Investment & Economic Outlook 2010
Now that all the economists, analysts, and mutual fund managers have finished flooding the news with their “outlook” predictions and recommendations of the “best places to put money this year” for 2010, my readers can enjoy my yearly Economic Outlook without all the circus.
Keep in mind the information in this article is not meant to be a set of predictions. It is meant as a discussion of highly probable scenarios of what we can expect to see happen, based on the information available today. By knowing the likely possibilities, we can plan for them. We can also capitalize on potential opportunities, and will not be caught off guard by possible negative events.
The Current Recession:
On Monday Nov 30 2009, Statistics Canada reported that the Canadian economy expanded 0.1% in the 3Q, which was the first quarterly gain since the 3Q 2008. On an annualized basis, the economy grew at a 0.4% in the July-September quarter. By way of comparison, the U.S. economy posted a 2.8% annualized gain during the same period.
The government economists and central bank’s technical definition of a recession is two or more consecutive quarters of economic contraction. And so the news, media, retail bank economists, and government were touting that the recession had ended. Like all “leading indicators” and official numbers reported by governments/central banks (CPI inflation, central bank rate, job numbers, etc), GDP growth may be a useful indicator for their purposes. But for the average person and investor, it means very little. We must look at a variety of indicators and metrics that directly affect us, in order to determine if we are indeed out of what everyone else knows as a recession.
We look things such as employment, household incomes, business profits, investments, spending, lending, capacity utilization, purchasing power, etc. I’ll talk more about the significance of employment further in this article, as many metrics that are useful to us are linked to employment and job generation. Looking at all those, we haven’t made it out yet really.
The good news is we’ve managed to avoid sinking into a depression. Last year we talked about how large and deep the economic problems were, and how they affected almost every nation due to global inter-connectedness. Throughout 2009 the problems of Dubai and more recently Greece (and the Euro zone) have illustrated this very well. It is not unexpected that we will continue to see more of this in the foreseeable future. At the root of the financial crisis problems were greed, excess, appetite for risk & credit, lack of responsibility, lack of ethics, short sightedness, and the sense of entitlement, all of which we have seen to be a global and widespread problem. Recent events tell us that nothing has really changed much on that front.
Although there has been much improvement in the condition of the global economy, it is still very weak. The debt worries in Greece show just how financially fragile the Euro zone is (in particular Greece, Portugal, Spain, Turkey, UK, Italy, Denmark). The bright spot in the world has been China, who had to cool their economy’s growth by recent rate increases and tightening of monetary policy.
Length Of The Recession:
Last year we discussed the recession (non-technical) lasting until at least the end of 2010, and was very heavily dependent on the automakers due to the sheer volume of jobs they provided. With the large taxpayer bailout, it is expected that we see some small but sustainable growth by the end of the year. The stimulus packages & bailouts from 2007-2009 require time to have a sustained impact, particularly on employment. Make no mistake, even with sustainable growth, the economy will still remain weak for some time. Recovery to strength will take a while. It is this reason that the term “growth” in the current economic situation gives the public the wrong impression. Think of our economy more like a patient who had recently survived hours in the Emergency Unit. We are now being monitored in the Intensive Care Unit. Our vitals have stabilized, but our pulse is still weak and our breathing is still shallow. Our condition is improving as the months go on, but its still to early to move us out of the ICU. With time we will be out, and real growth & recovery won’t be until then.
Economic recovery is heavily dependent on the employment situation, and that is why it is more likely that it will be a slow steady recovery. We must consider how many jobs have been lost by the many companies that have gone under in the last 2 years. There hasn’t been job creation of the same magnitude to offset those losses, and jobs are still being lost as of today. For example in January 2010, Walmart announced it will cut 10% (11,200 jobs) of its Sams Club workforce. Borders Group Inc announced it will lay off 10% of its corporate staff. On February 16 2010, Ford announced it will lay off 900 employees at its Michigan Mustang plant.
Don’t be overly influenced by the closely watched key monthly employment numbers (monthly job creation numbers) and non-farm payrolls that make the headlines on the morning business reports. What is important is the unemployment rate change over several months (at least 5-6), and the details in the Employment Situation Summary (which gives more detailed breakdown by industry). If the unemployment rate does not decrease significantly in a continued manner over the course of many months, then a recovery has not yet gained traction despite what governments, economists, banks, and analysts say in the news. Many times, they take a very small number of months (quarterly), rather than a larger period of time which is more indicative. They also tend to concentrate on the change in job numbers over the previous month.
