocks, but unlike stocks, there is absolutely no possibility of profit if things go right.
Even Helicopter Ben & Co. are starting to hint at the limits of printing money. The Fed recently indicated that evidence of either protracted inflation above 2.5% or unemployment rates below 6.5% would end quantitative easing. One, if not both, of those criteria will be met either by year-end or soon thereafter. Changing demographics and a more stable global environment will reduce unemployment and raise wages. Combined with rising energy costs and a weak dollar, you get consumer prices rising 3% by year-end along with sub 7% unemployment.
And that’s the short version…
Chief Investment Officer
Unless otherwise indicated, investment opinions expressed in this newsletter are based on the analysis of Clyde Kendzierski, Managing Director and Chief Investment Officer of Financial Solutions Group LLC, an investment adviser registered with the California Department of Corporations. The opinions expressed in this newsletter may change without notice due to volatile market conditions. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and Clyde Kendzierski believe this information in the commentary to be accurate and reliable, however, inaccuracies may occur.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
Investors should consider the charges, risks, expenses, and their personal investment objectives before investing. Please see FSG’s ADV Part 2A containing this and other information. Read it carefully before you invest
Performance results reported herein were achieved in actual accounts managed by FSG. These accounts serve as model portfolios for FSG’s Diversified Sector Program and Fixed Income Sector Program. These accounts belong to Clyde Kendzierski, Managing Director and are not charged advisory fees. Results reflect the net return to clients after expenses including advisory fees, commissions, fund management fees, and redemptions charges, if any, and reflect the reinvestment of dividends and other earnings. Performance returns are presented against the S&P 500 to show material economic and market conditions present during the period of time that FSG’s performance is presented and is not meant to serve as a comparative index. The S&P 500® is an unmanaged capitalization-weighted index of the prices of 500 large-cap common stocks actively traded in the United States. Results shown for the S&P 500 Total Return index represent total return including dividend reinvestment, but excluding commissions. The Total Return index is calculated using data provided by Standard and Poor’s. These results have not been audited. However, some results have been independently calculated and verified by an unaffiliated accountant. Where applicable, documentation is available by request.
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