The issuance of US Treasuries is set to fall by 16% this year, and tax receipts should jump. Demand for bonds will also increase, says Sentinel, both among pensions and individuals and overseas buyers, and quality small cap stocks should rise above the pack. Keefe, Bruyette and Woods suggests shorting stocks that will benefit from rising short-term interest rates.  Value-investor GMO isn’t buying in India or China. And according to the well-regarded Harvard Joint Housing Studies group, Philadelphia, Baltimore, Milwaukee, and Chicago may see a pickup in home remodeling this year.

Christian W. Thwaites, Sentinel Asset Management, Inc.

It paid to be practical in 2010. We started the year with relief that we averted catastrophe but were dimly aware it would be tough. How could it not be? Financial markets were in disrepair and the economy looked like it had only just made it through a re-stocking cycle. All other parts of the economy looked down for the count. But in the end, despite euro sovereign emergencies, deflationary fears and a phony currency war, both the real economy and financial assets had a strong year. It was hard to lose money: the dollar, US corporate bonds, overseas markets, US large caps and US small caps (the S&P) and (Russell 2000) returned between 2.5% to 25%.

But it came with volatility. The US market, for example, went through four distinct phases with a gradual upswing punctuated by two corrections of 9% and 17%. Similarly, bonds rallied hard in the first nine months despite (because?) of the European sovereign crisis yet sold off in the remainder of the year. As we’ve said before, this is not, and won’t again be, a buy-and-hold market.

All this is explained by the Fed. Its twin mandate of full employment and price stability conflicted in 2010. Full employment won. So the Fed re-tooled to move the politically and socially important employment numbers down from the grim 10% April peak. In doing so, it sent unequivocal messages to the markets that have proved tolerably accurate in combating weaknesses in the economy.

Let’s look at these before moving to 2011.

The gloom lifted on the productive and manufacturing economy almost immediately after the September announcement of the $800 billion asset repurchase program or QE2. Business surveys improved and the output data appeared consistent with a 4Q GDP of 3%. Importantly, the growth is organic and sustaining as opposed to the inventory rebuild which accounted for well over half of growth in the first nine months of the year. We’re decidedly in the “glass half full” camp on this one and our reason is simple: purchasing and supply manager surveys look at order flows for up to a year ahead and businesses are slow to engage labor (it’s easier to extend overtime). Both have shown positive readings for months (December was the best in 20 years). We think a virtuous cycle has started.

As orders grow, so goes the labor market. Remember that employment job losses in the 2008 recession were more than the prior four recessions combined. Recovery was always going to be hard. The construction and housing industry accounted for 8% of GDP in 2006. Today the number is 4%. We used to sell 1.2 million houses a year. This year, we’ll be lucky to sell 280,000. The market is glutted. This left a lot of workers in the wrong part of the country with the wrong skills. The 2001 recession took four years for full job recovery. This one will take more than five. But after two years of near zero interest rates, unmistakable signs of a reemerging job market appeared towards the end of the year. By December, the unemployment rate had fallen to 9.4%: that’s 727,000 people back to work from the same time last year. Yes, the workforce increased by 1.1 million and we have miles to go. But it’s enough to instill much needed confidence.

Much is made of the financial imbalances, particularly the public sector. True, government borrowing has escalated sharply from the 2008 abyss. But it has been easy to finance because the private sector moved into surplus. Households paid down debt (there’s been a huge collapse in demand for revolving credit) and slashed spending. Corporations hold over $1.2 trillion in cash as operating cash flows exceeded the demand for new investments…indeed capital expenditures barely kept up with depreciation allowances. And amid  the handwringing, the issuance of US Treasuries is set to fall by 16% in 2011.

So government indebtedness is not such a big deal simply because it’s not what the government owes but a) how it’s financed and b) where the sum of private, government and corporate borrowing stands. In this context, the debt looks comfortable and we’ll be surprised by how much the deficit shrinks as tax revenues increase in 2011.

No deflation and no inflation. We must admit, because we trashed it at the time, that QE2 had its intended effects: there’s no deflationary fear. Sure, it will be interesting to see how the Fed unwinds its balance sheet and there’s a risk of asset price distortion…but we’re not there yet. Since late August, TIPS spreads have moved from 130 to 240. That’s the inflation break-even and as good an indicator as any of the forward inflation rate. It’s dead on where the Fed wants it. The best inflation measure is the PCE[3] core, which is at less than 1%…so if the indicator is at 2.3% and actual at 1%, it tells us that low rates will be with us for a while because (simply) the Fed has not met its QE2 goals.

