2010, Quarter 2
Global Economic Forecast
The “Great Recession” appears to be behind us but the U.S. economy is still burdened by a struggling banking sector, damaged credit markets, and a weak housing market. Credit markets appear to be loosening, but the days of easy credit for high-risk borrowers are over. Traditional banks are benefiting from a steep yield curve, but they have a long way to go to clean up their balance sheets and generate significant profits. Housing prices, whose historic fall has been a huge drag on the economy, have stopped their descent, but the risk of further price declines loom as the Federal Reserve stops purchasing mortgage backed securities and mortgage rates tick upward.
The unemployment rate in the U.S. remains high at 9.7% despite recent reports that the economy is adding jobs at a modest pace. We expect the unemployment rate to stay high throughout this year and into 2011 as discouraged workers re enter the workforce and companies cautiously add new workers. The U.S. economy is facing large structural problems. Fiscal deficits and public debt are approaching alarming levels, and despite much posturing, there appears little political will in Washington to rein them in. This spells trouble down the road, and in the next few years the country is likely to hit a tipping point when investors begin to doubt the ability of the government to repay its debts without deflating the U.S. dollar. When this happens interest rates will rise, thereby choking off economic growth. It is clear that both President Obama and Fed chairman Ben Bernanke believe the risk of a “double dip” recession is high, and that significant government stimulus must remain in place. Bernanke is ending the Fed’s purchase of mortgage backed securities but appears months away from raising the Fed Funds Rate, and President Obama is promising large budget deficits for years to come. Both Obama and Bernanke might be correct regarding the weak recovery, but huge fiscal deficits and loose monetary policy are sowing the seeds of inflation and are causing the tipping point to approach faster than it otherwise would. We are cautious on the prospects for economic growth in the U.S. over the next few years and are bearish on the dollar’s prospects. We expect the U.S. economy to grow 3.0% in 2010, which certainly cannot be considered robust given the recent severe economic contraction.
The healthcare bill recently passed into law is adding to the uncertainty facing the U.S. economy. Health economics is a complicated field and it’s difficult to predict with certainty how the new law will impact government finances, healthcare profits, and productivity levels over the long term. The non partisan Congressional Budget Office (CBO) contends the law will reduce the federal budget over the next 10 years, but many argue the assumptions in the CBO’s models are unrealistic and mask the law’s true costs. Some of the law’s proponents argue plausibly that increased access to health insurance and healthcare will increase productivity, as more people are afforded access to preventative care. Our view is that the new law will have some positive economic benefits, but is likely to cost the federal government more than the current administration is thinking, and will add further pressure to the deficit and national debt down the road. Interestingly, most healthcare stocks were up the day after the bill’s passage. This reaction is meaningful since the bill’s passage was not fully discounted even the Friday before the final vote in Congress — passage was in doubt even the day of the vote. In contrast to conventional wisdom, the law might be beneficial for health insurance companies, since more people are now required to buy insurance. The effect on the healthcare industry over the long run is unclear, but is likely to be innocuous for most companies in the sector. The more difficult and consequential questions about the cost of care were left for future political debates, and are unlikely to be tackled any time soon.
The yield curve for U.S. Treasuries is still steep and has been inching up as investors continue to gain more faith in the economic recovery and look to buy higher-yielding assets. The 2-year is set to yield 1.05%, 27 basis points higher than a month earlier, while the yield on the 10-year is up 26 basis points to 3.83%. Rising yields are consistent with our forecast of a modest economic recovery and increased expectations of inflation. We expect the yield curve to continue rising in the second quarter and for the rest of this year, and therefore we are avoiding long duration bonds.
Oil is now selling at $85 a barrel, up from $71 in early February. This rise is even more significant since, unlike previous periods of rising energy prices, the U.S. dollar has been gaining over this time period. The strength in energy prices is indicative of a strengthening global economy, and we expect prices to continue to increase as global economic growth continues and demand increases.
