This is a quarterly update of economic conditions and investment strategy.
For the U.S. economy, 2010 was a year of consolidation and recovery from the deep recession of 2008-2009. Three quarters of positive real GDP growth to start the year (and estimates pointing to a positive fourth quarter) restored the economy to near pre-recession GDP.
Similarly, 2010 saw aggregate corporate profits return to their previous high water mark. Globally, 2010 real GDP growth was characterized by weak growth in Europe and Japan, and robust growth in the largest emerging markets.
Progress in the U.S. was uneven in 2010 with two important pillars of consumer financial health strugglingto join the recovery, namely, employment and the residential housing market. Unemployment remained above 9% for the entire year and house prices were again falling into negative territory on a National basis by the end of the year. While there were signs of job market stabilization and an improvement in hiring trends going into 2011, the recovery in residential real estate is likely to be a slow, painful, multi-year process. As noted in previous letters, consumer confidence (and thus spendingwill return to a sustainable growth trajectory when we have a much healthier employment and housing picture. Improvement in U.S. employment requires the creation of at least 250,000 jobs per month for a sustained period. Given stresses in the public sector (15% of the U.S. workforce), jobs will need to come from the private sector, and that will be a big challenge.
The recovery has been dependent on extraordinary Federal intervention. Fiscal measures included a stimulusspending package of unprecedented size, an extension oflow income tax rates, and payroll and corporate tax cuts. On the monetary side, the Federal Reserve kept short-term interest rates at virtually zero and directly intervened in fixed income markets by purchasing mortgage and Treasury securities. Through these measures, GDP growth has been restored, but sizable risks remain: continued stimulus may create new asset bubbles and removing stimulus too soon may reveal a weak economy that returns to recession. Also, the magnitude of future Federal actions is limited by the size of the Federal debt.
Moreover, there are also a number of potentially destabilizing imbalances abroad. In the Eurozone, sovereign debt problems in peripheral countries have been contained, but not resolved. Should the crisis spread to larger countries (e.g. Spain, Italy or France), stressed European institutions may not be able to coordinate an effective response. A common characteristic of Eurozone and U.S. finances is found in demographics: each made expensive promises to aging populations.
Meanwhile, in China, impressive recent growth has been powered to a remarkable extent by the construction industry. With inflation beginning to reach uncomfortablelevels, the Chinese government has tapped the breaks by increasing lending rates and requiring banks to hold more reserves. If the authorities are unable to engineer a soft landing, the ripple effects of a Chinese slowdown would be felt globally, especially on the suppliers of key commodities that have benefited from the current building boom.
On balance, we expect 2011 to be a year of moderate growth for the U.S. economy, in the range of 3%, but we will be closely watching the myriad issues outlined above.
In this economic climate, nothing is more important than thematic positioning of portfolios. Briefly, this means a focus on stocks of industries that will grow in spite of volatile economies, and on bonds that will withstand credit quality issues and, importantly, a long-term seculartrend of rising interest rates. Background and some measures that we are undertaking are noted below.
The broad U.S. stock market as represented by the S&P 500 index returned 15.06% in 2010. Global markets also did well, with the MSCI World index gaining 12.44%. Equity returns were led by cyclical and commodity stocks with the energy and materials sectors posting the largestgains. Client stock performance continues to excel;overall portfolio returns are muted by bond holdings, which served us well during the recent economic crisis—validating the merits of balanced portfolios.
The phenomenon of home country bias has been a permanent fixture of investors’ portfolios since the beginning of public markets. Investors have a tendency to hold a far greater weighting of their home country securities than would be the case if they built portfolios based on size of each national market (e.g. total capitalization) or the size of each national economy (e.g. GDP) as a percentage of the global total. This bias is the product of legal and administrative difficulties in foreign investing (capital controls, costly currency transactions) as well as discomfort and unfamiliarity with foreign economies and firms. For investors from small countries, this bias can have devastating consequences. When the home country experiences difficult economic conditions, investors may suffer large losses at the same time his or her source of employment and currency are under pressure. Historically, home country bias has been less of a problemfor U.S. investors because they have benefited from a large, diversified, relatively rapidly growing economy. However, the global composition of economic growth is changing. Emerging market countries now account for roughly 50% of global GDP on a purchasing power parity basis. While investments should not be allocated by the size of each market, it would be unwise to ignore the many opportunities in foreign markets, especially in the fast growing economies of the developing world. Also, foreign securities can offer investors diversified currency exposure, serving as a hedge against a potential loss of purchasing power of the home country currency.
It is not necessary to invest directly in developing markets to benefit from their growth. There are consumeroriented multi-national companies, U.S. and foreign based, that derive much of their revenue and profits from emerging economies. We believe investors were slow to recognize this attribute. We have purchased stocks in large, well capitalized companies, many with attractive yields, that share in emerging markets’ growth with less potential “event risk” than local companies. At the same time, we recognize that emerging economies are and will continue to grow their own local champions and will not willingly cede large domestic markets to foreign suppliers.As rules of law and accounting standards improve, we will increase direct investments in emerging markets.
We have closely monitored—and invested in—agricultureand related water services sectors. It is becoming increasingly clear that population growth, changing diets in prospering emerging markets, reduction in productive farm land, and water shortages will continue to pressure food supplies. Accelerating climate changes are contributing additional pressure.
China and India are importing more grain. Arable land in China has been declining for many years due to soil erosion and drought, and it is reported to be reduced to about 120 million hectares, the minimum level to meet domestic needs. India is in a similar dilemma: the farm land in Punjab, the grain basket of the nation, is suffering from excessive fertilization and depletion of ground water reserves (reported in 13 D Research). The long-term implications of the aforementioned include: significant inflation in the cost of food and water; foreign exchange volatility in countries well situated and poorly situated; and profit margin volatility for food and watersuppliers. Long-term investments that support farm and food productivity and improved water services are investments that we believe will trump market volatility.
Happy New Year
Chevy Chase Trust, January 2011