2010, Quarter 3
The United States
The Great Recession of 2008 – 2010 is over but weak demand in the U.S. is still holding back growth. The unemployment rate remains at a stubbornly high 9.5%. Jobs figures released in late June were disappointing with private sector job growth basically flat. Investors are worried that the government is running low on policy options. The European debt crisis has temporarily boosted the dollar as investors retreat to the perceived safety of U.S. assets, but this will hinder U.S. growth as exports become less competitive. Continued weakness in the housing market has prevented the recovery from taking hold more forcefully. Home prices appear to be stabilizing in many of the hardest hit markets—South Florida, California, Las Vegas, and Phoenix—yet the possibility of continued falling prices looms, and with it the risk of a double-dip recession.
Fed Chair Ben Bernanke has been winding down the Fed’s quantitative easing program, most notably by no longer purchasing mortgage backed securities, yet disappointing growth in the U.S. combined with increased nervousness in equity markets regarding the European debt crisis make an increase in the Fed Funds Rate unlikely this year. Bernanke did not foresee the recession early in 2008 but nobody can accuse him of being timid or unimaginative in his response to the crisis. Over the last two years Bernanke has clearly shown himself willing to risk future inflation to decrease the risk of the U.S. falling into a second Great Depression. The tepid pace of the recovery will prompt him to keep rates low for a while longer. When the Fed finally begins to raise rates, probably early next year, it will try to do so slowly and cautiously, barring sudden gains in inflation and inflationary expectations.
Certainly there are many things worrying policy makers and investors alike, yet there are also reasons to be optimistic on the U.S. economy’s prospects in the short and medium term. Job growth has been disappointing in recent months but it has been positive, indicating that aggregate demand is finally beginning to perk up. Credit markets are still not back to where they were before the crisis hit in 2008, but they are in considerably better shape than in the darkest days of early 2009. Many bailed out financial firms have repaid their TARP funds and are gradually repairing their balance sheets. We expect the U.S. economy to grow 3.3% for 2010 as the private sector begins to grow again, government stimulus continues, and aggregate demand picks up. We do not believe the economy will fall back into recession. The U.S. economy will continue to grow at a 3.0% rate in 2011.
Of special note is the financial regulatory reform bill in Congress. The bill offers some important and useful changes to the financial system, yet some of the fundamental issues that helped cause the financial crisis are not resolved by the legislation. Restrictions on proprietary trading by investment banks, added protections for borrowers, and increased regulation of exotic derivatives are important reforms, yet the fundamental issue of giant banks posing a systematic risk to the economy is not adequately addressed. Regulators will not be required to break up giant banks and bank regulators will again be allowed to use taxpayer money to pay the creditors of banks facing collapse. Clearly, the issue of moral hazard will not be resolved by these reforms, and the seeds of the next financial crisis may already be in place.
The Euro Crisis
The original budgetary restrictions on Euro zone countries designed to ensure fiscal discipline were never enforced and now Germany and other countries with responsible fiscal policies have been forced to bail out their profligate southern neighbors. The question of moral hazard is unresolved and the status quo is politically unsustainable in the long run. The EU’s bailout package announced in May was designed to prevent a Greek default and to assuage investors’ fears of possible defaults in Portugal, Spain, and Italy. However, the package has not proven to be the silver bullet European leaders had hoped for. 
New worries about Hungary defaulting on its debt sprung up in early June, posing a risk to the very fragile and highly interconnected European banking system. In late June Moody’s announced that it had placed Spain’s sovereign bonds on review for a possible downgrade. The Euro has continued to fall against the dollar and speculation is growing that key Euro members – most notably Germany – may eventually decide to pullout of the monetary union. Investors are becoming increasingly skeptical about European leaders’ ability to maintain the Euro in its present form. As the Euro falls, the pressure on politicians increases and the risk grows that collapse of the Euro may become a self fulfilling prophecy.
The Euro in its present form will only be saved by a fast recovery in the global economy, coupled with a calming of credit markets both in Europe and around the world. If growth returns to Europe soon it will buy EU leaders time to reform the Euro. If Europe and the global economy fall back into recession and credit markets remain in turmoil, the Euro will continue to fall and the growing political pressure facing European leaders will prompt more to advocate pulling out of the currency. Much of this hinges on Germany, which is the linchpin of the European currency and whose pullout would result in the Euro’s collapse. Our forecast is for economic growth to pick up later this year in Europe, thereby giving leaders more time to make the needed reforms to the Euro. We believe the Euro is likely to survive, though not in its present form nor with its present framework. Some countries may be forced out and budgetary requirements will have to be more strictly regulated. In any event, it is likely to be a bumpy ride for the Euro over the next six to twelve months. The Euro-zone will grow at a rate of 1% in 2010 and by 1.5% in 2011.
