2010, Quarter 4
The United States Economy
Serious imbalances have formed in the United States economy over the last few decades, including too much private consumption and too little savings, too much public spending and public debt, excesses in the availability and price of credit, lack of effective regulatory oversight, and overpriced houses and real estate across the country. The last two and a half years of recession and slow growth have been very painful as these imbalances unwind and the economy moves toward a long-term equilibrium. The National Bureau of Economic Research, which studies macroeconomic cycles and determines the length of recessions for academic purposes, recently declared that the Great Recession ended in the summer of 2009, and that the U.S. economy has been growing since then. That growth, however, has been tepid. It is clear that we are still living with the hangover of the recession and the structural problems that caused it: readjustment in housing prices, a still damaged credit market with many banks unwilling to lend even to creditworthy borrowers, a damaged financial industry, and ultimately, diminished aggregate demand which has led to 10% unemployment. This recession is the deepest and most serious since the Great Depression of the 1930s.
Some of the basic problems in the U.S. economy are easy to see. Many families are underwater on their mortgages so they cannot refinance and, therefore, cannot move to look for work, thereby increasing unemployment in the hardest-hit cities in the country Miami, Phoenix, Las Vegas, and parts of California, among others. Hundreds of thousands have suffered foreclosures and personal bankruptcies, ruining their credit for the foreseeable future and making future home ownership an unlikely prospect, at least in the short-term. People are saving more, which is good for their personal finances, but is bad for the economy in the short run since it lowers demand. Credit markets are still damaged yet the federal government has pressured banks to increase capital ratios, resulting in less lending. The politicians in Washington have attempted to prop up demand with heavy stimulus spending, but political constraints and economic miscalculations made that spending less effective than it might have been. For example, much of the money from President Obama’s 2009 stimulus plan still has not been spent. And much of the spent stimulus money was used to maintain the jobs of state government workers. Clearly political considerations played a role in how stimulus money was spent. A majority of Americans now believe the stimulus bill has failed to create jobs and it is unlikely another stimulus will be passed.
The Federal Reserve has certainly been responsive since the severity of the recession became clear in 2008. The Fed Funds Rate – the rate the Fed uses to control monetary policy – has been set at 0 – 0.25% since December 2008, and the Fed bought hundreds of billions worth of agency mortgage-backed securities and Treasuries last year to lower mortgage rates and interest rates generally. That was achieved, but the housing market is still lethargic and unemployment is far higher than the typical 4-5%. In late September the Fed announced that core inflation, at 0.9%, was lower than its target. Chairman Ben Bernanke indicated the Fed is ready to initiate another round of quantitative easing (purchasing more Treasuries and agency mortgage-backed securities) if necessary. The Fed’s previous forecast of 3.5% GDP growth in 2010 and 4.0% growth in 2011 is now looking very optimistic, and further quantitative easing is more likely. However, we believe the economy will slowly pick up in the coming months and that any new quantitative easing project would be modest.
As we approach the 2010 congressional elections it appears likely that the Republicans will pick up a majority of seats in the House of Representatives, and will gain seats in the Senate, though probably falling just short of a majority there. The Democrats are in full retreat on the campaign trail, and most are not strongly defending their major (and currently unpopular) legislative initiatives over the last two years: the stimulus bill and healthcare legislation. Even if the Democrats manage to hold on to the House they are unlikely to push major legislation during the next two years. Republican gains in the Senate would make gridlock in Washington through the presidential election in 2012 very likely, and a Republican storming of the House all but ensures it. We are forecasting legislative gridlock in Washington, which may be the best outcome for the economy. A Democratic victory in November might lead to more fiscal stimulus, but President Obama’s original stimulus was not targeted properly, and it is unlikely the Democrats would do much better a second time around. More stimulus spending would increase the budget deficit and national debt beyond its already very high levels, and likely would only marginally help the economy in the short-term. A rejuvenated opposition tangling with a Democratic president precludes much more stimulus and even creates the possibility of some budget cuts (or at least a slowdown in spending increases), which would aid the country’s long-term financial standing.
The most contentious issue in this round of elections is tax policy. The Republicans support maintaining the Bush tax rates on the highest tax bracket, while Democrats favor allowing federal incomes taxes to rise to almost 40% for those making over $250,000 a year. Ironically, the Republican plan would increase the budget deficit in the short-term, contradicting Republican promises to decease the deficit. Democrats are arguing against raising the deficit in this way, though they haven’t shown much compunction about controlling the budget deficit in their last two years in power. 
