2011, Quarter 1
The Global Economy
The world economy grew in 2010, continuing its path out of the worst recession since the Great Depression. The fastest growth occurred in China and other emerging economies, while the U.S., Europe, and Japan all grew slowly – not enough to bring unemployment down to acceptable levels in the U.S. and Europe, and not enough to make up for the negative growth reported in 2008 and 2009. Indeed, the world economy has divided roughly into two zones: the fast growing emerging economies which have positive demographic trends, low inflation and low debt levels (generally), and the slower-growing developed economies of the U.S., Japan, and Europe. The developed economies face poor demographics, nagging questions about their sovereign debt levels, unsustainable budget deficits (especially in the U.S.), damaged credit markets, and a continuing housing crisis in the U.S. and parts of Europe. Historically, the developed economies have come out of recessions in much better shape than emerging economies. Things are very different this time around and, barring drastic and politically difficult reforms in the U.S., the emerging economies are poised to continue posting the fastest economic growth during the next few years.
The United States
The U.S. economy grew around 2.8% in 2010, a disappointing result given the sharp recession of 2008 and 2009. Any positive number is welcome after a dismal 2009, yet the country needs far higher growth to bring down its unacceptably high unemployment rate (at around 9.8%). Federal Reserve Chairman Ben Bernanke announced a second “quantitative easing” program (printing money to buy government debt) as the economy threatened to fall back into recession, yet opinions of the plan were mixed and there are increasing divisions among Federal Reserve governors. Proponents argue that QE2 is necessary to keep interest rates low and to spur economic growth, while critics contend that low interest rates are not the economy’s fundamental problem, and that QE2 risks unacceptably high inflation in the years ahead. We agree with the latter argument.
Low interest rates are desirable in a recession, yet are insufficient to boost growth in an economy with deeply damaged credit markets and a continuing housing crisis. Demand exists for credit at the low rates presently seen yet banks are still not lending enough for the economy to grow adequately. Many businesses are starved for credit and individuals are prevented from accessing new mortgages. The problem isn’t that interest rates are too high, the problem is that many banks won’t lend to all but the top credit tiers at any interest rate. Given this situation, we agree with Kansas City Fed governor Thomas Hoenig, who argues that QE2 risks unacceptably high inflation in the future and that the Fed Funds Rate (the Federal Reserve’s target interest rate) should be raised from its current low level (0 0.25%). The Fed is using the tool it has – monetary policy – yet that tool is inadequate to get the economy out of its present malaise. The credit markets need time to heal, and monetary policy will do little to aid that healing process. As tempting as it is to use monetary stimulus, there are times when it does more harm than good. We are in such a time now.
Year-Over-Year U.S. GDP Growth
The housing crisis continued to drag on in 2010, with data in late December showing that prices are still falling in some of the worst hit parts of the country: south Florida, Phoenix, and parts of California, among others. The housing crisis has been truly devastating for millions of Americans. As prices collapsed and the economy suffered a deep recession, millions have faced foreclosure and have seen their credit scores ruined. For these people low mortgage rates offer little personal benefit – credit markets are closed off to them. Many more are trapped in upside-down mortgages, forced to remain in economically depressed areas with little hope that prices will turn around soon. Many households are barely staying current on their mortgages and could still default and flood the market with more foreclosed houses, further depressing prices.
Consumers have hunkered down over the last two years, increasing savings and paying down personal debt. This has further depressed aggregate demand, yet retail numbers in late 2010 showed some signs of recovery. Workers filed fewer new applications for jobless benefits than was expected in late December, a sign that the labor market is slowly improving and that the economy is continuing to mend, albeit at a disappointing pace. Even if the economy grows 3-4% in 2011, the headline unemployment rate is unlikely to improve much since discouraged workers will continue to reenter the labor market.
