Encore, Encore! The Outlook for 2011
By Walter Frank
Moneyletter.com
Anyone looking down from a helicopter on the economic and market outlook for next year could readily come to the conclusion that everything is in place for another positive year. The odds are high at year-end that the U.S. will see decent growth in 2011. The U.S. economy came to life over the last quarter of this year and, as it did, it also received two shots in the arm: one from the Fed, initiating a policy of "quantitative easing," and the other from the tax compromise worked out by President Obama and the Republican leadership.
Widening the view to Asia, China and India (the two Asian behemoths) are growing very rapidly, and further rapid growth is the almost universal expectation. Much of Asia is expected to follow, pulled along by the tow of the giants as well as other forces. The only part of the landscape where growth is not apparent is Europe. An experiment in austerity is underway there. Some European economic leaders are confident that austerity will not stifle growth. Many observers are skeptical. We are among them. We find it hard to accept the claim that austerity is consistent with growth. Still, the big European powers do not appear to be facing anything more than stagnation, if the austerity experiment fails. In a nutshell, the helicopter scan of the 2011 horizon depicts a generally positive global investment outlook.
In last year's year-end outlook, we started off saying that throughout the globe everyone was out to achieve maximum economic growth. Everyone still wants growth, but the desire is more nuanced as we look at the various regions of the globe. The U.S., of course, with its economy operating well below capacity has not changed its approach from last year ("full speed ahead"). China, on the other hand, is throttling back a touch, a little concerned about the inflationary and speculative fallout from too rapid growth. India too is trading some growth for restraint on inflation. As for the European region, growth is no longer the prime object of policy, keeping the European Union intact and preserving the euro is now the focus. The push for austerity is surely the EU's response to the sovereign debt crisis.
In terms of economic growth for next year, the U.S. stands out, not because the outlook is for runaway growth, but because we should enjoy the largest improvement, with the opportunity always present for upside surprises.
What is most striking about the U.S. economy now is that optimism has returned. This is most evident when looking at the consumer. Pessimism was the order of the day after the market's crushing dive last spring brought on by Europe's debt woes. Despite the gloom, the economy hung on and continued to grow, however slowly. As growth continued the consumer, to the surprise of many, came out of her shell and with that optimism also began to emerge. All this, mind you, was occurring before the tax compromise between the Administration and the Republicans.
Why do we start with the change of mood? Because one of the features of 2010 is that the "animal spirits," as Keynes put it, were missing from the American economy. Business, for example, is stuffed with cash, but it has been reluctant to invest commensurate with its rapidly growing earnings. More than one reason has been offered for this situation, but surely an important one is skepticism about the economic prospects here.
Now that we have the tax compromise and much better fourth quarter activity, the outlook for next year's economy looks considerably brighter. As usual the forecasts encompass a range, but the forecasters we pay attention to are looking for GDP growth of 3.5%-4.0% over the year. It seems reasonable to us.
Keep in mind that growth of close to 4.0% is faster than we have seen since the recession began in 2007, and then take a look at earnings growth recently. Even with sluggish growth last year and this, earnings have had a remarkable run, continually beating expectations. Given the more rapid growth outlook, we would expect another good year of earnings growth.
Analysts' estimates of this year's operating earnings per share have been running at $85 per share (S&P). A recent Bloomberg News survey of strategists (not analysts) for next year's earnings averaged out at $92 per share. Meanwhile analysts' estimates are running higher at $95 per share. We would side with the analysts.
Right now the S&P 500 price/earnings ratio, using analysts' estimates of next year's earnings, is 13.1. The historical average for the ratio, as we know, is about 16. As you can see the market has room to run.
The same Bloomberg survey referred to above found strategists looking for an 11% gain for the S&P next year. Considering the level of interest rates (we expect interest rates to remain low next year) we would look for something more like 15%, bringing the price-earnings ratio up to a reasonable 15. We expect a rewarding market next year.
We do not think that Asia and the emerging markets will play as large a role in portfolio performance in 2011 as they did in 2010. However, one of our mantras has been 'go where the growth is' and Asia is surely where the most rapid growth will be next year. China is still aiming at 8.5% growth, and expectations are that the conditions are in place for China to hit its target and perhaps more. India too is growing at 8.0% plus and expectations are for such growth to continue next year.
Growth is one thing and the market price for investing in that growth is another. Asian markets are just not as cheap as they have been, as Matthews Asian Funds' Robert Horrocks has been reminding us lately. According to Horrocks the Asian markets (ex-Japan) are selling at about 10% above their long-term average. This is certainly not enough to set off alarm bells, but it does call for reduced expectations.
Having said that, expectations for earnings growth next year in the emerging markets overall remain high. They vary from country to country. According to Standard & Poor's, China's earnings are expected to grow about 15%, while India's will total about 23%. Brazil is tabbed at 18%, with Russia at 13%. (Remember, U.S. earnings are expected to grow about 13%).
In considering the outlook for China and India as well as other emerging markets, inflation is a problem that has to be taken into account. Both China and India have been tightening monetary policy, each in its own way, in attempts to check inflation. China has used a combination of regulatory restrictions and curbing bank lending (raising reserve requirements on banks). India is following the more traditional path of raising interest rates. In either case, money is not flowing as easily in these markets now as it did before. We expect the markets will not pay as much for earnings as earlier.
With all our reservations thrown in, Asia ex-Japan is the only other area, aside from the U.S., that offers the potential of better-than-ordinary performance next year. As noted, China and India are both on track for rapid growth. Right now, if we had to choose among overseas markets, we would go with India. We say this despite the fact that the Indian market remains more expensive than the other Asian markets (it is traditionally so). What impresses us is that India has a huge backlog of infrastructure spending that will keep it busy for many years.
As we know all to well something can come out of left field at any time to upset the most well grounded expectations. Who expected the sovereign debt crisis, essentially a European problem, to tear to shreds a stock market and halt an economic recovery? At the moment, though the outlook for the American market is quite favorable, as is the outlook for world markets in general. Another positive we have not touched on is that it is likely the American investors love affair with the bond market will cool next year.
We are just beginning to see the first signs of a cooling. This goes back to the optimism referred to at the beginning of this article. The public has been extremely risk-averse since the Great Recession unfolded and flows into bond funds have been historic. We expect we will see stages of reversal of that trend next year as the economy improves. A changed attitude toward risk on the part of the public may be more important than anything else for next year's market.
We look forward to 2011 after the Perils of Pauline behavior of the market this in 2010. The most important item to keep one's eye on it's the response of the American consumer to the tax breaks contained in the tax compromise. Another item it the success India and China achieve in turning down the inflation curve. Also, we should not forget that Europe is far from solving its debt troubles. It remains a day-by-day affair. Still, while the year ahead is not promised to any of us, the odds do favor a most pleasant outcome.
Editor's Note: Walter Frank is Chief Investment Officer of MONEYLETTER.com, 479 Washington St., P.O. Box 6020, Holliston, MA 01746. 1 year, 24 issues, $180.
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