Inflation
Inflationary expectations have remained benign so far this year, and interest rates fell in June as investors shunned risky assets and bought Treasuries. The extremely low interest rates seen at the end of the second quarter will not last, however, as the specter of inflation is hanging over the United States and other developed economies. The Fed has kept interest rates very low for almost two years in response to the worst recession since the Great Depression. A new depression has been averted but Bernanke seems to have fallen into the
same trap that has ensnared other Fed chairmen: adjusting interest rates from very high to very low, constantly chasing the present crisis and never getting ahead of the next. Alan Greenspan followed these same policies by raising interest rates, which helped spur a recession in the early 2000’s, and then set the stage for the housing bubble with very low rates thereafter. We agree with Dallas Fed president Koenig that the massive increase of the monetary supply over the last two years is likely to lead to unacceptably high inflation in the future and that the Fed should begin to increase interest rates very soon to stem that threat. Inflation in the U.S. is likely to increase to 4-5% in the next few years, significantly outside the Fed’s target zone. The Fed is likely to respond to this by quickly raising rates, thereby continuing the boom and bust policies begun under Greenspan. Inflation in the EU is also set to rise as aggregate demand recovers this year and next, though it is unlikely to rise as high as that of the U.S.
Emerging Markets
Economic growth prospects are much better in the emerging markets than they are in the developed countries. China will grow by 10% in 2010 and by 8.5% in 2011 as its economy continues to transition away from low tech manufactured goods to high tech products. The Chinese government recently tightened mortgage rules for individuals buying investment properties in a move designed to slow down the country’s booming real estate market. Rapid increases in the Chinese real estate market are reasons for concern but the long term prospects for the Chinese economy remain very bright. Countries supplying China with natural resources – including Australia, Brazil, Chile, and Indonesia – will benefit greatly from China’s growth during the next 5-10 years. Brazil should grow at a rate of 6% this year while slowing down to 4.5% in 2011. India will grow by 7.5% this year and by 8.0% in 2011. Indonesia will grow by 5.5% this year and by 6% next year.
There is risk that many investors plowing their money into the emerging markets fail to differentiate among the highly varied countries in the sector. Investors must be cognizant of this reality because in the long-term growth levels among the emerging markets will depend largely on each individual country’s levels of education, regulatory regimes, and government stability. The developing countries excelling in these categories will have the highest growth over the long-term. Investors should put their money in the emerging market countries with the best long-term prospects (i.e., China, Brazil, Chile, and Taiwan) and should avoid countries such as Russia, Argentina, and Peru, which have unacceptably high levels of corruption and less transparent legal and regulatory frameworks.
Currencies
The U.S. dollar has strengthened significantly so far this year vis-à-vis the Euro as investors doubt the long term viability of the European currency. The Euro will continue declining as news of Europe’s fragile banking system scares investors and Euro zone politicians continue to argue about the currency’s future. The dollar, however, is not an especially attractive currency for investors, as budget deficits in the U.S. remain at alarming levels and public debt levels escalate. Treasury yields are very low and have fallen in the last month but eventually U.S. public debt will hit a tipping point in the minds of investors and the dollar will no longer be considered completely safe. Such a change is likely to happen very suddenly and unexpectedly in the market, and may only be a few years away. Given the troubled prospects of the Euro and the U.S. dollar, investors should diversify into the fastest growing parts of the developing world, such as Brazil, India, China and countries in the developed world with responsible fiscal policies such as Canada and Australia.