In the 2009 Economic Outlook article, we discussed the real possibility that the US unemployment rate would hit the low double digits, due to a variety of causes. In December it was 10.0% (was 9.4% in May, and hit 10.2% in October), which is the highest level in seven decades. The Canadian December rate was 8.5%. In more recent months, the January labour statistics in the US showed it was 9.7%, and remained at that rate in February. In Canada, the rate was 8.3% in January, and 8.2% in February. These are very high numbers.
What will cause the unemployment rate to decrease, is a continued increase in jobs across various industries, and in most parts of the country. It will likely be led by factory jobs (because they would employ such a vast number of citizens that had previously been laid off), then next by the industries that had provided (and also lost) the most number of jobs, and so on. For manufacturing, we want to see current factories increase their number of production lines, and new factories to be opening. Similarly in industries such as retail, you need new retail shops opening or expanding their locations and sales force.
For economic growth in general, companies need to grow & expand, increase sales & production, win significant contracts, and increase capital spending (or R&D spending). Look and listen for this type of news in a variety of industries (retail, industrial, manufacturing, financial services, technology, energy, etc) rather than job creation numbers. With this type of growth, and subsequent employment across the board, household incomes will return to normal levels, and along with it consumer spending.
The US automakers provided 1.6 million US jobs (approx every 1 out of 3). With the corporate restructurings, a significant number of those jobs were lost. Automakers are still struggling. GM has sold Saab to Stryker, and Hummer & Saturn are set to be wound down. Governments also shifted focus to invest in facilities with Japanese automakers, which have recently experienced troubles of their own. Massive safety recalls from Toyota will cost the company significantly in terms of current and future profits. However, the immediate costs are rising on a daily basis. Aside from Toyota, other manufacturers have also initiated massive recalls of their own including GM, and Nissan. Looking forward, the industry will remain weak as competitors juggle with taking market share away from each other while containing costs. Note, that many automakers already experienced financial difficulties prior to the recession.
8 percent of all US jobs were in banking, brokerage, investment, and insurance. A significant portion of those jobs were lost. We’ve seen most of the big banks in both the US & Canada report profits in the later half of 2009 and the 1st quarter of 2010. However, even though delinquencies have declined significantly, they still remain at high levels. Household debt in both countries are at very high levels. A good indication of this is the surge in debt management & debt consolidation advertisements on the radio & TV. Looking at the financial reports of banks, we can see that mortgage delinquencies have declined for several quarters, but still exist. However, credit card delinquencies have increased over the course of the year, as people have shifted from mortgage debt to credit card debt and other personal loans (auto, etc). The reason again, has to do with the poor employment picture.
In February 2010, the Federal Deposit Insurance Corp (FDIC) reported that 702 US banks (local, regional, etc) were at risk of going under, which was the highest level since 1993. The number had increased steadily since the beginning of the recession. 13% of banks on the list have been seized by regulators. Last year, 140 lenders were closed in the US, and already 20 have failed this year. The FDIC expects that number to pick up over the course of the year. Assets, deposits, and banking operations of seized banks are usually purchased and assumed by other banks.
Obama Bank Reforms:
The bombardment began on January 14th, with a proposed ten-year tax on big banks’ liabilities. But it intensified greatly on January 21st with a plan to cap their size, ban their “proprietary” trading (bets made for their own account) and limit their involvement in hedge funds and private equity. Obama wants these measures to be wrapped into a broader set of reforms that is being discussed in Congress and debated by the Senate. It has been characterized as a return to the Glass-Steagall act, but the plan falls short of the Depression-era law. The Glass-Steagall act separated commercial banking and investment banking (repealed in 1999). Banks would be able to continue to offer investment banking services to clients (underwriting securities and making markets). Officials aim is to stop Wall Street from gambling in capital markets with subsidized deposits. The US president meanwhile, proposed draft legislation on a variant called the “Volcker rule.” However, these reforms still do not address the root problem, which are risky bets. The degree of risk being taken is dangerous whether they made on banks’ own accounts, or placed for clients. The quantity is not the problem.
