This is a quarterly update of economic conditions and investment strategy.
The expected recovery in the U.S. economy is underway, with final 3rd quarter GDP growth of 2.2% and an expectation for continued, albeit sluggish, growth in the next few quarters. Growth was driven by Federal stimulus spending and a small uptick in consumer spending, primarily from the “cash for clunkers” program which probably borrows from future demand.
We expect a slight improvement in the employment picture and inventory restocking to aid in the rebound, but we are a long way from a full recovery. Understanding that, the Federal Reserve and fiscal policy makers are likely to be accommodative with low short-term interest rates extending well into 2010. We expect renewed discussions of more stimulus spending— despite what its impact would be on the Federal budget deficit.
Economic data support the cautionary headlines about excessive debt. During the past ten years, household debt has increased 44%, State and local debt has increased 96%; and the Federal debt had doubled from $3.7 to $7.5 trillion, as of midyear, and is now $12 trillion—after a decade when U.S. GDP
increased by about 28%.
The ten year jobs picture is no better. While the U.S. population grew from 273 to 305 million in the last decade, employment has grown only slightly. Of more concern is a change in its mix, with government employment up 10%, health/education employment up 30%, but a significant loss of one-third in U.S. manufacturing employment, a very important sector.
Not surprising, the U.S. dollar also has had a difficult time. Despite its advantageous position as the reserve currency, the dollar has fallen 49% against the Euro and 59% against the Swiss Franc during the past 10 years.
A major positive surprise during the economic crisis has been the good economic performance of some of the larger emerging economies. China’s stimulus spending has been, proportionally, larger than that of the U.S. and has sensibly targeted infrastructure development. Brazil avoided a recession, created jobs at a brisk pace, and has strong reserves. India, too, avoided much of the crisis and with more attractive demographics than China is likely to exhibit excellent long-term growth.
For the United States, the fundamental question is what happens when the stimulus begins to wind down and
expansionary monetary and fiscal policies are reversed—at the same time taxes begin to increase. Our very early projections, based on preliminary data and compared to the experiences of other downturns, suggest extremely slow growth. However, these projections are much too preliminary to be useful in
formulating investment strategies.
U.S. equity markets rebounded sharply from their March, 2009 lows and ended solidly higher. Foreign markets also did well along with gold, oil, corporate bonds, and municipal bonds— essentially all “risk assets” produced solid returns last year.
Investment priorities are generally unchanged. Equity investments include global industrial and consumer brand companies, especially U.S. and foreign multi-national corporations with strong cash flows and respectable dividends. These companies have attractive valuations, are well-exposed to the developing markets, and are a safer way to invest in the emerging economies. In a period of slower growth, the focus will be on businesses that are likely to grow faster than GDP. For example, electrical infrastructure to accommodate new technologies like auto batteries; seed technology to offset major losses in desirable farm acreage; and clean water projects, all of which are not likely to be postponed.
The investment process is dynamic and anticipatory. For example, important developments in the U.S. energy market are likely to change the platform for energy investments. A handful of small to mid-size U.S. exploration companies have developed a new technology for accessing natural gas deposits
that were not economic to extract in the past. An improved fracturing technology that permits extraction of natural gas from large deep rock formations has greatly increased economically accessible US natural gas reserves. These emerging “shale plays” have been found in Texas, Alabama, Pennsylvania, Western Canada and elsewhere. The new gas reserves could be a game changer for the U.S., a source of
cleaner (albeit with its own environmental challenges) homegrown fuel that will serve as a bridge to an era when alternative energies will reduce dependence on fossil fuels. Our energy holdings have been adjusted for the prospects of greater natural gas usage, with positive implications for high-dividend pipeline companies that are effectively toll booths for natural gas movements.
As noted, we believe in the long-term growth of emerging markets. Short-term, we are cautious, especially of China where we observe serious economic imbalances, namely, possible excess industry capacity, weak internal consumption, inflexible currency policies, real-estate speculation and an opaque banking system.
Consequently, we are maintaining a reduced exposure to companies that primarily benefit from strong growth in China. We were early to this investment theme, benefited, and hope to again when the aforementioned issues settle.
Our bond portfolios are similarly dynamic. Short term interest rates have been near zero; longer U.S. Treasury rates are in the 3-4% range. Massive Federal spending, along with the debt levels cited above, tilt the odds to higher rates—perhaps substantially higher—over the next 12 to 24 months. There is great risk in losing substantial principal by reaching for yield— not a great idea for the safest part of client portfolios. Our core bond portfolios remain safe and short term. But there are opportunities: high quality corporate bonds, preferred stocks, AAA-rated agency step-up notes, longer term municipals, and other instruments offer higher yields with less risk. When rates move up, we will have funds to take advantage of them. In the interim, we will not expose portfolios to the erosion of buying
power that will be pervasive in those weighted to longer maturities.
Over the years, an opportunistic approach and global outlook have served us well. We continue to position portfolios to take advantage of growth opportunities around the world.
Chevy Chase Trust, January 2010