2010 Market Outlook

O ffsetting F orces
T op T en T hemes

for

2010

Gene D. Balas, CFA

and

B eyond
January 2010

gbalas03@gsb.columbia.edu

Executive Summary
1. Dollar: Neutral in early 2010, but renewed economic weakness in US relative to other
economies after (temporary) boost from inventory build and fading effects of stimulus
in second half of 2010 cause dollar to resume fall, particularly against certain emerging
economies.
2. Potential for rising interest rates by Treasury’s borrowing needs offset by increasing
consumer savings and shift of household assets into fixed income securities, given new
retail investor focus on income and safety. Wild card is Fed exit strategy, particularly in
MBS purchases, which flow through to other asset classes.
3. Need for US to increase taxes and cut spending offset by potential for US simply to “print”
money to avoid difficult political choices. Cities and states cutting services and raising
taxes will crimp economic growth and offset federal fiscal stimulus.
4. Will exports (11% of US GDP) offset weakness in domestic consumer demand (70% of US
GDP)? As to the China theme, I note that exports to China are only 0.5% of US GDP but
Chinese exports to US are 7% of China’s GDP .
5. If the dollar falls, higher import prices due to falling dollar will be offset by output gap
and weak pricing power, eroding margins of exporters to the US. Deflation is a more likely
theme than inflation, though not “severe” in nature. Note that falling velocity of money
indicates increase in amount of cash in system less likely to be inflationary.
6. Are commodities and gold safe havens for dollar debasement? Baltic Dry shipping rates fail
to confirm real-economy demand for commodities, indicating speculative activity; contango
issues limit commodity ETF use; gold helpful hedge against currency debasement but is a
crowded trade, which may limit gains, but may be offset by central banks reallocating into
gold as “currency” of choice.
7. US consumers pay down debt and save more. Third quarter GDP report showed (temporary)
consumer spending spurt was funded entirely by an unsustainable drawdown in savings
triggered by government stimulus programs that encouraged purchases of houses (and
furnishings, electronics, appliances, etc.) and cars.
8. Inventory build could boost GDP in short run, or will limited financing available to fund
inventories curtail build (i.e., CIT bankruptcy) or be offset by retailers’ desire to avoid need
for clearance sales? What is role of technology in lean inventories?
9. Global spending on infrastructure: who will or can it actually employ? How much does
federal spending offset cuts by states and cities?
10. Rising emerging market prosperity: societies building domestic consumption are more
attractive than those dependent on exports of finished or crude goods.

Offsetting Forces

Top Ten Themes for 2010 and Beyond

I

magine that you are an ordinary individual, making $50,000
a year. Say you already have $40,000 in credit card debt,
but since you’re spending $55,000 a year, you rack up another
$5,000 in debt this year, partly to pay off principal and interest
on your other loans coming due and part of it to give away
to friends so they can buy a new car or house. Even though
you’ve always paid your bills on time and in the full amount
due (you’ve been demanding your neighbors loan you the
money or you won’t buy their items at their garage sale), who
would lend more money to this person?
Suppose this “person” is the US government. The
proportions of debt and deficit spending of the US federal
government and GDP of the US are roughly similar to the
debt, excess spending and income numbers of the “person” in
the example stated above. The “neighbors” in this case are our
trade partners, who have been financing our deficit spending
because we send them more dollars than we earn to buy goods
and services from them. (The “cash for clunkers” program
seems to have helped our trading partners quite a bit, given
the surge in imports in the recent trade balance figures.) Even
the above example is being generous, as GDP is, of course, a
much broader measure than federal government receipts, and
I have not even included the potential unfunded obligations
of Social Security and Medicare. While government fiscal
stimulus and deficit spending can, if done correctly, stimulate
the economy so that the government can later recoup some of
its spending costs through taxes on an economy that would
then post greater growth, some stimulus measures add little to
long run growth, and thus tax revenue. Some good examples
of government spending that have paid dividends for decades
include the interstate highway system, the space program and
even the military buildup during the Cold War.
Giving money to overly leveraged consumers to encourage
them to take on more debt to buy a new car or house does not
add anything to long run growth, as cars and houses are not
productive assets that can lead to long-term economic growth
potential. Moreover, giving a homebuyer tax credit to existing
homeowners does not stimulate the same new household
formation as it did with the new homebuyers tax credit, which
was consistent with the uptick in sales of furniture, appliances
and electronics that we have seen in the last quarter (apparel
sales fell, indicating that consumer spending in other areas
is still weak). Instead, the government is now giving away
$6500 to an existing homeowner to move to a vacant house
and create a newly vacant house (the previously occupied
home) in its place. Additionally, by stimulating residential
construction spending, as we have seen in the latest GDP
report, we are only adding to the housing glut inventory, not
reducing it.

2

Gene D. Balas, CFA

Inserting a parenthetical thought related to the
homebuyer’s tax credit, I see in the third quarter GDP report
that residential construction increased by 23% from the last
quarter, at a seasonally adjusted annual rate (SAAR). The total
dollar amount spent on residential construction at $363 billion
at an annual rate would correspond, in a rough estimate, to
building 1.3 million homes (including rentals) annually at the
average price of $282,000 in the Commerce Department’s new
home sales report. There are already 4.4 million vacant homes
for rent and 1.9 million vacant homes for sale. In addition, at
the end of the third quarter, as many as 1.7 million homes are
in some stage in or near foreclosure that might not yet be listed
for sale or rent, an increase of 54% from a year ago. With this
“shadow inventory,” a total of 5.5 million homes are available
for sale as of the end of the third quarter.
Given that new home sales fell by 3.6% to a SAAR of
only 402,000 in September and it is already taking builders 13
months to sell their inventory, adding such a large amount of
new homes to the glut of unsold homes already on the market

Home prices will likely continue
to decline by the simple
nature of supply and demand,
especially with a near record of
2.5% of all non-rental homes
sitting vacant and for sale.
certainly does not bode well for the direction of future home
prices. Home prices will likely continue to decline by the
simple nature of supply and demand, especially with a near
record of 2.5% of all non-rental homes sitting vacant and for
sale. Overall, there are 18.7 million vacant homes in the US,
or 14% of the total. Add in the fact that effective rents have
deflated by 3% YoY according to Reis, a real estate information
service, and the price-to-rent metric further argues for
continued price deflation; as it is, price-to-rents suggest a
further 10% to 15% contraction to return to longer term norms
even without declining rental rates.
But, after digressing, I return to the budget deficit. The
point is, it is unsustainable, and what is unsustainable always
ends, and often ends badly. Since the capital account must
equal the current account, our trade deficits will at least
partially fund our budget deficits, but the factors that balance
the equation are the price of the dollar and interest rates.
Several themes emerge from this, including:

