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On the Economy, Interest Rates & Commodities

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
December 21, 2010

IN THIS ISSUE:

1.  The Latest on the Economy

2.  Fed Holds Steady, QE2 to Continue

3.  Will Commodities Rise More in 2011?

4.  Lame Ducks Go For Broke (Literally)

The Latest on the Economy

Most economic reports over the last couple of weeks have been encouraging.  The University of Michigan Consumer Sentiment Index rose from 71.6 to 74.2 in the first week of December.  That followed the better than expected rise in the Consumer Confidence Index in November.

The Index of Leading Economic Indicators rose 1.1% in November following a gain of only 0.4% in October.  The latest LEI for November marked the fifth consecutive monthly increase in the index.  The Conference Board which published the LEI noted:

“November’s sharp increase in the LEI, the fifth consecutive gain, is an early sign that the expansion is gaining momentum and spreading. Nearly all components rose in November. Continuing strength in financial indicators is now joined by gains in manufacturing and consumer expectations, but housing remains weak.”

Retail sales rose more than expected in November, up 0.8%.  Excluding autos, retail sales rose 1.2% last month; the pre-report consensus was half that much.  Chain store sales were also up 0.8% for the week ended December 11.  We also learned on December 7 that consumer credit rose well above expectations in October (latest data available).

Industrial production came in slightly better than expected in November, up 0.4%, after declining slightly in October.  The factory operating rate (capacity utilization) came in better than expected in November at 75.2%.

News on the housing front was mixed last week.  Housing starts for November came in at 555,000 units, which was a bit higher than expected  and better than 534,000 in October.  Building permits, on the other hand, were 530,000 in November versus 552,000 in October.  New and existing home sales for November will be released later this week, and both are expected to be higher than in October. 

Of course, not all of the economic news of late was positive.  One particularly troubling report was the November Producer Price Index (wholesale prices) which came in at double the rate of October, up 0.8%.  The higher than expected number was influenced to some degree by higher commodity prices, which I will revisit as we go along.  

As noted last week, many forecasters have increased their growth estimates for 2011 by one-half to 1%.  Some are now predicting GDP growth of 4% for next year.  I will be delighted if the economy grows by 4% next year, but for now, I think that’s too optimistic unless we see a brisk upturn in bank lending.

Fed Holds Steady, QE2 to Continue

The Fed surprised virtually no one last Tuesday when the FOMC voted to continue to hold the Fed Funds Rate unchanged at virtually zero.  Ditto for the Fed’s decision to continue with its $600 billion quantitative easing.  The Fed will continue buying medium and long-term Treasuries at the rate of apprx. $75 billion per month until mid-2011. 

The Fed’s primary purpose for implementing QE2 was to bring down yields on medium and long-dated Treasuries such as 10-year T-notes and 30-year T-bonds.  But instead of rates falling, they recently shot up to six-month highs as I discussed last week.

CBOE Interest Rate 10-Year T-Note

As you can see, yields on the 10-year Treasury note recently rose above 3.5%.  The 30-year Treasury bond yield spiked to near 4.6% last week, although it has since eased to below 4.5% as this is written.  These surprising jumps in interest rates, especially while the Fed is doing QE2, are causing more and more analysts to conclude that Treasury yields are no longer in a broad trading range and have broken out to the upside.

One such example is Bank of America/Merrill Lynch which revised its forecasts for Treasuries.  Last Wednesday, BOA/ML predicted that the 10-year T-note yield will rise to 4% in 2011.  The list of those raising their forecasts for medium and long-term interest rates next year is growing by the day. 

Of course, there are others who believe this is a great time to be buying bonds.  Most of those who are still bullish on bonds are bearish on the economy longer-term.  For example, Sri Thiruvadanthai, director of research at the Jerome Levy Forecasting Center,believes that the current jump in rates is simply a “growth scare” about 2011, and that bond yields are at or near a peak now.

Another example is Charles Dumas of Lombard Street Research in London who believes that the economy will grow by only 2% in 2011 and then dip back into recession, and he predicts that bond yields will fall to new lows in 2012.

The problem with these bond bulls is that no one knows how much bond yields will go up in the interim.  And yields have already gone up more than virtually all forecasters expected just 3-4 months ago.  The other problem with most of these researchers is that they believe bond investors have the patience to ride out a very painful loss in the value of their bonds and bond mutual funds.

Most investors don’t know how to “short” bonds when interest rates rise.  Traditional bond mutual funds don’t short bonds as a matter of policy.  But short has been the correct position for the last several months, and bond funds are down pretty much across the board.

For the record, ALL of the money that I have in Treasuries is managed by Hg Capital in their Long/Short Government Bond Program.”  This professionally managed program has the ability to go long or short in Treasury bonds, depending on the direction in interest rates.  Click hereto see Hg’s outstanding performance and get more information.  As always past performance is not necessarily indicative of future results.

Will Commodities Rise More in 2011?

As I discussed in my November 30 E-Letter, commodity prices have exploded on the upside since early 2009, and I believe this is a big reason why longer-term interest rates are rising.  Most commodity forecasters believe that prices will move even higher in 2011 because of sharply rising demand in many parts of the world.

Thomson Reuters/Jefferies CRB Index

As you can see in the chart above, commodity prices still have a long way to go just to get back to where they were in 2008 before the credit crisis tanked markets around the world.  Of course, there’s no guarantee that commodity prices will rise that high again this time.  On the other hand, there are many more people in the world today than there were three years ago.