Like the U.S., Europe faces heightened uncertainty and a difficult economic environment. Some of the E.U.’s smaller members are finding it difficult to roll over their very high debt loads. Greece has been the main story during the last few months, but the country’s problems are less important for the continent now that its debt crisis is unlikely to spread to the larger economies of Italy and Spain. The E.U. is still hashing out the details, but it appears very likely Greece will get bailed out with subsidized loans from the IMF and other E.U. countries in the next couple months. Greece’s woes have been bad for the euro and good for the U.S. dollar, as investors have moved their funds into U.S. assets in a “flight-to-quality” trade. The dollar was up 6% versus the euro in the first quarter. Greece’s plight has caused many to bet that the euro’s 10-year secular rise against the dollar is over, and that the dollar is poised to continue the rise begun last December. We are still pessimistic on the dollar’s prospects, however. The most serious fiscal problems facing the euro zone are within its more peripheral economies – Greece, Portugal, Italy – while its largest and most important countries – Germany and France – are in much stronger financial shape. The fiscal situation in the U.S. is considerably worse than that seen in the E.U.’s biggest economies, and loose monetary policy and rising inflation in the U.S. over the next few years will pressure the dollar. The European Central Bank’s single mandate of price stability has made its monetary policy significantly more restrictive than what is seen in the U.S., which should further bolster the euro.
Like the U.S. and the E.U., Japan faces continued slow economic growth and is grappling with a huge debt load. Japan’s public debt is approaching 200% of GDP and the country’s political class, famous for frivolous spending on worthless public works projects, appears unable to enact badly needed reforms. Japan is set to grow 1.5% in 2010 and will record moribund growth rates for the foreseeable future.
The prospects for economic growth are much better in the emerging countries of Asia and Latin America than they are in the U.S., E.U., and Japan. China’s GDP should grow close to 10% this year, and its appetite for commodities is fueling growth in other emerging countries. Brazil and Chile will expand around 5% in 2010, as they supply China with increasing quantities of agricultural products and raw materials. Indonesia and Malaysia will grow more than 5% this year, while India should grow even faster at 7%. The main issues that have held back emerging economies in the past – rampant inflation, debt crises, political instability – are less of a concern today as many of their leaders appear to have learned from their predecessors’ mistakes. There are countries in the emerging world still living with these old problems (Venezuela and Argentina are examples) but the overall environment in the emerging markets is much better than in the past, and prospects for economic growth are bright. The countries with political stability, strong governmental institutions, limited corruption, and high levels of education are likely to have the fastest growth. That makes us most sanguine about countries such as China, Brazil, and Chile, and more cautious about countries such as Russia.
China is the key driver of global economic growth, and will remain so for the foreseeable future. There are some storm clouds on the horizon for China, however, that pose risks to investors. Real estate prices in the country have been shooting up and there is risk that a bubble is forming. A popping of that bubble, whether by market forces or government intervention, will slow economic growth. We believe the Chinese government will be able to manage this issue without significant impact on economic growth, but this is clearly an important issue and one we are monitoring. Also, Google’s decision to pullout of China after refusing to censor search results could portend new strains in the relationship between the U.S. and China. Conflict is in neither country’s interest, however, and we expect the status quo of increasing trade and economic integration to continue. The Chinese authorities are likely to allow the yuan to strengthen modestly later this year. Doing so will tamp down criticism from Washington and will benefit Chinese consumers. China’s leaders have shown aversion to big moves, and any change will be slow and cautious.
Europe and the U.S. are coming out of this recession weakened and facing difficult economic and political tests in the future. Growth prospects are somewhat bleak as housing remains anemic, public debt levels continue to rise, and inflation threatens to debase currencies. Much of the emerging world, on the other hand, is coming out of the recession in relatively good shape, with huge foreign reserves, strong currencies, and excellent growth prospects.
Equity Forecast
Equity markets sold off in late January and early February as worries about Greece’s debt levels hit a fever pitch, but have since recovered as fears of contagion abated. Greece’s crisis does not currently threaten the larger E.U. economies of Spain, Portugal, and Italy, as was originally feared, and these countries have more time to get their fiscal houses in order. The ultimate solution to Greece’s predicament is still unclear as the first quarter is ending, but the country has already begun to cut spending and is likely to get subsidized loans from the IMF and/or other E.U. countries in the future.
The S&P 500 finished the first quarter up 5.38%, leading the world’s major indices, as investors put their money into the perceived safety of U.S. dollars. The MSCI Emerging Market Index finished the quarter up 2.34%, while the FTSE/Xinhua China 25 Index fund was down 1.94%, and the MSCI EAFE Index (Europe, Australia, and Japan) was up .98%. Small cap stocks within the U.S. did especially well, with the Russell 2000 Index up 8.85%.
Equities around the globe have experienced a historic bull market from their lows in March 2009, but are still far below where they were in mid-2008 when the severity of the recession and banking crises first became evident. Treasury yields are inching up, consistent with a strengthening economy, but are still low by historical standards (the yield on the 10-year note finished the quarter at 3.83%). Low interest rates are positive for stocks, and investors’ appetite for risk should continue to increase as economic growth picks up, banks get back on their feet, and credit markets normalize.