Offsetting Forces


1. Neutral View on Dollar in Early 2010, Potential
Weakness Later

There are some differences of opinion as to whether
and how far the dollar may continue to fall, given its
depreciation in 2009. Some people are now bullish on
the dollar, after some better-than-expected economic
data boosted optimism that a Fed rate hike might not be
far off and US investments may have attractive return
potential. Meanwhile, many developed economies have
a number of problems, and their currencies may not have
much room to appreciate against the dollar, but many
emerging markets, on the other hand, are in much better
shape than the US or other developed economies. Of
course, there are always those people who are perpetual
bears on the dollar and warn that the US will lose its
status as the world’s premier world currency. I am
not making the argument here regarding the dollar’s
reserve currency status; there are no viable alternatives
as most of the developed world has problems of some
sort or other. Instead, I am focusing on aspects that are
more mundane, such as risk appetite, investment return
potential and supply and demand.

Gene D. Balas, CFA

perhaps more realistic assessment of opportunities and
risks, we may need to wait until the effects of the stimulus
program fade and the US economy is left to stand on
its own before the dollar begins another downtrend.
Economic data has presented some perhaps encouraging,
but still mixed, signals. Currencies are a relative game,
however, and nuances of inflation, potential returns
(including economic growth and interest rates) of many
economies around the globe play a factor in determining
currency rates between the US and overseas economies. I
should note that currency forecasting is fraught with risk,
given the intricacies of the many variables involved.

However, a simplistic, yet easy, way of assessing
different economies would be to think of where investors
would like to invest, due to return prospects, inflation
potential and interest rates coupled with flow of funds
linked to trade. These considerations argue for a weaker
dollar later in 2010 against some Asia-Pacific and certain
Latin American currencies as fear of sovereign credits
recedes while the US economy languishes. Much of the
developed world has problems, the US included. In
my view, the prospects of rising short term US interest
rates before similar rates gain in other economies is a bit
During 2008 and early 2009, we had seen the dollar
misplaced. As discussed in related segments, US economic
strengthening and Treasury yields falling as fear-based
growth is likely to be anemic; high unemployment is
trades caused investors to flock to the safe-haven
likely to be a greater concern of the Fed than inflation
investments of US Treasurys. After March of 2009, when
might be, and other central banks are
risk appetite returned (sending
more likely to hike rates before the
global stocks and commodities
Goldman Sachs estimates that the
Fed does. Goldman Sachs estimates
higher), the dollar resumed
stimulus spending will add two
that the stimulus spending will add
its long term decline against
percentage points (annualized) to
two percentage points (annualized)
a trade-weighted basket of
GDP in the first half of 2010, and
to GDP in the first half of 2010, and
currencies from a nearby peak
then nothing after that.
then nothing after that, leaving the
earlier this decade (after the
economy to rely on private demand.
last bear market) and Treasury
Given the prospect of a softer economy in the second half,
yields rose (as I forecast in my 2009 Outlook). Then, with
investors may focus on opportunities elsewhere later in
the release of November payroll data in early December,
2010, at the same time that the US is busy trying to raise
optimism about US economic growth and Fed rate hikes
funds to fix its economic woes.
took hold, with the dollar rebounding.
As we enter 2010, we are at a juncture where the
strength of the global economy and financial markets are
flashing mixed signals. On one hand, we see concerns
with sovereign debt issues in some smaller economies
(e.g., Greece, Dubai, etc.), while at the same time US
economic growth appears to be gaining some traction
in a few areas, stabilizing in others or, in the case of
unemployment, continuing to disappoint. These mixed
signals make it difficult to discern an accurate near term
direction for the dollar in early 2010.
During the first half of 2010, with some consolidation
in equity markets as investors’ optimism gives way to a
3

Now that the Treasury is continuing to borrow to
finance record budget deficits and investors may no
longer feel a need to focus on safety globally later in the
year, the mechanism for a price that will clear the market
is through some combination of a falling dollar (similar
to cutting prices on clearance merchandise) and/or rising
interest rates. This is if there are no lurking sovereign
debt problems discovered as the year progresses. (The
question of whether interest rates might rise is discussed
below.) A primary component of my views is that
economic growth, particularly consumers’ incomes and
spending, will be weaker than official forecasts and

Offsetting Forces

result in lower tax revenues and therefore higher budget
deficits than predicted.
However, improving economies abroad, including
both select developed and many emerging markets, along
with their higher potential investment returns and rising
short term interest rates in some countries should result
in pressure on the dollar as investors seek better return
potential and distaste for our profligate spending and
borrowing needs. Add in the carry trade of borrowing
in US dollars to buy risk assets globally and further
pressure builds, although a sudden reversal to repay
those dollar-based loans for whatever reason, such as a
rise in US interest rates, could trigger a snap back in the
price of the dollar. Importantly, a significant case for the
dollar’s continued weakness is that the US government,
loathe to either increase taxes or cut spending, may
choose instead to “reflate” its way out of its fiscal mess
by simply printing more money.

