Thoughts on the Current Outlook -- July, 2014

Volatility in Surprising Places

With two major bear markets in stocks within the last 15 years seared into investors’ memories, we have come to expect high volatility in stock prices.  Conversely, we tend to view the US economy as a lumbering giant, moving slowly but constantly forward, with only something as large as the Great Recession able to throw off its trajectory.  

Lately, we have seen volatility in the stock market decline rather dramatically.  Actually, this is pretty typical of a sustained run of positive returns like we have had since the middle of 2011 and we also saw in the mid 2000s.  However, we have seen the opposite in reported GDP over the past year.  The quarterly numbers have bounced around a lot (+4.1%, +2.6%, -2.9% and +3% estimated for the last four quarters).  If we just look at the year over year increase though, we find that GDP has grown at less than 2%.  

This raises a couple of questions.  Is 2% as good as it gets, now that the economy seems to be hitting its stride in this long recovery?  Does 2% growth really support the kind of rally we have had in stocks?

We believe there are a number of structural reasons why this 2% level of growth may be closer to the economy’s new growth potential, down roughly a third from the 3% we became accustomed to for several decades.  Productivity growth has slowed for at least two reasons: (1) chronic underinvestment in business capital equipment in the post-Great Recession period and (2) changes to the size and composition of the labor force occasioned by demographic shifts.  While productivity will be boosted somewhat by advances in mobile technology, these other factors will likely offset that boost, holding our growth back.

There is both good news and bad associated with lower potential GDP growth.  The good news is that we need fewer new jobs to sustain employment at a relatively high level (we are seeing this play out in the rather quick drop in the unemployment rate over the last 18 months).  The bad news is that we could be much closer to triggering a bout of renewed inflation from wage pressures than the Federal Reserve currently believes.  And, on a cyclical basis, we are getting close to a point on capacity utilization that typically results in inflation pressures.  

From an investment perspective, this result is by no means terrible.  Growth at this new potential with renewed wage inflation will mean higher nominal GDP growth.  Corporate profits and stocks can likely grow at that nominal rate.   Interest rates on bonds will drift up to at a more normal spread to long term inflation expectations (elimination of Fed buying will let rates seek this natural level).  Overall, we should expect returns to be lower than those of the last three years, when both stocks and bonds did quite well.  

Returning to the second question of stock prices relative to growth prospects, we view US small cap stock valuations as very stretched and US large cap stocks as fully valued.  As we look at individual companies, we often see valuations that reflect a great deal of optimism about  earnings growth when the reality is that earnings will likely grow slowly.  It takes a great deal of searching to find growing companies at reasonable prices.  We are much more positive about the prospects for non US stocks as growth is beginning to accelerate and prices are lower.

Global Growth Takes a Positive Turn

Globally, we see economic growth trending more positively with renewed contributions from Japan and Europe offsetting lower growth in China and many other emerging markets.  In Japan, the long-awaited, third and critical arrow of Abenomics will soon be announced.  It will be interesting to see how bold Mr. Abe will be in his proposals for labor market reform and, if he is bold, whether the Japanese people will continue to support him.  Please see the previous blog post on this website to read our publication about Japan entitled Big Change in the World’s Third Largest Economy? 

Continental Europe is still struggling to emerge from recession.  The process is slow and central bank stimulus continues to expand.  Without a strong central force for fiscal stimulus, the European Central Bank’s monetary stimulus is the only game in town.  The ECB is still fighting off the effects of fiscal austerity plans put in place across southern Europe several years ago.  Those economies are now bouncing back after severe recessions.  On the other hand, the UK, which retained control of its own currency and fiscal matters, has recovered well from recession and is now looking at monetary restraint to make sure inflation doesn’t become an issue.  

China continues to forge ahead on its economic and market reforms at the same time it seems to be going in reverse politically.  Numerous incremental changes have been made in the financial markets that all point to a more market-oriented approach to economic policy.  A series of important domestic policy initiatives have been announced that will allow more individual economic freedom.  However, censorship is as strong as ever and China is flexing its military and political muscle on regional territory issues, including most surprisingly Hong Kong.  

Cautiously Overweight US Stocks, Aggressively Overweight Non US Stocks

In most portfolios, we hold the maximum weight permitted in international stocks, particularly smaller company stocks, as we believe valuations are more compelling and better growth lies ahead.  We have increased our weightings in hedged equity and continue to be underweight in fixed income, with a relatively defensive stance within those holdings.   

July 9, 2014                   

© Essential Investment Partners, LLC

All Rights Reserved

Big Change in the World's Third Largest Economy?

We recently had the opportunity to spend 11 days in Japan, our first trip to a country that boasts the world's third largest economy.  Honestly, we weren't sure what to expect because Japan has spent much of the last 20 years wrestling with recessions and deflation.  And, if a two decade hangover from the 1980's party wasn't enough, the country is also recovering from a devastating tsunami that has shifted their entire energy policy away from nuclear energy.

Viewed from this side of the Pacific, the launch of Abenomics 18 months ago is having a positive impact on economic growth and inflation.  But the history of Japan's government stimulus programs over the past 20 years is littered with failures.  So the question is: is it really different this time?

Certainly, in structure, scale and scope, Abenomics is much greater than prior efforts.  The three "arrows" -- fiscal stimulus (deficit spending), monetary stimulus (quantitative easing) and structural reforms to boost competitiveness -- are designed to be mutually reinforcing (a Japanese folk tale says that three arrows held together cannot be broken).  The first two were readily implemented and are producing results.  The third is very much a work in progress, requiring both legislative action and great deal of change to Japanese work life.  

So what did we observe in our brief trip?  First, we were consistently struck by the great deal of pride each person we encountered took in their work.  As we settled into our first taxi ride -- with an extraordinarily polite, uniformed driver and an immaculate vehicle -- we could only imagine the horror of a Tokyo native who hails a cab for the first time in New York or Chicago.  This pride was evident everywhere we went and in every service provider we encountered.  So refreshing and so different than the US!

Second, we sensed real optimism about the direction of the economy.  Having family in Michigan, we have seen the impact of pervasive economic devastation first hand.  We sensed none of that in the three cities we visited.  On the contrary, the people we encountered were upbeat, welcoming and focused on their work.  

Our visit came on the heals of the consumption tax increase from 5 to 8% that took effect on April 1.  Japan's retail sales reports for March and April showed the impact (a big pull forward increase and then a large decrease).  However, we found retailers to be sanguine about the changes, even if they were acutely aware of its short term impact.  We came away thinking that Prime Minister Abe must have done an excellent job of communicating his policies.  People understood and seemed to accept the tax increase as part of a bigger plan.  

So what was negative?  You have to look beneath the surface to find it.  First, unemployment is very low and many people are employed in ways we would not conceive of here.  At department store elevators, we encountered three elevator ushers, assisting shoppers to the next available car, when we wouldn’t even have one here.  In our eleven days, I can’t remember ever having to wait to be assisted – there was always some one ready, willing and able to help.  (Mind you, we scrupulously avoided the queues at the most popular outlets – the first “street” queue we encountered was for Garrett’s Popcorn.  Those of you from Chicago will instantly remember the Garrett’s lines on Michigan Avenue – the same situation exists at Garrett’s near Harajuku in Tokyo.)

Second, the lack of immigration is painfully obvious.  The elevator ushers, the hotel bell persons (many female) and the cab drivers were all Japanese.  The corollary is that the workforce is not growing, either by birth rate or by immigration, and this will work to limit the growth in the economy.  It also implies that while unemployment is low, many workers are performing far below their potential.   As part of his structural reforms, Mr. Abe wants to encourage greater female participation in the labor force.  However, that would at best provide a one time boost to the work force, likely in the service sector.  

Finally, with the first two arrows of Abenomics firmly in place, the government is showing some success in creating economic growth and inflation.  However, the third arrow – labor market reform is critical for several reasons.  First, with little slack in the current labor force, even modest raises in wages could easily ignite a labor cost-driven inflation cycle that would be difficult to contain.  Worst case, Abenomics could give rise to a stagflation situation – high inflation and low growth.  Second, for the labor market to be more productive, employers need to be free to hire and fire.  Third, to have sustained growth in the labor market (and, by extension, the overall economy), some immigration will be required, as the domestic population simply isn’t growing on its own.  And boosting it with female participation won’t be sufficient.

