INSIGHTS

On January 05, 2011

The Black Swan Hoax? - Five unlikely things that could screw up 2011

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By now I am sure you have heard many commentators discussing the unusually bright prospects for the U.S. financial markets in 2011. Not to be left out, we also have a very bright outlook for 2011 with returns from U.S. equity markets potentially eclipsing 20% or more. The FED has not only provided us with a punchbowl to party with, but this time they have built and filled a “punch pool!” The result should be a “perfect storm” for risk assets, in our opinion. With all this optimism, there is a bad feeling in my contrarian core. Are we overlooking something that could really mess up the party? What would it take to derail the good times?

The questions continue to be asked by investors. Have we really begun the long-awaited economic recovery? Does the U.S. consumer live? What happened to the “new normal” which looks a lot like the old normal? In so many ways this recovery is a textbook example that we have seen so many times before. We have seen success given that we have merely not paid attention to the “Doom Sayers” and followed the playbook that has always worked the recessions of yesteryear. Our themes have included:

1. Never fight the FED.
2. Never bet against the U.S. consumer
3. Meet fear with greed and meet greed with fear.

These aren’t very sexy themes but they seem to work; in fact, they seem to work time and time again. Although we don’t see our themes changing, are there things out there we should be concerned with? There certainly are. Here is my fear list for 2011 that could change the outcome of an otherwise very bright year!

1. China slips into recession in a hard landing – Highly unlikely, but the centrally-controlled government of China lacks significant experience in trying to control their economy through economic cycles. If this should happen, the potential increase in demand for commodities and goods anticipated for China would not be required and we would expect a correction in prices. Remember, we believe we are in the middle of a secular bull market in commodities. As such, China stumbling would not change our macro picture but could induce a cyclical downturn.
2. Euro country default – This story is not new but continues to be at the forefront. The nasty budget and debt mess continue to creep slowly across the European continent with no end in sight. We think a default is unlikely as the ECB has made it clear that the members will do what is necessary to defend each sovereign from bankruptcy if - in turn - they will tighten their belts and cut deficits. The U.S. has chosen to go a different direction, electing to stimulate the economy with spending and extending tax relief. I think the U.S. has it right and we are in the midst of seeing the proof.
3. The FED gets their wings clipped – The new chairman of the House Financial Services Committee, Ron Paul, is dead-set in reigning in the FED. In his recent book, he has publically advocated doing away with the FED. He is a hard-currency advocate who wants to return the U.S. to the gold standard. We believe that his colleagues understand his nature and the utmost importance of a non-political FED. We don’t see him getting significant traction; however, if he did, it could upset the global applecart.
4. Sharply rising long term interest rates – If the U.S. began to experience sharply rising long-term interest rates, it could signal a significant inflationary threat. Although we don’t see a threat of inflation with the U.S. unemployment rate in the mid 9%, we would be mindful that the FED has been using extraordinary measures to stimulate the economy. Higher interest rates in the short term are expected with any economic recovery, but large rises in long rates might signal something else. Should we see inflationary pressures return with a vengeance, we would expect the FED to do an about-face and aggressively tighten monetary policy. That would cut the party short and send investors home early.
5. Bond vigilantes stop buying U.S. Treasuries – Again very unlikely scenario, in our opinion, as the U.S. Government guarantee is still the most valued in the world. However, the U.S. is booking trillion dollar deficits annually and those trillions could add up to be the straw that breaks the camel’s back. We saw this aversion to U.S. debt back in the 1970’s when the FED owned about 30% of the outstanding U.S. Treasuries. We have recently seen bond buyers shunning euro sovereign debt. Could this aversion to sovereign credit spread to U.S. markets? Unlikely, but if it did expect an immediate belt tightening ala Tea Party-style.

I understand the odds of these things happening are low. I am not postulating that any of them will come to fruition. However, being the attentive “Nervous Nellie” that I am, I needed to be looking for things that others have overlooked. We remain very bullish on risk assets for 2011 and believe that markets will reward our behavior. We remain vigilant for changes in the “economic tea leaves” that could cause the story to abruptly change.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.