2. The potential for rising interest rates is
offset by rising consumer savings and shift in
household asset allocation

It is easy to make the argument that the US Treasury’s
borrowing needs will push up interest rates, but is that
really the correct answer? Above, I suggest that the price
mechanism will be a falling dollar. Here, I must consider
the argument that the forces of supply and demand
will result in higher interest rates, but instead I propose
that interest rates will likely not rise significantly. The
operating word is “significantly,” as I am not necessarily
forecasting that rates would actually decline either. Many
pundits make the case that the $3.4 trillion of cash on the
sidelines will push equity markets higher. Stocks are not
the only investment in town! Investors have been badly
burnt by two bear markets this decade, and while it has
risen from notable lows, consumer confidence in the
economy is still consistent with a recessionary backdrop.
These two psychological hurdles must be overcome
before retail investors return in droves to stocks. Any
corrections in the equity markets may further reinforce a
trend of reallocation toward fixed income assets.
With an aging population and baby boomers entering
or nearing retirement and with allocations to Treasury
notes and bonds as a percentage of household assets
sitting at very low amounts relative to their historical
levels, it is more likely that this cash on the sidelines will
be invested in fixed income securities. Recent mutual fund
flows demonstrate that point, with bond funds taking in
more assets, while equity funds have seen outflows in
recent weeks (which is especially significant given retail

4

Gene D. Balas, CFA

investors’ propensity to chase returns, given the huge
rally we have seen recently). If this cash on the sidelines
were used to reallocate (e.g., increase) investors’ assets
back toward longer term norms of fixed income assets as
a percentage of household balance sheets, much of the
Treasury’s supply of note and bonds can be absorbed
without a rise in interest rates.
Then there are the banks. The Obama administration
is exhorting banks to lend money…but isn’t that what got
us into this mess in the first place? We still have another
banking calamity looming on the horizon: Goldman Sachs
recently estimated that losses on commercial real estate
accruing to banks would be about $180 billion. Goldman
also noted that banks are carrying their approximate $2
trillion in commercial real estate loans at 96 cents on the
dollar. Ever notice how many empty store fronts you see,
or “For Lease” signs on office buildings, not to mention
hotels and apartments?
Given this backdrop of a mountain of bad debts
looming on the horizon, would a bank really prefer to
take another gamble of loaning money, when it could
just as well invest in Treasurys? Given the steepness of
the yield curve, the net interest margin provides a decent
profit with no credit risk. As an aside, doesn’t Uncle Sam
need quite a big loan these days? Banks buying Treasurys
has also driven equity and commodity markets higher.
How? Well, they have to buy the bonds somewhere! If
banks do not buy Treasurys at the auction, other investors
selling Treasurys (e.g., hedge funds, long-only portfolio
managers, etc.) take the proceeds and invest them in risk
assets. Continued Treasury buying by banks can boost
prices of not only bonds, but stocks as well.
There is a huge caveat to this argument. As I
point out above that banks buying Treasurys can send
other markets higher, so too can the Fed’s purchase of
mortgage backed securities to bolster the housing market.
Where do investors selling mortgage-backed bonds into
demand supported by the Fed’s purchases invest the
proceeds? Stocks? Treasurys? As the Fed curtails its
MBS purchases in 2010, that flow of funds through the
MBS market into other asset classes can undermine a
crucial area of support, which may send Treasury yields
higher, given the US’ continued issuance of bonds. Of
course, the timing of the Fed’s exit from MBS purchases
will roughly coincide with the time that the homebuyer’s
tax credit will expire, and demand for mortgages from
homebuyers will likely plunge, along with issuance of
MBS securities. All the homebuyer tax credit likely did
was pull demand forward from people who would likely

Offsetting Forces

have bought homes anyway; now that they did, demand
for homes (and mortgages) will likely fade.

3. Rising taxes and cuts in government spending
choke off economic growth at some point…or
will the US just “print more money”?

This is a point that is probably at least in the back of
everyone’s mind...not the least of whom are consumers.
As economics textbooks suggest, the potential for rising
taxes in the future can limit spending in the present as
consumers’ spending is tied to their expectations for the
future (which is why consumer spending is correlated
only to the “Expectations” component of the Conference
Board’s consumer confidence survey and not to the
headline figure). As to the point I made previously that
what is unsustainable always ends, and usually ends
badly, eventually, federal government receipts have
to rise, spending is cut, or the US government tries to
“reflate” the economy by printing more money. To the
latter point, higher inflation will make it easier for the
government to pay back borrowed money in the future
with dollars that are essentially worth less.

Gene D. Balas, CFA

of 2010. The remaining shortfalls must be covered by
spending cuts and/or tax hikes.
According to the National Governors Association,
states have cut over $55 billion from budgets from the
current fiscal year (most of which began July 1), still
leaving deficits of nearly $15 billion and after instituting
tax hikes of nearly $24 billion. This $94 billion in enacted
or pending spending cuts and tax increases offsets about
half the federal stimulus spent this year. State general
fund spending dropped 5.4% in the past year, the largest
drop since records began in 1979. Further budgets cuts
are coming: the Center for Budget and Policy Priorities
estimates that states face a budget shortfall of $180 billion
for the coming fiscal year.

That money must come from somewhere: either
cutting spending or raising taxes, as states cannot just
“print money”, unlike the federal government. The result
is that either states must raise taxes, and hurt consumer
spending, or cut services and institute more layoffs and
furloughs, which would hurt consumer incomes. Putting
these spending cuts in context, it may be more helpful
to think in terms of how many potential layoffs would
be needed to close budget gaps this
From an econometric point
size (the average municipal salary is
of view, cutting taxes could
about $46,000 according to PayScale.
actually boost economic growth
If half of the 2011 state budget
com, across several categories of
to increase overall tax revenues
shortfall of $180 billion comes from
employees), rather than comparing
in some cases, but tax rates have
cutting salaries, hypothetically,
the size of the cuts to broad US
already been cut from levels from
that is nearly two million jobs.
GDP. If half of the 2011 state budget
years ago and the government
shortfall of $180 billion comes from
is still running deficits. In an
cutting salaries, hypothetically, that is nearly two million
extreme example, one can see that cutting tax rates to
jobs, for the purposes of this illustration.
say, 1%, would likely not result in higher tax receipts,
nor would increasing tax rates to 99% result in higher tax
The longer-term effects of cutbacks to education can
revenue, as economic activity would be suffocated. The
be profound, as it could threaten the competitiveness of
complicated area is determining tax rates somewhere
the US when our children reach the labor force. Moreover,
in the middle. Higher taxes are politically unpalatable,
the stresses to the social fabric and personal health of
but so too are spending cuts. Neither higher taxes nor
citizens is difficult to quantify, as health care programs
cutting spending will help economic growth, but some
are cut and prisoners released early from jail with little
combination of the two will eventually have to be
employment prospects and fewer social services to help
done. Aside from cutting spending or raising taxes, the
them integrate successfully into society. Will increased
government can simply print more money, which argues
crime be the result of early releases of prisoners occurring
for a falling dollar: the more there is of something, the
at a very challenging period in the labor markets?
less it is worth.
Then there are the cities and states to consider. Even
after the help to cities and states from the fiscal stimulus,
states still face budget shortfalls. States filled about 30%
to 40% of their budget shortfalls with the approximate
$250 billion that was part of the federal stimulus bill,
most of which will have been distributed by the end
5