Washington’s response to the recession and financial crisis has been sadly predictable: massive yet poorly-targeted stimulus and deficit spending, with no credible plan for long-term spending cuts and balanced budgets. This risks higher interest rates in the years ahead. The U.S. budget deficit in 2010 was over 10% of GDP while the number for 2011 will be similarly high. Stimulus can make a lot of sense during recessions, but when a country’s debt to GDP ratio is approaching 70%, a plan for long-term spending cuts and balanced budgets is badly needed. Unfortunately, neither political party has pursued meaningful budget reform when actually in a position to control policy, and neither side offers much hope of doing so in the future.
So far foreign investors and central banks have continued to plow money into U.S. Treasuries, keeping interest rates low. But there is increasing risk that they will eventually be spooked by the dismal debt situation in the U.S. and will move their money out of Treasuries. Evidence is already mounting that markets are concerned with U.S. debt levels: rates on U.S. Treasuries increased markedly after President Obama announced a continuation of present income tax rates and some increased spending in early December. The politicians in Washington are playing a dangerous game. They’re betting that the economy will improve quickly and tax revenues will increase soon enough to close the budget deficit before the debt balloons even more and interest rates rise, choking off economic growth. If they’re lucky, crisis may just be averted. If they’re not, the U.S. could face a sovereign debt crisis, which will mean increased inflation and higher interest rates since the Federal Reserve will respond with more quantitative easing.
We forecast that the U.S. economy will grow a modest 3.0% in 2011. The economy is slowly improving as credit markets gradually thaw and consumer spending increases, yet the depressed housing market will continue to be a drag on growth.
The Euro Zone
The real fireworks in 2010 occurred in the euro zone, where the European Union was forced to organize bailouts of Greece and Ireland with the IMF, and the future of the euro was left in serious doubt. German politicians, led by Chancellor Angela Merkel, deeply resent being forced to bail out their more profligate neighbors in the currency block’s periphery, and are pressing for reforms in the euro zone. As 2011 begins investors are warily eyeing Portugal and Spain as possibly the next countries to face sovereign debt crises requiring bailouts. Euro skeptics argue that Greece, Ireland, Portugal and others would benefit from exiting the euro – these countries are not able to devalue their currencies to encourage exports, the typical policy track chosen during recessions. Moreover, Germany and the euro zone’s more responsible governments would also benefit from a breakup of the currency – the argument goes – since they would no longer be forced into costly bailouts.
We believe that the euro will survive its present hardships, though reforms are obviously needed. The two largest economies in the euro zone are France and Germany, and France is deeply supportive of the euro. German politicians are grumbling loudly but there is reason to believe that Germany, in the end, will decide that its interests lie with a single European currency. First of all, a return to the deutschmark would hurt German exports and, therefore, economic growth in the short term, since the deutschmark would almost certainly appreciate relative to most European currencies. Also, a breakup of the euro would deeply damage the long-term German goal of economic integration within Europe. European political integration, which has been a decades-long goal in Germany and most other European countries, would also take a serious hit if the euro were to crumble. The rise of China and other emerging nations makes political integration in Europe even more important to Germany. Additionally, many banks from the euro zone’s core (Germany, France, Holland, and Belgium) hold significant amounts of sovereign debt from Greece, Spain, Portugal, and Italy. A breakup of the currency would result in depreciating currencies in these countries and huge losses for banks in the core. These banks are already on shaky ground so a breakup of the currency block is even less attractive for the core governments. For these reasons we believe that in the end Germany will swallow hard and will decide to stay on with the euro. With Germany and France behind it, the currency is likely to survive.
Economic growth in the euro zone was anemic in 2010, at around 1.7%. We expect a similar number for 2011 as questions of sovereign debt levels persist and aggregate demand remains diminished. Germany will be the top performer in the euro zone in 2011, yet its GDP will grow only a modest 2.2%.
