The story of Goldilocks continues to make its mark

January 14, 2011
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Yes, you have caught us. We are using this title to grab your attention. We know it does not feel like we are experiencing a Goldilocks economic recovery. However, the headline contains an element of truth. After all, we are in an economic expansion. While the unemployment rate is way too high, those who have jobs are less concerned about losing them and are spending more.

Additionally, people are saving more than they were before the financial crisis. This is important because our country needs to rebuild its savings. If we improve our balance sheets too quickly, it will have significant negative economic ramifications. As uncomfortable as the current environment feels, not too fast and not too slow is what we need to give us time to solve our longer term economic problems.

First, let’s look at some of the positives. We are now in the 17th month of an economic expansion. Yes, the growth has been slow and, to a degree, it has been artificially induced by government actions, but it is still a recovery. Historically, the average post-World War II recovery has lasted 62 months, with the shortest being 12 months during the 1980-81 recovery and the longest 120 months during the 1991-2000 recovery. An additional encouraging trend is that the Economic Cycle Research Institute’s Weekly Leading Indicator turned positive this past month. Historically, this has occurred 29 times since 1968. After this indicator turns positive, the economy has generally continued to strengthen, and the stock market has been up 83 percent of the time during the following four months.

Domestically, the current political trends imply an improving environment for business. The joint sharing of political power has historically been good for the financial markets, and the current administration appears to be moving away from its previous anti-business rhetoric. Additionally, the two political parties compromised and passed a continuation of the current tax regime.

The worldwide geopolitical environment also is looking better. China seems to be intervening with North Korea and there has been a defusing of tensions. The United States and Russia recently agreed to a new treaty to reduce nuclear weapons and renew weapons inspections. In Europe there seems to be a good debate on how to resolve the fiscal problems of their weaker member states. We don’t yet know how it will be resolved, but any negotiated settlement over time is better than an unexpected financial collapse.

On the negative side, interest rates are increasing. However, we do not believe they will increase so dramatically as to derail economic growth. Since interest rates have already moved substantially higher from the artificially low rate of 2.5 percent earlier in 2010, the 10-year Treasury note will likely trade in a range of 3 percent to 4 percent during 2011. Additionally, controversy over the Federal Reserve’s current monetary policy aside, we believe inflation will remain moderate and the risk of high inflation is very low.

Another negative for the market right now is commodity costs. Food, metals and energy costs have increased dramatically. Higher oil prices in particular are having a negative impact as they are so intertwined with our economy, acting as a tax on consumers that could slow economic growth.

While this is a significant risk, we are hopeful that the price increases will abate. China is currently fearful of inflation. It has increased interest rates twice in just over two months. Brazil also has signaled that it may increase rates soon. These two economies have been the source of much of the marginal new demand for oil. If they are successful in slowing their economies, oil prices should go down and help support our economy.

One of our biggest concerns right now is that investors say they are bullish on the financial markets and are more inclined to accept greater risk. As contrarians, we hate being on the side of the consensus. However, we really wonder if it is more talk than action. Investors have been pulling money from domestic equities for a long time. Bonds have been the investment vehicle of choice. Although that trend has changed in the last few months, the majority of money is still going into international equities versus investment in the United States. These trends bode well for the future returns from domestic equities.

We remain cautiously optimistic. We are hopeful for positive low double-digit or high single-digit equity returns and low to mid single-digit fixed income returns. If we had to guess what could surprise us during the coming year, we would have to say a higher than expected equity return. That being said, we have already had a sizable rally, and a 5 percent to 10 percent correction during the next few months would not be unusual.

Scott W. Wagasky is principal, director of business development, for AMBS Investment Counsel LLC of Grand Rapids.

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