Just about the time the markets were thinking that the economy was going to deliver strong growth, the reality of the harsh headwinds we face hit home. The expiration of the housing tax credit has left the housing market teetering on the brink of further declines. While corporate profits are still quite healthy, companies are reticent to add full time employees, preferring the flexibility of longer hours for current workers or adding temporary employees.
To these domestic concerns, we can add the sovereign debt issues facing Greece and other southern European countries. The austerity measures that accompanied the agreement by the EU to backstop the debt of Greece, Spain and Portugal will put a drag on Europe’s growth. However, the quick devaluation of the Euro – about 15% versus the dollar so far this year – will make German and French exports much more competitive. The export growth from these large economies should more than offset the drag of austerity from the smaller economies.
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.
Right now, the markets are focused on the downward pressure these factors are placing on the U.S. economy. First quarter growth was revised down a couple of times to finish at 2.7%, hardly a robust showing. And, expectations are that the second quarter will be weaker. We do think that one or two quarters of negative growth are likely over the course of the next twelve months. However, we don’t expect a repeat of the sharp declines we saw in late 2008 and early 2009.
The U.S. economy has demonstrated once again its unique ability to withstand enormous strains and move forward. So we expect the economy to muddle along, with slower than typical growth. The employment picture will improve very slowly with the unemployment rate staying uncomfortably high. The real estate market will remain in a precarious position as foreclosures and excess inventory get worked off. Consumers will increase their spending slightly less than their incomes grow, raising the savings rate. Corporate profits will continue to be very good, helped by the dramatic cost reductions that were taken over the past eighteen months.
Relative to earnings, we think stocks have become inexpensive. The question is whether earnings gains will hold up. The stocks in the Essential Growth Portfolio℠ are chosen for their ability to deliver consistent earnings so we have seen many opportunities to buy great companies at very attractive prices.
As concerns about the economy and sovereign debt in Europe took center stage, prices of U.S. treasury notes and bonds soared in the second quarter, driving yields to very low levels. This flight to quality hurt prices of corporate bonds, which we believe are now very attractive, relative to both inflation and default risks.
About nine months ago, we did a special report entitled “Inflation vs. Deflation – The Most Important Investment Decision of the Next Five Years.” That report concluded that deflation was much more likely to become a problem than inflation, citing the four major headwinds described above. We think it will take several more years for these headwinds to dissipate so our conclusions are still the same.
We continue to believe in the strong growth stories emanating from Asia and have maintained dedicated equity investments there. Certainly there is the probability 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.
Just published is a piece on the real implications of the “Flash Crash” in which we call for a fundamental rethinking of the financial regulatory structure. This piece is posted on the Blog section of this website. Unfortunately, the bill currently pending in Congress is long on text and short on progress on the important issues underlying the credit crisis of 2008.
The effect of the expiration of the housing tax credit stunned many observers. More important, we believe, will be the effects of the tax increases associated with the new health care bill and the expiration of the Bush tax cuts.
Client portfolios remain relatively conservatively positioned, with significant over-weights to fixed income and absolute return oriented investments. The third quarter could continue to be rocky for the equity markets – a rough patch on the long road to overcoming the structural headwinds we face.