This is a quarterly update of economic conditions and investment strategy.
Real gross domestic product (GDP)—the output of goods and services produced by labor and property located in the United States—increased at an annual rate of 2.7% in the first quarter of 2010 (revised down from 3.0%). The increase was driven primarily by personal consumption expenditures and inventory re-building. We expect some strength in the second quarter, followed by a weakening of growth in the second half of 2010, lasting through 2011. We believe GDP growth is likely to be under 3.0 percent during the latter periods. (The consensus forecast is for a 3.5 – 4.0 percent increase.)
Three percent GDP growth is not sufficient to reduce the high level of unemployment. In our view, reducing the unemployment rate is the single most important factor in restoring healthy economic growth. The poor job picture in contrast to previous recoveries appears to be caused by high levels of household debt at a time when the largest asset on household and bank balance sheets (houses) continues to deflate despite unprecedented efforts to reverse it. The extraordinary Government stimulus is responsible for nearly all the modest economic growth to date.
Without the stimulus, economic conditions would likely weaken until such time as deleveraging clears the markets. In fact, Government stimulus has been much less effective in this recession than in the last by a wide margin. During the last year and a half, it took more than five dollars of Government stimulus (direct transfers and tax cuts) to generate each dollar of incremental spending. The 2001-03 stimulus generated a one-for-one increase in spending. As noted, we attribute this to high debt levels, weak house prices, low wage growth and a new desire on the part of consumers to reduce their debt load.
All this points to a lengthy period of sub-par growth in the United States. Although this would hardly dent the nine percent plus unemployment rate, ultimately, it would permit markets to clear and debt levels to reduce. Also, the unhealthy reliance on Government for growth may come to an end as markets price in the risks of an overextended U.S. brought on by the massive transfer of private sector debt to Government balance sheets and the future liabilities of Government entitlement programs.
A more conservative consumer/investor in a slower growth economy may create a climate less susceptible to the formation of bubbles. This potentially more favorable climate, paid for with years of discomfort, also may produce forces that result in tax policies and changes in entitlement programs that could form the basis for a lengthy period of healthy economic growth. Such changes would accelerate real wage growth and be very positive for financial markets.
It is unfortunate that the Federal debt burden has reached such a dangerous level, but if it results in leaving behind a sense of complacency and sets the stage for an effective long-term fiscal policy, it would be worth the price.
We implement investment strategies on an individual basis; each client account is different. We select asset allocations, asset classes and a wide range of investment instruments accordingly.
Timing, time horizon, tax liabilities, taxability, risk tolerance and objectives are all unique to each client. Despite this latitude and customization, the current economic climate, including the financial conditions of Government and consumers, as well as geopolitical issues, presents challenges to preserving and growing investment portfolios unlike any time in recent memory.
For example, we find the fixed income market fully priced across all maturities. Long-term rates imply no meaningful inflation risk or credit risk for the next twenty to twenty-five years. This is a bad bet, in our view. Intermediate rates are somewhat better; but securities in this time frame are also vulnerable to drops in price if either of the risks noted materialize. Short-term rates are almost non-existent; yet on a risk adjusted basis, this sector is most attractive. First, short term securities preserve principal; second, they permit flexibility to move out the yield curve when rates increase; and third, they provide a positive return with much less credit risk in a deflationary economy. We are emphasizing short-term fixed income instruments over longer maturities.
For taxable accounts, the likelihood of higher marginal income tax rates enhances the appeal of municipal bonds, but here too are complications—frail municipal finances has us acting selectively, but with caution. Our objective is to capture tax-free income while minimizing credit risk.
For equities, this is one of the rare times when large investment grade, dividend paying, multi-national corporations are more attractively priced than other equities. These corporations have the financial characteristics one traditionally looks for when purchasing “safe” bonds. Our list includes multi-national corporations with capitalizations greater than $10 billion, relatively strong returns on equity, steady or rising dividends, reasonable debt levels and attractive stock prices. Accounts are sprinkled with these large cap stocks, which continue to be high on our buy list.
Also, on the buy list are the industries discussed in past reports that stand in front of strong secular trends, e.g., energy, food, water, infrastructure, and healthcare.
Last quarter, we promised to elaborate on water as an investment theme. We believe that it is the world’s most precious commodity—the only one for which there is no substitute—and it is rapidly becoming a scarce one. Water tables are dropping in countries harboring half the world’s population. As many as 900 million people have no access to clean water. In New Delhi, demand for water exceeds supply by more than 300 million gallons a day. Drought in China has reportedly impacted 61.3 million people, including the provinces of Guangxi, Sichuan, Guizhou, Yunnan and the city of Chongquing. Food and water shortages are widespread and about five million hectares of farmland have been compromised or destroyed.
The Tibetan plateau is the principal watershed in Asia, the source of ten major rivers, the lifeline not just of China and India, but nine other Southeast Asian countries. Some believe it to be the world’s largest storehouse of fresh water. Beijing controls the 2.5 million square kilometer Tibetan plateau giving it a powerful position in the region. Reports of China’s plans to build the world’s largest hydroelectric plant on the Great Bend and its long range plans to divert waters of three major Tibetan rivers, the Yangtze, the Yellow River, and the Brahmaputra to China’s drought-stricken north will greatly impact the other Asian countries, especially India.
Chinese Prime Minister Jiabo has said that water scarcity threatens the “survival of the Chinese nation.” Clearly, the water issue is a very serious problem that will require enormous expenditures and diplomatic ingenuity to solve. Few countries will skirt water shortages. We maintain significant investments in one country that will (Canada) and we are stepping up investments in several other self-sufficient countries. Also, we monitor a number of water infrastructure and technology companies and many food, seed and energy companies that depend on a large and reliable water supply.
Have a Pleasant Summer!
Chevy Chase Trust, July 2010