So the bottom-line on the economy: It’s in decompression mode. Settling in after trauma…it takes a while. The Fed runs an expansive monetary policy. There’s nothing inherently bad or weak about the US economy but it’s going through some painful adjustments after a decade of excess. And this means for 2011:


Fed buying of the seven- to ten-year Treasuries space after QE2 meant the market offloaded most of its gains and inventory in the back end of the year. This was not some cerebral debate about the inflationary consequences of easing and money quantity. It was an outright barroom brawl with the street locking in gains and selling to the only buyer in town. Rates increased quickly from 2.5% to 3.5%, erasing the return from the GT10[5] from 14% in the January to September period to 9.7% for the year. That’s what we mean by “expect volatility.” But it’s not all bad news. There’s a lot of liquidity out there…we can see how well bid corporate and any good standing bonds remain. New issuance market (NIM) has been slow: it was down 22% in 2010, but expect a pick up in the New Year and the bond market to stabilize. Also, note that retail, foreign and pension demand will return in early 2011. Each one has a very real need to remain overweight in bonds. So don’t discount bonds in 2011. The retail investor is not about to dump bonds and as long as inflation is so low and cyclical unemployment high, the Fed won’t let higher yields choke the economy.


Stocks have weathered well this year but what was disarming to see was “good” companies (low P/Es, dividends, strong balance sheet) underperforming. It was a second good year for small caps but, again, those with a speculative element made the running. We’re fine with this. When markets run fast, correlations narrow and the index/ETF buyers carry the weak. But it doesn’t last forever and eventually quality will out.

Get used to volatility because that’s the pattern when global policies are discordant and economic problems are as diverse as they are right now (e.g. China: inflation and consumers, Germany: bailouts, US: employment). Also, the more the market trades on macro news, the more swings we get…because it’s mood driven and the link between economic data and equities is weak.

Mark Pawlak and Siddharth Jain, Keefe, Bruyette and Woods

Since long rates began rising in early November, asset sensitive stocks have rallied strongly. In our view, this rally is driven by a view that the move higher in long rates will soon be followed by an increase in fed funds. We believe that this is a mistaken view as the Fed has clearly signaled that fed funds will remain low indefinitely. As a result, we believe that there is an investment opportunity to buy shares that truly benefit from a steepening curve and short shares that will primarily benefit from a rise in short term rates.

In our view, the best way to invest in this theme is to go long the KDX (KBW Financial Sector Dividend Yield Index) and short the KIRSI (KBW Interest Rate Sensitive Index). KDX has 38 stocks across the financial sector and is calculated using dividend yield weighted methodology while KIRSI has 18 stocks across the financial sector and is calculated using equal weighting methodology. Given the recent stronger consumer data in the US and an expectation that the jobs market will improve, there has been heightened discussion of whether the Fed might cut QE II short and perhaps hike short rates sooner than had previously been thought. Feeding into this has been a rotation onto the Federal Open Market Committee (FOMC) of several regional Fed presidents that market participants believe may create a FOMC that is more hawkish than that of 2010.

To backtrack briefly, it is important to remember that the FOMC consists of Fed governors that are nominated by the President and confirmed by the Senate and regional Fed presidents that are chosen by the board of directors of their respective Federal Reserve banks. Currently there are six Fed governors with a potential seventh, MIT Professor Peter Diamond, currently held up in the confirmation process at the Senate. All Fed governors are voting members of the FOMC. There are twelve regional Fed presidents. The New York Fed President, currently William Dudley, is a permanent voting member of the FOMC. Of the remaining eleven regional Fed presidents, four are voting members of the FOMC serving one-year terms on a rotating basis.