We believe that extending the lower tax rate for another year or two would be beneficial for small businesses and the economy at large, though it is true that its long-term benefit is partly negated by increasing the national debt. Eventually that debt will have to be reined in or the U.S. will face rising interest rates and higher inflation, both of which will choke off growth. Obama has been adamant in his opposition to changing the tax law and tax rates are likely to increase in January. Some Democrats in Congress would like to allow the current tax rates to continue, but Democratic leaders have ruled out any change before the November election and the lame duck Congress afterward is unlikely to change the law. It would take President Obama changing his mind for the tax rates to stay as they currently are, and that seems unlikely to happen either this year or next.
We believe the U.S. economy will return to more normal growth rates in the next few years, but more time is needed to work through the tremendous disruptions – the collapse of the housing market, the credit crisis, decreased private consumption and increased savings, the collapse of the banking industry – that have struck it over the last three years. Policymakers have done a lot, and except for tax policy, it’s probably best for them to take a break and allow the economy to adjust to a new equilibrium. The budget deficit and national debt, however, is a very serious concern. International demand for Treasuries has remained remarkably strong throughout the financial crisis and recession. At some point, however, investors and foreign governments will view the fiscal position of the U.S. government as unsustainable and will demand much higher interest rates to hold Treasuries. This will slow economic growth in the U.S. and make it much more costly for the government to finance its already huge debt. Neither Democrats nor Republicans seem truly serious about addressing the budget deficit, in spite of the rhetoric on both sides.
The Global Economy, Currencies, and Energy
For years there were doubts about how euro zone leaders would react to a financial crisis – whether a crisis would lead to further integration of the monetary union or lead to the euro’s demise. Europe’s debt scare this spring has shown that, at least in the short-term, the countries in the euro zone are on track for more integration. Greece, Portugal, and Ireland are under no immediate threat of expulsion and the larger countries of Spain and Italy, which also have troubled public finances, have recovered significantly in recent months. Ireland, Greece, and Spain held successful debt auctions in mid September, and it appears the immediate crisis is over. Over the long-term the euro zone may be forced to expel its most profligate members, but the end to the debt crisis buys European leaders time before radical reforms are required. We expect the euro zone to grow only 1.5% in 2010 and another 1.5% in 2011. Germany, the economic engine of the region, has reported surging exports to China and should grow 3.0% in 2010 and 2.0% in 2011.
The true engine of global economic growth, now and for the foreseeable future, is China. The country’s GDP will expand 10% in 2010 and 8.5% in 2011. China’s leaders are nervous that their economy may overheat and have taken some measured steps to slow down the country’s real estate market. Borrowing restrictions have been implemented which seem to have had the desired effect, as the real estate boom has abated somewhat. The risk of future inflation is real, but for now China’s leaders seem to have successfully prevented the economy from overheating. China’s economic rise is no mirage. The country recently surpassed Japan to become the world’s second largest economy and is continuing to power ahead. China faces some headwinds, such as an aging population, lack of transparency in government regulation, and the possibility of internal political conflict. But the country’s potential is obvious to see – China has a dynamic population that values education and is eager to advance up the value chain in the global economy. We believe China’s rise will be the most important factor in the global economy during the next decade.
China’s voracious appetite for commodities has greatly benefitted other countries in Asia, most of Latin America, and important parts of Africa. Past commodity booms have often ended in tears, but there is reason for optimism this time around. China’s emergence is real and the country’s high growth rates are likely to continue, thereby sustaining heightened demand for commodities years into the future. Just as important, most emerging market countries are coming out of this global recession in relatively good macroeconomic and fiscal shape. For example, debt levels across Latin America are manageable, inflation is low, and macroeconomic policies are generally sound. In the U.S. and EU, on the other hand, public debt is uncomfortably high and is set to rise even higher during the next few years. We expect Brazil to grow 7% in 2010 and 5% in 2011. Indonesia will grow 6% in 2010 and 2011, while Chile will grow 5% this year and 5.5% next year. All emerging market countries are not created equally, however, and we are more pessimistic about the long term growth prospects for Russia, which has endemic corruption and terrible demographic trends. Within Latin America, we expect growth in Mexico to trail that of the region as a whole, mainly due to the country’s economic dependence on the U.S. In the developed world we are optimistic about growth prospects for Australia and Canada, which have manageable debt levels and sound macroeconomic policies. These countries are benefitting from China’s growth and rising commodity prices. Australia is set to grow 3% in 2010 and 3.5% in 2011, while Canada will grow 3.2% this year and 3% next.