Obama’s proposal of the bank fee/tax is seen somewhat as a revenge tax as well. Why put additional tax on banks, especially those that already repaid TARP? TARP money was not free, and it came at a hefty interest rate (approx 10%), as well as preferred shares that had special conversion features. Make no mistake, the government and tax payers did not give money away to banks. At the same time, why not push reforms or put an additional tax on auto manufacturers that received bailout money, or the high paid labour unions that benefited? Yes, the banks did some stupid things and made risky investments, but not all banks. Insurance companies and the lending institutions of Freddie Mac and Fannie May are also to blame for the mess. Many insurance companies also made risky investments. The country as a whole is to blame, as these activities were able to take place for years. Restrictions on bank activities were loosened even as far back as the Clinton administration. As we can see, a blanket set of bank reforms is not adequate, and a more customized and detailed set of reforms would be more effective. Reform debate has been ongoing for months. However, governments usually pass blanket reform bills, so its likely that it is what we’ll see. Banks will be affected, but we can also expect that they will find ways to remain competitive and profitable in the global market place. Obama’s proposals do not automatically mean that bank stocks will be bad investments.
According to the Bureau of the Public Debt, an agency of the US Treasury, the current US debt is at about $12.5 Trillion. President Obama’s forecast last year was for about an additional $2 Trillion a year in deficits (debt) but that has changed along the way. In February, the US president unveiled a $3.83 Trillion budget. In Canada, the situation was not as extreme. But the current government was pressured by opposition parties to spend more, which further increased the federal deficit. This year’s deficit is projected to be $56 Billion. Last year we were discussing the impact on the working and middle class, who would most likely be paying for it in the form of higher taxes. This outlook has not changed. Taxes are the number one revenue source for all governments.
In Canada, we’ve already seen and are likely to see more hikes to property taxes, fees, services, and everything else we can think of in the foreseeable future. Although the current Conservatives’ budget for 2010 does not include many tax increases, the push for them is strong. For example, Liberal Senators are asking for an increase in the GST back to 7%. The Canadian Federation of Independent Business (CFIB) projected that Canada’s Employment Insurance fund is likely to have a shortfall of $14.7 Billion by the end of 2012, which would mean that an automatic 15% increase in premiums every year would be triggered, until a $2 Billion surplus is restored in 2016. EI premiums are considered a payroll tax. Higher property taxes, business taxes, and increased user fees were part of the proposed 2010 operating budget of Canada’s largest city, Toronto. These examples are only the beginning, and it’s good to be prepared when the bills come due for all of the government spending.
I know much less about health care systems and their fine details than I do about everything else I’ve discussed. But what I do know is that health care will continue to be a huge drag on the US and Canadian economies (more so in the US) for some time. Health care costs per person in the US, are the highest in the world when compared to nations with and without universal health coverage that is provided by both public and private insurers. In a recent CNBC interview, Warren Buffett mentioned that costs in the US were “$2.3 Trillion a year and growing” and are like “a tapeworm eating at our economic body“. He mentioned that countries like Canada and France are quite high as well.
Unfortunately, there is no quick & simple reform that the government will be able to come up with that will solve this. It is a very complicated issue, and those who are in the actual health care industry must be consulted throughout the process. Even with reform, the economic impact will not be felt for many years.
I came across a graphic once, and although it may not be 100% accurate it illustrates the seriousness of the problem.
The Cost of Care [National Geographic Blog]:
Inflation & Interest Rates
Only a month ago economists & analysts were still saying inflation (I’m not talking about CPI numbers here) will not be a problem. But then we see the US Fed thinking about ways to reduce the money supply quickly, in an attempt to keep inflation at bay. Again, do not be confused with inflation and the headline inflation numbers you hear in the news. See article: Why Are There Conflicting Views Of High Inflation? [Understanding Inflation Numbers]
In my past articles I discuss in depth why high inflation is a real possibility. See articles:
– How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices
– The Implications of The Federal Reserve’s Purchase of Treasuries: Inflation
To put things in perspective, here is an indication of what is to come. On Jan 20 2010, the province of Quebec (Canada) has announced that they have reopened the provincial bonds with a settlement of 1/25/2010 and matures 12/1/2010. The coupon is 4.50% per annum. Yield to maturity is 4.12% semi-annual or 4.16% annual.
Don’t’ forget that provincial government bonds are relatively risk free as well. TD Canada Trust is offering a “5-Year Stepper GIC” that will pay 5% in the 5th year. Considering that “high interest” bank savings accounts are giving a measly 2%, the 4-5% sounds amazing. But is it really? The economy has not yet recovered and the financial environment in general is not very good. Yet, they are offering 4-5% in these long term investments. This means they expect when the 5th year rolls around, 5% will not be much relative to the inflationary environment.
