There is an old saw that one should have the ability to tie one of the analyst’s hands behind his or her back before any presentation. That way, one can avoid the inevitable “but on the other hand” backslide that allows most analysts to claim that they are almost always right.

As we approach the end of a volatile year, it isn’t hard to spot the emergence of a new beast: the Three Handed Analyst. These very erudite types will explain carefully that there are three possible outcomes: total meltdown, muddle through and return to strong growth. The recommendation is that somehow one should prepare for all three at once with a diversified portfolio of silver bars, ammunition, spam, US Treasuries, income producing apartment blocks, dividend paying stocks, some high beta growth stocks and a bit of AAPL on top for good measure. Confused? Well, you are in good company. But don’t let that get in the way of a sensible investment plan.

So what will happen in 2011?

Although all three possibilities do exist in theory, in reality only the muddle through scenario makes sense. The global economy is on the mend but like an older patient, the healing process will take a bit more time than usual. The main reason why we will not fall into a “Mad Max” hyperinflationary cycle is because the US and Europe are recovering from a financial crisis. The same reason explains why we will not see Global GDP surging ahead at 5%. In both cases, the major developed country banks are nursing years of write offs and receiving massive Central bank support. The write offs are a strong deflationary drag on what would otherwise be an overly accommodative monetary policy. And there are natural limits to the Central Banks powers. After QE2 resulted in higher rather than lower interest rates, it is hard to argue that the Federal Reserve will be able to print money without restraint. The Bank of England and the European Central Bank have already backed away from quantitative easing programs.

Let’s take it by regions.

The biggest piece of the puzzle is the US. Many bits have been spilled on the subject by far more qualified observers so I will just simplify it to a few indicators. I expect that we will see very sluggish consumption through the year which will be accompanied by a persistently high unemployment rate and weak overall housing market. Exports will do reasonably well but the effect will be crushed and amplified by the inventory cycle which I would expect to be fairly volatile (building inventories increases GDP, selling them down decreases GDP). Interest rates will bounce around but generally head a bit higher. What would I look for? Mostly positive signs…lots of M&A activity would be a key sign that corporations are starting to spend their cash hoard at what they perceive to be the bottom of the market. In the initial stage, I would expect to see industry consolidation rather than conglomerate building.

The EU is equal in size to the US in terms of GDP but institutionally, it has unique challenges. The Union is being tested to its limits by the financial woes of its peripheral states. The problems will not go away quickly and the regions affected will take years to regain competitiveness to start paying back the debt. This means that Europe is hardly going to be driving the global recovery. Germany is doing well and France is holding its own but the banks in those two countries are heavily exposed to the sovereign debt of the troubled countries. Interest rates have already increased but one should be on the lookout for mispricing. Neither Germany nor France can afford to let the Euro implode so a panic may afford some short term opportunities in five to ten year government bonds. If Europe moves to issuing “blue” Eurobonds (that are within the prescribed debt limits) and “red” sovereigns (for the excess), we could see a very exciting bond market develop (which may account for the enthusiasm for this idea amongst bond traders).

Asia is interesting because it has been supported by the massive investment led stimulus of the Chinese economy. The investment boom sustains demand for commodities from Indonesia, Malaysia and Australia (Thailand to a lesser degree). India’s growth is more of an internal affair. It is sucking in imports to support healthy growth but seems somewhat out of sync with the rest of the world. Although Japan is no longer a dragging anchor on Asian growth, it has yet to turn positive. As a result, China has surpassed Japan to become the second largest economy in the world and the one to watch in this region. How long will the property bubble last in China? There are signs that the government is taking serious steps to rein in bank lending, the primary fuel of the boom. So far, the tightening is mild compared to Zhu Rongji’s 16 point program which brought China to a screeching halt in 1995. But, if inflation persists, the government may be forced to take crude measures. How about the undervalued Chinese Yuan? Don’t look for anything more than a token revaluation. Most exporters are already suffering from higher wages and higher input prices which are cutting into their razor thin margins. Anything on top of that could result in very unpleasant economic repercussions. The interesting development in China is the wage inflation that is roundly bemoaned by the export sector. The US has asked China to develop more internal consumer demand for decades. It seems that China’s workforce has taken the project on by themselves.

Latin America looks well placed for another year of growth. Thanks to improving trade links, demand for commodities out of the big exporters (Brazil, Chile, Argentina) is set for another strong year. A new administration in Brazil will look to carry on the economic policies of Lula so despite some worries about hot money and capital controls, we are unlikely to see any disruptions in trade. Like Australia and Canada, the region is vulnerable to a big slowdown in Asia (China in particular) but a cooling off is unlikely to make a huge difference.

There is even some good news coming out of Africa as local multinational groupings supervise elections and hold leaders to the results. Foreign Direct Investment is rising and not just in South Africa. Even HIV/AIDS which has devastated working populations in a number of big African countries appears to have peaked out.

So, while the doomsday scenario does capture headlines, it is unlikely to unfold. The reason it sells well is because most investors (including most professional investors) were caught unaware by the severity of the financial meltdown in 2008. The rebound of risk assets in 2009-2010 is confusing to most because the recession is not typical. Rather than corporations being left hung out to dry by an inventory recession, this has been a balance sheet recession that took place in the household and banking sectors. Corporations that were not overextended were able to float through this period largely untouched. With the global economy well stocked with capacity, corporations have been able to keep more of the cash flow on their balance sheets as investment requirements shrunk.

Expect some of these factors to unwind this year. Corporations will start spending their cash hoard and that will impact valuations as new investment or acquisitions are initially dilutive to earnings.

So that is the one side of the ledger. What about the other side…investor demand? Interest rates are too low for most pension systems. Although there has been a big shift to defined contribution plans, there is still a significant amount of pension liabilities which are to be met with currently unrealistic investment return expectations (6% – 8% is hard to find in risk free Treasuries these days). From that most conservative group all the way to hedge fund investors, the desire for better investment returns will keep money shuffling back and forth between higher risk assets. Appetite for risk will remain healthy although it could suffer from bouts of indigestion.

How should you invest?

Although financial markets overall will be largely trendless, look for trends in subsectors and segments of the financial markets. Gold/Silver, Treasuries, Bonds, Stocks and Commodities will all enjoy periods of brief enthusiasm followed by slow returns to earth. Do not be shy about taking profits and cutting losses during the year. Bombed out sectors could become high flyers in a quarter or two so keep your investment universe as broad as practical. And, whatever you do, remember to separate the asset selection and trading processes.

Seeking Alpha Portfolio

Seeking Alpha Portfolio RankingWe sold our DBA for a small profit of $448.10 and put the proceeds into 160 shares of EWW, the Mexican ETF. For the week, TUR continued to weaken, particularly on Friday so we ended up with a loss of 1.32% on the portfolio for the week. Overall, the portfolio is down 6.8% since the middle of November when we started.

Although one always hopes to make gains rather than losses, the portfolio should be well placed for a “January Effect.” This year should see a moderately strong January Effect as institutions place money back into risky assets in the New Year.

Since there are no changes in the ranking, we will ride through the holiday season with Turkey, Hong Kong and Mexico.


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