As 2010 comes to a close, investors should be looking ahead to determine what, if any, changes they want to make in their portfolios in 2011. The Fed's controversial second round of quantitative easing, which it hinted at in late August and initiated in early November, is slated to continue until mid-2011. Almost every asset class received at least a short-term boost from those plans. On top of that, it seems certain that the Bush-era tax cuts will be extended for everyone for at least the next two years, which has caused many economists in the United States to revise their growth projections upward for next year. These are just a few of the latest issues investors should pay attention to heading into the new year. Here are five themes that you'll probably be following throughout 2011.
Deficits remain a concern. The proposed tax cut deal that's making its way through Congress would add almost $1 trillion to the U.S. deficit through a mix of tax cuts and spending initiatives, like extending unemployment benefits. Deficit hawks are crying foul, while economists are saying the tax cuts extension is vital to growth in the future. "Tackling the deficit right now is secondary to the economy growing again," says Paul Zemsky, head of asset allocation at ING Investment Management. Most economists say that if the tax cuts were left to expire, GDP predictions for the United States would be cut by about 1 percentage point—from about 3 percent to about 2 percent. One of the best ways to cut the deficit, Zemsky says, is by growing the economy.
The stated goal of the Fed's quantitative easing program was to lower interest rates across the board in hopes of spurring more lending and increase economic growth. Yields on the 10-year treasury bond have actually risen since the announcement, which some experts attribute to concerns that the U.S. deficit is becoming unsustainable. Moody's even issued a warning this week cautioning policymakers about the budget deficit. Meanwhile, across the Atlantic, the debt crisis has again reared its ugly head in Europe—this time in Ireland. The European community reacted swiftly with another bailout package, and for now, most economists seem content with the austerity measures taking place there. Whether the crisis will spread to other troubled Eurozone countries will be another story to watch next year. "There's definitely still risk, particularly with Spain, which is probably too big to save if it got into a big problem," Zemsky says.
Trouble for treasuries. Since the financial panic of 2008, investors have piled into bond funds because of their perceived safety, and shunned more volatile stock funds. Rising yields are generally associated with an economic recovery, but rising bond yields mean falling bond prices, which will lead to losses in certain funds—such as those that are heavy on treasuries. "The only rationale that I can see for being in treasury-type bonds is that I'm so worried about everything else that I just want to hide out because it's very difficult to concoct a longer-term story that you're going to increase your wealth in real terms by owning bonds," says Brett Gallagher, deputy chief investment officer for Artio Global Management.
As the economy recovers, Zemsky says he expects treasury yields to rise from about 3 percent currently to a more typical yield of about 5 percent. There are other opportunities in the fixed-income market, Zemsky, says, like corporate and high-yield bonds, the latter of which yield roughly 8 percent. "They represent a good halfway point between high-quality bonds and stocks, in terms of risk and reward," he says.
U.S. stocks continue to sizzle. An improving economy and higher inflation expectations generally bode well for stocks, says Christian Hviid, chief market strategist for Genworth Financial Asset Management. So far this year, the S&P 500 Index has gained about 11 percent, and small-cap stocks have returned about 24 percent. "The story for flows in 2011 will be people's increased appetite for risk, and that implies outflows out of bonds into riskier assets such as equities," Hviid says.
In 2011, a 10 percent gain in the S&P, with the index finishing the year at around 1400, isn't out of the question, Zemsky says. While small-cap stocks have already sustained a rather large rally, Eric Marshall, comanager of Hodges Small Cap fund, says they still have room to run. He sees more mergers and acquisitions on the horizon, given that cash on company balance sheets is approaching historically high levels. "Larger companies will acquire smaller companies in order to facilitate their own growth because of the lack of organic growth companies are seeing in their revenue base," Hodges says.