Outlook for the Economy

I continue to believe that the economy is just beginning its improvement cycle and can bolt ahead for two or three more quarters just from catalysts that are relatively visible today. If economic conditions line up correctly, and we avoid external shocks to the economy, the second half of 2010 could show continuing growth.

Beyond that, my crystal ball grows cloudier. Specifically, I am looking for 3.5%-4.0% growth in real GDP in the fourth quarter of 2009 and 3.5% for all of 2010, with the front half of the year a little stronger than the back half. My estimates are higher than the general consensus. With this higher growth rate, I expect inflation for 2010 to be closer to 3% versus general expectations of 2% price increases.

In a world of faster growth and higher inflation, long-term bonds might prove to be a dangerous place to invest. Now that the economy has made its initial rebound off the bottom, it may be time to upgrade stock portfolios as well. Many risky and smaller-cap stocks were given up for dead last spring (and priced accordingly) as the economy appeared to be in a free fall. However, when we stepped back from the abyss, and many of these companies survived, their stocks soared and led the market upward. Now as rates rise, these stocks could stall out, and higher-quality and later-cycle stocks could begin to move. In this environment, consumer staples, health care, and utility stocks could all prove interesting.

Two Broad Drivers
Although I could list a dozen or two factors that could lead to continued economic improvement in 2010, the two broad drivers are the typical progressions of an economic cycle and a slow and steady return to production numbers that are much closer to matching long-term natural demand (think housing and autos). Exports and stimulus spending on infrastructure are two other kickers for 2010. Given the depth of this cycle and how far we have fallen from natural demand in many categories, the magnitude of the recovery should be decent and stronger than a lot of forecasts. Debt levels, unfortunately, will weigh on some of that improvement.

The 10 recoveries since World War II have all been led by increased consumer spending, which leads to increased production and the restocking of inventories, finally followed by increases in employment and capital spending. The increased employment leads to more spending and more production, creating a virtuous, self-reinforcing cycle that is hard to stop, especially at the beginning of an economic cycle.

Consumer spending collapsed back in the second half of 2008. Believe it or not, consumer spending bottomed in December 2008 and has meandered upward for most of 2009. However, production didn't bottom until June 2009, and unemployment and business capital spending are just now closing in on their bottoms at the very end of 2009.

Improvements in production, inventory restocking, and increased employment will be the key drivers in the first half of 2010. Just as one example, if inventories did not increase or decrease in 2010, GDP could be aided by close to 1%. That is assuming just flat inventories, not increasing inventory levels, which is a more typical scenario. By the middle of 2010, consumer incomes and balance sheets should both be in better shape, potentially moving the economy forward for several additional quarters.

Two industries, auto and housing, continue to operate well below what I view as long-term replacement demand. Unless America permanently alters the way it lives and car decay stops following the laws of physics, demand will have to rebound. While the time frame is open to debate, the need for production levels that are almost triple current levels (as in the case of housing) will be necessary at some point over the next three to five years.

Our homebuilding team estimates that long-term natural demand for housing is in the neighborhood of 1.5 million units based on population trends and normal wear and tear. In the most recent months, housing starts have averaged fewer than 600,000 units, well below natural demand. In the short run, reductions in inventory levels, people moving in with their parents (or vice versa), and more couples staying together rather than divorcing (or even more uncomfortably, divorcing but not separating) have closed this gap between "production" and normal demand. However, I don't believe this trend will continue indefinitely. It is just not a stable way to live.

However, there are risks to my optimistic economic scenario. Commercial real estate markets are still very weak. All the unoccupied store fronts and office buildings mean that private, non-residential building will be a negative contributor to GDP through most of 2010 even as residential building improves. Commercial real estate loans also threaten smaller regional banks. Weaker balance sheets at small banks could mean less small-business lending, too. Wavering government policies, including health care and possible changes in taxation have not helped business confidence in the short run. A more ambitious legislative agenda in 2010 could further erode business confidence. There is also always the threat of additional wars or terror attacks that could potentially turn our delicate situation into a disastrous one.

With these types of risk, I would take the opportunity now to upgrade portfolios, re-revaluate the overall risk levels, and rebalance where necessary.

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