With difficult structural reforms ahead, Mr. Abe has his work cut out for him to establish a long term platform for growth.  Our observation was that people are optimistic about positive change. Whether Mr. Abe will have the will to propose sweeping labor and immigration reforms is an open question. Assuming he does, then we will see whether the people will continue to be supportive of him and his policies.  Only time will tell.  

Thoughts on the Current Outlook – April, 2014

The Weather Strikes Back!

It seems a bit ironic that we used a weather analogy as the framework for our 2014 outlook because the weather itself was the biggest economic story in the first quarter. East of the Mississippi, from Minneapolis to Washington DC, record cold and snow were served up repeatedly.

Against this frigid backdrop, retail sales slowed, car sales stalled and hiring took a hit. About the only thing contributing positively to a growing economy was the big increase in consumption of natural gas for heating! We don’t have a preliminary read on GDP for the first quarter yet but we expect it will be significantly slower than the fourth quarter’s 2.6%.

The weather-induced slowdown in the economy had another surprising effect: the bond market did better than stocks in the first quarter. By the end of 2013, bonds were all but given up for dead with most predicting that interest rate rises were imminent and a bond bear market was about to start. And, conversely, conventional wisdom was that stronger economic growth would help stocks. As is usually the case when a trend is so universally expected, something else happened.

The bond market seems full of surprises these days. Even with new Fed Chair Yellen signaling that interest rate hikes are likely to begin next year, longer term bond yields have barely budged. To be fair, intermediate term rates moved up and mortgage rates continue to creep up. But, the worst performing part of the bond market in 2013 – long term municipal bonds – were the star of 2014’s first quarter.

But Change Is in the Air

Despite all of the uncertainty created by the weather, there is one thing that is certain: the weather will change. And, with it, we expect that economic activity will resume at a respectable pace. Respectable is the key word here. There are many factors that will keep the economy from accelerating too quickly.

First, we believe the snapback in housing is now over and the future gains in home prices will be driven by longer term supply and demand dynamics. While those dynamics are favorable, double digit price gains are likely behind us and more consistent, inflation plus 1-2% gains are more realistic.

The employment picture is still solid, if unexciting. Except in a few, high-skill, high-demand fields, there is still a great deal of slack in the labor markets, meaning income growth will be restrained and wage-driven inflation will be non-existent.

Finally, consumers continue to be financially conservative, taking on little debt and using their credit cards sparingly. This is one of the positive legacies of the Great Recession. But it also constrains growth in our economy.

More Excitement Elsewhere

Ukraine is in focus as the world ponders Russia’s next steps after its annexation of Crimea and troop build-up on Ukraine’s eastern border. We have long expected Russia to use its energy influence and the war-weariness of the US to expand its regional influence. We believe that the markets are Putin’s biggest adversary – the ruble has plummeted and, if oil prices follow, his ambitions will be diminished.

The more important European financial story is its emergence, albeit very slowly, from recession. The peripheral economies still have a long way to come before they can claim recovery. Indeed, central bankers are concerned that inflation remains too low, with talk of more stimulus creating news. Discussions about a possible break-up of the common currency, all the rage just a couple of years ago, are all but dead.

India, the world’s largest democracy is about to embark on its largest election (800 million prospective voters) ever. At stake is a renewed focus on the economy, which has struggled to post decent growth of late. India is in great need of more forceful economic leadership but we remain skeptical whether this election will provide it.

In China, concern has shifted to the magnitude of the debt build-up over the last few years, even as growth has slowed. From a very big picture perspective, this combination of factors is very similar to the US situation in the mid 2000s. As we know, that did not end well. However, there are many, many differences between how China and the US are able to manage these circumstances. We expect the Chinese to accept much lower economic growth as they shift toward a more sustainable growth model. And, they will use their unique “market-oriented” approach to gradually introduce freer float in the currency and more risk of default into the debt markets.

Finally, in Japan, Abenomics has accomplished its first task of shifting psychology away from deflation to modest growth and inflation. Salary growth, a critical element of the shift, is showing signs of taking hold. An increase in the consumption tax is just now going into effect so the next several months will be critical in seeing how this impacts the economy.

The Bottom Line

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We have reduced our dedicated Asia investments but have increased the weightings in international small company stocks, expecting these strategies to perform well in a better economic environment. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to changes in market expectations about the future course of interest rates.

April 9, 2014              © Essential Investment Partners, LLC

2014 Investment Outlook

Sun Breaks Through the Clouds

One lasting legacy of the Great Recession is our pre-occupation with concerns about new crises that will lead to a reprise of that terrible period. 2013 was chock full of crises that were supposed to derail us. We started off with the fiscal cliff (sooo 2012…) which gave rise to surprisingly positive new tax laws. Then came the sequester, the chemical weapons crisis in Syria, the debt ceiling showdown and the government shutdown. Let’s not forget China’s growth slowdown and the launch of Obamacare. And lurking in the background was the imminent demise of the Eurozone and the common currency! All of these bogey men turned out to be not so scary and the US stock market not only shrugged them off but surged to new all time highs.

The biggest surprises of the year turned out to be Fed “taper talk” – first came the too-early discussion of it by Chairman Bernanke in May and June. While shocking the bond market, equity markets barely flinched. And then there was the big “nevermind” in September and the bond market rallied while the stock market just kept plugging along. Finally, the Fed closed out the year with a modest start to tapering its asset purchases, setting the stage for the new Chair to implement it. How ironic that the one entity trying to prop up markets gets the credit for creating the most volatility!

As we look forward to 2014, there aren’t even any faux crises on the horizon to be worried about. Even Congress, the best at creating crises out of thin air, decided to patch up their budget differences before the holidays, leaving no real fiscal accidents waiting to happen in 2014. It is amazing how forthcoming elections can focus the mind!

Of course there are lingering concerns in Europe, Japan, China and other emerging markets. But after six years of prospective crises, we find ourselves a bit uncomfortable with a moderately sunny outlook.

How Sunny Is It?

Let’s not get too excited. While the outlook is improving, it is hardly perfect. Here in the US, the employment picture continues to show resilience as the jobs reports have shown consistent, if uninspiring, strength. Stock market gains and home price increases have restored consumers’ net worth to pre-2008 levels, while debt service costs have dropped to a very low percentage of income. We are seeing this positive backdrop show up in solid gains in retail sales and strength in automobile sales. Housing continues to recover but a sharp back up in rates could well slow that recovery.

We expect that this consistent growth path will lead the Federal Reserve to wind down its bond purchase program in 2014. This will likely be coupled with repeated statements about holding short term rates low. That long term interest rates have stayed as low as they have might be a bit surprising. We think this is a function of low and contained inflation. Without labor cost pressures, we expect inflation to stay low for some time to come. The ten year Treasury bond yield was in a range of 2.50-3.0% for the second half of 2013. Over the course of 2014, we expect that range to move up to 3-3.5%.

But we also expect volatility in rates to be the norm as markets try to figure out how the Fed moves away from its bond purchases. It is certainly possible that long term rates could move up much farther and faster than anyone expects, tanking the bond, stock and real estate markets all at the same time.

Still Cloudier to the East

In Europe, we are now past the German elections so we would hope to see continued progress toward solidifying a Eurozone bank regulator. Austerity and, more importantly, labor and tax reforms in southern Europe are finally beginning to have an impact on those economies. But we are hardly out of the woods. While the recession has technically ended, growth is very anemic and there is a real risk of backsliding into another recession.

Much further east, Japan’s Abenomics program is having the desired short term impact: modest growth and inflation. However, big challenges lie ahead. For progress to be sustained, fundamental changes need to take place in the labor market. Companies need the flexibility to hire and fire according to market needs, rather than providing lifelong employment. And workers need to be rewarded for increased productivity so that sustained growth in wages can take hold. Finally, there is an enormous demographic problem building which will likely require new approaches to immigration and labor rules. Progress on these difficult structural issues is by no means assured.

And Just Plain Hazy in China

Meanwhile, China, the bigger growth engine of Asia, has completed its leadership transition and the Third Plenum. Billed in advance as reforms comparable in importance to those of the late 1970s, the high level plans that came out of the Plenum are important evolutionary steps. Whether they turn out to be revolutionary will depend on the implementation. Loosening of the one child policy, changes in land rights for farmers, reform of the household registration system and a definitive statement that market forces should guide resource allocation are just some of the key provisions of this new plan.

While we view these changes as quite positive, they will take some time to play out. In the meantime, China is still burdened by an economy too-dependent on fixed investment, financial and labor imbalances and strong state-owned enterprises. Perhaps most important for long term investors, China’s new leaders understand the problems they face and have crafted a plan to deal with them.

