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By Mitchell Stapley, Chief Fixed Income Officer
Fifth Third Bancorp

“Wikipedia is a non-profit. It was either the dumbest thing I ever did or the smartest thing I ever did.”
-- Jimmy Wales, Wikipedia Founder

Elections, economy, earnings and easy money

As this year concludes, I must confess that 2010 was anything but boring. For one, the world’s capital markets bounced up and down like a yo-yo as investors digested big picture news about oil spills, reform legislation, European financial distress and the like.

However, the overall picture of things continues to show improvement. Our country’s economy is expanding, but at a subdued pace. The Federal Reserve Bank — always on our mind — strongly positioned its policy on the side of easy money, near zero cash rates, money supply expansion via QE2 and supportive rhetoric.

Another factor that is critically important to investors has been this year’s story on company earnings — registering up near 30 percent! And lastly, our country experienced a “midterm” election cycle that has led to dramatic change in Congress and has left our president much more challenged than before.

In spite of the swirl of noise around us, financial markets have rewarded patient investors this year. As I scorecard results in early December, the standouts include: a) U.S. mid and small cap indexes up 19 percent plus; b) domestic bond indexes up about 6 percent; and c) international equity markets (both emerging and developed) up north of 10 percent. The ride to these higher levels hasn’t been easy, but we should feel satisfied that patience has been properly rewarded.

Policy risk factors dominated our thinking in 2010 and will likely remain on our radar screen in the coming year. However, some good news was announced in December. There may be bi-partisan support, which will lead to an extension of the current tax brackets. Moreover, they are talking about a possible 2-percent reduction in the payroll tax as well. As I said, things feel better…

Looking around corners

As with past Decembers, it is time for all investors to gear for things to come. The exercise of prognostication is always a dangerous business, but investment advisors are expected to scan the horizon, to look around corners for things to come. As such, I’d like to present our Top Ten Predictions for 2011 (+1) with acknowledgment that it will be retained and scored later in the year.