Offsetting Forces


4. Will Exports Drive the Economy?

First, let’s examine one popular theme: China. Everyone
talks about Chinese economic growth. How will that
affect US exports? Consider a few facts: US exports to
China in 2008 were about $70 billion (data from the US
Census Bureau) out of a US economy of roughly $14 trillion
with about 300 million people, or about half a percent
of US GDP. Chinese exports to the US were about $300
billion, out of a Chinese economy of about $4.5 trillion,
with a population of about
1.1 billion. It took nearly a
decade for exports to China
to increase by 300%, so it
seems unlikely for exports
to China to boost US GDP
by a significant amount
in the short term. A one
percent fall in US consumer
spending would swamp
the economic effects of
a doubling in exports to
China. Instead, given that
Chinese exports to the US
are a much bigger part of
the Chinese economy, and
since we depend on cheap
goods imported from China, it is unlikely that either
party really wants the yuan to appreciate significantly,
regardless of what US officials may say publicly.

US exports to China in 2008 were
about $70 billion out of a US
economy of roughly $14 trillion with
about 300 million people, or about
half a percent of US GDP.
That said, exports, which comprise about 11%
of the US economy (versus about 70% for consumer
spending) will be a bright spot, though not a savior, to
the US economy. Both goods and services will benefit
if a cheaper dollar makes our exports more competitive
abroad. US- based multinational companies are an
obvious beneficiary, but so are their suppliers, which
may include smaller firms as well. Industrials, materials,
healthcare and consumer goods, including food and
beverage companies, are all likely beneficiaries. This
theme of domestic-based exporters has been prominent
in my 2009 and 2007 Outlooks, and may likely continue
to benefit.

6

Gene D. Balas, CFA

5. Rising inflation due to both higher import
prices caused by a falling US dollar and
increased money supply is offset by deflation
due to weak domestic demand and excess
capacity of capital and labor

Let’s consider inflation for a minute. Many people say
that the cash injected into the system will cause higher
prices for goods and services. I point out that the velocity
of money has fallen significantly
recently, which makes the
increased amount of cash in the
system less inflationary. While
the cash in the system certainly
seems to be boosting the prices
of stocks and commodities (the
prices of the latter have also
been boosted by the falling US
dollar, discussed below), the
government’s printing press does
not seem to be causing prices
of goods and services to rise.
This is not surprising given the
output gap. The excess capacity
of capital (capacity utilization is
a very low 71% versus a morenormal 80% + rate) and labor
(high unemployment points to decreased labor costs,
which comprise about two-thirds of the costs of goods and
services in this country) argue for lower cost structures.
Weak pricing power due to a deleveraging consumer
sector makes it more difficult to pass through higher end
prices to the customer. Instead, I would argue that inflation
is not, in fact, a theme we will see, as firms’ pricing power
is significantly eroded given weak consumer sector and
the significant output gap. I believe deflation, though
not of a substantial degree, will be a more prevalent
theme. (See the quote from the National Federation of
Independent Business in #9 for further amplification.)
Anecdotally, the discounts offered by retailers even
in advance of and in addition to the traditional “Black
Friday” event would argue for the necessity of price
discounts to lure frugal shoppers to spend.

The velocity of money has fallen
significantly recently, which makes
the increased amount of cash in the
system less inflationary.

Offsetting Forces

As to import prices, consider that the trade-weighted
dollar has fallen by about 12% or so from its nearby peak
in March of this year (though it has been in a secular
downtrend since 2002), and it would seem like import
prices should rise in tandem. Yet, import prices have risen
by only by 1.6% during this period, based on the nonfuel imports price measure
published by the Bureau
of Labor Statistics. What
does this mean? Since
the dollar has fallen by a
much larger amount than
non-fuel import prices (in
dollars) has risen, foreign
exporters to the US likely
have taken a hit to margins.
Since pricing power in
the US is weak, given
the high unemployment
rate and difficult access
by consumers to credit,
foreign-based
exporters
have resorted to what
amounts to price cutting.
As such, even though a falling dollar makes investments
in foreign stocks more attractive, all other factors equal,
the fact that their margins are probably being hit makes
me a bit wary of foreign firms that depend on exports to
the US for a big chunk of their sales.

6.

Gene D. Balas, CFA

so a falling dollar often means rising commodity prices,
although that is not the only explanation.
The prospects for rising demand, limited supply, and
geopolitical concerns also weigh in on the direction of
price movements. Importantly, using the catchall term of
“liquidity” (whatever that may
mean) sloshing around in the
system is often used to explain
price movements.
Indeed,
it would seem as though the
printing presses of governments
around the globe seem to result
in at least some of that money
chasing commodity prices
higher, at least in US dollar
terms. Note, however, that
price increases of commodities
when expressed in euros, yen
or many other currencies are
much less than price increases
in the declining dollar, and
countries producing any of the
affected commodities are not
always enjoying a proportional increase in revenues in
local currency terms.

Commodity prices are difficult to forecast in the
shorter term, given vagaries such as geopolitical tensions
and the discovery of new supplies as but two examples,
but the longer-term relation of supply and demand
should continue to send commodity prices higher. Note,
Are Commodities and Gold Havens for Dollar
however, that the recent plunge in Baltic Dry shipping
Debasement?
rates would correspond to diminished demand for nonHaving just discussed non-fuel import prices, it is worth
petroleum commodities, leading me to believe the recent
noting that fuel import prices increased by 43% from April
price increases have been largely the result of investors
1 to October 31 (also courtesy of the BLS). (Speaking of
and speculators. An important point on commodities
oil imports, I see that gas prices are at a 12-month high,
and precious metals is that they are hard to value: there
costing the average driver $50 more per month. Without
is no cash flow to consider as is the case with stocks or
even considering trucking or mass
bonds, so commodity prices must be
transit, this threatens to drain over
taken with a grain of salt.
$120 billion a year from the economy,
The hike in gas and other
offsetting much of the benefits of the
energy prices on household
Now,
as
to
investing
in
fiscal stimulus program.) As such, the
finances, in aggregate, is
commodities…investing
in
ETF’s
hike in gas and other energy prices
analogous to offsetting the
that invest in futures contracts may
on household finances, in aggregate,
entire incomes of 2.4 million
not at all deliver returns anywhere
is analogous to offsetting the entire
households!
close to the changes in spot prices.
incomes of 2.4 million households!
Many commodities futures are often
Oil prices, of course have been very
in contango: prices for future delivery may be higher
volatile recently, peaking a couple years back at very
than prices today, and holding the futures bought at the
high levels, then falling precipitously, and then rising
higher prices has often resulted in gains substantially less
again this year. Many commodities are priced in dollars,
than the rise in the spot prices for the same commodity
(assuming spot prices increase). The remaining options

