This inflationary road was made long ago

Since 2007, we at Barnes Capital have been making predictions about what will happen in the New Year. Thinking about the future and what could happen is crucial for us in our role as a steward of people’s finances.  History has shown the importance of a diverse portfolio, particularly in times of great change. Although we are not negative about the future, worst-case scenarios are something we think about.
We positioned all of our portfolios for the continued debasement of fiat currencies (those currencies not backed by hard assets).  We did this mainly though investing in Gold and Silver bullion and some mining stocks.
The political headwinds of what many perceive – with merit –as a bankrupt economy propelled political and fiscal policy in 2010.  We believe that the Quantitative Easing II compromise struck by Obama in late November, means that the dominant themes that we’ve believed to be most likely, including high deficits, government bailouts, higher commodity prices and the debasement of currencies, will continue into and beyond 2011.
Economic activity is made up of government spending, corporate spending and consumer spending. Consumer and corporate spending have declined dramatically since 2007.  Government spending is trying to make up for the decline with increased spending of its own.  This government spending will be financed by the existing monetary system, which enables the debt to be issued by the Treasury department and purchased by the Federal Reserve.  This system is strongly supported by the creditor nations of the world, including China, Japan, and the European Core.  Ultimately, it is an inflationary path, and we are currently overspending governmental tax receipts by between one and two trillion dollars annually.
The choice and path down this inflationary road was made long ago.  And it’s not a terrible path; at its core, debt and currency erosion is populist in nature.  In the medium- and long-term, it harms creditors and help debtors.  That means that those most willing to spend (debtors) have greater means to do so, and those most able to have the purchasing power of their assets erode (creditors), pay the price for offering of excess credit — their own profligate ways (and the country’s).

2010 PREDICTIONS RECAP:

We got a lot of things really right in our 2010 predictions.
First, we predicted that Obamacare would become law, and that it would pale in comparison to the unemployment problem in 2010 and that did happen.
Real estate did have a tough year, as we predicted, but higher long-term mortgage rates didn’t materialize.  Gold did indeed mark its 10th straight year of upswings, as we predicted, but it was less volatile than we expected. It did indeed close the year strong at $1421, which is close to our $1450 prediction.  Municipal bonds performed better than we had predicted before weakening at the end of the year, and they delivered expected returns. Oil prices did indeed stay within our projected band of $65-$95.
Of our more unlikely predictions, the yield curve did become extraordinarily steep, but 30-year bonds failed to make it back to even 5%, let alone the 6% that we predicted.
The European sovereign debt crisis abated fears of a dollar meltdown, but nonetheless the dollar finished at a very low level of 79 on the U.S. $ index for the year.  A culture of thrift continued to exert itself, requiring another $600 billion in Quantitative Easing Part 2 in November as the jobless recovery continued and corporate profits continued to record the highest margins ever.
Amazon did do well, as we predicted, but Apple continued to be the beacon of fashion and success across all ages of consumers – and we predicted that that company might have problems within a culture of thrift.  That sure didn’t happen.
Democrats did lose the house as we anticipated, but Obama hasn’t got much veneer left, let alone Teflon. Finally, high uncertainty continues to reign, but risk assets, namely stocks, rallied through the last six months of the year to end at their highest levels.
The Federal Reserve continues to effectively print extra trillions of dollars each year to support the recovery. Stocks are more immune to this governmental Ponzi scheme of money printing; consequently, they are rising.
In many ways, 2010 was our Brian Downing year. Downing, a baseball player, was a career .275 hitter. On the 1979 division-winning California Angels squad, Downing hit .326  – and he never hit .300 again. We don’t expect to ever top our 2010 predictions in terms of accuracy. Nonetheless, here’s what we imagine for 2011:

