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   

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

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

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. 

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

Thoughts on the Current Outlook – July 2011

From one day to the next, the markets can’t seem to decide whether the European debt crisis or the US debt ceiling debate is potentially more damaging. If you think the former, you want to own US Treasury bonds as a “safe haven.” If you think the latter, then US Treasury bonds are the last thing you want to invest in. No wonder that rates on the benchmark 10 year note have bouncing around a lot lately!

The European debt crisis could be the world’s slowest train wreck in progress. However, it is possible to conclude that the Europeans are actually taking a much more logical approach to their problems than we are in the US. The so-called “PIIGS” have put in place or are considering forms of government austerity programs either as a condition to debt relief from the central bank and the IMF or to hold off the need for such relief. While there is a long way to go, the momentum is shifting toward fiscal responsibility and away from debt-financed public spending. There is still the risk that the markets grow impatient with the slow process, the Euro comes under great duress and the credit markets malfunction.

In the US, it seems clear that we do not have the political will to make the tough choices needed to get our fiscal house in order. The “debate” over the debt ceiling has been little more than both parties reciting their principles and the President wondering why no one will compromise. We think the President missed a great opportunity by not using the report of the Bipartisan Deficit Commission, co-chaired by Erskine Bowles and Alan Simpson. If we were really serious about a grand compromise, this report provides a great starting point. Instead, the current process is likely to drag on until the August deadline when a “mini-compromise” will get done to put off real debate until after the 2012 elections.

As we look at these debt problems, it is important to understand that they will take time and sustained effort to resolve. There is no “immaculate solution,” as one commentator recently described policymakers’ goal for a quick and painless way out of problems that are decades in the making. Because the Great Recession exposed the unsustainable levels of debt throughout developed economies, we will ultimately be forced to “eat our peas” as the President said recently. Until now, we have been able to do what my sister did growing up – scatter the peas around the plate so it looked like most of them were gone. Unfortunately, this time the markets recognize that the problems are too big to scatter around until they disappear. Europe may not have good means for resolving their debt problems, but they have the advantage of starting to address them ahead of us.

In the meantime, the debt debate is a side show to the continuing drags of unemployment and housing on the US economy. As we have said many times before, we expect unemployment to stay high for several years. Even as the private sector is showing some new employment life, the public sector – mostly state and local governments -- is cutting jobs to make sure budgets balance. These offsetting trends will persist for a while. The unemployment rate has now climbed back up to 9.2%, after hitting an artificially low 8.8% a few months ago. Because of the great number of people who left the workforce during the Great Recession, even the 9.2% rate understates the unemployment problem.

After the failure of a number of ill-advised programs designed to keep people in their homes, we are hopeful that policymakers take a break from trying to “help” the real estate market and let the market forces correct their imbalances. We believe that 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 should not be too surprising that growth is sub-par. We can expect business capital spending to continue at a solid pace as profitability remains very strong. And, perhaps surprisingly, led by autos, the US manufacturing sector had also staged a bit of a comeback until it was sidelined for a few months by the effects of the Japan earthquake.

First quarter GDP growth was 1.9% and most economists expect a similar number for the second quarter. Whether we get a boost in the second half of the year is the subject of much speculation. Optimists point to lower gas prices, a stronger rebound in auto manufacturing as supply chain issues resulting from the Japan earthquake are resolved and consumers’ continuing progress in reducing their debt. Pessimists point to employment, housing and the lack of government stimulus (both monetary and fiscal) as reasons for an even weaker showing.

For our part, we think any second half boost in the US will be modest – not enough to get anyone excited. We expect a continuation of the bifurcated global economy, with the developed economies of Europe, Japan and the US growing very slowly. Meanwhile, developing Asia and the resource-rich economies of Brazil, Australia, Canada and Scandinavia will likely continue to post very solid growth.

We have also believed for some time that the US dollar will remain weak for the foreseeable future. Recently, we added a dedicated currency manager (in mutual fund form) to many client portfolios. That manager has illuminated our thinking on the role of the US dollar in the world economy and we expect to cover this topic in more detail in an upcoming publication.

With the yield on the ten year US Treasury note right at 3% and spreads on corporate and high yield at tightened levels, it is hard to get excited about the return prospects in fixed income. In their search for yield, investors have also driven down the discounts on fixed income closed end funds to very low levels, leaving relatively few trading opportunities in that space.