7

Offsetting Forces

to invest in the space are somewhat indirect: specific
companies (miners, manufacturers and drillers, etc.), as
well as countries or regions that are commodity producers.
Remember that the effects of currency changes may

Investing in ETF’s that
invest in futures contracts
may not at all deliver returns
anywhere close to the
changes in spot prices.
complicate things when investing in companies abroad,
both as to the currency translation of the commodity
and the underlying stock. Given the complexities of the
space, I would suggest more research on a companyand country-specific level before investing. While more
thought would be required, I see price increases for
commodities over the long run. I would also venture
to say some commodity prices might be based on nearterm economic growth prospects that are overestimated
by investors, and as such, I might wait for a pullback in
commodity prices before investing in the space.
Gold, on the other hand, often marches to the beat
of a different drummer than commodities, but I am
discussing it here due to its role as an investment apart
from financial assets. It can be a commodity, as it has a use
in jewelry, but it also is seen as a store of wealth. It is not
necessarily a perfect hedge for inflation (but has done well
when inflation had been combined with weak economic
growth, such as the 1970’s). Instead, it may be best used
right now as a hedge against currency debasement. Fiat
currencies are little based on the gold standard now,

Gold is a crowded trade
given that Consensus, Inc.
(a survey firm) reports
that 78% of investors are
bulls on gold.
and governments are free to print money at will. As I
made a point of a falling US dollar above, here I suggest
that foreign central banks may want to increase their
gold holdings versus depreciating dollars as the reserve
“currency” of choice. Gold is a crowded trade, however,
given that Consensus, Inc. (a survey firm) reports that
78% of investors are bulls on gold. When something is
expected to occur, something else often occurs instead.
8

Gene D. Balas, CFA

That said, even though a high bullish figure can be a
contrary indicator, gold can continue to move higher
for some time. As such, even though it is likely that the
price already reflects investor sentiment to some degree,
the actions by central banks, while unpredictable, might
send gold prices higher still. I recently see that India is
increasing its share of gold in its central bank reserves by
200 metric tons, or $6.7 billion, absorbing half the supply
the IMF put on sale.

While the US government is going on a borrowing binge, the
over-indebted US consumer, faced with looming retirement
and shrunken assets, needs to pay down debt to a sustainable
level and save for retirement. (While the need for repairing
consumers’ balance sheets should seem fairly obvious, and
recent indicators such as consumer credit showing a remarkable
contraction recently [due both to banks cutting credit limits
on the supply side and consumers cutting borrowing on the
demand side], consumers are not always a rational bunch and,
as such, their behavior cannot be quantifiably predictable.)
This leads to one very important theme:

7. US consumer spending remains weak as
consumers pay down debt and save more

Overall, this theme will limit corporate revenue growth,
and thus corporate profit growth, over the next several
years, resulting in limited gains in US equities. As I point
out above, consumer credit has fallen remarkably recently,
as seen in the nearby graph. Meanwhile, consumers’
incomes (as measured by real disposable incomes in
chained 2005 dollars as reported by the Bureau of Economic
Analysis from the Commerce Department) have fallen in
each of the past four months through September. With flat

Offsetting Forces

or falling real incomes and consumers paying down debt,
it is hard to envision a scenario in which US consumers
significantly increase spending in light of the headwinds
of rising unemployment. It can go without saying high
unemployment bodes ill for real wage increases, either
measured in aggregate or in an individual worker’s
paycheck, nor does rising unemployment enhance the
mood to spend.
While we did see
a (perhaps temporary)
increase in consumer
spending in the third
quarter GDP report, I
note that the increase
in GDP was coincident
with an unsustainable
drawdown in savings
(also buried in the GDP
report) during the period.
In fact, the drawdown of
savings funded all of the
increase in GDP in the
third quarter…not the
makings of a sustainable
trend, yet this fact
escapes
the
public’s
attention. (As an aside, to throw some water on another
economic statistic, some people have been encouraged
by some reports on improving same store sales in the
retail sector. Remember, same store sales, by definition,
do not include stores that have closed! Given the fact
that tens of thousands of stores have closed [including
many that are not part of chain stores], focusing only on
stores that are still open is a bit misleading.)

The increase in third quarter GDP
was coincident with an unsustainable
drawdown in savings that funded all of
the increase in GDP in the third quarter.
Let’s explore the issue of the consumer’s financial
health further, with a particular focus on consumer
debt levels. This is an important topic, because the
rise in consumer debt levels, which funded consumer
spending growth beyond consumer income growth,
largely propelled the massive growth in corporate profits
over the past couple decades that fueled the markets
from 1982-2007 (with other factors such as increasing
multiples boosting share prices, of course). Without this
debt accelerant, how far can the economy go, considering
9

Gene D. Balas, CFA

that in recent years each dollar in GDP growth required
three dollars in credit growth?
In fact, consumer debt relative to consumer income
rose from about 64% in the 1960’s to 100% in 2000. It then
skyrocketed to nearly 140% a couple years ago in the
midst of the housing and mortgage bubble. Since then,
we have seen a massive undertaking to reduce household
debt (mortgages, credit card, auto loans, etc.), but in
fact household debt relative to
household incomes has only
decreased to 131% for the most
recent data. I will preface this
discussion by highlighting that
the painful recession we recently
endured was coincident with this
nine-percentage point reduction
in debt-to-income levels, and
note that we still have about 31
percentage points more to go to
get to a “normal” state of about
100%, where it was earlier this
decade. Doing a little math,
considering that there is about
$13 trillion of household debt
outstanding, we need to see that
reduced to about $10 trillion, a
reduction of at least $3 trillion to return to a serviceable
level.
Consumers could default on debt, of course, which
will cause further pain in the banking system and credit
markets and lead to continued economic weakness,
given that every dollar a bank loses is about ten dollars
in loans it cannot then make, given capital requirements.
As noted before, the US economy has in recent years
required three dollars in new credit to fund every one
dollar in GDP growth. Alternatively, households could
immediately save nearly 30% of their incomes to get
debt in line with a manageable amount (reducing debt
servicing ratios from over 14% of disposable household