What follows is a recent article from ADM Investor Services which believes that many commodity prices will continue higher in 2011:

“COMMODITIES NOW
London, 10 December 2010

Morgan Stanley sees most commodity prices moving higher in 2011 as global GDP, at an above-trend 4.2%, bolsters demand, led again by emerging market economies. After growing by nearly 5.0% in 2010, global GDP growth is poised to grow by 4.2% in 2011 — importantly, over 70% of this growth will come from the commodity-intensive EM, with China, India and Latin America poised to see GDP growth of 9.0%, 8.7% and 4.1%, respectively.

Growing demand, together with a tightening supply side, provides the fodder for our broad constructiveness across the commodity space. Declining inventories will not only lift spot prices but will also improve roll returns (as drawing inventories move markets from contango to backwardation).

Morgan Stanley are most constructive on crude oil, copper, gold, and corn and soybeans. They are least constructive on natural gas, live and feeder cattle, and zinc.

Morgan Stanley favourites: The need for increased OPEC production will lower spare capacity, sending oil prices above $100/bbl in 2011, in our view. Copper, our favourite base metal, should continue its move higher as strong OECD demand growth and resilient Chinese demand are contained by supply downgrades.

Corn and soybean prices both need to rise to ration demand — simply put, demand is running too hot given tight inventories and limited acreage. Gold will benefit from continued investment demand, stemming from a continued expansion in global money supply and lingering sovereign risks.

Risks: "Despite our constructiveness, we expect the ascent in price to be volatile. Lingering sovereign risks, fears of policy missteps in the EM, and bouts of USD strength will all present headwinds," say Morgan Stanley. Below is a commodity snapshot for 2011 (dated 10 December 2010).

Commodity Snapshot

Of course, it remains to be seen if Morgan Stanley will be correct in its forecasts, but economic growth in China and India is considerably higher than in the US and Europe, and demand from many other emerging nations continues to rise.  Also, keep in mind that there are dozens more commodities around the world than just those addressed in the chart above.

Lame Ducks Go For Broke (Literally)

For the last several weeks, I have warned that the Democrats would likely try to advance more of President Obama’s liberal agenda in this Lame Duck session of Congress – before the Republicans take control of the House of Representatives in early January.  Oddly, none of the conservative friends I’ve spoken to recently believed the Democrats would try to pass any politically sensitive bills during the Lame Duck session.  But they were wrong, as I have warned several times recently in these pages.

After President Obama compromised on extending the Bush tax cuts for all, that bill moved through Congress right away.  Not surprisingly, the president is still taking heat from those on the left for his decision to compromise with the GOP. 

Then the Democrats tried to push through a whopping $1.2 trillion omnibus spending bill that was loaded up with pork.  The nearly 2,000-page bill included $8.3 billion in “earmarks” (otherwise known as pork-barrel spending).  Fortunately, the Republicans held together and the bill was narrowly defeated.

Next, it was on to the so-called “DREAM Act” which would grant citizenship to several million illegal aliens who came to the US when they were minors.  This bill also failed in the Senate before it ever came up for a formal floor vote.

Following that there was “Don’t Ask, Don’t Tell” for gays serving in the military, which most political observers thought would not be voted on in the Lame Duck Congress.  But the Democrats insisted it be addressed now while they still have a majority in both houses of Congress.  In the end, DADT passed and the policy will be repealed next year.

Finally, there is the START nuclear arms agreement with the Russians that Obama wants passed in the Lame Duck session this final week.  As this is written, it looks likely that enough Republicans will cave and vote for ratification of this treaty, perhaps as soon as later today or tonight.  Those Republicans include Scott Brown (MA), Richard Lugar (IN), Olympia Snowe (ME) and George Voinovich (OH), plus at least two more who are said to be leaning toward voting yes.

That’s unfortunate because START is a very bad deal for the US, in my opinion.  As I understand it, START would stop US expansion of missile defense systems, here or around the world.  The treaty’s preamble suggests that we would not engage in any new military technologies to thwart nuclear weapons.  Why would we do this?

Elsewhere the treaty says we cannot convert any of our existing rockets into interceptors and it reportedly locks in about a 10,000 Russian advantage in tactical nuclear warheads.   START would reduce strategic warheads, which are about equal on both sides, but it does not address Russia’s huge advantage in tactical warheads.  Again, why would we do this?
 
Finally, why would we reward Russia by relieving them of the expense of building new missiles and defense systems?  The US is years ahead of the Russians in developing nuclear defense systems.  You may recall that President Bush agreed to deploy nuclear defense systems in Eastern Europe several years ago, but one of President Obama’s first actions was to cancel those plans.  There is some additional analysis on START in the links below.

In closing, while most conservatives seemed surprised that the Democrats and President Obama would push for passage of several politically-charged issues in the Lame Duck session, my readers were not.

Merry Christmas

The Christmas season is a very happy time for the Halbert household, especially this year as both of our kids are home from college.  When our youngest left for college in late August, Debi and I had to adjust to the “Empty Nest,” and that has NOT been easy for me.  So I’m delighted to have both kids home for about a month.

All of my in-laws came in this past weekend, which meant lots of cooking for yours truly, but it was lots of fun and we are definitely in the Christmas spirit.  I’m already looking forward to the candlelight service at our church on Christmas Eve.

Let me take this opportunity to wish you and your loved ones a very Merry Christmas!

Wishing you Happy Holidays,

Gary D. Halbert

SPECIAL ARTICLES

On Arms Control, Learn From Reagan (very good)
http://www.nationalreview.com/articles/255650/arms-control-learn-reagan-richard-perle-and-kim-r-holmes

What’s wrong with START
http://www.nationalreview.com/articles/255729/slow-start-editors

Lame Duck Isn’t Supposed to Exist (very interesting)
http://www.washingtonpost.com/wp-dyn/content/article/2010/12/17/AR2010121703572_3.html


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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