2010, Quarter 1
Global Economic Forecast
The U.S. economy will resume growth in 2010 as it slowly makes its way out of the worst recession since the Great Depression. The unemployment rate remains in the double-digits, but housing prices are stabilizing, consumer confidence is up, credit markets are thawing, and a falling dollar is boosting exports. GDP contracted around 0.25% in 2009, but the economy was growing in the second half of the year and will grow 3% in 2010.
Critical to a full recovery in the U.S. economy is a recovery in the financial sector. Some of the financial behemoths, including Citigroup and Bank of America, are still in bad shape as they face continued defaults on consumer credit cards and the remnants of toxic assets still hidden within their balance sheets. The steep yield curve, however, has helped banks recapitalize and will continue to help the industry make its way out of its present morass. This bodes well for economic growth since the unwillingness of banks to lend during the last year and a half has undoubtedly contributed to the recession’s severity.
Policymakers, concerned with the high unemployment rate (and its impact on their electoral prospects), are still considering ways to boost the economy. However, the likelihood of another round of fiscal stimulus is very low, given the growing popular uneasiness with the enormous amount of debt the U.S. Treasury will issue this year. The Federal Reserve is determined to keep the Fed Funds Rate low this year and into 2011. Indeed, the Fed has gone to extreme lengths to prop up the economy since the severity of the recession and credit crisis became clear in 2008. Fed Chairman Ben Bernanke has shown that he will keep interest rates low until it is virtually certain that a double dip recession is avoided. Lax monetary policy, however, comes at a significant cost. There are growing signs of inflation on the horizon (we need look no further than the surging price of gold) and many are encouraging the Fed to begin raising the Fed Funds Rate, which is currently targeted at a range of 0.0% – 0.25%. Others contend that given the tenuous state of the consumer and still sputtering housing market,
it is better to stay on the safe side and hold off raising rates until economic growth has picked up, even if that means an increased risk of inflation in the future. Ben Bernanke clearly identifies with the latter argument. Inflation has remained very low throughout the recession, bolstering Bernanke’s position and allowing him the leeway to promise continued low rates for an “extended period.” By the time Bernanke finally begins the process of raising the Fed Funds Rate – likely this summer – the seeds of future inflation may already be sown.
Treasury yields will rise as foreign investors and central banks become more worried about U.S. debt levels and the Fed’s commitment to a strong dollar. Chinese Prime Minister Wen Jiabao’s statement last year that global investors were becoming “a little worried” about U.S. debt levels should be seen as a clear warning that China will buy fewer Treasuries unless the U.S. cleans its fiscal house. The U.S. government seems to be ignoring Wen’s warning, however, and the Treasury will issue new debt worth trillions of dollars in the next few years. Given this situation, we are forecasting a further depreciation of the U.S. dollar and higher interest rates in the U.S. (in both nominal and real terms) as foreign central banks and investors reduce their allocation to U.S. Treasuries.
The European Union contracted close to 4% in 2009, and will grow a modest 1.5% in 2010. Italy, Spain, and Greece are facing fiscal crises of their own, while even Germany, long the model of financial responsibility, is forecasting public debt approaching an uncomfortably high 80% of GDP. The European Central Bank, unlike the Federal Reserve, has a single mandate – to maintain price stability – so EU governments cannot rely on the ECB for monetary stimulus. And given EU covenants regarding debt levels, their ability to continue fiscal stimulus through 2010 is severely limited. This will result in faster economic growth in the U.S. than in the EU this year. Even so, the Euro will strengthen against the dollar during the next few years as the Fed maintains a loose monetary policy and the global appetite for Treasuries wanes.
Japan contracted more than 5% in 2009 and we expect it to grow a modest 1.5% in 2010. The country’s fiscal condition is even worse than that facing the U.S., and its public debt will rise to 180% of GDP in 2011 after a $1 trillion spending plan recently announced by its newly elected government. Japan appears incapable of cutting its debt load and is destined to achieve moribund growth rates for the foreseeable future.
Japan’s last two decades of stagnant growth are worthy of scrutiny, given the fact that many fear the U.S. is destined for the same fate. Was the collapse in the Japanese economy, credit markets, and banking and the disappointing search for recovery a precursor to the recent disappointing decade the U.S. economy has experienced? Can we expect the disappointment of a continued slow recovery in the U.S. economy during the next five to ten years? Though the structural shocks recently experienced in the U.S. are similar to those of Japan, we think the parallels between the two economies are weak. The sun has set on Japanese growth, due largely to very negative demographics for the Japanese population. When a country has an aging population that is not replacing itself and a declining supply of labor, an economic headwind is created that is almost impossible to overcome. With a stable population and a labor force annual growth rate of 1.2%, the U.S. economy is more fortunate. As long as positive economic growth is sustained, there will be long-term appreciation in the value of housing, real estate, and other real assets. Unwise economic policy can reduce the economic growth of the U.S. significantly, but there will be considerable economic growth nonetheless. However, the U.S. economy will grow slower than the emerging economies of the world.
Thankfully, other parts of the world have excellent prospects for economic growth in the years ahead. China was hit by the current recession, largely as a result of falling demand in the U.S., EU, and Japan, yet still managed to grow more than 8% last year. The country will return to double digit growth in 2010. The development of a large middle class in China is, without a doubt, one of the most momentous economic developments of the early 21st century, and will increase domestic demand. In stark contrast to what policymakers in the U.S., EU, and Japan face, Chinese policymakers are in the enviable position of choosing between two largely desirable alternatives. They can continue the policies of the last decade – a continued tie up of their currency to the dollar, leading to massive trade surpluses used to finance the purchase of U.S. Treasuries. An alternative is to allow the yuan to appreciate, thereby increasing the standard of living of the Chinese people. We believe that China will gradually appreciate the yuan and also reduce its purchases of U.S. Treasury Securities.
