2011, Quarter 2
The Global Economy
The world economy can be divided into two groups: the lethargic economies of the US, euro zone, and Japan, and the commodity-fueled and fast growing (with some exceptions) emerging markets. The US is still struggling to recover from the housing crisis and is printing money to finance huge fiscal stimulus. Inflation has already picked up and is threatening to rise much higher. A wounded Japan is fighting to control the disaster at its Fukushima Dai-ichi nuclear plant and is still assessing the damage from the devastating tsunami in March. The earthquake and its aftermath will cut Japan’s economic growth this year, but the financial markets have overestimated the damage. The euro zone has avoided disaster – a breakup of the currency – but is still working to resolve long-term issues that threaten growth and stability. China’s growth continues unabated, however, and its voracious appetite for commodities is propelling economies throughout Asia and Latin America.
Japan in Crisis
The earthquake and tsunami that struck Japan March 11 were unquestionably devastating. 12,000 deaths have been confirmed and more than 15,000 are still missing. Many of those missing were taken out to sea by the tsunami and their bodies will never be recovered. The nuclear disaster at Japan’s Fukushima Dai-ichi plant is ongoing as the second quarter begins and it appears that it will take weeks, maybe months, to resolve the crisis. Radiation has leaked into the air and sea, though it appears that so far only those in the immediate vicinity of the plant are at risk. It might be months before radiation stops leaking, however, and radiation emitted from the stricken plants could be around for years. The ruined nuclear reactors were important electricity producers for Japan and economically-critical regions of the country, including Tokyo, are experiencing rolling blackouts. This is certain to have a negative impact on economic growth in the short term. There is excess capacity to generate electricity in western Japan but that part of the country uses a different frequency, so it is impossible to easily make up for the loss in supply.
The Nikkei index fell dramatically in the days after the earthquake, and at one time was down more than 15%, before bouncing back. The yen strengthened immediately after the disaster, as the currency markets anticipated that Japanese-]owned assets abroad would be liquidated and yen purchased to fund rebuilding in Japan. The G7 has intervened to weaken the yen, and the Japanese currency has fallen recently.
The World Bank estimates that damage caused by the earthquake and tsunami could reach $235 billion and that reconstruction could take up to five years. GDP growth in Japan will be 1.5% this year and is likely to speed up later in the year as the rebuilding effort ramps up. Japan goes into this crisis with very high sovereign debt levels, but is helped by a high personal savings rate which keeps interest rates low. Japan’s path out of this disaster will be long and difficult, but we believe that the equity markets have overreacted and are too pessimistic on Japan’s prospects. Japan will rebuild and will be stronger than before. After all, this isn’t the country’s first experience rebuilding after devastation.
Revolution in the Middle East
The revolutions sweeping the Middle East are undoubtedly historic, and their long term repercussions are very much in doubt. Change has been swift: few questioned Hosni Mubarak’s hold over Egypt just six months ago and now he has been pushed from power by a popular uprising. The same has happened in Tunisia, and Yemen’s leader is hanging on by a thread. As the quarter begins things are still simmering in Bahrain (home to the US Navy’s Fifth Fleet), where Saudi troops are helping Bahrain’s royal family cling to power. Syria is heating up, where President Assad is using a combination of violence and promises of reform to assuage growing protests there. Libya finds itself in a civil war, where Colonel Gaddafi’s forces are facing off against a ragtag force of insurgents from eastern Libya, as well as NATO air power led by France, the UK, and the US. Libya is important to the global economy since it is a major oil producer and holds 3% of the world’s proven reserves. Production there is currently a trickle, which has pushed Brent Crude near $120 per barrel at the end of March. Prices would be even higher, if not for Saudi Arabia, which ramped up its production to stabilize global oil output.
So what does all this mean for the Middle East, the global economy, and financial markets? Certainly there are dangers, not least of which is the possibility that newly forming democracies transform into religious autocracies, as happened in Iran after the Shah was deposed in 1979. This would be especially bad if it were to happen in Egypt, since that country is home to the Suez Canal, a vital hub for oil tankers and global trade. Despite this risk there are reasons to be hopeful. The vast majority of the protestors across the Middle East appear to be genuinely interested in a transition to democracy, and to reject religious dictatorship. The Egyptian military has proven to be a stabilizing force in that critical country and its promises of a peaceful transition to democracy appear credible. It seems very likely that Islamic political parties will hold at least some power in a more democratic Middle East, but Turkey and Indonesia offer hope that emerging democracies in Muslim countries can survive with Islamic parties active in politics.
