Annual Investment Outlook 2010

In 2009, the gloom of the first quarter gave way to euphoria in the financial markets in the last three quarters, as investors rejoiced that we had avoided a depression. Instead, we experienced a so-called Great Recession. If you look at the decline in GDP, this recession was roughly on par with the severe recessions of the early 70s and early 80s, with aggregate GDP dropping about 4% from peak to trough.

We believe that four other factors will give the Great Recession its lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers have begun to pay down the astounding levels of debt they accumulated over the last two decades and the nation’s saving rate will rise significantly; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply keep downward pressure on prices.

While many of the government’s actions over the past two years have been designed to restore stability and confidence in the financial system, other actions have created uncertainties that we believe will weigh on the economy in the coming year. In particular, uncertainties regarding health care costs and income tax rates may cause small businesses to be more reluctant than normal to create new jobs. And, extraordinarily high deficits leave open the distinct possibility of much higher interest rates in the future, effectively crowding out private borrowing, traditionally the source of capital for small business job creation. It is also tough to sort out the impact of stimulus programs for cars, housing and state/local governments – did these programs provide a bridge to a better environment or will problems resurface when stimulus ends? Finally, a protectionist orientation has been growing in our trade relations with Asia, which may limit U.S. exports, a promising source of growth in a weak dollar environment.

On the positive side, we see a bifurcated consumer recovery. Affluent consumers – those with high incomes and somewhat restored net worths – have begun to spend once again. Those with lower or no incomes will continue to struggle mightily, with full employment difficult to come by. Businesses that had drawn inventories down to very low levels will need to rebuild their stocks to meet nascent demand. All in all, we expect the economy to post positive, but anemic, growth of 2-3% in 2010.

Corporate profits will continue to benefit from the draconian cost cuts put in place in late 2008 and 2009. With revenues rebounding somewhat on top of a lower cost base (and financial stocks providing a positive contribution as write offs begin to fall), aggregate profits should show a very healthy increase in 2010.

Missing from the Great Recession has been the high level of credit defaults predicted a year ago. With liquidity having returned to the bond markets quickly, many issuers have been able to refinance ahead of maturities. Most affected are those smaller businesses that depend on bank lending, where defaults and charge offs continue at a high rate. In the public debt markets, credit spreads have collapsed to average levels.

On the international front, we continue to believe in the long term story of the growing middle classes in the large emerging markets. China will continue to be a major source of global growth, as will India. However, that growth will become more internally focused, rather than export- or outsourcing-focused. The command structure of the Chinese economy gives us some concern about potential excesses but the sheer size of the economic engine they have created ensures its growing dominance of the region.  The European Union will continue to struggle with very slow growth and the debt problems of some of its lesser members, while the resource-dependent economies of Canada, Australia and Brazil fare well in a healthy commodity pricing environment.

In retrospect, we were wrong in not hopping aboard the risk train in the early spring of 2009. Instead, we were content to take a much lower risk approach to earning very strong absolute returns for our clients, focusing on high quality U.S. stocks, international stocks and corporate/municipal bonds. Despite investors’ newfound appetite for risk, we do not think this is the time to significantly increase exposure to riskier equities. However, high quality stocks offer attractive return potential, particularly given the outlook for much stronger earnings in 2010. Many of the companies represented in the Essential Growth Portfolio℠ are heavily invested in the growth of developing markets. When valuations warrant, we expect to continue to increase direct exposure to these areas of long term growth. In addition, we plan to maintain a small but dedicated exposure to a broad-based basket of commodities.

In the fixed income area, we have brought durations (exposure to interest rate increases) down and quality up, as most of the easy money has been made. We have added exposures to non-U.S. debt securities and merger arbitrage strategies while continuing to exploit special situation opportunities in fixed income closed end funds.

As 2010 progresses, there is a wide range of variables that could have unexpected impacts on the global economy and financial markets. These include: withdrawal of US monetary and fiscal stimulus, demand for the large supply of U.S. government debt, ever-present geopolitical risks in the Middle East, actions of Congress on health care, tax policy and financial regulation, sovereign debt problems in southern Europe and terrorist activity, just to name a few. With the economy growing very slowly, an unexpected setback could easily trip the economy back into negative growth territory.

We remain very cognizant of the dramatic increases in market values we have witnessed since last March, virtually without correction. Investors’ current complacency can swiftly be replaced by fear arising from unexpected events beyond their control. In this risky environment, we are keeping client portfolios very broadly diversified and closely monitoring downside risk, relative to return potential.

January 6, 2010

© Essential Investment Partners, LLC