Perhaps we shouldn’t be too surprised in retrospect that Americans seem to have such short memories. Wasn’t it just eighteen months ago that our financial system came within a hair of complete collapse? And now, even a watered-down set of financial regulation changes draws a yawn from the American public. Dow 12,000 here we come!
We continue to believe that four fundamental factors will give the Great Recession of 2007-2009 a lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers need to pay down the astounding levels of debt they accumulated over the last two decades; (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 put pressure on prices.
While these four factors will continue to weigh on the rate our economy is growing, the fact is that the economy is back in a growth mode for now. And this growth seems to be stronger than these restraints would have allowed. Why has this been the case? One answer is the large government stimulus programs that have been put in place over the last year. But we think there is more to the story.
Being so close to the financial markets, we sensed a high likelihood of serious fundamental changes after the Great Recession – a re-pricing of risk, the return of a savings culture, unwillingness to take on debt, reduced demand for real estate as an investment and a new era of financial regulation.
However, even though many families are fundamentally changing their ways, in the aggregate these changes have only a marginal impact. They are marginal because the vast majority of Americans – once their confidence in the financial system and the security of their jobs was restored – returned to their normal lives.
Those normal lives included making a decent living, paying their rent or mortgage, shopping for necessities and periodically splurging on extras for themselves and their families. In particular, the highest earning households that account for a disproportionate share of consumer spending have begun spending again. For many, lower mortgage rates have provided some extra monthly cash.
Are they doing these things within the context of a financial system that has fundamentally changed? Certainly. The limits on the credit cards are lower, there is no home equity line to serve as a piggybank and bank rules for car loans and leases are tighter. So in the aggregate, consumer credit outstanding has fallen significantly, rather than rising as it would typically do in a recovery.
But, the U.S. economy has demonstrated once again its unique ability to withstand enormous strains and move forward. Have we returned to the “old normal?” Certainly not. The four limiting factors we mentioned above are still very much in place, preventing us from returning to the old normal for several more years. The employment picture will improve very slowly as companies will be cautious about adding costs back. Residential real estate remains a precarious market as foreclosures continue to rise, but with strong demand appearing in some regions particularly at lower price points.
In the meantime, we expect the economy will muddle along, with slower than typical growth. Corporate profits will continue to be very good, helped out by the dramatic cost reductions that were taken in late 2008 and early 2009 and now by rising revenues. Strong earnings should put a reasonably solid floor under stock prices for now and may allow stocks to move even higher in the months ahead.
While the U.S. stock market was staging a dramatic rally off of the March 2009 lows, the bond market, particularly municipal and corporate bonds, pulled off an historic rally as well. In the aftermath of this rally, we just published a special report on the fixed income markets entitled “Where Do We Go from Here? Seeking Attractive Returns on Fixed Income Investments” – it follows this piece.
On the international front, the fragile state of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) continues to dominate the economic news. There is broad concern that Greece’s sovereign debt problems could be the equivalent of our subprime mortgage problem for the European Union. We think it is more likely that a solution is found that continues to hamper prospective growth for the European economy.
We continue to believe in the strong growth stories emanating from Asia and prefer to focus more of our equity investments there. Certainly there is the probably of setbacks along the way, but the sheer size and momentum of the growth of the middle classes in China and India strongly argue for robust growth for a long time to come. In addition, we think the resource-dependent economies of Canada, Australia and Brazil will fare well in a healthy commodity pricing environment.
Investors’ current complacency can swiftly be replaced by fear arising from unexpected events beyond their control. And the effects of the tax increases associated with the new health care bill and the expiration of the Bush tax cuts bear close watching. The lessons of 2007-2009 are still important: stay very broadly diversified and closely monitor downside risk, relative to return potential.