This is a quarterly update of economic conditions and investment strategy.
Third quarter, 2008 GDP decreased at an annualized rate of .5%. We expect the fourth quarter to show a much sharper decrease to about 5% with recessionary conditions continuing for most of 2009 and perhaps longer.
Three of the four major sectors of the economy are very weak: consumer spending; business and housing investment; and net exports. The fourth, Government spending, is positive as it tries to make up for the other three. The industrial sector is experiencing significant production cutbacks and labor force reductions. Housing prices, as measured by the Case-Shiller index, fell 17% year over year through the third quarter. Unemployment, now at 7.2%, may crest north of 9% by the end of 2009.
The Federal response has been impressive. The $700 billion TARP legislation is very likely to be followed by a larger package, pending consideration. The makeup of this package and its execution will be critical in mitigating the damages of the downturn. The objectives of this historic level of Federal intervention are to restore the balance sheets of financial institutions, to assist with the mortgages of current and prospective home owners; and to drive interest rates down to stimulate economic activity. Infrastructure improvement is also an important objective. Ultimately, all of these measures will be assessed based on their impact on employment.
The deficit implications are enormous. The Congressional Budget Office has revised its deficit estimate for 2009 upward —more than doubling the prior projection to a deficit of $1.1 trillion. We believe this estimate is too low.
Keynes wrote of the “paradox of thrift,” in which he observed that while personal savings is important and useful for the individual, it does little to help an economy work out of recession. We may be experiencing this today—an increase in household savings rates, lower credit card debt, and more modest spending. These are desirable and necessary for household financial health, but will also lengthen the recovery.
In 2008, after seven consecutive years of outperformance, driven by an emphasis on energy and other resource-based companies, our clients experienced equity returns in line with the S&P 500.
With the virtual cessation of economic activity, prices for many goods and services—resources included—fell sharply, reflecting much lower demand. While we avoided much of the debacle in the financial sector last year, some of our core holdings declined with falling commodity and resource prices. Our task now is to continue to assess current holdings, and identify new opportunities, for their suitability in a much different economic environment, one in which demand for goods and services will be slow to recover in what is likely to be a protracted period of subdued U.S. and global economic growth.
We continue to see problems and imbalances in the long-term supply of fossil fuels; so we plan to maintain investments in companies holding deep reserves. These positions should prove highly profitable when global growth returns, and may do well prior should the U.S. dollar fall or merger activity pick up. Agriculture companies remain on our buy list for reasons cited in previous client letters (rising middle class overseas, global population growth, and scientific advancements in seeds).
Other resource sectors: chemicals, base metals, and precious metals will be held at more modest levels. Precious metals and their producers are a useful hedge against currency debasement and inflation, as well as having favorable supply/demand dynamics. Chemicals and base metals may be owned selectively as inexpensive options on global growth.
Our research is very active in several areas. Select large capitalization companies worldwide are attractively priced, notwithstanding the likelihood of reduced earnings in 2009 and, perhaps, 2010. Expected higher consumer savings offer good prospects for companies with credible brand recognition. Also, the market drop has produced some compelling values, including companies in strengthening currencies. Finally, in a slower-growth world, demographics will play an important role. Companies geared to meeting the demands of aging populations or younger populations, in a few nations, are well situated.
We are very interested in the credit markets. The gap between zero risk instruments (U.S. Treasury Bills, CDs) and those with some risk (investment-grade corporate bonds, municipals) is at an historical high, offering attractive investment opportunities. In addition to significant purchases of municipal bonds, we are taking advantage of good yields in short and intermediate term high grade corporate bonds in pursuit of capital appreciation and income for both taxable and non-taxable accounts.
We are moving cautiously. While some argue that the sharp markdown in global equities presents a buyer’s market and others argue a doomsday scenario, we view the current deleveraging process as unique and unprecedented. The world will recover and the opportunities will be significant, but unlike endowments and other investors with perpetual time horizons, we are investing within the context of client life cycles. This requires a high standard of fiduciary care and prudence.