The painful recession we recently endured
was coincident with a nine-percentage
point reduction in debt-to-income levels,
and I note that we still have about 31
percentage points more to go to get to a
“normal” state.
income to the long range norm of 10% to 11%), which
is unlikely, or they could boost savings/debt repayment

Offsetting Forces

Gene D. Balas, CFA

more gradually. If households were to boost savings
gradually to 10% of disposable income (roughly, where it
had been for many years) over the course of the next five
years, they could reduce household debt to a level about
equal to household income, viewed by some economists

Every dollar a bank loses is
about ten dollars in loans it
cannot then make, given capital
requirements. The US economy
has in recent years required three
dollars in new credit to fund
every one dollar in GDP growth.

as a sustainable amount. This would also bring debt
service to about 10% of income and the savings rate to
long-term norms of about 10% of income. Reducing the
debt in this fashion would result, of course, in lower
consumer spending in the near term.
In fact, by repaying consumer debt in this manner,
consumers would cut their spending by over $700 billion
over five years versus the status quo rate of debt reduction
(which assumes a 14.5% debt service ratio). Increased
savings and repaying debt would be a hit to GDP, versus
what it would be otherwise, of over 5 percentage points
over the course of the next five years, beyond cutbacks
in spending so far since the start of the recession and
assuming that real incomes increase annually by 1% to
2% over this five-year period. I note that real household
incomes since the start of the decade have essentially
been stagnant, so a 1% to 2% annual growth rate in real
incomes over the next five years could be optimistic,
given that the high unemployment projected over the
next several years could keep real wages from posting
significant gains. Another comment to put the savings
rate into perspective is the shift over the past few decades
from (employer funded) defined benefit pension plans
to (employee funded) defined contribution plans may
actually require the savings rate to be much higher than
that of a couple decades ago in order for workers to have
a secure requirement.
This forecast would argue against consumer
discretionary stocks but in favor of discounters, such as
Wal-Mart, Costco and BJ’s. I might also favor defensive
plays, such as healthcare and consumer staples stocks,
which may include companies with a global presence
and a strong brand with pricing power, and many of
these stocks have seen relatively muted gains relative
10


to riskier names during the recent stock market rally.
This theme might also favor those beneficiaries of higher
savings rates, such as some banks, although care must be
taken to consider the likelihood of aggressive accounting
techniques given the subjective nature of bad-debt
writedowns and the potential for future losses, especially

Increased savings and repaying debt
would be a hit to GDP, versus what
it would be otherwise, of over 5
percentage points over the course of
the next five years.
given the propensity for further consumer defaults.
Importantly, the pending disaster in commercial real
estate, trillions of dollars of which must be refinanced
in the next two years, is cause for fear of many banks.
Asset managers, though, may also benefit, especially
those that have an emphasis on more conservative
strategies (given that households may have been badly
burnt by the recent stock market rout), and companies
that serve as third-party retirement plan administrators
and other operational backbones of mutual fund
complexes as consumers increase 401(k) contributions
and participation rates.

Unemployment

To offer a few thoughts on unemployment, consider
first that the US economy needs to produce 100,000
to 150,000 new jobs every month just to keep up with
the growth of the labor force. We must also need to
consider that the workweek is near a record low number
of hours: before companies actually hire new bodies
to meet increased demand, they will likely give their
existing workers more hours. Moreover, any continued
strong gains in productivity may lessen the need for
substantial hiring. Considering that, how many jobs
does the economy produce during “boom” times? Well,
in 1999, at the height of the tech boom, the economy
added an average of 250,000 jobs per month, according
to the BLS. We now have over 15 million people who
are unemployed and looking for work, and 11.5 million
more who are either working part time but want full time
work or who are unemployed and would like a job but
have, more or less, given up on the job search for the time
being (the “marginally attached”).
For the sake of this argument, we will focus on the
15.4 million “officially” unemployed. To get to a state of
full employment, we would need to see 8 million of these
potential workers get jobs. Adding in the 2.3 million
in the “marginally attached” category and the analysis

Offsetting Forces

becomes even more daunting. Assuming we have an
(unprecedented) string of boom years in which the
economy creates, say, 250,000 jobs each and every month
for the foreseeable future and there are only 100,000
new entrants to the labor force, that leaves us with net
reduction in the number
of the unemployed of
150,000
per
month.
Conveniently
ignoring
the fact that older workers
may stay on the job longer
to replenish badly-needed
retirement savings, we
then see that it would take
over four years of aboveaverage job creation to get
back to full employment
(here, we will say that full
employment is 5%). And
that’s being optimistic.
From January 2003 to December 2007, an average of only
133,000 jobs was created each month. At that pace, it
would take 15 years to get back to full employment. (A
reduction in immigration may reduce the number of jobs
needed to be created each month to keep up with labor
force growth, but at the same time will heighten the issue
of an aging population.)