The real danger to the global economy and to financial markets is the possibility of instability in Saudi Arabia. Saudi Arabia is the world’s second biggest oil producer, just behind Russia, and uses its spare capacity to ramp up production (keeping prices steady) when turmoil erupts in other oil-producing countries. Saudi Arabia’s autocratic government looks a lot like others in its vicinity, which are either under extreme threat or have already been pushed from power. Saudi Arabia’s major oil fields are in the majority Shia eastern part of the country, near the Shia protestors seeking to overthrow Bahrain’s Sunni monarchy. So far the Saudi authorities appear to have things under control, and the Saudi government is famously capable in finding ways to survive. Even so, financial markets would react quickly to a protest that threatened the Saudi monarchy – the price of oil could easily spike to $150 per barrel or higher. This would threaten the fragile economic recovery in the developed economies and would slow growth worldwide. It appears that the Saudi leaders will escape this crisis, as protests seem muted and under control. Investors must keep their eye on Saudi Arabia, however, due to its crucial role in the global economy.
The United States
While the US economy remains in a fragile state, jobs numbers have been somewhat encouraging, with the private sector slowly adding workers and new unemployment benefit applications falling. The economy is at least growing again, albeit at a disappointingly slow pace given the severity of the last recession. The housing crisis is not yet over, as prices continue to fall in some parts of the country and the risk of a new wave of foreclosed houses looms over the recovery. There are positive signs for housing, however. New construction is very low and rental rates are rising, which makes buying a house more attractive. Mortgage rates have risen the last few months but, at around 5% for a 30-year fixed rate mortgage, are still low historically. Low rates are helping the housing sector but higher lending standards have been a drag on the sector and the economy. Credit generally has been hard to come by these last three years, as banks feared disaster and horded cash. The credit markets are loosening up, however, which bodes well for housing and for economic growth.
Unfortunately for the US, it entered the economic crisis in 2008 with few bullets in the chamber for policymakers to utilize. The budget deficit was high even before the recession hit, and debt levels were already quite elevated. The Federal Reserve reacted to the recession with massive monetary stimulus, beginning with QE1 (the purchase of US Treasuries and mortgage backed securities) and culminating with QE2 (only Treasuries this time), when standard monetary policy (Fed Funds rate at basically zero) failed to halt the recession. Fiscal stimulus was also massive, with budget deficits of $460 billion in 2008 and $1.42 trillion in 2009 (more than 12% of GDP), and total US Government debt held by the public approaching 70% of GDP. Worryingly, especially for bond investors, interest rates actually increased after QE2 was announced last year. QE2 is slated to end in June, and it is doubtful that foreign central banks and private investors will continue to buy Treasuries at their current low rates. We believe the stage is set for rising interest rates as inflation picks up (investors are already expecting future inflation around 2.5%, as reflected in inflation-protected Treasuries). Interest rates are being held down by Fed purchases of Treasuries, a continued “flight to quality” trade which looks to Treasuries as a safe haven in times of turmoil, and foreign central banks buying Treasuries as a way to prevent their currencies from rising. The first of these is set to end soon, and the second will diminish over time as investors see further signs of inflation and lose faith in the US dollar as a store of value. We are forecasting a moderate recovery in the US economy over the next year with growth around 3.0 – 3.5% in 2011. Interest rates will rise as inflation picks up and the real interest rate slowly rises.
The Euro Zone
A collapse of the euro was seen as a real possibility at the start of 2011, as Greece and Ireland required bailouts last year and Portugal appeared to be nearing default, which threatened to pull down Spain, a country that might prove “too big to save” for the European Central Bank and euro zone heavyweights Germany and France. Thankfully for Europe and for the rest of the world, things have calmed down significantly since then. Spreads on Spanish debt have fallen so far this year, and it is now quite unlikely that a default by Portugal would trigger collapse in Spain. Portugal will probably be bailed out by the ECB and IMF, but Spain and Italy are likely to avoid default and the two indispensable countries for the euro – Germany and France – are invested in the currency’s survival. Euro zone leaders have agreed to a new European financial stability facility with €440 billion, have amended the euro treaty to create a permanent rescue mechanism, have enacted reforms to enhance fiscal discipline, and have created a new system of macroeconomic surveillance. There is still much to negotiate as Europe’s leaders hash out the details, but it is clear now that the imminent threat to the euro has passed. Germany has taken the lead in negotiating a new currency regime. German banks have significant bond holdings from the troubled peripheral countries in the euro zone, and the bailouts of those countries benefit German banks considerably, which has undoubtedly entered into the calculations of German politicians. As long as the sovereign debt crisis doesn’t spread to Spain or Italy, which isn’t likely to happen now, the political negotiations will lumber on and the euro will survive. The euro zone will grow 1.7% in 2011, led by Germany, which will grow 2.6%. 