Other major emerging markets face issues unique to their own situations. One common thread is high inflation and low growth, a combination not likely to inspire investors’ confidence for some time. Relatively cheap stock prices in these markets reflect these poor fundamentals.

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to new dynamics.

January 6, 2014                                                       Copyright, Essential Investment Partners, LLC

Thoughts on the Current Outlook – October, 2013

All of the buzz in the financial markets since May has been about the Federal Reserve and the rise in interest rates in the wake of the expected “tapering” of their bond purchase program.  But in fact the real “rising” story has been stocks.  Hurdling a wall of worry that included higher interest rates, possible use of force in Syria and an impasse over the federal budget and debt ceiling, stocks have shot up this year.  For the year to date, US stocks have gained nearly 20%. 

Not to be outdone by the US, developed international markets also rallied strongly, gaining more than 16%.  However, emerging markets continued their lagging behavior as concerns about less Fed stimulus led investors to withdraw investments from emerging markets bonds and stocks.  Those economies with high inflation and slowing growth (think Brazil, India and Turkey) were particularly hard hit.

A hallmark of Federal Reserve policy under Ben Bernanke has been open communication, making sure the markets know well in advance what the Fed is planning to do.  This policy stood in stark contrast to the Alan Greenspan era when the former chair would go to great pains to ensure that whatever he said was indecipherable.  The Bernanke approach was closely followed until the September meeting when the Fed surprised the markets by announcing a deferral of the tapering plans that the Chairman had carefully laid out in the preceding months.  While not stated, we believe that the delay was less about economic data than a hedge against the impact of the impasse over the continuing resolution (CR) to fund government spending and the debt ceiling.

Negotiations over the CR and debt limit are noticeably more difficult this time around as the poisonous atmosphere in Washington has only grown worse with mid-term elections looming.  Adding drama, if not substance, to the debate is the launch of the open enrollment period that kicks off Obamacare.  At this writing, the government is in shutdown mode which we expect to continue until a longer term debt ceiling and full year CR are ironed out.  We view all of this as political theater, with the resolution unlikely to have a lasting effect on the path of the economy.

 
The biggest impact, we believe, is that the Fed will sit tight until the show is over and then begin scaling back its bond purchase program.  We believe the US economy is likely to continue growing at a below long term average rate (2-3%), but sustainably growing nonetheless.

With no structural changes happening, Europe remains in neutral, not going backward or forward.  China is now well through its power transition and policymakers are clearly focused on the key issues of excess credit creation and conversion to a domestic oriented economy.  Recent data from China has been more encouraging but we expect growth to be choppy. 

US interest rates are settling into a new trading range reflecting low inflation, modest economic growth and little or no Fed buying.  One thing clear from the Fed’s September announcements is that short-term interest rates are likely to stay low for at least two more years, particularly since inflation is well below the Fed’s stated 2% target.

Absent an external inflation shock, we expect inflation to stay low because of the slack in the labor market.  The unemployment rate will keep falling from a combination of lower participation and steady employment growth.  There has been much debate about whether the drop in the labor force participation rate is due to discouraged workers dropping out or baby boomers retiring.  No one really knows how much each factor contributes but it is clear that new college grads are still having a hard time finding jobs. And the baby boomers are the first generation with two wage earners retiring, sometimes simultaneously.  The debate about the cause is less important than the fact that the lower participation rate will keep the economy on a slow growth, low inflation path.

This kind of path should be good for stocks and that has certainly been the case this year.  We think US stocks are on the expensive side right now and need a breather to allow earnings growth to catch up.  International stocks had been cheaper but they too have rallied strongly of late.  While we remain overweight stocks and underweight bonds, we are trying to keep a modest cash reserve that we can deploy if we see a significant pullback. 

Within our general underweight in bonds, we believe there will be opportunities for reasonable total returns if we remain nimble.  However, the general trend for rates will be up, toward a more normal long term structure, so minimizing interest rate risk remains a paramount consideration.

October 4, 2013                        © Essential Investment Partners, LLC   

Explaining the Unexplainable: US Strategy toward Syria

We have been baffled by the Obama Administration’s statements and actions over the last month in dealing with the Syrian chemical weapons situation.  George Friedman, founder of Stratfor, a foreign affairs consultancy, penned an excellent article which we highly recommend.  It lays out in simple terms why we are so conflicted and unable to articulate a clear path forward. 

http://www.realclearworld.com/articles/2013/09/17/ideology_trumps_american_strategy_in_syria_105448.html

Thoughts on the Current Outlook – July, 2013

In last quarter’s Thoughts on the Current Outlook, we spent a great deal of time talking about the price risk in bonds.  Our view was that the US economy was gradually improving and that this would lead the Federal Reserve to cut back (and ultimately eliminate) its bond purchase program. This cutback would result in bond yields rising and prices falling as the Fed would no longer be the principal buyer.  We expected this adjustment to be gradual as a stronger, self-reinforcing recovery was by no means assured. 

Well, we were wrong about all the gradual stuff.  Bond investors, a notoriously impatient bunch, made the adjustment shockingly fast.  In May, the Fed hinted that it was considering reducing its bond buying and rates jumped about 4/10 percent.  In June, Fed Chairman Bernanke outlined a very specific timeframe for bond buying cutbacks, conditioned on continued improvement in the economy, and bond investors promptly ignored the conditional and pushed rates up again as much. 

Finally, the June report on non-farm payrolls, released on July 5th, was a solidly positive report and bond yields rose sharply yet again as investors became convinced that the end of Fed bond buying was a done deal.  From the lows in April, the 10 year Treasury yield rose nearly 1.1 percent. 

Normally, this type of rapid increase would cause stocks to fall as investors mark down future earnings with a higher discount rate.  Wrong again.  With just a two day hiccup, stocks resumed the 2013 rally.  However, emerging market stocks were hit hard on worries about negative currency flows, adding to already prevalent concerns about slowing growth and high inflation. 

The good news is that the US economy does appear to be doing somewhat better, if we look past the second quarter in which GDP growth will likely have been pretty anemic (think 1-1.5%).  The employment picture is positive even though many of the jobs being added are low-paying, part-time or both.  Consumers and small businesses are more confident than they have been since 2008 and consumers are even expanding their use of credit. 

With changes in future Fed policy now squarely on the table, we hope that stocks and bonds begin trading on more fundamental factors like future earnings prospects, economic growth and inflation expectations, rather than being artificially altered by Fed stimulus. Now that interest rates have moved so far so fast, we think that selected areas of fixed income show attractive value.  In particular, high yield corporate bonds are now trading at somewhat wide spreads to US Treasuries, even though default rates are still trending down (as one would expect if the economy is doing better). 

US stocks have streaked ahead of the rest of the world so we are being cautious in investing new cash here.  Outside the US, valuations are far more reasonable but there are reasons for concern.  In China, the new regime is working hard to rein in the shadow banking system that has created much more credit than is healthy.  While very necessary, their efforts run the risk of slowing China’s economy – the world’s second largest -- sharply. 

Other emerging markets have been hit hard by falling stock, bond and currency prices.  While the proximate cause of these quick declines is the knock-on effects of changes in US monetary policy, each major emerging market suffers from its own set of unique challenges with the common themes of slower growth and higher inflation.

Europe has shifted out of crisis and into chronic problem mode.  There are a few bright spots on the horizon, but these tend to be of the “less bad” news variety.  But recoveries are made out of “less bad” gradually changing over to good.  We expect the road ahead to continue to be bumpy, with many setbacks along the way, as the Eurozone puts in place the structural reforms needed. 

With all of these headwinds, non US stocks are now significantly cheaper so we have begun selectively adding to international investments for the first time in a long time.  Over the next few years, we expect the US to lead a global recovery which should be good for stocks around the world. 

Bond investors need to become nimble, after thirty years in which being a sedentary bond investor was the best strategy.  Within our general underweight in bonds, we believe there will be opportunities for reasonable total returns as current coupons compensate for inflation and periodic emotional reactions – like what we have just experienced -- drive prices to bargain levels. 

July 10, 2013                        © Essential Investment Partners

Fed Riles the Markets

In our “Thoughts on the Current Outlook” dated April 9 of this year, we said:

We aren’t suggesting that you rush to sell all of your bonds immediately because we don’t expect this rise in rates to occur suddenly.  But we are actively reducing the duration risk in client portfolios as we think this rise could happen as rates return to “normal” levels.  This normalization of rates comes with some good news though:  interest rates are likely to rise as the economy continues to recover and approaches its long term growth rate. 