We continue to believe that China will be the engine of global economic growth over the next few years and have positioned our equity portfolios to take advantage of China’s emergence. We own New Oriental Education, a private educational services company in China, which was up 13% in the first quarter. We also own the S&P China Index Fund and have added exposure to Australia with the MSCI Australia Index Fund. Australia, together with parts of Latin America and Africa, is benefiting greatly from China’s huge and increasing demand for commodities. We also hold some Latin American stocks, including America Movil, which has wireless services throughout Latin America, and Sociedad Quimica and Minera de Chile, which produces fertilizer and lithium used in medical products and batteries, including batteries used in electric cars. We also hold Enersis, a utility company focused in Chile but with operations throughout South America. The recent earthquakes in South America did not do much damage to Enersis’ Chilean grid, though there were some blackouts in the immediate aftermath of the main quake. Enersis stock has fallen somewhat in the last few weeks, principally because the Chilean peso has fallen, and we see this as a buying opportunity. We also own Petrobras, which stands to benefit from the huge oil reserves recently discovered in deep water off Brazil’s coast. The company is raising funds in preparation for a major ramp-up in production over the next 5 to 10 years. DBF portfolios also include U.S. companies set to benefit from emerging market growth, including heavy machinery maker Caterpillar, commercial airplane and defense giant Boeing, and truck maker Paccar.
We have maintained our positions in energy names Berry Petroleum, Range Resources, and Whiting Petroleum, and remain positive on the energy sector as global economic growth and demand for energy continue to increase. We’re maintaining our positions in the defense firm L-3 Communications, whose high-tech products are likely to survive budget cuts in Washington, and high quality healthcare companies Stryker, Johnson & Johnson, and Teva Pharmaceutical. We have maintained an underweight position in financials throughout the recession and banking crisis, though we currently hold Aflac, which was up 18% in the first quarter. We also hold high-quality U.S. companies Garmin, Ball, Alberto-Culver, and Fedex, all of which have excellent long-term prospects.
Stocks are poised to outperform bonds over the next year or two as economic growth continues, the banking and credit markets return to normal, and the flight-to-quality trade propping up U.S. Treasuries tapers off. The best performing sectors will be those benefiting from economic growth in emerging markets generally, and China in particular. Our portfolios are positioned with this in mind. However, given the big run-up in equities over the last year we’re cognizant of the heightened risk of a short-term correction, and we have raised cash to around 10-15% in most accounts. This cash will allow us to pick up some bargains if stocks pullback. We are currently investigating financial and energy names (including alternative energy) to add to the DBF portfolios.
Fixed Income Forecast
Corporate bonds continue to be the stars of the fixed income market; the investment grade corporate bond sector is up over 23% in the last 12 months. However, their momentum has slowed as yield spreads have dropped to pre-crisis levels on corporate bonds. Commercial mortgage-backed securities are leading all sectors year-to-date with a return of 9.10%. In the U.S. Treasury market yields ticked downward uneventfully during the first two months of 2010 until March when they reversed course. Improving economic news, combined with relatively weak Treasury debt auctions resulted in a spike in yields that continued into the first few trading days of April. As stated above, we expect Treasury yields to continue to rise across the maturity spectrum during 2010 and into 2011. We still expect to see the 2-year Treasury in a range of 1.5% – 2.5% by the end of the year, with the 10-year in a range of 4.0% to 5.0%. Consistent with our forecast of higher interest rates, we are investing in short duration bonds, which will allow us to quickly capture rising rates. We are avoiding long duration bonds.
The next Fed meeting is scheduled for April 28th and we don’t expect any change in the Fed Funds rate to come out of the meeting. However, given the recent improvements in economic data (rising payrolls, stabilizing unemployment, rising retail sales, etc.) we expect some changes in the language of the Fed statement, which should begin to transition market expectations toward an increase in rates. We still think the first rate increase will come sometime during Q3 of this year and it looks like the short-term bond markets are beginning to reflect that. We expect the yield curve to begin to flatten (short rates rising more than long rates) as this year progresses.
Inflation, seemingly benign according to many current indicators, is still looming down the road of this economic recovery. The Federal Reserve’s track record of anticipating inflation and/or market bubbles leaves a lot to be desired. We expect the Fed to begin to tackle the potential inflation problem as they remove some of these accommodating monetary policies over the coming months. However, we believe the horse has already “left the barn” in terms of future inflation over the next few years, which is why we still think TIPS (Treasury Inflation Protected Securities) are a safer haven than normal non-adjusting Treasuries.
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