It is not unexpected that the savings accounts will be offering 4-5% interest if that is the case. Thinking conversely, if we expect savings accounts to be offering 4-5%, imagine what the retail bank loan rates will be. P.S. Don’t be fooled/lured into locking your money in a long term “high interest GIC”. The retail banks have been aggressive this year with their marketing! On a personal unsecured line of credit, the current rate is around 5.50% at TD. What will it be when high inflation kicks in?
In Economics 101, the usual result of massive government spending like what has happened especially in the US, is massive inflation (and retail borrowing rates). Last year’s outlook on this matter has not changed. The federal government must reduce the money supply in a quick manner in order to contain inflation and its impact. This also depends on when the economy really picks up, which is when they will be able to raise rates more aggressively. If they do it any sooner, they will end up stalling economic recovery which was what all the spending was supposed to stimulate. Don’t count on the government’s ability to be able to do this in an efficient and timely manner.
It is expected that the Fed and BoC may still keep rates unchanged for one or two quarters this year. However increasing rates by 0.25 or even 0.50 percentage points is not unrealistic and would be inline with their own targets. We should not be surprised if the retail banks do not follow suit. If the rate is unchanged, we can still expect banks to raise their prime rate, as we have seen this before. Also, we cannot forget that the retail banks have continually changing spreads, and therefore constantly change their mortgage and lending rates policies. Do not be confused about the central bank’s rate, the retail bank’s prime rate, and mortgage/lending rates. They are all different things.
US housing starts increased in the month of January (six month high), but is seen as a one-off and does not look to be sustainable. Existing home sales fell sharply in the same month. There is no question that the US housing market is still very weak, with too much supply. Prices are still depressed and nowhere near the levels they were 3 years ago. Increased pressure will also come from any mortgage rates increases, which are poised to go up by the end of the year.
In Canada we have a much different picture. The housing sector has been very heated with demand outstripping supply across the country. The underlying supply/demand fundamentals are currently strong, with housing starts below long-term demographic needs. Inventories have continued to decline to very tight levels. Approvals for high-rise condo development have remained high as well. Contributing factors to the high demand include the historically low borrowing costs. When borrowing costs return to a more normal level, it is likely the housing activity will cool off, but still increase moderately due to supply/demand factors. Affordability will be the problem going forward, as increases in prices without significant growth in income levels would be unsustainable in the long run. However, the GTA is expected to continue growing by 100,000 new immigrants a year, and CMHC expects the population growth to sustain the demand and moderate growth in the long term (over the next two and half decades).
For more details see: Update on Canada’s Real Estate Market 2010
Commodities – Oil & Gold
There are compelling reasons for the likely increase in the price of commodities, in particular gold & oil. The debt problems of the US & Euro zone has already devalued the dollar & EUR. Gold is commonly seen as a hedge against inflation, and against the weakening or decreasing value of fiat money. Not much has changed in the outlook for gold within the last two years. Although gold has experienced both short term price increases & declines, the more recent debt problems over the past 12 months (Dubai, Euro zone) have added to the contributing factors. We can expect gold to increase significantly in the years to come, as an inflationary environment takes hold.
We can expect the price of commodities in general to also continue to rise, as the global economies recover and their demand slowly increases. However, like the stock markets, the commodity prices which get traded, will increase before the actual demand.
Oil has already risen from the artificial lows of $40 in 2008-2009 to about $80, within a short period of time. While it is difficult and almost impossible to put a definite target number on it, we can still expect oil prices to rise significantly. There are a number of strong factors that will influence the price of oil.
Most of the world’s “easy” oil has already been extracted, or is in the hands of nationalist governments. These governments will not allow foreigners to exploit it, which has left oil companies with little choice but to find new reserves in increasingly difficult to access and inhospitable areas. Some of the best examples include the Canadian tar sands, the deep waters off Africa, and the frozen oceans of the Arctic. It is important to note that many new discoveries also tend to be smaller than those in the past, with corresponding shorter lifetimes. Such fields also require expensive technology and processes, many of which take very long periods of time to develop, making it less profitable than those of the past. The financial crisis has also made many oil companies extremely cautious. Many had cut their capital spending and investments in future projects, and even halt/stop current exploration projects in order to save money. We’ve seen this in almost all industries, so it should come as no surprise One example include, Shell, which delayed expansion plans in Canada’s tar sands. We’ve also seen huge job cut announcements over the past year from BP (target of 90,000), Shell (envisions 10% of workforce), and ConocoPhillips (4% of workforce).