Higher growth will give rise to two conditions leading to higher rates.  First, the Federal Reserve will likely back off of its program for purchasing bonds, which we believe has artificially suppressed bond yields.  Second, better growth typically means a return of inflation as incomes rise, demand rises and prices respond. 

Events of last week jumbled the order we had anticipated.  Prior to last week, the Federal Reserve had only hinted at considering “tapering” their purchases of US Treasury bonds and mortgage bonds if the economy continued to improve.  Last week, in conjunction with the Fed’s regular meeting, Federal Reserve Chairman Bernanke laid out a relatively specific plan for tapering their purchases later this year and stopping them next year, effectively anticipating that the economy will continue to improve, or at least that is how the markets’ interpreted his comments. 

The markets’ reaction to this change in Fed intentions was violent.  Interest rates spiked, bond prices tumbled and stocks followed suit.  To give you a sense of the magnitude of the move in interest rates, the yield on the 10 year US Treasury bond was 1.64% on May 1, 2.16% at the end of May and it closed Friday at 2.51%.  We had expected that this rate might move into the range of 2.75 to 3.00% over the next year.  Instead, we got about three fourths of the move in just a few weeks. 

Markets don’t like surprises, particularly from the Fed, so bond and stock prices dropped swiftly.  And the downward moves in prices of closed end bond funds have been particularly stunning.  However, there is a silver lining.  This negative investor sentiment presents a great buying opportunity in our opinion.  Over the last few days, we have been selling open end bond funds and buying closed end funds at prices we view as exceptionally attractive.  We also expect to add to stocks as well, although those corrections have been more selective and we will be more cautious in our buys. 

We will be publishing our new investment outlook in early July.  It will have a much more complete discussion of the issues that the new Federal Reserve stance has created.  These issues extend well beyond our shores as the impact of the world’s largest economy changing its monetary policy has large ripple effects.

Thoughts on Current Outlook – April, 2013

There’s always a rally in bonds – either prices or yields are going up!

Do you find bond math confusing and counterintuitive? If so, you are in the vast majority! Fortunately, for the last 31 years, buying bonds and just hanging on was a good thing to do. But that long, pleasant ride may soon be over.

Most of us know that as rates fall, bond prices rise and conversely that prices fall when rates rise. From their current low level, there isn’t much room for rates to fall but there is unlimited room to rise. This is enough to warrant concern about the future of bond prices.

However, there is another major risk that bond investors face today that many non-professionals haven’t recognized. We will spare you the math but as bond coupon rates fall, bonds’ price sensitivity to interest rate changes rises. With rates now so low, price sensitivity to interest rate changes is exceptionally high.

At the current level of rates on US Treasury securities, the duration (a measure of interest rate sensitivity) on a 10 year Treasury bond is now about 9 and the duration of a 30 year bond is over 20. This means that if market interest rates rise by 1%, a ten year Treasury note would lose about 9% of its market value and a 30 year bond would lose about 20% of its market value.

If interest rates on 30 year Treasury bonds rise from the current rate of about 3% to over 5%, those bonds could lose about 40% of their market value. While a 2% rise in interest rates doesn’t seem unreasonable, the accompanying loss of value would be about the same as stocks suffered during the crisis of 2008!

We aren’t suggesting that you rush to sell all of your bonds immediately because we don’t expect this rise in rates to occur suddenly. But we are actively reducing the duration risk in client portfolios as we think this rise could happen as rates return to “normal” levels. This normalization of rates comes with some good news though: interest rates are likely to rise as the economy continues to recover and approaches its long term growth rate.

Better growth ahead for the US

Higher growth will give rise to two conditions leading to higher rates. First, the Federal Reserve will likely back off of its program for purchasing bonds, which we believe has artificially suppressed bond yields. Second, better growth typically means a return of inflation as incomes rise, demand rises and prices respond.

So what will give rise to this better growth? Four major trends that we have been talking about for nearly a year now continue to gain prominence: substantial progress toward energy independence, recovery in residential real estate, dramatic productivity enhancements resulting from mobile capabilities and the emergence of the echo boom generation as the driving force in the economy.

Interestingly, it seems the economy (and the markets) have begun to ignore the machinations in Washington, so long as they aren’t destructive. We cruised right into the sequestration-related spending cuts without so much as a hiccup (yet, anyway) as the markets seemed to decide that if this is the only way we can get spending cuts, so be it. The effect of these cuts and higher taxes may slow down GDP growth in the second quarter but we expect this effect to be temporary. The conversations now appear to have shifted to longer term entitlement reform, also a positive.

Didn’t think your bank deposit could be taken to recapitalize your bank?        Guess again!

Across the pond, things are not so rosy. Cypriots are up in arms about the plan to tax bank deposits as a way of funding part of the bail out their banks need. While the whole of Cyprus’ banking system isn’t meaningful in the context of the size of Europe, this plan sets a dangerous precedent. And, we think it works against the idea of a unified banking regulation and deposit insurance which is critical to a better functioning Eurozone.

Meanwhile, the rest of southern Europe is left to wonder: are we next? It is little surprise that markets in Italy, Spain and even France have not taken kindly to the Cyprian plan even while the bureaucrats that worked out the plan are saying it was a one-off. Given the inconsistencies, skeptics abound. We are somewhat puzzled about what will come next as politics may continue to get in the way of progress. Italy is having trouble forming a new government, the Socialists in France are struggling and elections in Germany are not far off.

Right now, we have the pledge of the European Central Bank to provide liquidity needed to support markets but very little progress has been made toward the structural reforms needed to keep the Eurozone alive indefinitely. We expected this road to be bumpy but the Cyprian plan is a new, large pothole. Meanwhile, the Eurozone recession drags on.

Emerging markets chart their own path while US and Japanese stocks soar

Both the Dow Jones Industrial Average and the S&P 500 stock index reached new historical highs in the first quarter. In the aggregate, we don’t believe US stocks are significantly overpriced. However, our bottom-up work on stocks tells us that it is much harder to find bargains.

Even while the US and Japanese stock markets rallied strongly in the first quarter on the heels of central bank actions, emerging market stocks were declining. Investors became concerned about whether the recent history of strong growth would revive, in the face of continued inflation. The combination of slower growth and inflation does not give investors confidence.

For the next few years, we expect stocks will be a better place to be than bonds, given the risks in current bond prices outlined above. However, if interest rates rise too quickly, stocks could tumble along with bonds as investors place less value on future earnings when rates are higher. We don’t think this is likely but are acutely aware of the risk.

Finally, we continue to like the prospects for high quality companies with worldwide sources of revenue growth. We remain cautious about European stocks as their recession continues. And we are reducing exposure to interest rate risk in the bond portion of client portfolios and adding to long/short strategies in both stocks and bonds.

April 8, 2013                               © Essential Investment Partners

Income and Estate Taxes – A Surprising Bit of Certainty

At a time when it seems that politicians here and abroad are contributing to the uncertainty of the world economy, the US Congress recently delivered a bit of certainty in two very important aspects of our financial lives.  It took two old line Senators – McConnell and (now Vice President) Biden – to hammer out a deal in the waning hours of 2012.  The final deal allowed both sides to claim victory – higher taxes on upper income taxpayers for the Democrats and permanently lower rates in all other brackets for the Republicans. 

Remember the phase-ins and phase-outs and constantly changing brackets of the 2000s?  Gone.  In the end, the lower tax rates initially established under President George W. Bush were made permanent for all but the highest income earners.  In addition, no major deductions or exemptions were modified and that pesky alternative minimum tax fix (that Congress has been doing annually for who knows how long) is now permanently fixed by indexing it to inflation. 

Congress also drastically reduced the applicability of the estate tax by making permanent the estate/gift tax exemption at $5,250,000, also indexed for inflation. Portability (sharing of the exemption between husband and wife) has been made permanent.  The quid pro quo?   A higher estate tax rate of 40%.  

This all seems too good to be true, right?  Well, if you make more than $200,000 (single) or $250,000 (married), your 2013 income tax calculation is about to get a lot more complicated.  We aren’t going to try to explain all of the nuances here but let’s summarize by saying that there are three new ways that your taxes will go up. 