On the positive side, we have seen an increasing trend of bringing hedge fund strategies to mutual fund form. Recently, we completed due diligence on and invested in several new funds of this type. A couple of these are managers whose hedge funds we were quite familiar with so the investment decision was easy. In many cases, however, the fancy strategies have given rise to high fees and low returns – not a combination we are interested in pursuing for our clients!

While hardly cheap, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth despite the slow growing economy. Technology and health care are two areas of focus where we can find companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

Unlike the markets’ almost daily shifts between “risk on” and “risk off,” we have kept asset allocation in client portfolios relatively stable. We are overweight international equities, with a dedicated exposure to Asian stocks, and also have a significant non-dollar weighting in fixed income. In addition, we have maintained the investments in absolute return-oriented strategies in client portfolios. Finally, we continue to be under-invested in small capitalization stocks, in favor of more reasonably priced larger companies with greater exposure to the world’s growing economies.

July 13, 2011

Thoughts on the Current Outlook – April, 2011

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

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

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

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

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

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

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

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

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

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

2011 Investment Outlook

In recent reports, we have been talking about the four pillars that inform our view that the U.S. economy will exhibit slower than normal growth for the next several years. Three of these pillars involve excess debt that needs to be worked off by consumers, banks and governments. The fourth pillar, under-saving by boomers for retirement, requires strong financial markets, increased savings and a stable or rising real estate market to fix. We are happy to report significant progress in resolving some of these structural problems. Let’s look at the good news first.

Consumers’ progress on their debt load is perhaps most striking. After reaching an historic peak of 13.9% in 2007, the percent of consumers’ income devoted to debt service has dropped to 11.9%, nearly back to its pre-2000 long term average. This reduction was achieved through repayments, lower interest rates, defaults and lack of growth in the base. Until October, aggregate consumer debt had fallen every month since late 2008. While still slow, this indicator grew in October and November, supporting holiday sales. If we can make headway on the employment front and see consumer incomes grow, we could see even more progress by consumers in handling their debt, clearing the way for more spending.

With the U.S. stock market up about 90% off of its lows in early 2009, boomers who stayed invested have recovered a substantial portion of the savings they lost in the Great Recession. And with the savings rate now stabilized at a mid-single digit rate (up from zero pre-recession), individuals are restocking their savings at a healthy rate. However, the uncertain state of the residential real estate market means that home equity remains an unreliable form of retirement savings. A lasting impact of the Great Recession, however, will be that boomers were reminded how fragile their savings picture really is and that working longer might be a desirable thing to do.

The picture for banks is mixed. Many larger banks have rebuilt their capital bases to the new higher standards and seem past the worst in terms of loan losses, at least outside of residential real estate. The larger banks also have the resources to cope with the blizzard of new rules arising from the Dodd-Frank financial reform bill.

For smaller banks, though, the picture is less bright. Long a bastion of real estate lending, many of their loan problems remain in work out. And capital is less available to them via the public markets. If that weren’t enough, Dodd-Frank raises their cost of doing business dramatically. In the banking business, talk has changed from “too big to fail” to “too small to exist.” With community banks often the source of lending to small businesses, we fear the availability of credit will continue to be restricted for some time to come.

Having helped the rest of the economy struggle through the Great Recession, many governments now find themselves in dire financial straits. Federal governments from the U.S. to Ireland to Greece to Japan are awash in deficits, with austerity programs and growth incentives running at odds with each other. While we believe it was smart to extend the Bush-era tax cuts, the Federal government is paying a higher price for its heavy debts as the Federal Reserve’s latest round of quantitative easing was met with substantially higher interest rates. (And all those who poured tens of billions into bond funds in 2009 and 2010 suffered bruising paper losses in a very short time.)

The budget problems of many large U.S. states have now come sharply into view as the press has homed in on the excessive promises -- and concomitant lack of funding – made to current and retired employees. Virtually no progress has been made in reconciling this problem even as state and local governments face declining property tax revenues as property values are marked down to reflect current market conditions. Increases in sales and income tax receipts in 2011 will provide a bit of relief. But with federal stimulus money running out in 2011, state and local governments face the prospect of draconian service (read, jobs) cuts to try to match revenues and expenses.

So there is reason for real optimism as we move toward resolving the structural problems left in the wake of the Great Recession. As we have previously reported, corporations are in great shape – earnings are strong, balance sheets are solid and revenues are growing. When we combine business investments with a solid, if not strong, contribution from consumers, we expect to see the U.S. economy grow around the long term trend (about 3%) in 2011. The biggest risk we see to the domestic economy is the lack of progress on employment and the real possibility that government sector cutbacks could make the problem worse in the near term. Residential real estate remains a wild card.