Emerging Economies
Fortunately for investors the emerging economies are continuing to exhibit excellent economic growth. China’s GDP grew about 10% in 2010, while Brazil grew around 5.5%. China’s emergence as an economic power has continued to send ripples throughout the global economy. Countries producing commodities, including many in Latin America, have benefitted the most from China’s rise. Rising gold, silver, and copper prices have propelled Chile, Peru, Malaysia, and Indonesia to all grow more than 5% in 2010. India grew more than 8% last year. We expect similar growth figures for 2011. China’s growth should slow down somewhat this year, as Beijing will continue to raise interest rates in an effort to rein in inflation. The country will still grow at 8-9% in 2011, which is excellent in any environment. China continues to rise up the value chain in the global economy and millions of Chinese are entering the middle class, increasing aggregate demand in the country. Worries persist about increasing inflation, possibility fragility in the country’s banking industry, and increasing real estate prices in some urban areas, but we believe that Beijing will be much better at smoothing out economic cycles than Washington has been. China’s emergence as an economic power is no illusion, and its continued growth will be a major story of 2011.
Investors must keep in mind that the emerging economies are not all alike, and that the best performers over the long term will be those with the most transparent governments, most predictable regulatory environments, highest education levels, and lowest levels of corruption. This has us especially optimistic about countries such as China and Chile, and pessimistic in the long term about countries like Russia, Argentina, and other recent high-fliers such as Peru. In the short run, rising commodity prices have lifted all boats, but in the long run deeper social and economic characteristics will differentiate emerging economies.
Energy and Currencies
Energy
The price of oil fell from nearly $90 per barrel in late April to below $70 in mid May as sovereign debt woes in Europe threatened the global economic recovery. As conditions calmed down in Europe and prospects for economic growth improved later in the year the price of oil rose, and finished the year at $90. Oil producers around the world are working hard to expand production to take advantage of high energy prices, but we believe energy prices will continue rising in 2011. Supply is increasing but it can take years for new wells to come online. Meanwhile global economic growth, especially in the emerging markets, continues improving and demand for energy is rising. The global demand and supply curves for oil and energy in general are relatively inelastic, meaning small changes in either supply or demand have a big impact in prices. The supply of oil is expanding but the demand is set to grow faster than supply in 2011, which has us bullish on oil. We expect oil to rise to $110 a barrel this year. 
Currencies
We continue to believe that the U.S. dollar will depreciate against other major currencies – both in the developed and developing world – in the years ahead. The biggest determinate of a strong currency is underlying economic growth, and the fastest economic growth will occur in the emerging world and not in the United States. Also, the European Central Bank has performed much less monetary stimulus than the U.S. Federal Reserve, which bolsters our belief that the dollar will depreciate against the euro in 2011. The euro has been dragged down by sovereign debt fears in Europe and increased risk that the currency itself may break up. Fears about sovereign debt levels will persist for a time but we believe that the euro will survive and will even appreciate relative to the dollar as its long-term viability becomes more clear. Beijing will continue to allow the yuan to appreciate against the dollar, though the appreciation will be slow and measured as Beijing is careful not to hurt Chinese exporters too much in the short run. We are also bullish on select emerging market currencies, such as the Chilean peso and Malaysian ringgit. Both countries’ economies are expanding rapidly.
Equities
Global stocks sold off in May as the European sovereign debt crisis intensified and investors fled to the perceived safety of U.S. Treasuries. Equities recovered in the third and fourth quarters and the S&P 500 finished 2010 up 12.8%, while the MSCI EAFE index (international developed stocks) was up 4.9%, and the MSCI Emerging Markets Index rose 14.8%. A typical DBF Diversified Core account finished 2010 up 20.4%, and is up 47.8% since January 1, 2005, outperforming the S&P 500 by 498 basis points annualized over that period. This outperformance is due largely to exposure to select emerging markets and our ability to identify undervalued stocks. A typical DBF Diversified Passive Core account was up 15.0% in 2010 and is up 38.5% since January 1, 2005, outperforming the S&P 500 by 383 basis points annualized. A typical DBF Balanced account (60% stocks, 40% fixed income) rose 14.4% in 2010, 653 basis points above its benchmark for the year and 319 basis points above its annualized benchmark since January 1, 2005.
