Thoughts on the Current Outlook – October, 2012

Bloomberg News reported today that the presidential campaigns, on their paths to spending $1 billion apiece, are on target to spend about $5 million per electoral vote in the battleground states. Since Colorado is one of these lucky states, our local economy has been bolstered by all of the advertising spending, even if it makes watching television unpleasant. And, the University of Denver just hosted the first of three Presidential debates, another economic boost both short- and long-term. Despite these local positives, we can’t help but think that the massive resources that go into our elections could be so much better spent on more productive pursuits.

Speaking of productive pursuits, the Federal Reserve really wants us all to invest in stocks and bonds. So much so, that it made two important announcements in early September: it expects to hold short term interest rates very low (near zero) until 2015 and, if that wasn’t enough, it will embark on a new round of “quantitative easing” some have dubbed QEternity. (In this context, quantitative easing is Fed-speak for increasing the size of its balance sheet by buying US Treasury or mortgage bonds.)

Importantly, the Fed announced that QEternity will stay in place until there is a meaningful reduction in the unemployment rate, so long as inflation is contained. The experience of the last few years tells us that lowering interest rates isn’t the cure for our economy or unemployment this time around. If it were, our economy would be screaming by now and the unemployment rate would have dropped precipitously. Instead, over the last couple of years, the rate has dropped mostly as a result of people leaving the work force and growth in the economy could best be described as anemic.

Complicating matters for the Fed, the most recent report – likely the most influential pre-election report – showed a meaningful drop in the unemployment rate (to 7.8%) even while the workforce expanded. Some of the underlying components of the report were positive (earnings, length of work week) but others were still very troubling (unchanged broad unemployment rate, large growth in part-time workers, loss of manufacturing jobs). We won’t know until well after the election whether this report was a precursor of more positive change or a statistical fluke.

Meanwhile, corporations are sitting on record amounts of cash and consumers continue to pay down the debts they accumulated over the last 20 years. So the economy putters along at 1-2% growth; not in recession but oh so close that any misstep could put us there.

What kind of misstep? Well, the “fiscal cliff” that we are screaming toward on January 1 is the number one candidate. (As a reminder, the cliff is a combination of tax increases and spending cuts that would come into being if Congress does what it is best at: nothing.) Many believe that the cliff is so steep and so well known that surely the politicians will do something to avoid it. We wish we could be so confident – having kicked can after can down the road and showing no propensity for compromise, we think counting on a solution before a crisis ensues is naïve.

After a weak first debate performance by the President, it appears that the presidential race has tightened up. Perhaps as important is what happens in the Senate races as control of that chamber is up in the air. With so much action required on federal tax and spending policies in the coming months, this election will shape the prospects for compromise. Much more so than normal, the resulting policy changes (or lack thereof) will directly affect the short term course for the economy, consumer confidence and employment.

Despite all of this political talk, we see four long term trends emerging here that we believe will ultimately lift us out of the shadow of the Great Recession. These are: (1) substantial progress toward energy independence; (2) stabilization of the residential real estate market; (3) dramatic productivity improvements resulting from mobile capabilities; and (4) the emergence of the echo boom generation as the driving force in the economy, reinforcing all three of the other trends. In the short term, political and policy news may make it harder to see the strength of these positive trends. However, we believe they will continue to move to the forefront regardless of the political environment.

Across both the Atlantic and Pacific Oceans, the trends which have been in place for the last two years stay in place. Europe, still struggling with the debt problems of its southern members, finds itself squarely in recession. Recessions in the south are quite severe, the result of austerity programs designed to reign in debt growth. In the north, the recession is much milder.

China continues its long transition from an export and infrastructure economy to a domestic consumption economy. The transition away from exports has been pushed along by slow demand from their trading partners elsewhere in the world. As a result, growth has slowed to a mid-single digit rate and stock prices have drifted down to early 2009 levels. This economic transition is further complicated by the political leadership transition that is also taking place.

We believe the biggest risk the financial markets face is an acceleration of the slowdowns across all three major economies – the US, China and Europe. As we have said, the fiscal cliff would likely be the chief short term culprit here at home. In China, policy inaction resulting from the political transition could result in growth slowing dramatically. Ironically, Europe, which has been the source of most concern for the past few years, seems to be more on track than the US and China. This is largely due to the European Central Bank’s vow to do “whatever it takes” to hold the Euro together, even as the southern countries’ austerity plans continue.

Of course, we need to keep in mind that unexpected geopolitical events could change the course of world economies abruptly. In the Middle East, Iran remains a wild card, moving toward nuclear capabilities even while the impact of economic sanctions is now reaching the streets. Expansion of the civil war in Syria to Turkey or other neighboring states (even if inadvertent) runs the risk of igniting conflict across larger powers in the region. And in Asia, a longstanding dispute over a tiny set of islands has spawned economic conflict between China and Japan at a time when neither economy can afford it.

While Europe continues on its bumpy road, we have significantly underweighted investments exposed to that region. However, our dedicated exposure to Asian equities remains in place as we believe the rise in consumer incomes and growth of a large middle class will continue. Among US stocks, we continue to focus on companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we find companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

Finally, we continue to avoid US Treasury bonds on which yields are suppressed by demand from the Federal Reserve. At the current level of yields, the risk to principal, once rates begin to rise, is astonishingly high. Quality corporate and municipal bonds still trade at attractive levels, relative to inflation, so our fixed income investments are focused in these areas.

October 8, 2012                           © Essential Investment Partners, LLC