Looking back to the 1990s, it is fascinating to see how much has changed on the international front. Emerging markets have become the drivers of worldwide growth even while they have their fiscal houses in order. The developed markets of the U.S., Europe and Japan have become the laggards, with large, structural debt problems. In the short term, it is possible that markets have overplayed the stories of the emerging middle classes of India and China and the resource rich economies of Australia, Canada and Brazil. However, we believe these economies will be the primary source of global growth in the years ahead. In 2011, we expect to move client portfolios even more toward these growing economies as opportunities arise.

With a new spirit of cooperation in Washington (we’ll see how long that lasts!) and a realization that there is a great deal of work to be done to get our economy into jobs-producing mode, we are heartened that the spirit of optimism that has broken through near the end of 2010 will continue to drive the economy forward in 2011. Of course, markets often run ahead of the good news so we would not be surprised to see some consolidation of the gains in the first half of 2011.

The bigger change we will be watching for is whether the nearly 30 year rally in long term bond prices is finally over. If we are starting a long economic recovery with higher input prices (oil, grains and a broad range of other commodities), then we could see interest rates start back up the long down staircase they have been on since the early 1980s.

Economic and Investment Outlook – Fourth Quarter 2010

The fixed income markets seem to have decided that economic growth will be slow, inflation will be non-existent and debt defaults are unlikely. Pretty much a “Goldilocks” scenario. Retail investors have bought into this scenario in a big way – pouring literally hundreds of billions of dollars of new investments into bond mutual funds in the latter part of 2009 and so far in 2010.

Until September, the equity markets couldn’t decide whether to go along with this “Goldilocks” theme. However, with talk from the Federal Reserve of “QE2”, the stock market finally joined the party. QE2 is not referring to an aging cruise ship but rather a second major round of “quantitative easing.” This is “Fed speak” for easing monetary policy further through direct Fed purchases of securities.

We are skeptical of this newfound optimism because the Fed has little ability to control the structural problems our economy faces. In a normal post recession period, the Fed’s current policies would have been more than sufficient to get the economy moving. Low interest rates would have stimulated consumers to buy houses and cars and businesses to respond by hiring people and making capital expenditures to meet this renewed demand. But things are different this time.

There are four pillars that inform our view that the U.S. economy will be stuck in low gear for a few years. First, the consumer continues to be overleveraged. After years of layering in more and more debt, consumers now need to pay down debt to get their financial houses in order. Indeed, they have been doing so either through repayments or defaults. Since peaking in July of 2008, the amount of consumer credit outstanding has been falling – not a sign of a healthy, growing economy.

Second, banks are overleveraged. This has come about in two ways – by regulators increasing the capital requirements and by customers not paying off loans as quickly as they did in the past. As a result, many banks are effectively out of the lending business until they too can get their balance sheets adjusted to the new regulatory model. Throw on top of this the pressure from bank regulators to write off any loan that looks potentially troublesome, and it will be a few years before banks will realistically be looking to expand their books of loans.

Third, the stock market declines of 2007-2009 had a deep impact on the retirement savings of baby boomers. As a result, many, if not most, will need to defer their plans to retire, increase their savings and extend their working careers.

Finally, governments are overleveraged. Just look at the massive federal debt that was incurred in 2008 and 2009 much of it in an effort to stave off the recession. Now that the fear of depression has passed, the staggering deficit has raised the debate about how big government should be and makes it less likely that additional spending “stimulus” will be forthcoming from the Federal Government.

Almost all fifty states face similarly difficult fiscal issues. Unlike the Federal Government, however, most states need to balance their budgets so they face large service (read, jobs!) cutbacks once federal stimulus money runs out next year. The real problem facing many state and local governments is that they have for too long over-promised and under-funded the liabilities for future pension and health care benefits. This problem will force several changes – a greater share of budgets devoted to funding, cutbacks in current retiree benefits and very significant reductions in new employee benefits.

All four pillars will result in a continuation of high unemployment and underemployment. Nearly eight million jobs were lost in the Great Recession and, with these four structural headwinds, we believe it will take a very long time before the economy returns to anything resembling full employment.

