This is the twenty-sixth time I have prepared a list of The Ten Surprises and I can tell you it doesn’t get easier. My definition of a surprise is a market-influencing event that the average investor would only assign a one out of three chance of taking place during the year, but that I believe is “probable,” that the event has a better than 50% chance of happening. The original idea for the Ten Surprises came from my analysis of my own investment performance. All the serious money I had made for myself and others had come from having a non-consensus idea that turned out to be right.
When I first started doing The Ten Surprises in the 1980s, I did not even think about keeping score, but that was naïve. Finance is basically a quantitative profession where everyone measures everything. Over the years I have generally gotten five or six of The Surprises pretty much on target, depending on how generous you want to be with the scoring. The purpose of The Surprises, however, is not to prove that I have some ability to predict the future. I do not believe anyone can really do that. The Surprises are presented to stretch my own thinking (and perhaps yours) so that you will seriously consider a set of reasonably possible events that you might have previously thought were unlikely. In this month’s Commentary I will present The Ten Surprises of 2011 and a set of “also rans.” The “also rans” or alternatives did not make the basic list because I thought their chance of taking place during the year was less than 50% or they were not events that I personally thought were as important as the basic list of ten.
But first let’s review The Surprises of 2010. Looking at the overall list, I think it’s fair to say it was a below average year. The previous year, 2009, was the best one I had ever had with about eight or nine of The Surprises working out, so perhaps I should have been prepared for a rough year as the process reverts to the mean. In assessing last year, it is clear that I was too optimistic on the United States economy and the Democrats’ performance in the November election and, like many, too pessimistic on bonds and the U.S. equity market. I completely missed the biggest surprise of the year: the Greek financial crisis and related sovereign debt problems in the European Union. Some of the surprises that were particularly off the mark early in the year began to look better in the fourth quarter, however.
Examining the first surprise on the U.S. economy, I might have been overly influenced by the strength of the fourth quarter of 2009. As it turned out, a large part of that was inventory building and that continued into the first quarter of 2010. Then the pace slowed down significantly. I had thought growth in 2010 might have been as high as 5% and the unemployment rate would drop below 9%. Those estimates were not realized. I was right that the Standard & Poor’s 500 would earn more than $80 (operating) which was one of the highest estimates at the time. It now looks like earnings will come in at $85. Because I thought the economy would be strong, I expected the Federal Reserve to engage in a series of tightening moves in the second surprise. In fact, the Fed was accommodating all year and began a second phase of quantitative easing in the fourth quarter.
In the third surprise I believed U.S. government bond interest rates would rise for two reasons. First I thought the stronger pace of the economy might force rates higher, and second I believed foreign investors would become concerned by the huge Federal deficits and demand a higher rate of interest on longer-dated bonds. As it turned out, the economy was weak and a general atmosphere of apprehension prevailed in the international investment environment, driving many into U.S. government debt as a kind of safe haven. That thinking also benefited gold, a long-time stalwart of The Surprises that was not on last year’s list. During the course of the year, the yield on the 10-year U.S. Treasury dropped from 3.835% to 2.33%, but closed the year at 3.4%.
The fourth surprise, my thought that the Standard & Poor’s 500 would be flat for the year, looked pretty good through the end of August. The S&P crossed 1115 no less than 165 times in the first eight months but bearishness became unsustainably extreme by the time of the convening of economists at Jackson Hole at the end of the summer, and the stock market took off in September, historically the worst month of the year for equities. The S&P 500 ended 2010 at 1258.
In my fifth surprise I thought the dollar would surprise investors in 2010 and be strong against both the euro and the yen. My argument for this was based on the observation that the dollar was attractive on a purchasing power parity basis. The euro dropped well below my 1.30 target but despite disappointments in the Japanese economy, the yen was exceedingly strong, dropping close to 80 to the dollar at one point. Longer-term prospects for the U.S. currency remain problematic because of the large trade and budget deficits and easy monetary policy.
In preparing last year’s Surprises I tried to analyze the Japanese market and economy carefully, concluding that there were many undervalued stocks there and the economy had a good chance of improving because of China’s growth. In the sixth surprise I thought Japan’s equities might actually outperform Europe and the United States. As it turned out the Nikkei 225 declined, slightly, but the strength of the yen against the dollar reversed the loss for an unhedged U.S. investor. On a dollar basis, the Nikkei 225 did outperform most European and Asian markets and caught up to the Dow Jones and almost exceeded the S&P 500.