From January 2003 to December 2007,
an average of only 133,000 jobs was
created each month. At that pace, it
would take 15 years to get back to full
employment.
Whether one uses an optimistic or pessimistic
view of potential job creation, the reality is that high
unemployment will be with us for at least several years.
The economics of this situation becomes difficult to
quantify, as it relies on the unpredictable nature of human
behavior and the resources available to the unemployed.
Some questions one might ask could be: How much
will a household cut its budget if a family member is
unemployed? That in turn depends on the household’s
ability and willingness to use savings to fund its expenses
and how much of its budget unemployment insurance
covers. Can the household raise funds from other
sources (borrowing from friends and relatives and/or
selling non-financial assets)? How much will everyone

11

Gene D. Balas, CFA

who personally knows someone who has lost his or her
job boost precautionary savings?
Moreover, since the ranks of the unemployed
included a different set of people over time, many more
households than just the 10% currently unemployed
have been, at some point
during this recession, been
without a paycheck. If we
say that, hypothetically, 20%
of households have seen
at least one member being
unemployed during the entire
recession, and we factor in all
of those people close to the
situation, this could engender
a sea change in American
attitudes towards savings
versus consumption that could
last many years.
To explore the issue further, let’s just make up a
few numbers for arguments sake, using a simplistic
calculation. First, there’s always going to be some
unemployment in any economy, so we’ll focus on the
long-term unemployed (over 26 weeks), who number
5.9 million according to the BLS for the November 2009
data. This is about 4% of the labor force, and would
likely be expected to grow until the economy creates jobs
in a meaningful sort of way. How much will they cut
their spending? That’s a difficult question to answer, of
course, as it depends on the items I raise above. We also
don’t know how much each of them made while working.
However, assuming these households cut their spending
by, say, 20%, and earned the median income of $50,233
(according to 2007 data from the US Census Bureau), that
would cut consumer spending by nearly $57 billion on
an annual basis (with the assumption that savings rates

Spending cutbacks by the long
term unemployed alone, over
the next four years, can offset
nearly 40% of the remaining fiscal
stimulus money not yet spent.
began at roughly 4% while employed). On a back-of-theenvelope basis, then, spending cutbacks by the long term
unemployed alone, over the next four years, can offset
nearly 40% of the remaining fiscal stimulus money not yet
spent. This is distinct from any trends towards increasing
savings/paying down debt by other households.

Offsetting Forces

According to the National Energy Assistance
Directors Association, 4.3 million utilities customers had
their utilities disconnected due to non-payment during
the past fiscal year, a 5.1% increase from the prior year.
This is despite increased federal assistance for utility
payments. If more households are having trouble
paying their utilities, then it stands to reason that cuts
in spending, defaults on debt (credit cards, auto loans,
mortgages), and rent (which brings to mind, yet again,
the problems in commercial real estate – doubling up on
space to save on rent will increase vacancies and decrease
rents), cannot be far behind. Tishman Speyer Properties,
LP and Blackrock, Inc. missing a payment on debt on
Stuyvesant Town and Peter Cooper Village in New York
is the latest in this saga; it is on track to become the
second largest commercial real estate default in history.
(The property is the largest residential housing complex
in New York and has over 11,000 units. It was purchased
in 2006 for $5.4 billion with $3 billion in debt and is now
estimated to be worth only $1.6 billion by Fitch.)
Another difficult question to answer is that
pertaining to defaults by the unemployed: how long will
a household go before possibly defaulting on credit cards,
auto loans, and the mortgage? Some may never default,
others may do so immediately, but as the duration of
unemployment lengthens for many Americans, we will
likely see further losses accruing to banks as the savings
of the unemployed become depleted and/or they exhaust
their unemployment benefits. Since accounting rules
now allow banks to continue accruing interest on loans
as many as 180 days past due, it may be well into 2010
before banks recognize losses on these (and other) loans.
Once the unemployed are working again, it may be a
while before a formerly unemployed person has repaired
his or her credit and/or re-established his or her work
history to the point of being able to take on new household
debt. (Given the likelihood of defaults occurring much
later than the surge in actual job losses, it is no wonder
that banks, wary of their perhaps questionable loan
portfolios, are not willing to bet their balance sheets on
making further loans.) This credit availability factor will
serve to curtail consumer spending in years to come, at
least at the margins.

Gene D. Balas, CFA

The remaining three themes include two that are temporary
and one that is structural. They include:

8. Inventory build boosts US economic growth
over the short term

At first glance, the graph below would appear to say it all
about the need for companies to boost inventories, which
would increase economic output at least for a little while,
given that the inventory-to-sales ratio is at such a low
level.

The current improvement in the manufacturing sector
is likely at least partly the result of an inventory boost. I
will be one of the first to admit that building inventories,
possibly to meet pent-up demand by consumers, who
have previously curtailed spending significantly, would
be an integral part of increasing economic activity,
possibly resulting in hiring and reducing spare capacity.
I do, however, want to consider a few alternative issues.
First, to what extent has a lack of credit, especially
vendor financing of inventories performed by such firms
as CIT, which declared bankruptcy, curtailed inventory
builds on retailers’ shelves and will this continue? How
much do retailers (and by extension, wholesalers and
manufacturers) want to keep inventories lean because
they are unsure about sales prospects and want to keep
inventory costs down and reduce the potential for the
need of expensive clearance sales to bring in new seasonal
merchandise with better sales prospects? What is the role
of technology in keeping inventories lean?
To answer these questions, at least from the
perspective of small businesses (which comprise about
17% of the US economy and are a good barometer of
domestic demand since relatively few are exporters),
consider the following excerpt from the recent press
release of the National Federation of Independent

12

Offsetting Forces

Businesses (which also addresses some of my other
themes):
Overall, the small business job machine is still in reverse,
due to continued declines in reported sales, rising labor costs,
and a need to cut costs. Reported capital spending is at historic
low levels, owners are still, on balance, reducing inventory
stocks (only seven percent reported increases, 32 percent
reported reductions) so orders to wholesale and manufacturing
firms for new inventory are weak. Price cutting is rampant
(though slowing) which combined with lower real sales
continues to produce record reports of earnings declines, one
reason capital spending remains low. Few firms report credit
availability as a problem, though those who are borrowing
report more difficulty and tougher terms than during the
expansion. Events in Washington are not supportive of more
optimism about the future – another reason not to spend or
hire.

9. Global spending on infrastructure

It seems that many countries around the globe are
targeting infrastructure as a way to boost their economies.
This is a particularly valuable way to enhance economic
activity in both the short and long term, as in the short
term it creates needed jobs in construction, engineering,
state and local governments, and of course, all of their
suppliers. In the long term, infrastructure can boost
productivity (think of the interstate highway system as
a prime example).
Now, let me provide some caveats. One must consider
the timing and the ability to implement these projects. It
takes quite a while for a large project to be debated before
it goes to the planning stage, let alone implemented.
That said, here in the US, indeed quite a few unemployed
people might be put to work in infrastructure projects.
The question is, how many of them would be both willing
and qualified to be employed for such projects? Would an
out-of-work investment banker be suitable for building a
road or bridge? Could a former retail clerk design a wind
turbine? If an opportunity arose in South Carolina, could
an unemployed auto worker sell his house in Michigan to
relocate? The infrastructure theme is likely to bear fruit
at the level of individual companies that can benefit, but
given the questions posed above, it may not be sufficient
in itself to have a significant and immediate economic
impact but will likely have societal benefits in the future.
Construction and engineering firms would likely benefit,
as well as those in the industrial and materials sectors.