These actions may create a shortage in supply output down the road, as projects which take years to become online, are not being initiated. When the global economies recover, the demand for oil may once again be greater than the amount of output. Even though there is a shift in the developed nations towards “green” and “eco-friendly” energy sources, the emerging BRIC nations (Brazil, Russia, India, China) which also have very large populations will still consume mainly older/cheaper energy sources. As they develop & industrialize further, their consumption will increase dramatically. The governments of those nations are not very concerned with environmental energy sources. In addition, oil will still be used for many other applications other than for energy. Demand will only increase.
Reaching something like a $100 a barrel within the next few years is not unexpected, but whether it will stay, surpass, or fluctuate at that level is a totally separate issue. At some point it becomes economically difficult to cope with. Yet there is also going to be a continuation of growing demand from both developed and emerging nations. It only makes sense that demand for oil and actual usage of oil, will be greater when the global economies recover, than it is now during the initial recovery stages. With current problems in the Euro zone its arguable whether the world is in the initial recovery stages, or if initial recovery stages are still in front of us.
On a related note the CDN dollar may rise, since Canada is resource heavy, and a major exporter of minerals/metals, and oil.
However, natural gas may not experience a substantial increase due to the large supply and current projects that have come online.
For the most part, the stock markets always precede the events of the economy. The markets decline before the economy actually goes into a downturn. Similarly, the market rallies/climbs, before the economy recovers. This is because the market is moved by the actions of people. They attempt to predict the health of the economy, which is reflected in their outlook of publicly traded companies. When people believe the economy will be getting better, their outlook for the companies and corresponding stocks are better. As a result stock prices are traded higher. This is often the reason why stock markets get ahead of the actual economic situation. This is usually the case whether it is a downturn or a recovery. For the most part, people change their views/predictions of the health of the economy very frequently. As a result, the markets fluctuate wildly.
However, it is important to note that the direction of economy will not tell us direction of the markets. And for this reason I do not predict the movement of stocks or the movement of the market. But what we can do is valuate individual stocks at their current prices.
Warren Buffett has also pointed this out in his 2008 Berkshire Hathaway letter to shareholders:
“But neither Charlie Munger, my partner in running Berkshire, nor I can predict the winning and losing years in advance. (In our usual opinionated view, we don’t think anyone else can either.) We’re certain, for example, that the economy will be in shambles throughout 2009 – and, for that matter, probably well beyond – but that conclusion does not tell us whether the stock market will rise or fall.”
For The Investor & The Individual
– As we discussed last year, the credit tightening should continue, and it has made it difficult to obtain credit/loans for investment purposes. Canada’s recent provisions for real estate loans announced earlier in 2010 have continued that trend. If you haven’t last year, make provisions for obtaining credit or loans now if you think you may need it. This trend is likely to continue further as well.
– Acquire secured lines of credit at current rates (whether for investment, mortgage, etc).
– Opportunity in stocks and real estate (US). In Canada there are fewer opportunities in real estate as we’ve mentioned briefly.
– Ensure you have an adequate personal finance buffer (emergency funds & plan), in order to allow you to make investments without having to necessarily shorten the time horizon on them (usually resulting in investment loss) if a difficult situation arises.
– Ensure you take into account the likelihood of high inflation and borrowing costs that will occur within 2-4 years time. Small rate hikes at the national bank level, may translate to larger increases at the retail level.
– Do not lock GIC’s into long term (multi-year) contracts due to rate increases.
– Revisit your long term investment & financial plan(s) (not to be confused with individual investment strategies).
– See if there are any current opportunities right now, or ones that may possibly come up, that would fit with your plan.
– Remember to also stick with a sound plan and proceed step by step.
– If it needs to be changed, then change it. But do so carefully and conservatively.
Understanding CPI & National Inflation Numbers [CPI Is Not A Cost Of Living Index]
How The Financial Crisis Will Affect The US Dollar, Inflation, Gold, and Oil Prices
Investment & Economic Outlook 2009
The Implications of The Federal Reserve’s Purchase of Treasuries: Inflation
Federal Reserve Considers Selling Term Deposits
Dubai Debt Delay Revives Fear of Financial Crisis
Thanks & Happy Investing!
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