For the seventh surprise I thought President Obama would assert himself on the climate control issue. Early in the year he announced plans for two nuclear plants to take the place of electrical power generating facilities using coal. Unfortunately he then became distracted by the healthcare bill, financial service regulatory reform and other issues and did not aggressively pursue environmental issues further, but at least he made a start.
Because I believed the economy would do better than consensus estimates, I thought the Democrats would lose fewer seats than the political pundits estimated. That was the eighth surprise. The performance of the economy was disappointing and a general anti-incumbent attitude overtook the American electorate. The Democratic Party lost control of the House of Representatives and its majority in the Senate was reduced as well. At the time of the November election it was the general feeling that the outcome would produce “gridlock” in Congress and that was viewed as a positive because it was thought that most legislation was unproductive and added to the deficit. Since that time a political compromise was reached, extending the Bush tax cuts and continuing unemployment benefits. While both parties claimed victory, I believe the passage of the bill represents a move to the center by the administration and is a positive sign for the political backdrop going forward.
The financial crisis of 2008 was surely going to lead to some regulatory changes for the financial services industry. While there was much concern throughout the industry about this legislation early in the year, I thought that the reform bill would be constructive when it was finally passed and would focus on areas needing attention like consumer protection, mortgage lending, derivatives and bank capital ratios and what that capital was used for (e.g., proprietary trading, hedge funds and private equity). Like the healthcare bill, the final legislation is not as onerous as some feared and that was the ninth surprise. While there are those who would argue that any legislation is bad, I believe this bill covers some important neglected areas (e.g., derivatives) and is generally positive.
The tenth surprise is usually a long shot and last year’s was no exception. I thought there would be a regime change in Iran and Mahmoud Ahmadinejad would be replaced by a more moderate leader who would not be so anti-Western and negative on Israel. The leadership in Iran did not change but the younger people in the country are putting pressure on the government to create more economic opportunity. The sanctions are hurting and the country needs aid and investment from the industrialized world. That will not happen as long as Iran is pursuing the development of nuclear weapons. The Green Movement that had some momentum after the 2009 election has been suppressed by the clerics, but it is not clear that the country’s present course will endure.
So that’s a review of last year. This year’s Surprises have a positive tone once again. In the investment business there is very little difference between being early and being wrong and I was clearly too positive last year, but perhaps the economy is improving and some of the events I was looking for in 2010 may take place this year. In reviewing the 2011 Surprises I find many of them are in the direction of the consensus, but my view is more extreme. For this reason they are perhaps not as “surprising” as in the past. As a result I have prepared a list of alternate surprises, the “also rans,” that includes some of my more speculative possibilities. While these alternates are less likely, I hope you find thinking about them useful.
The Surprises of 2011
1. The continuation of the Bush tax cuts coupled with the extension of unemployment benefits has put all working Americans in a better mood. Real Gross Domestic Product rises close to 5% in 2011 driven by improved trade and capital spending in addition to stronger retail sales. Unemployment drops below 9%.
2. The prospect of increasing Federal budget deficits and rising government debt finally begins to weigh on the bond market. The yield on the 10-year U.S. Treasury approaches 5% as foreign investors become more demanding. Spreads with corporate fixed income securities narrow.
3. Encouraged by renewed economic momentum the Standard & Poor’s 500 rises close to its old high of 1500. A broad range of sectors participate, but telecommunications and utilities lag. With earnings improving, valuations seem low and individual investors return to equities for the first time since the financial crisis. Merger and acquisition activity becomes intense and the market reaches a blow-off euphoria. Stocks correct in the second half as interest rates rise.
4. Although inflation remains benign, the price of gold rises above $1600 as investors across the world place more of their assets in something they consider “real.” Sovereign wealth funds of countries with significant dollar reserves also become big buyers. Hedge funds keep thinking the price rise is becoming parabolic and sell their positions and some even short the metal, but gold keeps climbing and they scramble back in.
5. Worried about inflation and excessive growth, the Chinese decide to use their currency as a policy tool. They manage the value of the renminbi aggressively to keep the growth of the economy below 10% and to prevent consumer prices from increasing above the 4%–5% range. The move is viewed as a precursor to the world-wide adoption of a basket including the renminbi as an alternative to the use of the dollar as the principal reserve currency.
6. Rising standards of living in the developing world seriously increase the demand for agricultural commodities. The price of corn rises to $8.00, wheat to $10.00 and soybeans to $16.00. Commodities become a component of more institutional portfolios.
7. The housing situation improves. Although the inventory of unsold homes remains high, the oversupply is drawn down substantially, contrasting with an increase in 2010. The Case-Shiller gradually heads higher and housing starts exceed 600,000.