In thinking about Fed policy, it is important to remember that unless QE II is cut short, the Fed is effectively easing until its end on June 30th. We are highly doubtful that the Fed would move quickly from an easing posture to a tightening one but would rather pause between to see the lagged effect of its past policies. In fact, before raising the Fed funds rate or the interest rate paid on excess reserves, the Fed would have to stop buying bonds, then use its newly created reverse repo and term deposit facilities to mop up excess liquidity (the money currently in the system has been estimated to be the equivalent of a negative repo rate) and then move short rates. Despite the involved machinations to do so, last year Kansas City Fed President and then voting FOMC member Thomas Hoenig dissented in favor of higher short rates at all eight FOMC meetings.

According to The Wall Street Journal this bested the longest string of consecutive dissents by a single official since 1994. The previous high had been five set by Dallas Fed President Richard Fisher in 2008 (more on him later). The eight consecutive meetings with a dissent also matches the longest recent string of dissents set from October 2007 to August 2008 with each meeting having a dissent in favor of tighter policy. (We ask you to make a mental note of how that turned out, i.e. policy eventually was loosened due to the financial crisis, for later in our discussion.)

In looking at this year's FOMC, we think the dovish tendencies of Fed Chairman Bernanke, Vice-Chair Yellen, and New York Fed President William Dudley are well documented. We think this group who we call the "Power Trio" will be the most influential in determining Fed policy in the future. We believe current Fed Governors Duke, Raskin, and Tarullo are less influential voices that are also largely dovish. While Fed Governor Kevin Warsh has made remarks critical of QE II we think in the end, he lines up behind the Power Trio. Moving on to the regional Fed Presidents who will vote on the FOMC in 2011, Chicago Fed President Charles Evans is widely seen as a dove and as recently as January 7th was quoted in Bond Buyer saying that changing the size of QE II would be a "pretty high hurdle" and that the Fed would continue to keep short rates low "for quite some time." While some feared that Minneapolis Fed President Narayana Kocherlakota might fall on the hawkish side because he believes that the structural unemployment rate is higher than most, he has come out in favor of QE II saying, according to Bloomberg, that he is "very comfortable" with it and that with "ongoing disinflation and a high rate of unemployment...this is not the time to start (an exit strategy)." We think Philadelphia Fed President Charles Plosser is a hawk. However, we think people are misinterpreting his desire to evaluate QE II at every meeting as one to cut QE II short.

Arjun Divecha, GMO

Ruminations on China and India

China: If you build it, they will come…

India: You’re not going to build it, but they’ll come anyway…

It occurred to me that this is a good metaphor for China and India and the resulting implications for growth and investment return. Last month I had a long chat with one of the people in China whose views I most respect. He is extremely plugged in with the fi nancial elite and serves on a number of government advisory boards. He told a very convincing story about how things were going to play out in China over the next few years, and which sectors would benefit. However, at the end of the discussion, it occurred to me that the entirety of his story depended on government policy and actions. In my travels around India over the last couple of weeks, I had multiple discussions with business and financial leaders about what is likely to happen in India over the next few years.

None of their thoughts depended on government action. If anything, their main fear was that government intervention/inaction was the thing most likely to slow down or kill the huge growth momentum that exists today. That, in a nutshell, is the relative case for China vs. India. China succeeds if the government gets it right; India succeeds if the government gets out of the way. Both could happen. Or neither. In both cases, long-term return to investors will depend not so much on the success or failure of the country in GDP terms, but on the ability of companies to deliver high return on capital.

So, what drives return on capital? One of my colleagues at GMO has written about the problems of overcapacity in China so I won’t spend time on it, but one thing is clear to me: building overcapacity is generally good for the consumer and bad for the producer. Thus, building multiple high-speed rail lines in China almost certainly improves the quality of life for the average Chinese, but it is inconceivable that the return on capital on those rail lines will be high, in pure fi nancial terms. If it were, the U.S. would surely have built plenty of high-speed rail lines by now. After all, the ability of the U.S. consumer to pay for transportation is considerably higher than that of the Chinese consumer. The fact that no high-speed rail lines exist in the U.S. tells you something about the potential return on capital on high-speed rail in expansive continental geographies. In short, overcapacity may lead to high social return, but almost certainly leads to low return on invested capital.

