A New Year brings new economic headwinds

December 31, 2010: 5:00 AM ET

Most analysts are looking forward to a strengthening economic recovery in 2011, but slowing growth and rising inflation around the globe suggest the opposite will prove true.

by Daryl Jones, Hedgeye

economic outlookFor the stock market, 2010 was a solid year by many standards. Despite some unfettered volatility, most major U.S. stock markets ended the year comfortably in the positive. Leading the way were small cap stocks with the Russell 2000 up more than 26%. While the broader market trailed the small cap index, the S&P 500, oft considered the benchmark for U.S. equity performance, was still up over 12%, coming in slightly ahead of its long run annual average.

With 2010 in the rearview mirror, it's time to look forward to 2011.

When contemplating the outlook for the upcoming year, the best place to start is consensus expectations. Currently, according to a Bloomberg survey of the strategists from 11 of the largest brokerage firms in the United States, the mean consensus target for the S&P 500 by year end 2011 is roughly 10% above current levels. Further, every single strategist is expecting a positive performance out of the index in 2011.

Suffice it to say, Hedgeye is decidedly non-consensus heading into 2011.

As it stands, we see a trinity of negative fundamental macro clouds on the horizon that have yet to be properly discounted by the market, and which are poised to cast a potentially long shadow over domestic equities heading into next year. The three key risks we see to these lofty consensus expectations heading into 2011 are: global growth slowing, inflation accelerating, and interconnected risk heightening.

Slowdown around the globe

We believe that growth, both in the U.S. and in certain major emerging market economies, will slow sequentially next year, though for very different reasons. Domestically, we believe consumer spending, which is roughly 70% of GDP, will be constrained as consumer confidence erodes alongside a further slide in home prices. This erosion in confidence, combined with a high structural unemployment rate and a tight credit environment, will lead to continued pressure on the American consumer next year.

Globally, the key growth issue is related to inflation. As we look at some of the major emerging market economies that are fueling global growth, it's obvious that inflation is accelerating. Most recently, China reported a 28-month high with its November CPI of 5.1% and Brazil reported CPI for the same month at 5.6%.

In both instances, these measures for consumer-based inflation are well above the targets established by each of the country's respective central banks. The obvious outcome if this level of inflation is sustained, as we believe it will be, is a tightening of monetary policy, and a subsequent deceleration of growth abroad.

In fact, globally, we are already seeing a number of central banks take steps to tighten monetary policy and slow inflationary pressures. Some of the data points we've been focused on over the past couple weeks include: Sweden raising interest rates by 25 basis points, Chile raising interest rates by 25 basis points, China taking its reserve ratio up by 50 basis points to 18.5%, and Brazil taking its reserve ratio to 20% from 15%.

While these are somewhat muted moves in light of some of the inflationary reports we have seen, we should expect more aggressive action in 2011, especially in light of accelerating commodity prices.  As the Chinese authorities recently foreshadowed, 2011 will be a "prudent" monetary policy year.

World contagion

The final bearish factor we're focused on heading into 2011 is the increase of interconnected risk. This factor considers rising market and asset correlations in combination with a mispricing of a number of global macro risks.

Increasingly over the last couple of years, we have seen a strengthening correlation between major markets and, really, all major asset classes. The implication for strengthening cross-market and cross-asset class correlations, particularly in the context of an increasingly interconnected global market place, is that a major dislocation or failure or one market is increasingly likely to reverberate similarly across other major markets. In the U.S., we saw this manifest itself via the U.S. dollar and European sovereign debt, which served as the key drivers of various major equity markets around the globe.

The key macro risk areas in 2011 that we see looming include: the domestic municipal bond market, European sovereign debt, and the continued implosion of the Japanese economy. As it relates to the municipal bond market, broadly speaking, we think that many are missing the combination of higher projected spending with a decline in local and state tax receipts.

In terms of sovereign debts in Europe, things will get worse before they get better and we have recently seen credit default spreads in troubled countries like Greece widen to a point that implies a default is becoming somewhat imminent.

Finally, the coming year is poised to be a critical one for Japan, which is buried in a mountain of debt and an aging population that the pension system cannot support. All this is framed with a volatility index, the VIX, which is flashing signs of complacency at its close year-to-date lows.

We are not being non-consensus merely for the sake of being branded contrarians, but if the last few years have taught us anything it is that when consensus is solidly leaning one direction we need to seriously consider that to be a contrarian indicator. Regardless of the consensus of views of major strategists, storm clouds loom on the economic horizon and thus we remain justifiably cautious heading into 2011.

Also on Fortune.com:

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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