Equities are still below their highs in 2007 but have bounced back significantly from the lows of early 2009. The best performing stocks in 2010 – both foreign and domestic—were those taking advantage of the prodigious economic growth in China and other emerging markets. New Oriental Education, a private education company in China and part of the DBF Diversified Core portfolio, was up 39% last year. The company provides English classes as well as SAT and GRE preparation courses for Chinese students – a red hot market with great growth prospects. We also own Sociedad Quimica y Minera de Chile, which produces fertilizers, iodine, and lithium in northern Chile. The stock was up 55% last year. We continue to hold America Movil, a telecommunications company with operations throughout Latin America. Cell phones are virtually ubiquitous in Latin America yet smartphones still represent a small percentage of the market. American Movil is set to benefit from the inevitable growth in smartphone and data use in Brazil, Mexico, and the rest of the region. America Movil was up 22% last year. We also hold Companhia de Saneamento Basico, a utility in Sao Paulo, Brazil, which finished 2010 up 35%.
We hold various domestic stocks, many of which are benefiting from emerging market growth, including truck maker PACCAR, up 58% last year, and heavy equipment maker Caterpillar, up 64% in 2010. Both companies are increasing sales to emerging economies and are poised to continue expanding production in response to increased demand in China, other parts of Asia, and Latin America. We added mine equipment maker Bucyrus to the portfolios in 2010 and made a nice profit for our clients when Caterpillar announced its purchase of the company in November.
Our equity portfolios are globally diversified with an emphasis on companies with a foothold in the fastest growing parts of the world. We are neutral on healthcare stocks and underweight financials. We have an overweight in energy stocks, and our investments there had a good year in 2010 with Whiting Petroleum up 64% and Rosetta Resources up 60% in the fourth quarter alone. Stocks still seem cheap relative to bonds, even with the increase in yields seen in December. Equity returns are often volatile but we believe that investors taking the long view by investing in companies rooted in fast growing regions and industries will see the best returns in the years ahead.
Fixed Income
Overall, 2010 was a solid year for the bond market and especially good for corporate bonds. Yield spreads on corporate credit continued to fall in the aftermath of the financial crisis of 2008. Not surprisingly, this rally in corporate bonds coincided with a strong rally in the stock market as investors began to regain their appetite for riskier assets. As a result of the improving economic outlook (and an increase in inflation expectations), the bond market ended the year on a sour note as yields climbed significantly during the last 3 months of the year. This rise in rates occurred despite a pledge from the Fed to buy another $600 billion in U.S. Treasuries in an effort to keep rates low and stimulate lending.
We expect the Federal Reserve to maintain their target rate of 0% -0.25% well into 2011, but we expect a shift to tighter policy sometime in the middle of the year. In the meantime, the short end of the yield curve will remain somewhat anchored by the Fed Funds rate, which will keep the yield curve very steep. However, we see interest rates heading higher across the curve in the coming year, boosted by a steadily improving U.S. economy in tandem with a tightening Fed. We expect the 2-year Treasury yield to exceed 2% over the next 12 months and we expect the 10-year yield to rise to the 4.0 4.5% level.
We continue to position our clients’ fixed income portfolios defensively. This positioning for higher rates paid off handsomely over the last three months as interest rates jumped; all our fixed income products outperformed their benchmarks by significant margins. In the near term we will continue to invest in relatively high premium mortgage-backed securities and Treasury inflation-protected securities (TIPS). Inflation expectations have moved higher during the last 3 months which has helped TIPS outperform their Treasury counterparts. The implied CPI inflation expectations as illustrated by the 5 year TIPS was 1.81% at the end of the year. We still believe inflation could end up being significantly higher over the next 5-year time horizon and therefore we still see value in holding a significant allocation of TIPS in our client portfolios.
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