2013 Financial Market Outlook

By A. Gary Shilling

A grand disconnect has developed between weak and weakening economies worldwide and optimistic investors hooked on continuing massive monetary and fiscal stimuli. The U.K. and the eurozone are in recession, the U.S. economy continues to be at risk and a hard landing is unfolding in China. Softness in these three paramount areas is dragging down the rest of the world’s economies.

Yet most investors seem totally unconcerned over the unfolding global recession. In fact, the globe’s economies and financial markets have become so dependent on monetary and fiscal bailouts and investors so enamored by them that they seem to have forgotten the dire circumstances that continue to precipitate these stimuli. Many market participants yearn for conditions that are so troubled that central banks and governments will be spurred to more ease. “Oh, good,” they seem to say, “the economies are so weak that the Fed or the European Central Bank or the Chinese government must act,” with positive implications for stocks. Conditions are so bad that some investors perceive that it’s good for their portfolios.

Near total reliance on monetary and fiscal stimuli, with little regard for fundamental economic performance, is a new phenomenon. Until quite recently, faith in government action was strong but coupled with the belief it would soon re-establish rapid economic growth. Many hoped for a magic fiscal or monetary bullet. But slow and now faltering global economic growth indicates that huge monetary and fiscal efforts are being more than offset by the gigantic deleveraging in the private sector.

To restore normal global growth will simply take time, the five-to-seven years for deleveraging to be completed. With emphasis now on the opiate of government stimuli, more and more is needed to keep investment addicts satisfied. Recent market actions suggest that QE3 is a classic case of buy the rumor, sell the news. This grand disconnect is profoundly unhealthy—and a reconnection is inevitable. We see a shock causing financial markets to nosedive and reconnect with faltering global economies. Candidates include the U.S. economy going off the fiscal cliff, the likely hard landing in China, energy price spikes due to Middle East turmoil, S&P 500 operating earnings dropping or the global fallout of a collapsed Euro bank.

With that in mind, here are my investment themes heading into 2013: long Treasury bonds, short stocks, short commodities and long the dollar.

Treasury bonds (favorable): The rally in Treasuries resumed in March as a safe haven in a sea of trouble and in response to slowing economic growth and looming global recession. The likelihood that inflation fears will turn soon to deflation worries also helped. The yield on 30-year Treasuries actually reached our 2.5% target, the 2008 post-Lehman low, in early June. A 2.0% yield is possible as economic and financial conditions deteriorate.

Income-producing securities (favorable): As many investors favor income over problematic capital gains, included are stocks of utilities, drugs and telecoms with high, safe and rising dividends. But all stocks are vulnerable to a likely bear market. Also, investment-grade corporate and municipal bonds and some Master Limited Partnerships are attractive.

The dollar vs. the euro and Australian dollar. Also the Dollar Index (favorable) The buck is the world's safe haven. The eurozone financial crisis remains unresolved and the recession there deepens. Australia has become a captive mineral supplier to faltering China.

North American energy (favorable) Americans have decided to reduce dependence on imported energy from high-risk foreign areas. We like conventional energy investments including natural gas, on- and off-shore drilling and Canadian oil sands. Natural gas prices appear to have bottomed, and pipelines are attractive. Renewable energy is problematic since it depends heavily on unpredictable government subsidies amidst federal cost-cutting. Ethanol suffers from drought-sired corn price leaps.

Developed country stocks (unfavorable) With a hard landing in China and the resulting negative effects on commodity exporters, a major recession in Europe and a strong dollar, earnings of U.S. multinationals will be hurt. A moderate recession in the U.S. will also damage corporate profits despite more cost-cutting in response. We look for $80 per share in S&P 500 operating earnings over a coming four-quarter period and a bottom P/E of 10.

U.S. major and regional banks (unfavorable) Major banks are being bereaved of proprietary trading and other profitable activities and are being busted back to less lucrative spread lending. Regional banks suffer from weak loan demand and bad real estate loans.

Junk securities (unfavorable) Despite recent pre-borrowing from yield-hungry investors, default rates are likely to leap in the global recession we foresee while junk prices drop.

Developing country stocks (unfavorable) China is close to a hard landing. She and other emerging exporters are vulnerable to economic weakness in the U.S. and Europe.

Commodities (unfavorable) The commodity bubble started to break in early 2011 due to a prospective hard landing in China and the global recession. Copper is already down substantially and excess inventories in China loom.

Homebuilders are unattractive if house prices tumble as we forecast.

Your house, second home or investment single-family houses aren't attractive. Excess inventories are likely to push prices down another 20% over the next several years.

 

Gary Shilling is president A. Gary Shilling & Co., an economic consulting firm and a registered investment advisor.   He has been a columnist for Forbes magazine since 1983.  His book, The Age of Deleveraging, accurately forecasted economic and investment trends following the 2008-2009 financial crisis.

 

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