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.
Emerging markets continue to lead. Between 1960 and 2000, emerging markets' share of global GDP cyclically fluctuated between 18 percent and 22 percent, according to the World Bank. In the past decade, emerging economies have broken out and now account for approximately one-third of global GDP. Many of these countries emerged from the recession much quicker than their developed counterparts. They're expected to continue to outpace developed nations like the United States, which will be held back by its large amounts of debt going forward. "It certainly looks like emerging markets—because of their low levels of household debt [and] their low levels of government debt—are in a fundamental position to sustain the type of growth that we've seen historically," Gallagher says.
That endorsement doesn't come without risks. In a recent note to clients, Gallagher wrote, "Emerging markets truly appear to finally be emerging. My only concern is the unanimity of investor opinion on the issue." Generally, he says, a consensus in the investment world about a given asset class doesn't bode well for its future success. He believes that a few issues, primarily the potential of a trade war breaking out between, say, the United States and China over currency manipulation, could derail growth there in the future. There are also concerns that these markets may be a bit overheated and that inflation could pick up, which would in turn force governments to raise interest rates. In that case, stocks would take a hit. But Gallagher believes rising interest rates would only slow growth in emerging markets momentarily.
Gold loses its luster. The biggest investing story in 2010 may have been the performance of precious metals like gold and silver, which investors flock to in times of uncertainty. Year-to-date, the world's largest gold ETF, SPDR Gold Shares (GLD), has returned 27 percent, while the largest ETF tracking silver, iShares Silver Trust (SLV), has gained a whopping 74 percent. Debt troubles in Europe and bond buyback programs like the Fed's quantitative easing plan made investors nervous, and they took refuge in the shiny metals.
But, Hviid says, there's no actual value to metals like gold and silver, and there are no cash flows by which to measure the prospects for future growth. Therefore, these metals trade on investor psychology—primarily fear. "Gold is a fear trade," Hviid says. "If fear is receding, the appetite for gold will naturally subside." Another flare-up in Europe or a slowdown in growth in the United States could spur another gold rush, but if the economies improve, the rally could slow. Hviid suggests investors take a more broad-based approach and get exposure to different types of commodities, like industrial metals, crops, and oil that will benefit from a pickup in global consumption. Zemsky believes oil could reach $100 a barrel next year.