Now, let’s look at India through this lens. In India (mainly due to poor government policy and implementation) everything is in short supply – too few roads, bridges, ports, educated people, etc. Thus, people have diffi cult lives, but it turns out that the average return on capital in corporate India is one of the highest of any country in the world (and has been for the last 10 years). The one area in India that has overcapacity is mobile phones. And that’s because it’s the one policy the government actually got right – by allowing unfettered competition (and giving away 2G licenses for a song). As you may guess, none of the mobile phone companies are making much money because mobile rates are the lowest in the world. In fact, the largest mobile phone company is trying to grow profi ts by investing in telecoms outside of India. This is what makes for the true irony of India – that bad policy has led to high profi ts because producers benefi ted from shortages. Another interesting consequence of bad policy-making (India consistently runs high budget defi cits) is the high cost of capital.

This forces producers to invest only in high-return projects (so as to be above their cost of capital) and benefi ts investors by delivering high return on investment.

Now this sounds like a contradiction for investors like us – is it possible that investing in India benefits from bad policy in the long run? And, if so, should we not invest heavily in countries that have bad governments rather than good ones? Or, maybe one should focus on countries where the local cost of capital is high? Brazil is another highcost- of-capital country that has produced high dollar returns despite mediocre economic growth.

I believe that sooner or later, the lack of infrastructure/education will start to bite and constrain India’s ability to grow. We already see inflation picking up in India, as rising incomes are not matched by rising food production, rising salaries are not matched by rising educational quality, and rising commodity prices are not ameliorated by better infrastructure. High inflation will eat away at the ability of companies to sustain high margins, and markets usually demand a discount from high-inflation countries. Bottom line, one should not expect bad governance to lead to permanent positive payoffs.

Nevertheless, India has one considerable advantage from my point of view: its business model is based on bottomup capitalism. Of course, anything is possible in the short run, but it seems inconceivable to me that state-directed investment policies could produce sustainable higher return on capital than those chosen by individual profi tmaximizers. In the fi nal analysis, one needs to make the distinction not only between countries, but between companies and sectors based on their ability to produce and sustain high profi tability rather than on simple metrics like GDP, which have very little to do with making money as investors.

In short, don’t focus on growth. Focus on profitability.

Obviously, as value investors, the single most important thing w look at is valuation – we are willing to pay a premium for profitability, but not to overpay for it.

Current positioning. At this point in time (January 2011), we are heavily underweight both India and China in our Emerging Markets Strategy, due primarily to high valuations in both countries relative to other emerging markets. In addition, in both countries, the central banks appear to be behind the curve and they will have to act strongly to bring inflation down, a task that is made much harder by the profligate monetary policies of the developed markets, particularly the U.S.  

Mark Luschini, Janney Montgomery Scott

Market lore would encourage us to predict that 2011 will produce another positive year for the stock market. This, by the way, would follow 2009’s gain of 26% and 2010’s return of 15%. The first days of trading in January have often been predictive in pointing to the direction for stock prices over the year as a whole. So far, the rally in equity prices in 2010 has carried over into the New Year. For the first week of 2011, the Dow Jones Industrial Average rose 97 points, or 0.8%, to 11,675.

The seasonal effects of renewed buying on the part of institutions eager to keep up with the market’s performance, contributions to retirement plans, and year-end bonuses all, in some way, contribute to the additional cash that finds its way to stock market at the beginning of the year. We believe there is good reason, however, for investors to commit funds to stocks at this time. Conditions in the economy are improving, corporations are in great shape financially, confidence is recovering and earnings – the necessary ingredient to move share prices – are expected to grow at a double-digit pace this year. With the Federal Reserve likely to remain accommodative and no real threat that interest rates will break rank and move decidedly higher, stocks become the asset class of choice for investors with a risk-tolerant time horizon.

In our opinion, among the key fundamentals for determining the attractiveness of equities are the metrics of valuation, the outlook for earnings, and the liquidity backdrop. On at least these three counts, the equity market outlook looks favorable. In fact, U.S. equities are trading at roughly 13 times 2011 earnings estimates while international stocks, developed and emerging markets, are valued at an even more appealing 11 and 10 times forward expectations. While much can happen to undermine the achievement of those estimates, it offers an inexpensive enough entre’ to offer some protection if the undershoot is limited. Our baseline scenario is an economic recovery that persists, allowing profit growth to occur, albeit below the past year’s pace. With this backdrop, we remain committed to an overweight stance in stocks for 2011.

Joint Center for Housing Studies of Harvard University, A New Decade of Growth for Remodeling.

