This is a quarterly update of economic conditions and investment strategy.
Fourth quarter, 2008 U.S. GDP decreased at an annualized rate of 6.3%, the second consecutive quarter of economic contraction and the worst drop since 1982. Japan, the world’s second largest economy, saw its GDP fall a stunning 12.1%. The economic shrinkage was worldwide in breadth and scope.
The causes are generally recognized to be an extended era of cheap money and lightly regulated financial markets that led to speculative bubbles in most asset classes throughout the world. In the fourth quarter, the magnitude of the crisis became clear: markets failed to function smoothly; financial institutions were forced into massive liquidations; and the global economy virtually froze.
Short-term remedies are under way and showing early signs of success. Financial markets are functioning, and, instead of the indiscriminate selling of the recent past, they are beginning to assess winners and losers. Credible planning for the handling of “toxic” bonds, credit default swaps, and other instruments of the era is under way but it is too soon to predict the outcome. Global destocking of inventories is nearing an end; an uptick in demand would have an immediate positive effect on economic activity.
The global response to the economic crisis has been massive and necessary. Short-term stimulus efforts will almost certainly have a measurable impact on economic activity, beginning in the second half of 2009 and into 2010. Manufacturing and housing activity should begin to flatten. Once we see signs of stability, companies will step-up the restocking of inventories and increase expenditures for plant and equipment.
The different viewpoints of Europe and the United States regarding regulatory reform and outsized fiscal stimulation are important. Europe (Germany and France the most outspoken) is emphasizing regulatory reform, the U.S., stimulus. Our view is that Europe is correct to be wary of too much stimulation and we hope that U.S. policymakers take more seriously the budget and economic implications of the many programs on the docket.
Longer term, the risks from a huge increase in U.S. government debt include some combination of inflation, a weaker currency, and the U.S. dollar losing its status as the world’s reserve currency. In addition, when the economy improves, it will be very difficult to navigate the wind-down of the stimulus programs. Adding to the aforementioned, a larger government role in the private sector and the prospect of increased consumer savings lead us to project subdued growth in corporate profits and real GDP from 2010-2012.
The past six months have been traumatic for global investors as prices fell at a magnitude either read about in history books or recounted by elder relatives–U.S. stocks falling, at one point, 53% from their one-year high. While our clients continue to experience returns far ahead of this figure, for most investors the past decade has been one of unusually subpar returns and, more importantly, returns that have not kept pace with inflation.
Ultimately, the goal of an equity investor is to maintain purchasing power plus some. While temptations are great to keep all funds safe and liquid during uncertain times, the conundrum is: stock prices are low when the news is bad; and “safe” assets, such as cash and short-term bonds, while a useful strategic allocation at certain times, have proven during most long term investment periods to generate inferior returns. Equity returns are most attractive from a low basis, that is to say, low prices. Movements in the market are unpredictable on a short-term basis, e.g. an investor who missed the 100 best trading days of the DOW in a 107- year period (about 27,000 trading days) would have reduced terminal wealth by 99.7 percent. A very small number of days account for the bulk of market returns and investors are unlikely to successfully predict the right times to be in and out of the market (CFA Digest, February 2009). Consequently, some exposure to stocks is almost always desirable.
In the credit markets, Federal actions have driven U.S. Treasury rates to levels that present, in our view, an unfavorable risk/reward. These actions have created imbalances in the credit markets. Consequently, we are maintaining significant positions in short-term instruments for safety, for liquidity, and so that later we will be able to purchase higher yielding securities. Also, investment grade corporate bonds and top quality municipals present an opportunity to enhance a fixed income portfolio with an acceptable tradeoff of risk and reward.
Stocks are attractive in several sectors and with certain characteristics:
While we typically focus on intrinsically strong companies, balance sheet strength has become an added competitive plus in this environment. Also, we believe that certain industry sectors, e.g., agricultural and energy companies, have the potential to be explosively profitable over the long term. Growing world-wide demand and supply constraints make a compelling case for these industries.
The bear market is providing opportunities to establish positions in large global name-brand consumer companies at attractive valuations. These, along with our favored resource companies, are an excellent hedge for inflation and a weakened currency. In addition, the budget proposals in Washington may provide attractive entry points for infrastructure, communication, health care, and transmission investments. Each of these areas is attracting fresh focus and attempts to innovate— we are paying close attention.
Assessing the risk of being a lender (owning bonds) is as critical as assessing the risk of being an owner (owning stocks). The right mix of stocks and bonds is neither formulaic, nor driven by planning modules. It is most sensibly arrived at through ongoing dialogue about risk tolerance, lifestyle needs, and then opportunities presented by U.S. and global markets. These principles constitute our platform.
Phil Tucker, Christine Wallace, Eric Kraus, Tom Frank, Ed Dobranetski, Sneha Senjalia, John Edwards, Alan Adler, Kathleen McGill