Is there any good news? Certainly. Corporations are in great shape – earnings are strong, balance sheets are solid and revenues appear to be growing. This is one of the reasons GDP is growing – business investment will continue as companies strive to make their operations more efficient while responding to limited consumer demand. If we could get some certainty surrounding tax policy and the costs of health care under the new scheme, we could see corporations expand their investments more and tiptoe back into the hiring market.

In addition, the low absolute level of interest rates is good for both businesses and consumers. Many large businesses have been able to lock in low cost, long term financing by issuing debt. And many consumers have seen their debt service costs come down significantly as rates on variable rate debt have plummeted.

We continually remind ourselves of the need to look at alternative viewpoints to make sure our sober view doesn’t miss the return of a strong cyclical recovery. Positive news can beget confidence which turns into optimism and then, before you know it, we are back to growth mode. Recently, the markets seem to think that we have enough positive news to sustain a recovery. And, if we don’t get positive news, the Federal Reserve will manufacture some. We are cautiously hoping that proves to be correct but investing as if the path may be bumpy.

Client portfolios remain relatively conservatively positioned, with significant over-weights to absolute return oriented investments. The fourth quarter will be dominated by election news and speculation about what may happen thereafter. For our part, we will be happy when we no longer have to listen to negative campaign ads. Now that should put everyone in a better mood!

Third Quarter 2010 Investment Outlook

Just about the time the markets were thinking that the economy was going to deliver strong growth, the reality of the harsh headwinds we face hit home. The expiration of the housing tax credit has left the housing market teetering on the brink of further declines. While corporate profits are still quite healthy, companies are reticent to add full time employees, preferring the flexibility of longer hours for current workers or adding temporary employees.

To these domestic concerns, we can add the sovereign debt issues facing Greece and other southern European countries. The austerity measures that accompanied the agreement by the EU to backstop the debt of Greece, Spain and Portugal will put a drag on Europe’s growth. However, the quick devaluation of the Euro – about 15% versus the dollar so far this year – will make German and French exports much more competitive. The export growth from these large economies should more than offset the drag of austerity from the smaller economies.

We continue to believe that four fundamental factors will give the Great Recession of 2007-2009 a lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers need to pay down the astounding levels of debt they accumulated over the last two decades; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply put pressure on prices.

Right now, the markets are focused on the downward pressure these factors are placing on the U.S. economy. First quarter growth was revised down a couple of times to finish at 2.7%, hardly a robust showing. And, expectations are that the second quarter will be weaker. We do think that one or two quarters of negative growth are likely over the course of the next twelve months. However, we don’t expect a repeat of the sharp declines we saw in late 2008 and early 2009.

The U.S. economy has demonstrated once again its unique ability to withstand enormous strains and move forward. So we expect the economy to muddle along, with slower than typical growth. The employment picture will improve very slowly with the unemployment rate staying uncomfortably high. The real estate market will remain in a precarious position as foreclosures and excess inventory get worked off. Consumers will increase their spending slightly less than their incomes grow, raising the savings rate. Corporate profits will continue to be very good, helped by the dramatic cost reductions that were taken over the past eighteen months.

Relative to earnings, we think stocks have become inexpensive. The question is whether earnings gains will hold up. The stocks in the Essential Growth Portfolio℠ are chosen for their ability to deliver consistent earnings so we have seen many opportunities to buy great companies at very attractive prices.

As concerns about the economy and sovereign debt in Europe took center stage, prices of U.S. treasury notes and bonds soared in the second quarter, driving yields to very low levels. This flight to quality hurt prices of corporate bonds, which we believe are now very attractive, relative to both inflation and default risks.

About nine months ago, we did a special report entitled “Inflation vs. Deflation – The Most Important Investment Decision of the Next Five Years.” That report concluded that deflation was much more likely to become a problem than inflation, citing the four major headwinds described above. We think it will take several more years for these headwinds to dissipate so our conclusions are still the same.

We continue to believe in the strong growth stories emanating from Asia and have maintained dedicated equity investments there. Certainly there is the probability of setbacks along the way, but the sheer size and momentum of the growth of the middle classes in China and India strongly argue for robust growth for a long time.

Just published is a piece on the real implications of the “Flash Crash” in which we call for a fundamental rethinking of the financial regulatory structure. This piece is posted on the Blog section of this website.  Unfortunately, the bill currently pending in Congress is long on text and short on progress on the important issues underlying the credit crisis of 2008.

The effect of the expiration of the housing tax credit stunned many observers. More important, we believe, will be the effects of the tax increases associated with the new health care bill and the expiration of the Bush tax cuts.