Emerging Markets
The emerging market economies continue to be propelled by increasing demand for commodities. China is growing at 8-9% and its seemingly unquenchable thirst for commodities is pushing up prices and aiding growth in Latin America, southeast Asia, and Africa. Commodity-intensive developed economies Australia and Canada are also benefiting from high commodity prices. Fast growth has led to rising inflation across the emerging markets – China’s inflation is up to 5% and inflation in Brazil is 6%. The risk of further inflation is serious and many governments in emerging economies are taking steps to confront it. At the same time, these governments are careful not to raise interest rates too quickly, since doing so would further strengthen their already strong currencies, and would hurt exports. China has raised interest rates during the last six months and is likely to further tighten monetary policy in the months ahead. Brazil is trying to stem the rise of the real and has put into place new taxes on international bond sales, while Brazilian banks that sell the US dollar short (recently a profitable strategy) face increased reserve requirements. Such policies are unlikely to have much of an impact as the US Federal Reserve continues to buy Treasuries and promises to keep monetary policy very loose for the foreseeable future, which debases the dollar. China will grow 8-9% in 2011 and commodity prices (including oil) will rise further this year. This benefits countries like Brazil, Russia, and Colombia, which rely on commodity exports. We aren’t optimistic about Russia’s long term growth prospects, however, due to its poor demographics and rampant corruption. Prospects are better in Brazil and other emerging economies, including Chile, Colombia, and Malaysia. The risk of inflation in the emerging economies is serious, but for investors the long term prospects are much better there than they are in the US, Europe, and Japan.
Equities
The equity markets fell from mid-February to mid-March, but then bounced back and ended the quarter higher. The MSCI World index was up 4.5% in the three months through March, the S&P 500 rose 5.9%, the EAFE index (developed stocks ex-US) was up 3.5% and the MSCI Emerging Market index rose 2.2%. A typical DBF Diversified Core account rose 6.5% in the quarter, while a typical DBF Passive Core account was up 4.7%. Emerging markets trailed the S&P 500 significantly through the end of February, but made up a lot of ground in March. The MSCI Emerging Market index has a forward price to earnings ratio of 10.6, which is very attractive given growth prospects in the emerging economies. The EAFE index, which tracks developed markets outside of the US, is also attractive, with a forward PE ratio of 11.9. The MSCI World index has a forward PE of 12.8, while the S&P 500’s forward PE is 13.7. Stocks still look cheap relative to bonds, and emerging market stocks appear most attractive among equities. They are trading at a significant discount to the S&P 500 (US stocks only), yet the growth prospects are much better in the emerging economies than in the US (emerging market stocks also offer protection from a falling dollar). Equities are volatile and can suffer big swings in the short term, but patient investors would be wise to have a large equity exposure now, given the state of the bond market and the potential for further growth in China and other emerging economies.
Oil prices are set to rise even higher, and we continue to hold oil companies Rosetta Resources, Berry Petroleum, and pipe-maker Tenaris. Solar stocks jumped after the nuclear disaster in Japan began, as the market anticipated better prospects for alternative energy companies. DBF holding Trina Solar was up 28% in the first quarter. Oil’s rise is being driven by increasing demand in China and other emerging economies. This isn’t going to change any time soon, and we think oil will rise higher. Given the lack of supply coming out of Libya, some excess capacity is already being utilized, making the oil market more vulnerable to unexpected supply shocks. We are increasing exposure to the energy sector as the second quarter begins.
Many of our equity holdings are benefitting from emerging market growth and global infrastructure development, including Caterpillar, Cummins, and Eaton. We added Tata Motors, an Indian car maker, to the portfolios in the first quarter. The company is growing quickly and gives us exposure to fast-growing India. We also added Sims Metal Management to the portfolios in the first quarter. The Australian company is a world leader in recycling, with operations around the globe, and is cheap with a forward PE ratio of 14. We also bought Whirlpool, which is very cheap at 10 times earnings, especially given its operations in fast-growing Latin America. We continue to hold America Movil, the Mexio-based telecom provider, which has operations throughout Latin America, and Latin American utilities Companhia de Saneamento Basico, and Enersis. Enersis struggled early in the first quarter, due to a drought in Chile which lowered reservoir levels. This is a temporary issue for the company and Enersis has great prospects for growth in Chile, Peru, Colombia, and Brazil, where it also has operations.
We have maintained a neutral weight in healthcare, and hold Teva Pharmaceutical, Stryker, and AstraZeneca. Our portfolios are underweight financials, though we do own Australia’s Westpac Banking, as well as American Express. We are not sanguine about the prospects for the big American banks such as Citigroup and Bank of America, as they struggle to work through toxic assets picked up before the financial crisis hit in 2008.