First, the 3.8% Medicare surtax will apply to net investment income to the extent the $200,000/$250,000 threshold income is exceeded.  Second, at incomes above $250,000/$300,000 personal exemptions and itemized deductions begin to phase out.  Finally, at incomes over $400,000/$450,000, a new higher income tax rate of 39.6% applies and the capital gains rate increases from 15% to 20% (in addition to the Medicare surtax).  

Behind each of the these general ways that taxes may rise is a somewhat complicated formula – best left to your tax accountant. 

Stepping back from the details, it seems pretty likely that those with high incomes and estates exceeding $10.5 million will look to shift income-producing assets out of their estates by way of gifts below the gift tax exclusion amount.  The secondary benefit is that the income from those assets could be taxed at substantially lower rates in the hands of a lower tax bracket recipient.  

Our advice – seek the counsel of your tax accountant and estate attorney early in 2013 – as asset and income shifting might be an important part of a smart estate and income tax strategy.  The sooner you look at your options, the more effective they will be in 2013 and future years.

Good News from Essential

2012 turned out to be a very good year – our clients experienced strong absolute returns and we were blessed by the expansion of our client roster.  We closed 2012 at just over $100 million in assets under management and plan to continue to grow in a measured way that puts client service first and foremost.  

Speaking of continued growth, we are pleased to announce that Mark Asaro, CFA,  has been promoted to Portfolio Manager.  Mark has done an excellent job in all aspects of our investment research – he and Jon Zeschin now co-manage all client portfolios. 

In addition, we have named Marce Webster to the position of Client Service Director.  Marce is the consummate client service professional, making sure that all aspects of our clients’ interactions with us and their custodians run smoothly.  

A great deal of the credit for our clients’ investment success goes to Mark and Marce – they are always ready to do whatever is needed for our clients.

2013 Investment Outlook

Success in 2012 seemed to be mostly about staying the course: not reacting to each bit of news out of Europe or China or, heaven help us, the fiscal cliff negotiations. We should have expected our politicians to copy their European counterparts by doing the absolute minimum at the last possible moment to avert a crisis and deferring bigger decisions until later. This exercise in procrastination did achieve two important things, however: (1) the new tax law made the income and estate tax rates permanent, providing some certainty about tax policy and (2) by deferring any action on spending cuts, they delayed the economic impact of the cuts to a later date, making a recession much less likely.

We had been concerned that higher income taxes and the expiration of the payroll tax holiday, combined with spending cuts, could be an immediate 1.5-2% hit to our economy. This could easily have thrown us into a mild recession. While the hit from the tax hikes (mostly the expiration of the payroll tax holiday) will be about 1%, we are pretty confident now that spending cuts will get pushed into the future. And, some of the short term impact of the tax hike will be mitigated by lower gasoline prices. Bottom line, intransigence may prove to be just what we needed to avoid recession – isn’t it incredible how Washington can work this magic!

We should caution that we are by no means out of the woods. When you govern by brinksmanship, there is always the risk of a major self-inflicted wound (like the 2011 debt ceiling debacle). So we will be watching the spending and debt ceiling debates closely. But for now, we believe that “absolute minimum at the last possible moment” is the governing philosophy.

So what of our burgeoning deficit, insufficient revenues and unrealistic social promises? They are left to another day. We can only hope that these words from the preamble to the report of the National Commission on Fiscal Responsibility and Reform (Simpson Bowles) prove prophetic: “We believe that far from penalizing their leaders for making the tough choices, Americans will punish politicians for backing down – and well they should.”

For nearly four years now, we have been talking about the legacies of the Great Recession: high unemployment, consumer savings and debt payoffs, reduced bank lending and the housing drag.

Chronically high unemployment is certainly still with us. Even though the “headline” rate is 7.8%, down a long way from the peak, much of this has been accomplished by a drop in the labor participation rate. This participation rate – currently at 63.6% – is near a 30 year low. Recently, the Federal Reserve has set its monetary policy targets based on achieving a 6.5% jobless rate, an interesting target given that there is little evidence that the aggressive Fed policies have spurred job growth to date.

Speaking of the Fed, its low interest rate policies have helped consumers deal with their debt issues. So far, most of the progress has been made on debt service costs (now near historical lows, as a percentage of income) rather than principal reduction (about halfway back to the long term average, also as a percentage of income). Because consumers have limited the growth in debt very sharply even while incomes have expanded, we expect slow but steady progress.

Almost left for dead by many, real estate has staged an unexpectedly strong turnaround. In particular, demand for multi-family housing is very robust and prices reflect that dynamic. Single family housing inventory is now only five months, well below long term average of seven. Most importantly, residential real estate is no longer the financial and psychological drag it once was.

Finally, banks are coping with greater capital requirements and huge regulatory burdens, not to mention very low interest rates. So lending isn’t a big priority now and, honestly, demand for loans isn’t high either. Consumers don’t want to take on a lot of debt and larger companies have more cash than they have had in a very long time. Instead, fee income has taken precedence. Recently, we had a major bank charge a client $40 for returning a wire that was sent to them in error. To us, that showed just how far banks are searching for new fees to charge. Get used to it!

Except for high unemployment, we believe the other legacies of the Great Recession will fade as new trends replace them. We see four long term trends emerging that will drive our economy forward in the next few years. These are: (1) substantial progress toward energy independence; (2) rebound of the residential real estate market; (3) dramatic productivity improvements resulting from mobile capabilities; and (4) the emergence of the echo boom generation (boomers’ children) as the driving force in the economy, reinforcing all three of the other trends. So while Washington dithers, there are trends in the real economy that will drive growth, which is the best prescription of all for reducing the deficit.

Mired in recessions, severe in the south and moderate in the north, Europe is largely in a holding pattern, as the Eurozone slowly debates the type of new structures needed for closer unity. In the meantime, the European Central Bank has clearly stated its intent to do “whatever it takes” to keep the Euro in place. Knowing that the Eurozone is about promoting prosperity while preserving peace, Germany will ultimately provide the leadership needed but only once it believes the correct structures have been established. How long this will take is anyone’s guess. So the weaker economies are left to struggle with austerity while the stronger economies likely begin to recover from a mild recession.

China continues to be the big question mark in Asia. How will the new leadership team stimulate the economy? How will it deal with excess debt accumulated in the real estate sector? Will it become more territorial militarily as it looks to secure energy resources? These and hundreds of other questions are waiting to be answered as the once-a-decade transition of power continues through March.

One thing is clear, however. China and its emerging Asia neighbors will continue to grow much faster than the developed world. But how that translates into future investment returns remains to be seen. Already, spreads on emerging market sovereign debt have plummeted to historic lows. And, Asian stocks posted a strong 2012. That said, we believe that there is opportunity in the uncertainty surrounding China and will look for ways to take advantage of that for our clients.

Caution is warranted on fixed income investments. Even a moderate recovery in global growth will pressure prices. Combining that pressure with excess supply (particularly once the Fed stops buying) will cause rates to rise. From these levels, the loss to principal from higher rates could be substantial. We don’t expect a sudden move but we could look back a year from now to find Treasury and corporate bond rates at a meaningfully higher level.

Among stocks, we still like the prospects for large multinational companies with diversified revenue streams, particularly those with substantial emerging market exposure.  And, with the continued uncertainties we face in the US, we continue to like a mix of absolute return oriented strategies (such as long short debt and equity) combined with shorter term fixed income investments.

January 8, 2013                                           © Essential Investment Partners, LLC

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

Reinventing America’s Economy

The cover of the July 14th issue of The Economist magazine featured a buff, bulked-up Uncle Sam under the heading “Comeback Kid.”  Subtitled “America’s economy is once again reinventing itself,” the cover story described several very positive trends.  Their story largely overlapped our April 2012 “Thoughts on the Current Outlook” in which we said the following:

On a longer term basis, we are increasingly focused on four factors that we see as likely to help our economy over the next several years. We believe these four trends will help lead us away from some of the nearly four year old legacies of the Great Recession, particularly high unemployment and excessive debt.

They are:

1. the push for energy independence, supported by major discoveries and new technologies in North America as well as a moderately favorable regulatory environment;
2. the petering out of the housing debacle – with foreclosures concentrated in a few severely depressed markets and affordability at an all-time high, we believe the stage is set for stabilization of home prices nationally;
3. a new wave of business productivity enhancements, sparked by the convergence of highly functional, user friendly mobile devices and an explosion in software targeted at these devices;
4. the overarching theme is the emergence of the echo boom generation as the driver of each of the three themes above. Think energy efficiency, housing needs, mobile productivity – we think those six words succinctly summarize the mindset of current 20- and 30-somethings.