Client portfolios remain relatively conservatively positioned, with significant over-weights to fixed income and absolute return oriented investments. The third quarter could continue to be rocky for the equity markets – a rough patch on the long road to overcoming the structural headwinds we face.

Second Quarter 2010 Investment Outlook

Perhaps we shouldn’t be too surprised in retrospect that Americans seem to have such short memories. Wasn’t it just eighteen months ago that our financial system came within a hair of complete collapse? And now, even a watered-down set of financial regulation changes draws a yawn from the American public. Dow 12,000 here we come!

We continue to believe that four fundamental factors will give the Great Recession of 2007-2009 a lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers need to pay down the astounding levels of debt they accumulated over the last two decades; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply put pressure on prices.

While these four factors will continue to weigh on the rate our economy is growing, the fact is that the economy is back in a growth mode for now. And this growth seems to be stronger than these restraints would have allowed. Why has this been the case? One answer is the large government stimulus programs that have been put in place over the last year. But we think there is more to the story.

Being so close to the financial markets, we sensed a high likelihood of serious fundamental changes after the Great Recession – a re-pricing of risk, the return of a savings culture, unwillingness to take on debt, reduced demand for real estate as an investment and a new era of financial regulation.

However, even though many families are fundamentally changing their ways, in the aggregate these changes have only a marginal impact. They are marginal because the vast majority of Americans – once their confidence in the financial system and the security of their jobs was restored – returned to their normal lives.

Those normal lives included making a decent living, paying their rent or mortgage, shopping for necessities and periodically splurging on extras for themselves and their families. In particular, the highest earning households that account for a disproportionate share of consumer spending have begun spending again. For many, lower mortgage rates have provided some extra monthly cash.

Are they doing these things within the context of a financial system that has fundamentally changed? Certainly. The limits on the credit cards are lower, there is no home equity line to serve as a piggybank and bank rules for car loans and leases are tighter. So in the aggregate, consumer credit outstanding has fallen significantly, rather than rising as it would typically do in a recovery.

But, the U.S. economy has demonstrated once again its unique ability to withstand enormous strains and move forward. Have we returned to the “old normal?” Certainly not. The four limiting factors we mentioned above are still very much in place, preventing us from returning to the old normal for several more years. The employment picture will improve very slowly as companies will be cautious about adding costs back. Residential real estate remains a precarious market as foreclosures continue to rise, but with strong demand appearing in some regions particularly at lower price points.

In the meantime, we expect the economy will muddle along, with slower than typical growth. Corporate profits will continue to be very good, helped out by the dramatic cost reductions that were taken in late 2008 and early 2009 and now by rising revenues. Strong earnings should put a reasonably solid floor under stock prices for now and may allow stocks to move even higher in the months ahead.

While the U.S. stock market was staging a dramatic rally off of the March 2009 lows, the bond market, particularly municipal and corporate bonds, pulled off an historic rally as well. In the aftermath of this rally, we just published a special report on the fixed income markets entitled “Where Do We Go from Here? Seeking Attractive Returns on Fixed Income Investments” – it follows this piece.

On the international front, the fragile state of the PIIGS (Portugal, Ireland, Italy, Greece and Spain) continues to dominate the economic news. There is broad concern that Greece’s sovereign debt problems could be the equivalent of our subprime mortgage problem for the European Union. We think it is more likely that a solution is found that continues to hamper prospective growth for the European economy.

We continue to believe in the strong growth stories emanating from Asia and prefer to focus more of our equity investments there. Certainly there is the probably of setbacks along the way, but the sheer size and momentum of the growth of the middle classes in China and India strongly argue for robust growth for a long time to come. In addition, we think the resource-dependent economies of Canada, Australia and Brazil will fare well in a healthy commodity pricing environment.

Investors’ current complacency can swiftly be replaced by fear arising from unexpected events beyond their control. And the effects of the tax increases associated with the new health care bill and the expiration of the Bush tax cuts bear close watching. The lessons of 2007-2009 are still important: stay very broadly diversified and closely monitor downside risk, relative to return potential.

Annual Investment Outlook 2010

In 2009, the gloom of the first quarter gave way to euphoria in the financial markets in the last three quarters, as investors rejoiced that we had avoided a depression. Instead, we experienced a so-called Great Recession. If you look at the decline in GDP, this recession was roughly on par with the severe recessions of the early 70s and early 80s, with aggregate GDP dropping about 4% from peak to trough.