The U.S. dollar is still the world’s reserve currency and is seen as a safe haven in times of turmoil. The dollar strengthened significantly vis-a-vis other major currencies in the second half of 2008 when the banking system collapsed, and strengthened again earlier this year as the European debt crisis played out. Longer term, however, prospects for the dollar are not bright. The U.S. Federal Reserve has pumped hundreds of billions of dollars into the economy and higher inflation is a threat in the years ahead. Huge budget deficits are piling trillions of dollars onto the national debt and it is likely that at some point foreign governments and investors will lose faith in the strength of the dollar. China is already increasing its holdings of euros and yen, though Chinese leaders still promise that they are dedicated to investing in Treasuries and support a strong dollar. The dollar is down this year against the Japanese yen, as well as the Australian and Canadian dollars. We are negative on the U.S. dollar in the medium- and long term and have positioned our portfolios to take advantage of its fall. We expect the euro to strengthen against the dollar and yen, though its prospects against the major emerging market currencies are not as bright, given Europe’s debt problems and macroeconomic uncertainty. We are more optimistic about the Canadian and Australian dollars, as these countries have manageable public debt levels, responsible fiscal and monetary policies, and are in a position to achieve robust economic growth. We are bullish on some emerging market currencies, notably the Brazilian real and Chilean peso.
There is much hand wringing in the U.S. regarding the value of the Chinese yuan. It is clear that China’s peg to the dollar keeps the yuan lower than it would be if the currency were allowed to float freely, and this is helping China continue its long-term growth strategy of increasing exports. Chinese Premier Wen Jiabao, however, said in late September that the yuan’s value is not the most important factor in the U.S. trade deficit with China, and it seems unlikely that China will allow a rapid appreciation of the yuan any time soon. A slow and measured gain in the yuan is much more likely, as this would allow the Chinese economy time to adjust to a new equilibrium.
Energy
Crude oil is trading around $78 per barrel, down significantly from where it was this spring, but up from its lows of the summer. The price of oil has been highly volatile in recent years, from close to $140 per barrel in early 2008 to close to $30 later that same year. Demand from oil and energy is generally highly correlated with global economic growth, and we expect the price of oil to rise as the emerging market countries continue their hefty growth rates, and the U.S. and EU gradually return to more typical growth levels near 3%. The relatively inelastic supply and demand curves in the oil market results in big price moves with either a demand or supply shift. With this in mind, continued growth in the global economy could result in oil back over $100 per barrel in the next 12 months. This bodes well for energy companies and countries dependent on oil exports, including much of the Middle East, Brazil, and Russia, among others. Natural gas prices have fallen this year, and are now around $4 MMBtu. We anticipate a bottom in the housing market in the U.S., which has us bullish on natural gas and the sector.
Equity Forecast
Stocks were up in the third quarter and the S&P 500 is up 2.3% for the year. The EAFE index, which represents the developed world ex-U.S., trailed the S&P 500 earlier this year but outperformed in the third quarter, rising 15.8%. The MSCI emerging markets index was up 17.1% in the third quarter, while the FTSE/Xinhua China 25 Index rose 9.4%. Corporate spreads over Treasuries are low, despite the fact the equities are barely up so far this year. We see this as negative for corporate bonds and positive for equities. We continue to hold a healthy allocation of emerging market stocks, mainly from China and Latin America. We hold Chinese private education company New Oriental Education, whose stock is up 30% so far year-to-date, and up over 130% from our original entry point in 2009. The company has a high multiple and is susceptible to disappointments in earnings, as all growth companies are. However, the private education industry in China is booming and we remain optimistic on the company’s long-term prospects. We also own Trina Solar, a Chinese company that makes solar panels, whose stock is up over 60% since June 1.
The DBF portfolios have exposure to Latin America, another fast growing part of the world. We own America Movil, which provides cellular phone service throughout Latin America, whose stock is up 15% year-to-date. We also own Chilean electric utility Enersis, which has operations in Peru, Colombia, Argentina, and Brazil. The stock has risen over the last few months, but is still cheap given the long-term potential for economic growth and increased demand for energy in the region. We own Companhia de Saneamento Basico, a water and sewage utility in Sao Paulo, Brazil, and Brazilian steel maker Companhia Siderurgica Nacional. We own Sociedad Quimica y Minera de Chile, which produces lithium and fertilizer in northern Chile’s Atacama desert. There is huge potential for the company’s lithium reserves since lithium is used in hybrid and electric car batteries. The company’s fertilizer business is also poised to do well as agricultural production increases in Asia, North America, and South America. The company’s stock is up over 25% year-to-date. All these Latin American companies are poised to benefit from economic growth in the region, which is largely dependent on continued growth in China and the rest of Asia.