Anticipating the view that America’s economy is not exactly humming along now, The Economist said:  “What should the next president do to generate muscle in this new economy?  First, do no harm.  Not driving the economy over the fiscal cliff would be a start: instead, settle on a credible long-term deficit plan that includes both tax rises and cuts to entitlement programmes.”

We couldn’t have said it better.  As our most recent outlook indicates, we are most concerned about the self-inflicted wounds we seem destined for over the next six months as the fiscal cliff arrives.  If we can get through this period with a reasoned approach that sets in place a solid long-term course, there is much to be optimistic about.  Unfortunately, this is a big IF – it seems that both political parties are more concerned with posturing around problems rather than solving them. 

So put us in the short-term cautious, long-term optimistic camp.  Regardless of who wins the election in November, the new president would be well-advised to heed the urgings of Lucy to Charlie Brown: “Lead, Charlie Brown, Lead!”

Thoughts on the Current Outlook – July, 2012

“This is like déjà vu all over again.”

Perhaps Yogi Berra’s most famous quote, this could be turned into a theme song for the financial markets. US economy slowing down with a double dip likely…China’s growth slowing rapidly…Europe caught up in the problems of excessive debt, unified currency and disagreeable governments. All of these have been market themes in the summers of 2010 and 2011 and now 2012.

Here at home, the Citigroup Economic Surprises Index (which measures the trend in economic data exceeding or falling short of expectations) has turned sharply lower, just like it did in each of the last two years. Indeed, a raft of data from ISM manufacturing reports to regional Fed surveys to non-farm payrolls have all been soft in the last two months. The question is whether these soft readings congeal into negative GDP reports later this year or early next.

We believe the chances of recession have inched up to 50/50 for two main reasons: (1) actions by the Federal Reserve (like so called QE1 and QE2 in 2010 and 2011) are likely to be less effective this time and (2) it is highly unlikely that Congress will act by year end on the massive tax increases and spending cuts that take effect January 1. In the face of this uncertainty, we think businesses will pull back on hiring and investment plans and consumers will choose to save more and spend less.

Fortunately, there are some countervailing trends. Gas prices are following the price of oil, which has fallen about 20% from its peak earlier this year. Lower gas prices leave consumers with more cash in their wallets at month end. And, two stalwarts of a typical post-recession recovery – housing and autos – which were all but left for dead in the Great Recession are now showing signs of life. Auto sales recently rose above a 14 million annual rate, a more than 50% increase off the trough in 2008. We expect this production rate to keep rising driven by the replacement cycle and demographics.

After four years of torturous price declines, housing inventories are now very low, affordability is exceptionally high and prices are starting to reflect this dynamic in most cities. Unfortunately, housing is now such a small percentage of GDP that the impact of renewed strength will be muted for some time. More important, however, is the positive psychological effect stable home prices will have on consumers.

If it weren’t for the self-inflicted wounds of the coming tax hikes and spending cuts, we believe the US economy would continue to bump along at 1.5 to 2.5% growth. With so much riding on the outcome of the November elections, we find it hard to be confident of the environment we will face in 2013.

“If you don’t know where you’re going, you might wind up somewhere else.”      (Yogi Berra)

European “summits” are piling up faster than we can count them. The latest, at the end of June, resulted in some apparent movement toward a single pan-Eurozone bank regulator. This is one of several very important steps toward a comprehensive “solution” to Europe’s debt problems. However, the timetable is aggressive, the hurdles high and the written agreement weak. After a day of euphoria, the equity and debt markets fell back to pre-summit levels.

We have said many times that we believe the Eurozone will survive, largely on the will to keep it alive. That said, this is a political process, involving many democratic countries with unique perspectives, so it will be a long, uncomfortable ride and it may appear at times that they have no direction or destination. The risk of failure is high but all of the players know that failure comes at a greater cost than union.

In the meantime, Europe will stay in a modest recession as the south deals with deep recessions built on austerity plans and the north maintains the status quo, benefiting from the weak currency. We believe the biggest risk is that the bond market loses patience with the political process and causes a crisis in which individual countries are forced to protect their own interests, leading to a disorderly unraveling of the currency union.

“You can observe a lot just by watching.” (YB)

A personal visit to mainland China in May provided some much needed perspective on the economy, which has been the subject of so much hand-wringing about whether the growth story is ending. Are there excesses? Certainly. Unused highways, bridges to nowhere, partially built apartment complexes, the list goes on. No doubt some will end up as waste, others were just built in anticipation of future needs. But there is a bigger picture.

There is a rapidly growing middle class which has no desire to turn back the clock. The sheer power of the market economy that has been unleashed in a very short time (just a little over three decades) is hard to fathom. We had the benefit of talking to many young people who are truly excited about the opportunities in front of them and are prepared to work hard to succeed. These young people have seen firsthand how much better their lives can be than those of their parents and grandparents and they want to ensure that the same is true for their children.

Bottom line, China’s export engine is slowing sharply – there is no doubt about that. But the seeds have been sown for strong domestic growth (by Western standards) for many years to come. The transition may be bumpy, but for those businesses positioned to benefit, the tough ride will be worthwhile.

“When you come to a fork in the road, take it.” (YB)

In a period of high uncertainty involving all three major economies, it would be easy to conclude that holding cash is a good strategy. But by providing no nominal return whatsoever for the next couple of years, we believe cash provides a negative real return we prefer not to accept.

We believe there are opportunities for solid, if not spectacular, returns. Among stocks, we like companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we are finding companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices. While the drama in Europe continues to play out, we have significantly underweighted investments exposed to that region. However, our dedicated exposure to Asian equities remains in place.

Finally, we continue to avoid US Treasury bonds. These now trade entirely on the basis of demand for a safe haven or temporary 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.

July 11, 2012                      © Essential Investment Partners, LLC

Thoughts on the Current Outlook – April, 2012

After nearly two full quarters of uncertainty last summer and fall, the financial markets settled on the conclusions that (1) the US economy was recovering from the summer soft patch; (2) China’s slowing growth rate was not likely to be a crash but an expected slowing due to a shift away from exports; and (3) the Europeans, with the help of their central bank, were likely to stave off default by Greece for the time being. From the peak in April of 2011 to trough in early October, US stocks dropped nearly 19%, just shy of the magic bear market line. Since then, they have rallied nearly 30%, bringing us to levels not seen since 2007.

Here at home, recent statistics on GDP growth, employment, manufacturing and housing have been positive, if not overwhelming. Bears point out that seasonal adjustments are out of whack because of the warm winter and that future reports are likely to be much weaker. They also point to slowing in Europe and China that will ultimately spread here. Finally, the “tax” of higher gas prices will ultimately drag down consumer spending.

Bulls counter that employment is showing sustained growth, with initial jobless claim numbers supporting solid growth in non-farm payrolls. Risks in Europe and China are well-known and likely to have only a moderate impact on us. The booming market for domestic energy is driving job growth, and that, combined with low prices for natural gas, more than offsets higher gas prices.

On a longer term basis, we are increasingly focused on four factors that we see as likely to help our economy over the next several years. We believe these four trends will help lead us away from some of the nearly four year old legacies of the Great Recession, particularly high unemployment and excessive debt.

They are:

1. the push for energy independence, supported by major discoveries and new technologies in North America as well as a moderately favorable regulatory environment;
2. the petering out of the housing debacle – with foreclosures concentrated in a few severely depressed markets and affordability at an all-time high, we believe the stage is set for stabilization of home prices nationally;
3. a new wave of business productivity enhancements, sparked by the convergence of highly functional, user friendly mobile devices and an explosion in software targeted at these devices;
4. the overarching theme is the emergence of the echo boom generation as the driver of each of the three themes above. Think energy efficiency, housing needs, mobile productivity – we think those six words succinctly summarize the mindset of current 20- and 30-somethings.

Expect us to expand on these themes in future publications as they come increasingly to the fore.

Coming back to what is directly in front of us, we remain in the slow growth camp, and believe there remains a relatively high risk (but likely less than 50% chance) of recession. Employment and housing are typically strong drivers of GDP growth in a traditional post-recession recovery. Without their fuel, it is not surprising that growth is sub-par. Business capital spending may also taper off a bit this year after so much was front loaded into 2011 because of advantageous depreciation rules. One recent bright spot has been cars – auto sales have been strong, boosting employment and incomes.