8. Continuing demand from the developing world and a failure to bring onstream new supply causes the price of oil to rise to $115 per barrel. The higher price at the pump fails to discourage driving, increase sales of hybrid vehicles or cause Congress to initiate conservation measures.
9. Frustrated by the lack of progress against the Taliban and the corruption of the Karzai government, President Obama concludes that whenever American troops return home, Afghanistan will once again become a tribal state ruled by warlords. He accelerates the withdrawal of most military personnel to the end of 2011. Coupled with the pullout of forces in Iraq, this will leave the Middle East without a major Western presence in the face of rising fears of terrorism.
10. Under duress Angela Merkel leads the way in European financial reform. The weaker countries, having pledged to cut their budget deficits in half by 2014, are provided additional transitional aid by the European Union (with Germany’s backing) and the International Monetary Fund as long as they implement their austerity programs, increase some taxes and still show modest growth. The European financial crisis becomes less of a concern. The policies put in place prove psychologically satisfying to the financial markets but harmful in the longer term because they are palliative and do not represent solutions.
"ALSO RANS”
11. While Afghanistan and Iraq cool down as trouble spots, Pakistan and North Korea flare up. The former continues to be a troublesome breeding ground for terrorists and the latter initiates further hostile attacks on South Korea. China does not become involved in a major way and the international community seems helpless.
12. The broad international sanctions on Iran finally begin to work. Mahmoud Ahmadinejad enters into negotiations to scale back the country’s nuclear weapons development program in exchange for financial aid and foreign investment. Pressure from the country’s youth to provide more economic opportunity is the key factor in the change in policy. Talk about bombing by Israel or the U.S. subsides.
13. Rising interest rates and a strong economy allow the dollar to strengthen against the euro and the yen. Although the European financial crisis abates as austerity programs and higher taxes are put in place and Japan avoids falling back into recession, America becomes the developed market of choice for global investors.
14. Sarah Palin announces she will seek the Republican nomination for President amidst the cheers of Tea Party supporters. More moderate Republicans fear her candidacy will diminish the chances of their party winning in 2012 and try to blunt her efforts. Rick Perry, governor of Texas, becomes a contender. Mike Bloomberg is mentioned. On the Democratic side, liberals feel Obama has betrayed them and desperately try to find a challenger. With the economy improving, the prospect of a second term for Obama becomes more likely.
15. The Russian government decides it is the laggard of the emerging markets and steps up its efforts to become more investor friendly. The Kremlin agrees to further nuclear weapons reduction and provides assurance to companies willing to invest there that the rule of law will prevail. The Russian equity market soars.
16. Laws related to marijuana usage are liberalized in more states. Recognizing that the drug may not be addictive, the public’s attitudes have evolved over the last thirty years, and this, along with a desire to alleviate the over-crowding of jails, causes state legislatures to take a more liberal position. Drug abuse groups are outraged.
17. Infrastructure problems in the United States become serious. New York subways are inoperative for days as a result of an electrical problem in the signal system. Gridlock snarls Los Angeles freeways, and to encourage cooperative commuting, high-occupancy vehicles are required to carry three or more people. State and local governments complain they lack the funds to deal with the problems and Washington refuses to help.
18. A major state fails to pay interest on a municipal bond issue because of a lack of funds, causing havoc in the municipal bond market.
19. In spite of fears of tenth anniversary terrorist attacks, 9/11/11 becomes a peaceful non-event because of excellent intelligence and surveillance.
20. While climate change activists remain shrill, the issue recedes in importance in the United States. Cold weather prevails during the winter and the summer heat is not oppressive. Support increases for a broader use of natural gas by utilities and public transportation and its price rises to $6.00 per mcf. In Europe and Asia, however, environmental initiatives continue to move ahead.
Next month I will discuss The Ten Surprises of 2011 in more detail. The first step in doing The Surprises is to identify the consensus; you must have a clear idea of that so you can determine what might be a “surprise.” I had a harder time than usual doing that this year. I work on The Ten Surprises over a period of several months and discuss various possibilities with a number of people. I especially want to thank George Soros, who has been helpful in the process since the 1980s. Also providing ideas and criticizing my own are James Hoge and Gideon Rose of Foreign Affairs at the Council on Foreign Relations; my Third Thursday discussion group of former Wall Street research directors; the person I refer to as The Smartest Man in Europe in my July essays; Tom Bailey, founder and former Chairman of Janus Funds; my former colleague at Morgan Stanley, Henry McVey; and countless others who e-mail their thoughts to me. The final list is my own and I am accountable for it. If this year’s surprises work out we all will have made some money and the world will be a better place, so I’m cheering for them even more than ever.
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