Slowly but surely, the US home improvement industry is emerging from its worst downturn since the government began tracking spending in the early 1960s. Homeowners who deferred maintenance and improvements during the recession may soon start to spend more freely. Lower household mobility in the wake of the housing market crash could also mean that homeowners will focus on upgrades with longer paybacks, particularly energy-efficient retrofits.

The industry is also beginning to benefit from spending on the rehabilitation of foreclosed properties. Over the com­ing years, real spending on homeowner improvements is expected to grow at a 3.5 percent average annual pace, ensuring that the industry captures a large share of the resi­dential investment market.

Remodeling spending peaked nationally in 2007, well after the housing bubble burst but before the collapse of the US finan­cial system sent the broader economy into recession. By Joint Center for Housing Studies estimates, the overall remodeling market—including spending on maintenance and improve­ments of rental as well as owner-occupied units—fell by 12 percent between the 2007 high and 2009. The peak-to-trough drop in homeowner spending alone was well over 20 percent.

The composition of homeowner expenditures also changed over this period. The share of spending on discretionary proj­ects—kitchen and bath remodels, room additions and altera­tions, and other interior additions—declined by about three percentage points (from 49 percent to 46 percent) while the share of spending on exterior replacement projects and sys­tem upgrades increased by almost exactly the same amount. The share devoted to property improvements and disaster repairs was thus largely unchanged.


At almost $290 billion in 2009, the remodeling market held up much better than new residential construction during the down­turn. Indeed, the maintenance component of remodeling expen­ditures increased slightly in 2007–9—not surprising since this spending category tends to remain fairly stable across cycles.

Improvements to rental units also increased modestly over this period according to Joint Center estimates. Expenditures by rental property owners have historically been about as volatile as spending by homeowners. During the recent housing market crash and economic recession, however, falling home prices, high unemployment, and record foreclosures discouraged homeowners from making improvements to their properties.

At the same time, a growing share of households chose to rent. This in turn encouraged rental property owners to upgrade their buildings after years of underinvestment. After averaging 2 per­cent compound annual growth from 1995 to 2007, remodeling spending on rentals continued to grow at this rate in 2007–9 even though overall home improvement expenditures declined. The entire drop in total spending during the downturn thus came from a cutback in improvement projects undertaken by homeowners.


The recent downturn notwithstanding, remodeling spending has in general been on a healthy upward climb. From 1995 to 2009, the remodeling market nearly doubled in size in nominal terms and was up over 36 percent in real terms, effectively matching the pace of expansion in the broader economy. With the return to modest growth in 2010, the remodeling market likely approached $300 billion.

In recent decades, expenditures on home improvements and repairs have averaged 40–45 percent of total residential invest­ment. However, changes in the remodeling share tend to be countercyclical: when the economy and housing markets are strong, spending on new construction generally grows faster than on remodeling, pushing the remodeling share down. For example, when national housing starts exceeded two million units at the top of the home building market in 2005, the remodeling share of residential investment dropped below 40 percent for the first time in more than two decades.

During housing market downturns, the home improvement share of residential investment rises. When housing markets crashed between 2005 and 2009, the remodeling share thus climbed to more than two-thirds of total residential investment. With continued weakness in construction activity in 2010, par­ticularly in the multifamily sector, the remodeling share of resi­dential investment probably increased further.


Based on local market conditions in 2009–10, several metropolitan areas appear well-positioned for an upturn in remodeling activity. While many of the stronger metros are among the traditional top-spending markets, conditions in a handful of other areas—such as Philadelphia, Baltimore, Milwaukee, and Chicago—also appear promising. These mar­kets may be poised for faster recoveries because they have older housing stocks, higher incomes and home values, and a larger share of upscale remodeling expenditures. In contrast less favorable market conditions point to slower recovery in overbuilt areas of Florida, as well as Las Vegas and Phoenix. In addition to facing continued home value depreciation in 2010, these areas had the lowest median household incomes and the newest housing stocks in 2009.

Although remodeling activity in distressed metropolitan areas is unlikely to recover quickly, current housing market troubles may also provide new remodeling opportunities. Indeed, improvement spending in overbuilt markets with high foreclosure rates should increase as homes are sold and the new owners attempt to make up for undermain­tenance during the downturn and the often protracted foreclosure process.

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