Our performance in equities is off to a good start in 2011. A typical DBF Diversified Core portfolio in the first quarter beat the MSCI World Index, the S&P 500, the EAFE index, and the MSCI Emerging Market Index. This is on top of 2009 where the composite Diversified Core portfolios were up 39.6% (the S&P 500 rose 26.5%), and 2010 when the composite Diversified Core portfolios rose 20.7% (the S&P 500 was up 15.1%).
Fixed Income
The fixed income markets experienced a volatile first quarter. Interest rates spiked sharply during the first week of February, but headed lower until late March. For the quarter, Treasury yields were slightly higher across the maturity curve. The 2-year Treasury yield was up 23 basis points to 0.82%, while the 10-year moved higher by 0.18% to finish at 3.47%.
The Fed is on course to tighten U.S. monetary policy. The only question concerns the timing of interest rate increases. With respect to the timing of policy moves there is considerable disagreement amongst Fed officials as evidenced by recent speeches and interviews. However, it’s clear the tide is shifting in favor of tighter monetary policy as soon as this year. We expect the first of many future Fed Funds rate increases to occur in the fourth quarter.
Regardless of Fed actions, the fundamentals are in place for rising interest rates in the U.S. over the next one to three years (and possibly much longer). The rise in interest rates will be driven by the following: 1) stronger economic growth, which implies a higher real cost of capital, and 2) higher inflation. In its effort to prevent Japan-style deflation in the U.S. during the financial crisis of 2008, the Fed embarked on an unprecedented spate of monetary creation. Year-over-year M2 money supply growth jumped from 6% to over 10% in late 2008 as the Fed bought U.S. Treasuries and mortgage-backed securities. This boosted the monetary base (bank reserves) by over $800 billion. We have included a graph from the St. Louis Federal Reserve bank that shows the spike in the monetary base during 2008, and another jump with the Fed’s second round of securities purchases beginning in late 2010.
At the same time the Federal Reserve was attempting to guard against deflation, federal government outlays as a percent of GDP jumped to a level not seen since World War II. Combined with the precipitous drop in tax receipts, the U.S. now has trillion dollar deficits, which we’re all reminded of on the nightly news and CNBC. Public debt as a percentage of GDP exceeds 100%; as a nation we owe more than our entire economy produces in a year. Fortunately, there are central banks in countries with export-driven economies that continue to purchase U.S. government “IOUs” despite America’s overwhelming debt load. Why? As we mentioned earlier in this forecast, these foreign central banks don’t want their currencies to strengthen versus the U.S. dollar for fear of reducing exports to the United States. As a result, these central banks (specifically China and Japan) sell their currencies and buy dollars and invest these dollars in U.S. Treasuries. This trend can subsist so long as China and Japan believe the U.S. will make good on its promise to pay what it owes in interest and principal on its debt.
Now we have a world that is awash in Treasury bonds (which are a claim on dollars). As of January 2011, China holds $1.15 trillion in U.S. Treasuries, Japan holds $885 billion, and the rest of the world (outside the U.S.) holds $2.4 trillion. We believe the Federal Reserve has laid the groundwork for the U.S. government to pay back its debt, but with much cheaper dollars. The purchase of trillions of government obligations by the Fed is outright debt monetization. The U.S. is simply devaluing its currency, which is illustrated by the recent free fall in the dollar versus a basket of 6 major global currencies. Inflation has already begun showing up in commodity prices (Brent crude oil at $120, gold at $1450/oz.) and we believe that could be just the tip of the iceberg. It’s very likely that unless the federal government can figure out a way to reduce its trillion dollar deficits, the dollar will lose its spot as the world’s reserve currency. There are already emerging signs of this as evidenced by China’s recent efforts to arrange yuan denominated trading in oil and other global commodities. The Inter-American development bank and private companies in Mexico and Brazil are looking to issue “huaso bonds” — Chilean peso-denominated notes issued by foreigners — in another sign of rising global demand for local-currency securities. If central banks around the world begin to lose their appetite for Treasuries and dollars, inflation and interest rates could head to levels not seen since the 1970s.
We expect U.S. Treasury yields to head higher by 100 to 150 basis points over the next year, with the 2-year yield above 2% and the 10-year yield north of 4.50%. This forecast could turn out to be conservative if U.S. economic growth and inflation are more robust than expected. Our fixed income client portfolios strongly outperformed their benchmarks during the first quarter of 2011. Our intermediate duration client portfolios are up 1.11% for the first three months of the year, while the Barclays Aggregate index is up only 0.43%. Meanwhile, our short duration product is up 0.93%, versus just 0.03% for the Merrill Lynch 1-3 Year Treasury Index. The significant allocation to TIPS (Treasury Inflation-Protected Securities) in client portfolios was the primary driver of returns during the period, although mortgage-backed securities also did relatively well. We still think there is value within the TIPS sector so we will likely maintain or add to TIPS positions going forward.
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