We believe that four other factors will give the Great Recession its lasting reputation: (1) very high unemployment and underemployment that will last for several years; (2) consumers have begun to pay down the astounding levels of debt they accumulated over the last two decades and the nation’s saving rate will rise significantly; (3) bank lending will remain on hold for much longer than is typical in a post-recession period as banks take several years to rebuild their battered capital bases and adjust to more stringent regulatory requirements; and (4) housing will continue to be a drag on the economy as foreclosures and excess supply keep downward pressure on prices.

While many of the government’s actions over the past two years have been designed to restore stability and confidence in the financial system, other actions have created uncertainties that we believe will weigh on the economy in the coming year. In particular, uncertainties regarding health care costs and income tax rates may cause small businesses to be more reluctant than normal to create new jobs. And, extraordinarily high deficits leave open the distinct possibility of much higher interest rates in the future, effectively crowding out private borrowing, traditionally the source of capital for small business job creation. It is also tough to sort out the impact of stimulus programs for cars, housing and state/local governments – did these programs provide a bridge to a better environment or will problems resurface when stimulus ends? Finally, a protectionist orientation has been growing in our trade relations with Asia, which may limit U.S. exports, a promising source of growth in a weak dollar environment.

On the positive side, we see a bifurcated consumer recovery. Affluent consumers – those with high incomes and somewhat restored net worths – have begun to spend once again. Those with lower or no incomes will continue to struggle mightily, with full employment difficult to come by. Businesses that had drawn inventories down to very low levels will need to rebuild their stocks to meet nascent demand. All in all, we expect the economy to post positive, but anemic, growth of 2-3% in 2010.

Corporate profits will continue to benefit from the draconian cost cuts put in place in late 2008 and 2009. With revenues rebounding somewhat on top of a lower cost base (and financial stocks providing a positive contribution as write offs begin to fall), aggregate profits should show a very healthy increase in 2010.

Missing from the Great Recession has been the high level of credit defaults predicted a year ago. With liquidity having returned to the bond markets quickly, many issuers have been able to refinance ahead of maturities. Most affected are those smaller businesses that depend on bank lending, where defaults and charge offs continue at a high rate. In the public debt markets, credit spreads have collapsed to average levels.

On the international front, we continue to believe in the long term story of the growing middle classes in the large emerging markets. China will continue to be a major source of global growth, as will India. However, that growth will become more internally focused, rather than export- or outsourcing-focused. The command structure of the Chinese economy gives us some concern about potential excesses but the sheer size of the economic engine they have created ensures its growing dominance of the region.  The European Union will continue to struggle with very slow growth and the debt problems of some of its lesser members, while the resource-dependent economies of Canada, Australia and Brazil fare well in a healthy commodity pricing environment.

In retrospect, we were wrong in not hopping aboard the risk train in the early spring of 2009. Instead, we were content to take a much lower risk approach to earning very strong absolute returns for our clients, focusing on high quality U.S. stocks, international stocks and corporate/municipal bonds. Despite investors’ newfound appetite for risk, we do not think this is the time to significantly increase exposure to riskier equities. However, high quality stocks offer attractive return potential, particularly given the outlook for much stronger earnings in 2010. Many of the companies represented in the Essential Growth Portfolio℠ are heavily invested in the growth of developing markets. When valuations warrant, we expect to continue to increase direct exposure to these areas of long term growth. In addition, we plan to maintain a small but dedicated exposure to a broad-based basket of commodities.

In the fixed income area, we have brought durations (exposure to interest rate increases) down and quality up, as most of the easy money has been made. We have added exposures to non-U.S. debt securities and merger arbitrage strategies while continuing to exploit special situation opportunities in fixed income closed end funds.

As 2010 progresses, there is a wide range of variables that could have unexpected impacts on the global economy and financial markets. These include: withdrawal of US monetary and fiscal stimulus, demand for the large supply of U.S. government debt, ever-present geopolitical risks in the Middle East, actions of Congress on health care, tax policy and financial regulation, sovereign debt problems in southern Europe and terrorist activity, just to name a few. With the economy growing very slowly, an unexpected setback could easily trip the economy back into negative growth territory.

We remain very cognizant of the dramatic increases in market values we have witnessed since last March, virtually without correction. Investors’ current complacency can swiftly be replaced by fear arising from unexpected events beyond their control. In this risky environment, we are keeping client portfolios very broadly diversified and closely monitoring downside risk, relative to return potential.

January 6, 2010

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