So why is there such a high risk of recession? Politics and debt. We believe the political environment in Washington is as poisoned as we have ever seen it. No compromise is too small to refuse, no position too unimportant to make a principled stand on. When you layer this poison atmosphere on to the burning need for political compromise to solve our long term fiscal problems, you get self-inflicted wounds like last summer’s debt ceiling fiasco. At the end of 2012, we face monumental fiscal constraints as the Bush-era tax cuts expire, other stimulus programs run out and mandatory spending cuts kick in. To us, this has the makings of more self-inflicted harm. And, no amount of liquidity from the Fed will be sufficient to offset the fiscal drag we will see if Congress can’t or won’t act.

As if all of this wasn’t enough, we are in full presidential election mode so absolutely nothing but posturing will get done between now and November. So put us in the short term cautious, long term bullish camp.

Meanwhile, in Europe, the European Central Bank’s LTRO program provided a great deal of needed liquidity to the banking system, effectively forestalling a liquidity (not a solvency) crisis. The solvency problem remains and the austerity programs forced onto Greece, Portugal and Spain virtually assure a very deep recession in these countries. And with each successive round, the budget targets get harder and harder to meet. We can’t predict how or when this cycle will end but count on another crisis being necessary before politicians take any meaningful action.

In China, short term cautious and long term bullish is also apt. They are turning their aircraft carrier of an economy inward, focusing on wage growth and consumer spending, at the expense of export markets. Long term this is extremely healthy but in the short term, growth will slow markedly, with repercussions across developing Asia.

After nearly two decades of slumber, Japan’s economy is beginning to show some signs of life. What we don’t yet know though is whether this is a brief rebound from post-tsunami rebuilding or something more sustained.

In an uncertain economic climate, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we are finding companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

In client portfolios, we have underweighted international equities dependent on Europe’s economy and maintained exposure to Asian stocks. Early in the year, we added to small capitalization stocks as they will benefit from increased liquidity and an improving economy. In fixed income, we continue to like corporate bonds and high quality municipal bonds but have stayed away from US Treasuries because we believe their yields are artificially suppressed by the Fed and price risk is very high at the current low level of yields.

April 6, 2012                                         © Essential Investment Partners, LLC

2012 Investment Outlook: Euro Drama Drags, Slow US Healing Continues

Euro Drama Drags On

We have long thought of Europeans as much more advanced culturally than the US. If for no other reason than having a history that spans a few thousand – rather than a few hundred years – it seems entirely appropriate that European tastes in all things cultural – theatre, art, food – should be more refined. Until this year though, we hadn’t appreciated how far the Europeans might take their appreciation of theatre.

Since early 2010, the tragic story of the debt problems of southern Europe has been on stage. With only a few short breaks, this play has dragged on despite repeated (and mostly half-hearted) attempts to end it. Today, we remain, like most others, wondering what the next plot twist will be. The European Central Bank has stepped forward most recently with three year liquidity arrangements for the banks – this provides the politicians the window needed for structural reform. But whether they will seize the opportunity is an open question.

We continue to believe that ultimately the choice will be unity but only after (1) strong, centralized fiscal authority is established; (2) debts of the weakest countries are restructured with private participation; and (3) the European banks appropriately value their debt holdings and raise sufficient capital to operate safely going forward. Until these things happen – and we seem only marginally closer as the months roll on – we are stuck here. We find it ironic that after two world wars that defeated Germany’s military aspirations, the Eurozone finds itself desperately in need of Germany’s economic leadership. Knowing that the Eurozone is about promoting prosperity while preserving peace, Germany will ultimately provide the leadership needed but only once it is certain the right structure is in place.

In the meantime, fiscal austerity measures being implemented across the Eurozone virtually assure a recession in 2012. The only question is how severe it will be. This is very difficult to assess as the outcome is so dependent on the actions of governments the course of which is just not very predictable. As a result, we have consciously reduced our weightings in international stocks dependent on the European economy and are focusing instead on opportunities in the US and Asia.

The big story in Asia continues to be China’s struggle to maintain strong economic growth while increasing domestic incomes and consumption, reducing its reliance on exports and limiting inflation, particularly in the housing market. For a large, complex economy, this is a very difficult set of tasks. It appears that China’s policy actions are having the desired effects on inflation and housing prices but the impact on growth – both from policy and reduced export demand from Europe – remains to be seen. We are encouraged that China continues to move its economy in the right direction but a patient, dedicated approach to investing here makes sense to us.

Three Years and Counting: Great Recession Healing Continues

Here at home, the economic news of late has been mostly positive. The employment picture has turned more positive, consumer confidence is up and holiday sales were strong. We have a few short term concerns for 2012 though. A small business tax incentive – that encouraged capital investment in 2011 – has expired so the recent strength we have seen in business investment may have been front-loaded. And, Congress just extended the payroll tax break and unemployment benefits for two months so we will be right back into the debates about further extension when Congress reconvenes later this month.

For some time, we have been talking about the legacies of the Great Recession: high unemployment, consumer savings and debt payoffs, reduced bank lending and the housing drag. Even though the employment picture has become more positive lately, we are still a long way from making a significant dent in the millions of jobs lost. We have made only a few steps on our journey of a thousand miles.

Conversely, consumers’ progress on their debt load has been nothing short of monumental. With interest rates so low, consumers’ monthly debt service requirements are now below long term averages. We still have a long way to go in reducing the aggregate debt levels, compared to income. But with aggregate indebtedness growing slowly and the savings rate having stabilized at a more healthy level, we expect continued progress on this front as well. We think one of the best ways government could help is to put in place a program that would allow those with government guaranteed mortgages who are current to refinance without re-qualifying for the loan.

Speaking of housing, we have seen some encouraging signs in new construction and existing home sales recently. With vacancies dropping and rents rising, it is not surprising to see a flurry of activity in multi-family residential construction. We expect this to continue for some time as the demographics continue to drive greater young household formations. And, for those with the income and savings needed to be active in the home purchase market, today’s existing homes offer exceptional value, relative to new construction. With lending standards still exceptionally tight, we think progress here will be slow and tied to continued employment progress. However, we are not optimistic that new single family home builders will see much demand until the overhang of existing homes gets cleared.

The fourth legacy of the Great Recession – reduced bank lending – continues on. Banking is not a good business to be in today. Heightened capital requirements (fewer loans per dollar of capital), extraordinary volume of new regulations (higher costs), diminished income opportunities (reduced interchange fees, no proprietary trading) and a bad public image, all add up to a bad banking environment. Expect tepid loan growth and less support for the economy.

Bottom line, we are cautiously optimistic about the US economy in the short term and we are making progress on the long term legacies of the Great Recession, albeit slowly. However, more self-inflicted wounds, like those surrounding the debt ceiling debate, could easily derail us. In particular, the lack of any progress on our structural debt issues remains a major long term concern. We believe Congress and the Administration made a major error in not acting on Simpson Bowles Deficit Reduction Commission framework. We can only hope that in the course of the presidential election cycle, this plan or something similar gets revitalized. Otherwise, we could see our debt downgraded again and the dollar’s status as a reserve currency come seriously into question.

2011 was a year of small returns and big volatility – the reverse is much more attractive but we don’t expect that result for 2012. Europe in flux, US presidential politics, China in transition, Iran and North Korea re-emerging as potential hotspots. Any one of these could emerge as the dominant theme of 2012. But whether it is one of these themes or something else completely unexpected, we do expect volatility to continue at a high level.

From an investment perspective, we still like the prospects for large multinational companies with diversified revenue streams. And, with US economic prospects a bit better, we are warming up to small caps after a long period of dislike. Finally, even though hedged strategies did relatively poorly in 2011, we continue to like a mix of absolute return oriented strategies combined with fixed income focused on corporate debt.

January 9, 2012                                   © Essential Investment Partners, LLC

Whither the Eurozone – A Special Commentary

Number three on our list of ten surprises for the coming decade (published in June) was: 

The Eurozone survives and thrives amid new integration strategies spawned by the age of fiscal responsibility. But this is not before its weaker members survive near-death experiences. Debts of Greece, Portugal, Ireland and Spain are restructured in the first half of the decade, causing the banking system to recapitalize with help from the European Central Bank. By facing the debt crises head on, the Europeans adapt and change well ahead of the U.S.

We still believe this is the likely outcome.  However, the process of getting there is turning out to be painfully slow.  This should surprise no one who has ever tried to get a committee to decide anything, much less a committee of 17 governments! 