2011 PREDICTIONS

1)     Municipal bonds are cheap, again.  We expect that they’ll decline in volatility and deliver solid after-tax returns for investors in the 25% tax bracket and higher. We are delighted to buy California General Obligation bonds, which deliver 4%-7% tax-free yields on coupon-bearing and zero coupon issues.  For a typical California investor in the 40% marginal tax rate, our 5% bonds are yielding an equity-like 8.33% return on an after tax basis.
2)     Gold.  Gold is real money. That’s not really anything new; we’re in the late innings of the ballgame on this one. But the biggest money in any bull market is made in the final, speculative 3rdpart of the cycle.  We may be approaching that third and final phase, which we imagine will last for 3-plus years.  Gold will climb again in 2011 and finish above $1600/oz.
The following is a list of the spot price of Gold on the last day of the year for 12 years.
1999 — $288
2000 — $271                     -6%
2001 — $278                      2%
2002 — $348                      25%
2003 — $415                      20%
2004 — $437                      5%
2005 — $516                      18%
2006 — $634                      23%
2007 — $833                      31%
2008 — $881                      6%
2009 — $1096                    24%
2010 –$1421                       30%
3)     Oil will break out to more than $100 a barrel, and this will reduce global growth as it did in 2008, stalling the economic recovery, again.
4)     Real estate will continue to bottom. Corporate real estate will fall between 5 to 10 percent and residential prices are likely to remain flat or go down as well, as low mortgage rates and higher dividend and capital gains rates support many current market prices in real estate.
5)    Stocks will actually perform decently and with less volatility than the last several years.  The current policies of Federal Reserve, however, are leading to trouble. It won’t happen this year, however. That Armageddon is destined for a Judgment Day in 2012 or perhaps during the ironic 2013 centennial of Ponzi banking system of the Federal Reserve.
Unlikely to Happen: but it wouldn’t surprise us if . . .
6)     Equities become the rage du jour, and stocks start to party like it’s 1999.  Why? Because perceived safe bonds pay paltry interest rates (10-year taxable treasury is 3.4%), whereas many blue-chips stocks are paying 3-4%, and stocks offer inflation protection, which bonds do not.  The Dow Jones delivers an 18% return to finish within shouting distance of 2007 levels.
7)     Some states seek the political cover of economic receivership due to budgetary impasse.  Without this cover, existing contracts cannot be renegotiated.  This roils the markets for a number of weeks, but like the European sovereign debt problem, it doesn’t de-rail the strong year for equities.
8)     The foreclosure problem hasn’t been solved.  Many homeowners continue to be unable to afford their homes.  Meanwhile, four out of five economics professors predict that Orange Countyhousing prices will rise 2-7% in 2011.  The fifth says it’s falling 9%.  Since housing declines tend to last a decade, and this one started in 2006, our money is with the minority forecaster.  A number of different issues could bring another 10% decline real estate in 2011.
9)     The Simpson Bowles plan manages to stay on life support throughout 2011.  This was the ambitious plan to reduce the national debt with real cuts in Medicare, Social Security, and other large entitlement programs.  This plan is currently DOA following the QE2 issuance and other Obama compromises, which affectively drove a stake through the heart of the Simpson Bowles austerity proposal.  America has no appetite for austerity.  Thrift perhaps, austerity – “Nein! Danke”
10)   Gold fever turns speculative.  Gold flirts with $2000/oz prices and gold stocks double with the Joe Public finally buying his pieces of gold.  Like any bull market, the most money is always made (and lost) during the speculative phase.  When the speculative phase in precious metals arrives, we expect it to last for multiple years, and as with the Internet, the dot-coms, and real estate, it will go on for far longer, higher and further than anybody believes possible.  QE 3 next autumn might kick off gold’s speculative phase.

IN CONCLUSION

The year 2011 shows signs of a cyclical rebound driven by government spending, government-subsidized low interest rates, large corporate balance sheets and an increase in risk appetites.  There’s a chance that the balanced money manager (me) could be underinvested in risky assets this year. After strong performances in 2009 and 2010, we enter 2010 underweighted in risk assets and we will not be surprised if we underperform market returns in 2011.
Today’s values in stocks and bonds are not overly compelling.  We see modest returns over the next five years in the mid-single digits.  Therefore, we will not increase our risk exposure substantially this year, in order to achieve a pyrrhic one-year victory.  Our clients’ primary needs are wealth preservation.  We believe that real wealth preservation in inflation-adjusted terms is going to be difficult to achieve this decade and our investment strategy is focused on safe returns, not optimal returns.  We remain believers in the solid returns of strong dividend-paying stocks, covered call writing, and municipal bonds, including California General Obligation bonds and Gold and Silver allocations.
A cataclysmic meltdown seem unlikely this year, there is simply too much money being printed by the policies of Ben Bernanke with the Federal Reserve for things to fall apart.   Austerity, it isn’t. But, to employ an overused cliché, we’re just kicking the can down the road.  Let the next president preside over structural change; this one’s just muddling through as best he can.