“Once-dreadful financial and economic metrics are now merely bad.” This line, from a recent publication by Morgan Stanley Smith Barney LLC, captures the essence of the “optimism” that has pervaded market thinking for the last few months.
This optimism brought the US stock market a very strong return of nearly 16% for the quarter. Not to be outdone, corporate bonds rallied too, bringing spreads versus comparable Treasury securities down to typical recession levels. And, municipal bond prices rallied while Treasury prices fell, bringing municipal yields closer to their normal yields relative to taxable alternatives. While we too prefer to be optimists, we think a dose of realism is most important at this point.

“Less bad” is better than “bad” but it is a long way from “good.” We do believe that with timely and mostly correct actions by policymakers, we have avoided an economic and financial meltdown. However, the markets have rallied to a level that real economic progress is needed to continue the advance. We don’t expect progress to be quick so we expect stocks to tread water or even move lower from here. As we have said previously, there are many reasons why restoring economic growth will take some time and it will come slowly.

The unemployment rate has now jumped to 9.5% and job losses so far this year are estimated at well more than three million. The ranks of the under-employed continue to grow as the average weekly hours worked number continues to fall. It is now clear that the unemployment rate will top out in excess of 10% during this recession. Even though growing unemployment bodes ill for consumer discretionary spending, it also means that companies are making themselves leaner and more efficient. When revenue does begin to turn around, corporate profits should bounce back pretty quickly. But aggregate consumer demand will remain tepid, making this profit recovery uneven.

The savings rate for individuals surged to nearly 7% in May, up from near zero over the past few years. We expect the savings rate to stay at this level or move even higher over the next couple of years as consumers rebuild their “personal balance sheets.” This means a greater focus on paying down debt (aggregate consumer credit outstanding has been dropping since September, 2008) and adding dollars to savings to replace value that has been lost through falling home and stock prices. These are positive trends for the long term health of the U.S. economy but in the short run, they mean less discretionary spending and lower growth.

Who would have thought a year ago that we could absorb the bankruptcies of GM and Chrysler within a matter of weeks without endangering our entire economy? Well, with Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and AIG all going bust ahead of the automakers, the markets, policymakers and creditors were all much more prepared than for the others that went before. These bankruptcy filings will allow GM and Chrysler to dramatically restructure in ways that would have been nearly impossible outside of bankruptcy. The short term pain will be great but the result will be a healthier, more competitive manufacturing sector over the longer term.

We were happy to see the government allow the healthiest banks to repay their TARP money. Policymakers wanted to make sure that those who repaid now won’t need to come back to borrow again in the next year or two. Perhaps most important was that this first test of a government “exit strategy” from the private sector worked reasonably well. There are many more private sector investments the government will need to exit in coming years – we expect that some of the others will be more difficult to navigate.

Another positive development in the second quarter was the resumption of companies issuing debt. Starting first with the highest quality companies and later continuing down to lower rated companies (although still excluding the lowest rated), companies found surprisingly strong demand for their debt securities among investors. This healthy functioning of the credit markets is critical to the functioning of the US financial system and investors’ spirits were raised by the sense of movement toward “normalcy.”

Finally, concerns about the prospects for re-emergence of inflation entered some investors’ minds during the quarter. While we believe it is reasonable to have some inflation-protected investments as part of a well-diversified portfolio, we continue to believe that deflation, not inflation, will be the problem we will likely battle for the next few years. Labor markets are exceptionally weak and are likely to stay weak for some time so labor demands simply won’t be a contributor to price increases. Similarly, capacity utilization is very low in industrialized countries so there is a great deal of slack to be taken up before supply shortages could contribute to inflation. Commodity prices alone are not likely to drive inflation because they don’t represent a large enough share of production costs to drive a sustained increase in prices. Finally, the large government stimulus is only inflationary if the velocity of money stays constant or increases. All indications are that velocity has likely fallen recently, as it has in similar periods in history.

We continue to maintain a conservative investment posture. Despite the rally of the second quarter, bonds continue to offer very attractive returns relative to long term expected returns on stocks. Within stock allocations, we continue to use the Essential Growth Portfolio℠ alongside mutual funds that tend to offer more downside protection. We remain significantly underweight in small capitalization stocks, contrary to what might be expected at the beginning of an economic recovery, as we think the markets have gotten ahead of the economic fundamentals. We have maintained our investments in international stocks, particularly in Asia, as we expect the Asian economies (ex Japan) to perform better than the U.S. and the dollar to continue to be weak.

July 7, 2009