1. No recession in 2011. Is there risk of a double-dip recession? Not really. But with the housing sector still weak, secular deleveraging in play, and unemployment rising, we’re bracing for GDP to pace at 2.50 percent +/- for the new-year, which is below the historic average of 3.00 percent growth. If we are wrong, the likely bias is to the upside.
2. However, labor markets remain mixed. So far, we are suffering in a jobless recovery. Unemployment has been ticking up and Americans should brace for mixed news in the coming year. We see the rate of unemployment remaining above 9 percent for most of the year. Why? Labor market conditions seem challenged in structural ways, and macro-growth is too slow for noticeable improvement.
3. 2011: Stock prices outpace earnings growth… i.e. P/E expansion. As we see it, our market is now moving from recovery and into the next phase of what we hope will be multi-year equity cycle. Fundamentals — revenues and earnings — have expanded at a historic level and will likely continue to grow in 2011. We see U.S. company profits up more than 15 percent over 2010 results. Investors should prepare their wish list of stocks during the holidays. We see stock prices outpacing EPS growth for a change and are predicting PE expansion. Expect domestic returns to exceed 20 percent in 2011!
4. New year, new leadership for stocks. Last year, factors influencing stocks were more macro by nature, and volatility in the markets suggested a lack of conviction. The coming year will be different. We see stock selection and active managers doing better as fundamentals become the central focus. At this time, we like certain sectors that have experienced under-earnings and are likely to benefit from an earnings reversion back to their normal potential. Our sector positioning includes energy, financials and technology. Moreover, we are positioning portfolios into higher cap, higher quality plays for 2011.
5. Most overpriced asset? Treasuries! Given the unsatisfactory condition found in the labor markets, it is unlikely that the Fed will pull back on monetary stimulus until the recovery is concrete. And given the Fed’s balancing act with future inflation risk, we see their next move as withdrawal from QE2 or QE3 (lost count). You should plan for higher rates by year-end, and the Fed’s balance sheet to shrink later in the year. For bond investors, the implications are clear: a) treasury yields are artificially low; b) cash yields are essentially zero; and c) spreads will not likely tighten further. Play the bond market more conservatively in 2011.
6. Retail inflation (CPI) remains subdued. Two reasons for below average inflation next year: 1) slow growth and obvious slack in the economy; and 2) wage pressures are non-existent. Investors should consider the inflation risk factor to remain in check for the coming year. However, our crystal ball is providing us with a longer-term inflation picture that is concerning. We won’t be talking too much about this issue in 2011, but are searching for signs of change.
7. Oil prices rise (maybe to triple digits). Bear in mind, the economic condition of the world has turned for the better —not great, but better. Further, economic growth will be uneven and strongest in developing economies like Asia. They are resource starved and will place further demand pressure on input materials and commodities like oil, paper, metals, etc. Investors should incorporate these thoughts.
8. German taxpayers dictate EU survival. One of the biggest stories of the year emanated from Europe. Building fiscal nightmares found in the “PIGS” — Portugal, Ireland, Greece, and Spain — led to market worries over issues of insolvency and sovereign debt exposure. Naturally, the banks were knee-deep in these bonds, and this risk has led to questions regarding the viability of the Euro and the very existence of the European Union. As we see it, the problems are early stage and the EU will only succeed through a concerted effort. At the heart of the solution will be the German taxpayers. A question to answer: will they step up and shoulder the financial burden created by past behaviors of their neighbors?
9. Merger activity escalates in U.S. Several factors lead us to a bullish stance on mergers activity in 2011. For one, U.S. companies are posting record profits and have shored up their balance sheet conditions. Financially, companies are in their strongest footing in years. Secondly, the storm that hit the world in 2007/08 has stifled the pace of transactions in the private sector. The pent up demand to deploy their capital strategically is high. We see a busy calendar of M&A activity, and this may inject additional life into the stock markets. Investors should focus in this regard.
10. Forget New Jersey…Jerry Brown is the story. New Jersey’s Governor Chris Christy dominated the political front in 2010 with his strong effort to curtail massive spending. However, we would look west for the story of 2011. California’s image is in the toilet and most people suggest that the state is insolvent. However, the midterm elections of 2010 brought Jerry Brown back to his old job, and most people have forgotten that, while he may be a social liberal, he is very much a fiscal conservative. The best thing to happen for California may, in fact, be his reelection to office. Like Nixon going to China in the early 1970s to establish diplomatic relations, Jerry Brown may launch the state down a path of fiscal recovery. Don’t expect a miracle — expect the state to turn in the right direction. A healthy California is important for a healthy U.S.
11. Baseball enjoys 2011! American’s pastime is still baseball. As we look ahead to next year, some thoughts pop forth. One, the Yankees signed Derek Jeter to a multi-year contract that will keep him in pinstripes for the remainder of his career. This will lead to their participation in the World Series, again! Watch out, though. The Cincinnati Reds or the Philadelphia Phillies may be in the other dugout. Can’t wait for spring…

In closing, I have learned much about the Wikipedia (not Wiki-leaks) story and its founder, Jimmy Wales. It seems that he came up with the idea for this web-based, user-supported encyclopedia while a student at Auburn. It relates to an F.A. Hayek theory regarding the “use of knowledge in society.” Hayek posited that free societies are most benefited from a grassroots distribution of information, not by way of a central method. Socialism, as an economic system, is flawed for this very reason. Wales dreamed of this theory in application — an encyclopedia that is supported by users, is updated by users, is corrected by users. In this way, all people are privy to information that is expansive, convenient and free. It may not be perfect information, but it is under constant improvement. We like stories like this one. America needs to encourage this type of free enterprise, risk taking and entrepreneurship. Again, we thank our clients for the opportunity to serve them. And to our readers, we wish you only success in 2011.

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