Energy
Oil prices have declined in recent months as risks of a further slowdown in the global economy have increased. The disastrous oil spill in the Gulf of Mexico, however, will help push up oil prices in the medium term. We were bullish on oil before the spill and the certainty of future restrictions on deep-water drilling around the world have us even more bullish on energy now. President Obama’s plan to increase off-shore drilling, announced just weeks before the destruction of the Deepwater Horizon rig off the coast of Louisiana, is in tatters. The U.S. will almost certainly be much more cautious about allowing new off-shore drilling, especially in deep water. Other countries with good prospects for offshore drilling — most notably Brazil — have undoubtedly taken note of the terrible situation in the Gulf of Mexico and will be forced to put new restrictions on ocean drilling. This will help push oil prices up during the next few years. Increased demand from China and other emerging economies will push energy prices higher also, as will the nascent recovery in the U.S. and Europe. Investors should keep in mind the relatively inelastic global demand and supply curves for oil, which lead to large price increases when global demand increases and supply decreases
Equity Forecast
Stocks have fallen since early May as the crisis in the euro zone has worsened and the possibility of a double dip recession has increased. U.S. equities have outperformed international stocks from developed markets so far this year, with the S&P 500 down 7.6% year-to-date. The MSCI EAFA index, which includes stocks from Europe, Australia, and Asia, has been hurt by the crisis in Europe and is down 12.8% year-to-date. Emerging markets stocks are down as well, with the MSCI Emerging Markets Index off 6.1% year-to-date, and the Xinhua China 25 Index down 4.7%.
The emerging market economies have the best prospects for growth in the years ahead and we own many emerging market equities. We own Chinese, Hong Kong, and broad emerging market exchange traded funds, which should all do well as China continues to grow and demands more commodities. Latin America is benefitting from China’s voracious appetite for commodities and we are bullish on Brazil and Chile. We continue to hold Sociedad Quimica y Minera de Chile, which produces fertilizers and lithium used in hybrid car batteries. The stock is down somewhat this year but its long-term growth prospects are very bright and its valuation is compelling. 
We recently added Companhia de Saneamento Basico to the portfolios, a water and sewage utility in Sao Paulo, Brazil. The stock is set to rise as Brazil continues growing and basic water services are expanded to more people in the giant state of Sao Paulo. We continue to hold New Oriental Education, a Chinese company providing English and test preparation classes. The stock is up 20% so far this year and has more than doubled since early 2009, making it one of the best performing stocks in the portfolio. We recently added Trina Solar to the portfolios, a Chinese company that makes solar panels for commercial and residential use. The stock is down so far this year and given its excellent growth possibilities looks like a bargain at current prices. We hold Whiting Petroleum, which is up 22% year to date, and Berry Petroleum, which is up 9%.
We have maintained an underweight position in European stocks and have avoided much of the fallout from the Euro crisis. We recently added two financial positions to the portfolio – American Express and Hartford Financial – which are poised to benefit from a recovering economy in the U.S. and continued healing in the credit markets. We still have a slight underweight in financials, however. We are maintaining a neutral position in health care stocks, with positions in Teva Pharmaceutical, Stryker, and Amgen. We continue to hold Boeing, whose ultra modern 787 will enter service later this year, and L-3 Communications, whose high-tech defense products are in high demand. We own positions in other companies that will benefit from a global economic recovery, including heavy machinery maker Caterpillar, power management company Eaton, truck maker Paccar, and railroad operator Norfolk Southern.
With the decline in equity prices, we have put cash to work and are now fully invested. We are more bullish on stocks than we were earlier this year, as the market has sold off in response to trouble in Europe and slower than expected growth in the US. A lot of bad news has already been discounted by the equitymarkets and we think stocks are poised to increase as economic growth in the US becomes stronger than expected and growth in the emerging markets continues to be strong. The DBF Diversified Core portfolio is down 5.82% year-to-date, outperforming the S&P 500 by 175 basis points and the MSCI World Equity Index by 460 basis points. Over the last year the DBF Diversified Core is up 17.96%, beating the S&P by 584 basis points. Since January 1, 2005 the DBF Diversified Core is up 15.54% and the DBF Diversified Passive Core is up 11.70%, outperforming the S&P 500 on an annualized basis by 560 basis points and 496 basis points, respectively.
Fixed Income Forecast
The recent events in Europe and the flood of money into U.S. assets has pushed Treasury yields down significantly. This, in combination with the ongoing risks to the U.S. and global economy is likely to keep Federal Reserve interest rate policy on hold in the near term. Inflation has remained very benign, which gives the Fed added flexibility to maintain an accommodative monetary stance for a while longer. We have adjusted our short-term forecast of interest rates and inflation given these factors, but our overall theme for the next 18 to 36 months remains in place: higher U.S. Treasury yields, and unanticipated high inflation in the range of 4%. We expect interest rates to remain volatile but to rise modestly over the next couple quarters. We expect a sustained rise in interest rates in mid 2011 as a self sustaining U.S. economic recovery gains traction and the Fed scrambles to tighten monetary policy. We expect yields between the 2-year and 10-year Treasury to be 25 to 50 basis points higher by the end of this year, and 100 to 120 basis points higher by the end of 2011.
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