The DBF portfolios hold many domestic stocks as well, including heavy equipment maker Caterpillar, which is up 35% year-to-date, railroads Union Pacific and Norfolk Southern, waste disposal company Republic Services, and truck maker Paccar. We recently sold Alberto Culver, up almost 30% year-to-date, after Unilever announced its intention to acquire the company. We are maintaining an underweight in financials, though we hold Aflac, American Express, and recently added Australia’s Westpac Banking to the portfolios. We are neutral on healthcare with holdings Johnson & Johnson, Amgen, and Israel’s Teva Pharmaceutical, among others. We are bullish on the energy sector and hold Rosetta Resources, Whiting Petroleum, Berry Petroleum, and pipe maker Tenaris. These companies all have exciting growth potentials and are poised to outperform as energy prices increase. We continue to hold natural gas producer Range Resources, whose stock has underperformed so far this year. Range stock has been hurt by falling natural gas prices, but we think natural gas is poised to rise over the next 12 months and we’re bullish on the stock.
We are most optimistic about companies in the emerging markets and those in the developed world that will benefit from emerging market growth. We rebalanced the DBF Passive Core portfolios in September, increasing our exposure to emerging market and international developed (ex-U.S.) equities. We added exposure to Australia. We are maintaining exposure to the inflation protected Barclays TIPS Bond Fund in the DBF Balanced portfolios. Inflation has been low so far this year, but loose monetary policy by the Federal Reserve is likely to lead to higher inflation in the years ahead. A typical DBF Diversified Core account was up 15.9% in the third quarter, is up 9.1% year-to-date, and has risen 5.3% annualized since January 1, 2005, outperforming the S&P 500 by almost 500 basis points. A typical DBF Passive Core account was up 14.4% in the third quarter and is up 6.1% year-to-date, outperforming the S&P 500 by more than 320 basis points. A typical DBF Balanced portfolio (which includes about 40% fixed income) was up 9.1% in the third quarter, is up 8.4% year-to-date, and has risen 5.8% on an annualized basis since January 1, 2005.
Fixed Income Forecast
Yields on U.S. Treasuries fell to new lows for the year during the third quarter. The 2-year Treasury yield fell 18 basis points to a level of 0.42%, while the 10-year dropped 42 basis points to end September at 2.51%. Corporate bonds continued their dominance over other bond market sectors with a 4.71% return for the third quarter. The biggest gainers within the corporate sector have also been the lowest rated companies, which shows investors are hungry for yield and are willing to take more risks to achieve it. Treasuries returned 2.73% for the quarter, while mortgage-backed securities returned only 0.63%.
At their September meeting Fed policymakers said they believed inflation to be too low and their comments pointed to an inflation target of about 1.5%. They also indicated their willingness to implement further easing of monetary policy by increasing purchases of U.S. Treasury bonds by the Federal Reserve, which would have the effect of increasing bank reserves even further. We are dubious about the benefits of further asset purchases by the Fed. With banks already sitting on $1 trillion of excess reserves, would another few hundred billion in reserves suddenly trigger lending by banks? We doubt it.
The question in the back of everyone’s mind seems to be whether or not the U.S. is headed for a Japan-style regime of slow deflation, high government borrowing, and sub-3% interest rates for the next 15 years. We don’t believe the U.S. will be Japan II, but the probability is certainly greater than zero. The Fed is doing its best to guard against that possibility by boosting bank reserves to unheard-of levels. However, that may be equivalent to “pushing on a string” because consumers are reluctant to borrow and banks are reluctant to lend. Thus, it is the transmission of monetary policy that has broken down in the banking system. Banks are paranoid about lending given the current economic picture, and more importantly, all the new regulation being placed on them by governments around the world. Consumers are not borrowing either as is illustrated by the dramatic increase in personal savings rates from 0.7% of disposable income in 2005 to 5.8% now in 2010.
Yield Curve and Forecast
This cycle of caution and fear that pervades the economy will eventually be broken by a combination of the following: a bottom in housing prices, improvement in jobs and employment, a flattening or reduction in savings rates by consumers, and stability in banking regulation and capital requirements. The timing of these outcomes is uncertain, but we do expect slow improvement over the coming quarters. As the economic picture gradually improves, interest rates will rise and the yield curve will flatten. Short-term rates will rise swiftly when the Fed signals its intent to tighten, which may not happen until mid-or late 2011.
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