Thoughts on the Current Outlook – April, 2011

The Great Recession started in late 2007 and officially ended about two years later. As we look back from April of 2011, the recession that ended about 18 months ago is still etched clearly in our minds. Indeed, for many Americans, the recession has not ended. And, how often have you heard “in these tough economic times…” as an introduction for the announcement of a failed business or a cutback in spending or hiring?

Statistically, the recession is long over and we are well into expansion. Expansion is defined as that period of growth after a recession when we have more than recouped the GDP lost in the recession. Private sector employment is finally starting to grow and the unemployment rate has dropped a full percentage point since November. Yet, recent consumer confidence reports have shown a significant drop in consumer confidence. Why is that?

Let’s take a quick look at the statistics. The latest report on GDP (the final revision for the fourth quarter of 2010) showed that the economy grew 3.2%. This is a good, but not great, number. Most economists are predicting growth around this level in 2011. This is slightly below the long term average – respectable, but not exciting. While consumers were solid contributors to growth, they did it by dipping into savings as their incomes rose less than their spending.

What about employment? The unemployment rate fell to 8.8% in March and private employers added well over 200,000 jobs. Again, respectable but not great. The unemployment rate is particularly troubling though. The Wall Street Journal recently reported that if we added back to the unemployed and the base all of those who have left the labor force since the start of the Great Recession, the unemployment rate would be a full two percentage points higher. Looked at this way, the employment picture goes from respectable to lousy.

On top of these woes, we can add a 33% increase in the price of gasoline over the past six months that has the effect of wiping out most, if not all, of the payroll tax break Congress included in the extension of the tax cuts at the beginning of the year. Of course, one of the reasons for the gasoline price increases is the expanded unrest in the Middle East. Uncertainty over the fate of nations across the region, from Libya to Bahrain to Iran to Pakistan, adds to our concern about the impact of disruptions in oil supplies and the possibility of wider conflict into which we might be drawn.

Finally, fights about government fiscal problems are breaking out everywhere. From the capital of Wisconsin to the capital of Portugal, governments are trying to figure out how to implement austerity measures that will put their budgets back on a sustainable path. Here in the U.S., we expect finances at the state level to get worse this year. Even though sales and income tax revenues are bouncing back, real estate tax collections are depressed and will stay that way for some time to come. So we also expect state governments to shed workers throughout this year and next as layoffs and service reductions are the only ways for budgets to be balanced.

As for the granddaddy of them all – the U.S. federal deficit – we just survived a government shutdown showdown over the current year budget. Next up is a similar but potentially more damaging battle over raising the federal debt limit, which we will reach very shortly. These current arguments are just warm ups for the major struggle about how to really control the level of federal spending. Absent a change of course, the U.S. is surely daring the bond vigilantes to force us to change our ways. For now, U.S. debt is seen as a safe haven by the rest of the world and our interest rates are low. While that works for us now, one day it may not.

Even without an abrupt change in market sentiment toward U.S. debt, we might be facing the prospect that the long bull market in bonds is over simply by virtue of an increase in inflation and inflation expectations. If we are starting a long economic recovery with higher input prices (oil, grains and a broad range of other commodities), then we could see interest rates start back up the long down staircase they have been on since the early 1980s. The real key to inflation, however, is wages. So long as we have lots of slack in the labor market, wage increases will be constrained. If we begin to make substantial progress on the employment front, look for inflation expectations to show real signs of life.

In the meantime, the stock market is shrugging off all of these concerns as it seems to be focused on solid earnings growth from corporations and the steady stream of liquidity provided by the Federal Reserve. While bargains are much harder to find at these price levels, we are very pleased with the prospects of the companies we own in the Essential Growth Portfolio, relative to their stock prices. As the Fed begins to withdraw its quantitative easing program this summer, we will see how much of the market’s advance was liquidity driven and how much was based on earnings fundamentals.

Several years ago, there was much talk about the possible “decoupling” of the emerging markets from the developed markets, with the former gaining domestic growth momentum so that they were no longer dependent on exports to the developed markets. Now the decoupling discussion is about the emerging economies trying to slow their growth and keep inflation in check while the developed markets are in full stimulus mode, attempting to jump start their economies. We believe the emerging economies of Asia and South America as well as several energy rich economies will continue to be the primary source of worldwide economic growth. This doesn’t mean there won’t be setbacks along the way, both manmade and natural. However, we believe the strong economic and fiscal fundamentals these economies enjoy set the stage for solid growth for many years to come.