13

Gene D. Balas, CFA

10. Rising emerging market prosperity over the
long term, especially those with developing
consumer demand

We can think of demand coming from two sources:
internal, or domestic consumption, and external, or
exports. We can then divide exports into commodities and
finished goods. Now, we have seen that the falling dollar
has likely brought pain in the form of crimped margins
to exporters of finished goods to the US, and we can also
see that the falling dollar has meant that commodity
prices in dollar terms does not translate into price gains
in local currency terms. In fact, the currency gains of
some commodities exporting countries negate much of
certain commodities’ dollar-price gains. Moreover, as I
point out above, the drop in Baltic Dry shipping rates
suggests that volumes of non-petroleum commodity
and finished good shipments are soft, suggesting price
moves may be the result of speculators. I note that
Australia, a commodity exporter, recently reported a
drop in exports in its trade figures. That leads me to
want to focus on emerging economies that are focused on
growing internal demand, although I must point out that
nearly all countries engage in activities that would be a
combination of domestic consumption as well as exports
of finished goods and/or commodities.
First, many consumers in emerging economies save
much more as a percentage of their incomes than do
their counterparts in the developed world. Much of
their savings is precautionary, so in order to get them to
consume more, their governments need to provide safety
nets for things such as health insurance, unemployment
benefits and disability benefits, things that we in the
developed world take for granted. Once these safety
nets are put into place, they allow consumers to direct

The drop in Baltic Dry
shipping rates suggests
that volumes of nonpetroleum commodity
shipments are soft,
suggesting price moves
may be the result of
speculators.

more of their incomes toward consumption, and some of
their precautionary savings can be then directed towards
spending. As such, countries instituting these policies
can see an outsized consumption gains quickly, relative

Offsetting Forces


Gene D. Balas, CFA

to incomes, simply by alleviating the need for households
to have such a large cash cushion against calamity.

The investment themes are profound. Investors will likely
eventually conclude when deconstructing equity returns that,
over the very long term, stock returns are dependent on profit
Second, the financial crisis emanating from the growth. Profit growth over the very long run cannot exceed
developed world highlighted very saliently the need nominal GDP growth (otherwise, corporate profits would
for emerging countries to attempt to insulate their eventually theoretically consume all of GDP), and nominal
economies from the vagaries of demand from the rest GDP growth cannot deviate markedly from nominal income
of the world; in other words, to develop more robust growth: lower wages eventually will equal lower profits. The
and diversified economies. It seems that this point was era from 1982 through 2007, during which massive amounts
especially taken to heart in Asian economies, which seem of borrowed money drove growth in consumer spending well
to have rebounded relatively well. These economies,
in excess of growth in consumer incomes,
and certain others, appear poised to
finding its way into corporate profits
revert toward longer-term growth
A realistic number for US
and fueling a tremendous bull market,
trends more quickly than many
nominal GDP growth over
is now over. A realistic number for US
economies in the developed world
the long term is, perhaps,
nominal GDP growth over the long term
might, presenting opportunities for
5% to 6%, and thus
is, perhaps, 5% to 6%, and thus underpins
investors, notwithstanding the recent
underpins likely US equity
likely US equity performance over time.
surge in share prices. Of course, this
performance over time.
The important exception to this formula is
theme will play out for many years
profits from global trade.
and is not just a 2010 play.
The opportunities outside the developed world are
Following that, given the global economy, companies tremendous. In the preceding discussion, I compare a few
with international brands with strong export distribution facts about China’s economy to that of the US. While China
chains would be a favored way of playing emerging market itself may not be quite as open to either US investors or US
domestic demand. These companies could be located in exporters, it may serve as an example of the potential of the
any country. There would also be local companies that emerging world. China’s per capita GDP is less than onemight benefit, especially in the consumer discretionary tenth of that of the US. Given the right catalyst of appropriate
area, along with their suppliers. As I noted previously, I policy measures and global free trade, there is considerable
might tend to underweight companies and countries that potential for the emerging world to catch up to the developed
are reliant on exports of either crude or finished goods world, providing investors with abundant profit prospects.
to the developed world. Plenty of opportunities exist to
The beneficiaries would likely include firms that can adapt
invest in local companies that serve the local market, but
finding and researching these companies will take on- to rising prosperity in new locales, companies with global
the-ground research.
brands and distribution, strong pricing power and good
corporate citizenship. Companies that will benefit are those that
supply the world’s growing need for “things:” commodities
on cl u s i o n
The financial crisis that arguably started in 2006 with the of all types, including food; infrastructure; pharmaceuticals,
deflation of the housing bubble and the first hints of looming (including serving an aging developed world population);
subprime defaults and then cascaded into the worst global and finished goods, both consumer goods and those related to
recession since the Great Depression has perhaps left an capex alike. Services are also increasingly global, and demand
indelible mark on consumers and policymakers everywhere. from the emerging world is important here as well. Many
In a sense, things may never be quite the same, or at least not of the companies providing these goods and services are
for a while. Consumers in the US, and indeed, much of the located in the US and the rest of the developed world. Despite
developed world, are learning that discretionary items are consistently falling employment in manufacturing, we may
not, in fact, essential to their well being, and are making do see that sector increase in importance in our economy as the
with a newfound frugality. Meanwhile, certain developing falling dollar boosts our competitiveness.

C

economies, especially in Asia and certain other economies,
are learning that the developed world is not, in fact, essential
to their well being and are preparing for a new world order,
perhaps not immediately, but at least in the not-too-distant
future.

14

Due to the seismic shifts of the global financial markets
and the Great Recession, the speed with which the world
realigns may be sooner than we once had anticipated. Active
management is essential.

Offsetting Forces

Gene D. Balas, CFA



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15

2010 Market Outlook

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