However, China will not disrupt the global economic system by suddenly reducing its investment in U.S. Treasuries. Countries providing China with the raw materials necessary for its development will achieve prodigious growth in the years ahead. Brazil should grow close to 4% in 2010 while Chile and Colombia will grow more than 3.5%. Emerging Asia ex China will report good growth numbers in 2010 as well, with Indonesia, Malaysia, and Singapore all growing around 4%. The emerging markets will appreciate in 2010 at a much faster pace than the U.S., EU, and Japan.
2009 was a tumultuous year for the equity markets, as could be expected given the persistence of the worst recession since the Great Depression. The continued unraveling of the U.S. housing market and the slow thawing of credit markets have led to a bumpy ride for investors. The good news is that the S&P 500 has appreciated by more than 67% from its lows in early March, finishing the year with a gain of 23%. Stocks, however, are still well below their highs in 2007.
Emerging markets, which fell the most in late 2008 as the seriousness of the global recession became apparent, have led the way since March. The MSCI Emerging Market Index is up 104% since March 9. The most crucial emerging market, of course, is China, whose return to robust economic growth is greatly benefiting countries supplying it with commodities including Australia, Brazil, and Chile, to name only a few. Latin American stocks returned even more than Chinese stocks in 2009 – S&P’s Latin America index finished 2009 up 88% compared to the 70% gain of S&P China Index.
The U.S. and EU are both emerging from severe recessions and should register good growth in 2010, especially during the second half of the year. However, high public and private debt loads, especially in the U.S., will present headwinds to economic growth and to equities in the years ahead. The deleveraging of the American consumer is likely to take a few more years to play out and will slow down economic recovery. Even more troubling for the U.S. is its large public debt, which will be 90% of GDP in the next few years. Given the unlikely prospect of increased taxes or decreased government spending, the Federal Reserve may monetize the debt (printing dollars to buy up debt) as the least costly option available. This will lead to higher inflation. Ben Bernankehas made it clear that he is more concerned about avoiding a double-dip recession than with rising inflation, and will keep the Fed Funds Rate low through 2010 and beyond. However, we believe Bernanke is sowing the seeds of inflation in the years ahead, which will result in a continued depreciation of the dollar and will make dollar-denominated assets lose value in relative terms.
As a result we expect foreign stocks and emerging markets to continue to outperform during the next few years. China’s economy is growing at near double-digit growth rates, even as demand from the U.S. and EU for Chinese products remains lackluster. It is still early in China’s development as a global economic leader, and equity investors need to have significant exposure to China either directly through Chinese stocks, or through other stocks benefiting from China’s rise. The DBF Diversified Core Portfolio is well positioned to benefit from growth in the emerging markets. For example we hold China’s New Oriental Education, Latin American telecom giant America Movil, and Chilean electric utility Enersis (recently added to the portfolio). DBF holdings Caterpillar, Petrobras, and Tenaris all stand to benefit from continued growth in China as well as other emerging markets. The DBF Diversified Core also has many high quality domestic stocks, including the high tech defense company L 3 Communications, Johnson & Johnson, Aflac, Garmin, and Fedex. We recently added Boeing to the portfolio which will benefit from a recovery in the global economy and increased demand for air travel. Technical glitches with its new plane, the Dreamliner, appear to be largely resolved and now the company’s biggest issue is to ramp up production.
Our overall forecast for equities during the next few years remains unchanged. Given the low yields on bonds, we believe that stocks will outperform bonds in the years ahead. We also believe that the U.S. stock market will underperform foreign stocks, especially the emerging markets. However, the strong rally since March makes us more cautious over the short term and we have increased our cash position to 7%. Given the recent run-up in stocks we believe this to be a prudent strategy. If stocks continue to increase in the short-term, we will raise more cash.
The DBF Diversified Core portfolio appreciated by 41% in 2009, outperforming the S&P 500 Index by more than 1450 basis points. This outperformance can be attributed to our emerging market holdings and to superior stock selection.
Fixed Income
Higher inflationary expectations, a recovery in economic growth, and record issuance of new Treasury debt has caused interest rates to begin to rise in line with our previous predictions, and will continue to place upward pressure on the yield curve. The rise in long term rates has resulted in an unnatural yield curve as Fed policy has continued to hold the short term end of the yield curve at artificially low levels. Treasury security yields rose between 25 and 60 basis points across the maturity spectrum during the past month, and we expect a further rise in yields during 2010. The yield curve will continue to look like a bent crowbar, that is very steep at the short end and flatter at the long, until the Fed finally throws in the towel and starts to raise the target Federal Funds rate. This will happen during the next few quarters as the Fed becomes more confident that the economic recovery is for real and accelerating. Expect to see a more normal Treasury yield curve by the end of 2010 with short-term rates in the 1.5% to 2.5% range and long-term rates in the 4.5% to 5.5% range.
Our fixed income clients enjoyed excellent performance during 2009. Our intermediate duration portfolios returned an average of 6.75% during the vis-à-vis 5.93% for the broad investment grade bond market. Our short duration portfolios returned an average of 5.74% during 2009 vis-à-vis 0.78% for the benchmark index. We have positioned our fixed income portfolios defensively. We are maintaining duration shorter than the benchmark indices in both products and we are also maintaining a significant allocation to TIPS (Treasury Inflation Protected Securities). We expect returns for 2010 to be lower than what the bond market enjoyed in 2009. This is due to rising interest rates and rising yield spreads as the Fed reduces some of its accommodative monetary policies and securities purchases within certain sectors. However, this will set the stage for higher returns in 2011 and beyond.
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