Germany, who holds the title of most fiscally responsible in the Eurozone, is holding tight on the bailout reins, forcing two things to happen:  (1) the weaker states to put in place meaningful fiscal reforms and (2) setting the stage for changes to the structure of the Eurozone that call for much tighter, centralized fiscal controls and strong penalties for non-compliance. 

Even though the markets may be impatient, Angela Merkel’s strategy is working.  Indeed, look no further than the fact that the heads of the governments of three weaker states – Greece, Spain and Italy – have all lost their jobs to fiscal conservatives who are supporters of the Eurozone policy trajectory. 

Next up, expect focus on the structural changes at the summit this weekend. 

These are all positive developments but there remains very difficult work ahead.  Most importantly, the banking system will need to come clean about the valuations of banks’ sovereign debt holdings. (As will the rest of the bondholders in a forced restructuring for the worst credits and a significant write down on the others.) It is already abundantly clear that they will need recapitalization.  TARP you say?  Not so fast. 

In the fall of 2008, the US was able to put TARP in place (about $800 billion) without any concern on the part of the markets about the creditworthiness of the US Treasury.  In the Eurozone, no one’s credit is above reproach -- the recent downgrade by Standard & Poor’s just reinforced what markets already knew. Germany is the best but it doesn’t have nor does it want to offer the resources to bail out the entire European banking system.  That means a delicate dance will need to take place around how to structure the debt that will ultimately recapitalize the banks.  This will not be quick or easy. 

After the fiscal reforms and tight centralized controls are put in place, then we will see how this recapitalization plays out.  We think that some sort of Eurobond will be necessary but, with Germany in the lead once again, we expect the scope to be strictly limited to the “emergency” lending needed to recapitalize the banks.  All members of the Eurozone will be expected to share in the burden but how the weakest members, already swimming in debt, do so will be a difficult puzzle to solve. 

This process will grind on methodically over the coming year but it will move forward.  The alternative – a breakout of the Eurozone and failure of the common currency – is not in anyone’s interest.  Failure likely puts the entire region into depression – with no country emerging as a winner.  While the grinding continues, Europe will likely be in recession (negative GDP growth) and those who export to Europe will see a significant slowdown. 

From an investment perspective, we expect continued headline risk as good news is mixed with setbacks and delays.  And, with a third of the world’s economy in recession, it will be very difficult for the other two thirds to grow strongly.  Therefore, we will focus our efforts on finding investments that maximize exposure to growing markets and minimize exposure to Europe.  Looking a year or two out, we could easily find ourselves swapping the US for Europe in this equation – as Europe deals with its problems now and we wait until after the 2012 elections before even beginning a discussion. 

Essential Investment Partners among 2011 Denver Five Star Wealth Managers

For the second consecutive year, we were selected to be on the list of Denver’s Five Star Wealth Managers.  Five Star Professional partners with 5280 magazine and ColoradoBiz magazine to determine wealth managers in the Denver area who provide exceptional service and overall client satisfaction.  The list is constructed from the results of surveys of more than 73,000 households and more than 8,500 financial services professionals.  A further review of client complaints, regulatory history and civil actions and final review by a panel of experts culls the list to about 4% of Denver’s wealth managers. 

Full details of the selection process and the complete list of wealth managers appeared in the November issue of 5280 magazine. 

Thoughts on the Current Outlook – October 2011

Markets dislike uncertainty. Unfortunately, uncertainty has been the only thing we have been able to count on for the last couple of months. From the perils of European sovereign debt, to concerns about slowing in China, to dire forecasts for the US economy, markets were faced with uncertainty at every turn. Not surprisingly, investors marked down the prices of any “risk” asset severely, including stocks of all types, corporate bonds and currencies.

Even though the quarter started with the self-inflicted wounds of the US debt ceiling debate, by quarter end, investors focused on the US as the safe haven. As a result, US Treasury bonds reached record low yields and the US dollar rallied strongly.

Focus continues to be on the events in Europe as the daily remarks from French and German officials are parsed for the latest indication of a possible path toward resolution. There are several sets of complex issues that require a solution and the Eurozone is simply not built for delivering them.

The most immediate issue is dealing with the financing needs of the weakest states – Greece and Portugal. While the markets view default as almost a foregone conclusion, government leaders do not as they view an “uncontrolled” default as their “Lehman” moment, which could give rise to a credit crunch that would be reminiscent of 2008.

The credit crunch scenario is a realistic possibility because of the European banks’ exposure to the sovereign debt of the weak countries. Memories of the questionable viability of US banks in late 2008 are still fresh in the minds of policymakers and rightfully so. It is clear that a coordinated plan to recapitalizing the banks is critical before a default is allowed to happen. German Chancellor Merkel and French President Sarkozy have been in close contact about this issue as their countries need to take the lead. However, the rub is that bank regulation is not region-wide. Rather, it remains the responsibility of each government. So, Germany and France can lead, but they can’t force others to follow.

These debates inevitably lead to the question of whether the Euro structure is simply too flawed to fix. As some commentators have pointed out, the structure worked so long as economic growth was strong and debt levels manageable. But with weak economic growth, high debt levels across the region and austerity likely to make the situation worse in the short run, serious questions have been raised about the whole common currency experiment. It is little wonder then that stocks, bonds and the currency fell precipitously in the third quarter.

Germany and France have pledged their support for the currency union and all of its trappings. The resolve of the political leadership, facing tepid taxpayer support, will certainly be tested. For now, we remain cynical and expect that the politicians will do only the minimum required by the markets to put off the next crisis. This isn’t a recipe for less uncertainty in the short term.

Meanwhile, speaking of politicians doing the least amount required, here in the US we have moved into full election mode. This is surely a path toward no progress. Unfortunately, there remains serious work to be done. The Super Committee spawned by the debt ceiling deal is about to start its work and absent action from Congress, payroll taxes will rise and unemployment benefits begin expiring in the new year.

The presidential candidates are all about “jobs” as if their election could turn a tide of high employment on a dime. If only that were so. More likely, regardless of who sits in the Oval Office, we face several more years of a sluggish economy and frustratingly high unemployment. This is simply a result of the need to work off excessive debt accumulated by consumers over the two decades preceding 2008. We have made a good deal of progress but there is still a long way to go.

We expect unemployment to stay high for several years. Even as the private sector is showing modest but consistent new employment life, the public sector – mostly state and local governments -- is cutting jobs to make sure budgets balance. These offsetting trends are likely to persist for a while.

After the failure of a number of ill-advised programs designed to keep people in their homes, policymakers have taken a break from trying to “help” the real estate market. Longer term, we need to let market forces determine home prices, without artificial props from the government. As existing home prices drop to a significant discount to replacement value, buyers will begin to step in. This bodes poorly for new home construction but recovery in that sector will likely need to wait until existing home prices have found a solid base.

Employment and housing are typically strong drivers of GDP growth in a traditional post-recession recovery. Without their fuel, it is not surprising that growth is sub-par. Business capital spending is likely to continue at a good pace as corporate profits and liquidity are solid. But this isn’t enough to drive the economy forward at a faster pace.

There has been much talk of whether the US is headed for another recession later this year or early next. Recent economic reports have been a bit stronger than expected so it looks like recession beginning this year is unlikely. However, absent action from Congress to renew or expand existing stimulus programs, the risk of recession in 2012 is pretty high. We expect a 2012 recession, if it occurs, will be modest and the impact muted as most Americans believe we have never come out of the Great Recession. And, indeed, we still haven’t recovered all of the economic output lost in 2007-2009.

The wildcard remains Europe. A credit crisis there could quickly spill over to the US and cause real dislocations in our markets. While our banks are much better capitalized and corporations far more liquid than they were in 2008, the effects of credit crisis emanating from Europe are hard to gauge.

Even though yields on Treasury bonds reached record lows in the third quarter, spreads on investment grade corporate, non-US sovereign and high yield bonds widened significantly. As a result, yields on these types of bonds look pretty attractive but we need to be mindful of the risks. So we have stayed with a broad mix of these types of bonds (using funds), slanted toward higher quality issues.

In an uncertain economic climate, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we are finding companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

We are also overweight international equities, with a significant exposure to Asian stocks, and continue to be under-invested in small capitalization stocks as they are more directly affected by weakness in the economy. Finally, we continue to add to absolute return-oriented strategies such as hedged equity and managed futures which we believe can provide solid returns with controlled risks.

October 11, 2011                    © Essential Investment Partners, LLC