Shaping a Portfolio for 2011 (l): a macro view

I’m envisioning writing four posts on how I’m shaping my portfolio for 2011.  They are:  a macro view; what’s discounted in today’s markets; what I think about different sectors + overall trends; and, finally, my conclusions.  I can’t guarantee that I won’t deviate somewhat from this plan as I go along, since I tend to use the act of writing stuff down as a way of refining my thoughts.

Today is the macroeconomic view, or at least as much of it as I think an equity investor needs to know.  Actually, better make that as much of it as I’m aware of.

The most basic fact, I think, is that the world is in recovery.  That is to say, global economies are generally starting to grow again in a healthier way than they have been over the past four years or so.  I don’t mean that the world is healthy yet, just that it is in the process of repairing itself.  “Repair” means substantially different things in different parts of the world.

the US

The epicenter of the problem.  In early 2007, what proved to be a massive speculative real estate bubble began to unwind.  Two consequences:

1.  At the depths of the ensuing crisis, the entire world banking system froze up, as financial institutions stopped lending to anyone, even overnight, for fear the counterparty was insolvent and wouldn’t repay.  This problem, which caused the world economy to lurch to a halt, has long since been fixed.

There has been one lasting effect, however.  Industry responded with a rapid contraction of production, including deep layoffs.   Companies have learned that they could operate with far fewer employees than they had imagined.  Therefore, they have been slow to rehire.

2.  Crazy bank lending meant that when the bubble burst and house prices began to decline:

–Lots of people ended up with houses whose value was less than the mortgage and with too much credit card debt

–The country ended up with, to pluck a number out of the air, 10% more houses than anyone wanted/could afford.  The same for commercial–especially retail-oriented–real estate.

This is an enduring issue that is affecting the speed and scope of economic recovery, in the following ways:

a.  Unlike food or out-of-fashion clothing, excess houses and strip malls don’t wear out and can’t be moved.  So until the excess inventories are used up, there won’t be much new construction.

b.  People, especially soon-to-retire Baby Boomers, are trying to get their debt under control and will consume less.  Demand for luxury goods is already back above its pre-crisis peak.  But less buoyant middle- and low-end consumption will be with use for some time to come, I think.

c.  The housing bubble retarded for almost a decade the adjustment of US workers in labor-intensive jobs to the fact of competition from China, India or other low labor-cost countries.  This is likely to be a chronic social problem, and a reason why the unemployment rate won’t improve very quickly.

The federal government response to the crisis has been to flood the country with liquidity by stimulus spending and reducing short-term interest rates to effectively zero.  The idea has been to, as it were, take extraordinary measures to restore a sick person to health, even if doing so may create problems in the future.

From September 2010 onward, signs are that this strategy is beginning to work.  Hiring is happening at a faster rate.  Consumer confidence is rising.  The rate of economic growth is picking up.

My guess is that this trend will continue, and modestly accelerate, through 2011.  I think the recovery will continue to have a 90/10 aspect to it, however.  For the 90% of the workforce who are employed, life is returning to normal.  For the other 10%, however, it seems to me that their situation hasn’t changed for the better so far.

The net of all this is that I think 2011 will be at least as good economically as the consensus expects.  I expect that the aggregate numbers, by ignoring the 90/10 split, will underestimate the strength of high-end consumption and be too optimistic about ordinary Americans.

Two other points:

1.  Not all the liquidity flood has remained in the US.  A lot has flowed through currency pegs maintained by developing countries into the emerging world.

2.  I think there’s still one more economic shoe to drop in the US–state and local budget deficits.  My general picture is that during the boom times, governments of every stripe spent every penny that came in.  Now they are facing retrenchment.  This will mean layoffs of government workers, rather than tax increases.

At the same time, a potential crisis is brewing over the generous medical and pension benefits retired government workers typically have.  Part of this may be envy, part may be partisan politics, part may be dismay that the full cost of government workers has been hidden from the voters–but no matter what the cause, this could become a big issue later in the year.  To what effect?–renegotiation of benefits would result in less spending by government employees.


The UK is like the US, writ somewhat smaller and with one exception, noted below.  Also, most of the toxic transactions made by US financial institutions flowed through London, even though they may have involved US assets and US parties.  Why?  –UK policy was “regulation lite,” in return for which it got lots of tax revenue.

True, the sub-prime mortgage crisis may have originated in the US, but the ultimate “dumb money” in the banking world is state-controlled banks in continental Europe.  And,sure enough, they have ended up holding tons of dubious debt securities and derivatives.

But that isn’t the only economic problem the EU has.  It’s an association of countries that has agreed to maintain a common money policy, but whose members have had very different growth rates–a slow-growing core (Germany and France) and a fast-growing periphery (most of the rest).  A money regimen that’s appropriate for the center has proved to be as overstimulative for Ireland, Spain and Portugal as anyone imagined–and then some.  All that “extra” money sloshing round in the peripheral countries has not been soaked up by the countries in question through restrictive fiscal policy–as it should have been–but allowed to flow into speculative real estate deals.

What’s worse, Greece has been falsifying its national accounts for years.  And Irish banks somehow passed the European stress tests despite being thoroughly bankrupt.

The EU response to the banking crisis has been waffling.  It knows what has to be done–closer fiscal integration–but can’t bring itself to pull the trigger.

Unlike the US, the EU and UK response to government deficits has been austerity.  That is, higher value-added taxes and severe government budget cuts.  The idea has been to fix the problem no matter what the cost in near-term economic progress or pain to the EU citizen.

Not a place to look for domestic growth in during 2011.


International investors have traditionally described emerging economies as acting like options on developed world economic growth, meaning that they move in the same direction as the developing world but with higher highs and lower lows.

That hasn’t been the case this time around.  The financial crisis has been almost completely a developed markets problem, leaving emerging economies relatively untouched.  To the degree that they provide raw materials or industrial/consumer products to each other or to the rest of the world, they have prospered.  And by the World Bank’s purchasing power parity measure, emerging economies in the aggregate product almost half the world’s output–scarcely an option any more.

To the extent that they peg their currencies to the US dollar, emerging economies are in somewhat the same position relative to the US as the peripheral countries in Europe have been to the core.  That is, hugely accommodative money policy in the US is communicated to the local economies, where it’s exactly the wrong thing, though the peg.  In addition, developed world investors have been shifting immense amounts of portfolio capital to the developing world as they search for better returns.  This increases the money stimulus.

The big question for many emerging countries is how to cool themselves down.


These commodity-producing countries have by and large escaped the financial crisis.


In the early Nineties, Japan decided that it would forgo economic progress if that were the price it had to pay to preserve its traditional way of life.  To a Westerner, that continues to be a horrible bargain.  An obsolete industrial base, an aged population and no economic growth in sight.  I haven’t looked for statistics, but I’d be willing to bet Japan is experiencing a huge brain drain as skilled young people move elsewhere.

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