The stock market and investor sentiment have recovered since the March lows but going forward are we out of the woods? Negative economic news is subsiding and confidence is building. We see this in the renewed interest in US stocks as well as bonds and international investments. The financial turmoil of the past two years rocked consumers and investors around the globe and changed attitudes toward spending and risk. Corporate, municipal and individual balance sheets took a devastating hit as debt levels and years of spending caught up with us. It is unreasonable to expect a normal recovery while we materially change the way we spend and invest. As Bill Gross of Pimco says, we need to adjust to the “new normal”.
We can look back and compare this global economic free fall to past recessions and the Great Depression or we can look forward and think about the opportunities and challenges ahead. Below are some thoughts and potential problems as the economy moves toward full recovery:
Extraordinary events and threats invite government intervention. World banks dramatically lowered interest rates and inked the presses to provide liquidity to shore up the financial markets. The potential result is inflation and higher interest rates. This recession will most likely be followed by a not- so- robust recovery. Slower than normal spending and growth could be a blessing in disguise. Run- away inflation and higher interest rates are less likely if growth is slow for the next several years. It is hard to tell if we are really in a recovery mode. For example, the auto industry has been bailed out in several ways – with funds to restore financial health as well as the most recent “cash for clunkers” program. Have government supported auto sales today taken away from future demand? Stimulus checks in the mail shored up spending and the housing market has been supported by first time home buyer initiatives. Will the “green shoots” we see as economic recovery die when the government steps aside? Will the government be able to step aside or will they continue as the consumer and investor watchdog? Capitalism as we know it is threatened if governments intervene too much or for too long to shore up world economies. Private enterprise and capital formation are the life-blood of the American system and need to flourish if we are to remain the dominate world power. This means some risk taking with plenty of incentives to invest. We would have laughed at government ownership of our largest banks and major auto company but here we are in America’s lost decade. Barak Obama the candidate said “what Washington needs is adult supervision”. He also said “you will not see your taxes increase one single dime”. Is it possible to have bailouts and numerous plans to “supervise” and grow government without higher taxes?
It will be some time before consumers and corporations reduce debt levels and recover from the spending binge of the past decades. US consumer spending comprised 72% of GDP in 2007 while household savings dropped to zero. The wealthier we felt the more we spent! The rest of the world went along for the ride. The US consumer is now in a multi-year contraction as we wean ourselves off this consumption binge. For the first time in 20 years Americans have turned off the lights – literally. US power consumption is down as fears of job loss prevail. The new consumer bargain hunts, saves money before buying, worries about finding or keeping a job and is trying to pay down debt. Year 2010 marks the beginning of the retirement phase for the Baby Boom generation. These 77 million people will spend on the items they need – healthcare, food, etc. – and not on discretionary items such as furniture, jewelry and designer clothing. The acquisition phase is behind the Baby Boomers who will no longer create asset bubbles as they age. This generation is projected to see a decline in their wealth by 2018 with a net draw down in pension assets and 401k plans. This shift in wealth and spending patterns will have a dramatic impact on our economy, corporate profitability and the capital markets.
US GDP growth may be as high as 4% in the next quarter as the economy swings back from recession but going forward we can expect more muted growth. Retail spending will not rebound as it has after past recessions as savings becomes the new norm. We are witnessing a profound shift in the drivers of our economy.
Bernanke has his hands full! His academic understanding of the Great Depression helped us see that to sit back and do nothing could and would have had dramatic consequences. It is likely the jobless rate will remain high long after the economy is in recovery mode. Unemployment benefits will run out and with a slower than normal economy companies may not have robust revenue growth and be reluctant to increase payroll costs. The government will continue to fund programs to help those in need while trying to reform the healthcare system. How does Obama keep his promise not to raise taxes a dime? When economic health is restored the task of unwinding the massive borrowing and reduce the deficit will be daunting! If global growth accelerates we could be in a slower than normal US economy with rising inflation and interest rates. The Fed and other central banks inked the printing presses and inflated the world out of the downturn. Warren Buffet coined the term “greenback emissions” meaning there are too many dollars circulating in the system. Bernanke will have to turn off the tap slowly and gradually raise interest rates to restore our financial system to normal. A delicate balance in the face of so many challenges!
Growth is not dead as we count on the emerging markets to carry the ball. America dominated the world markets for most of the 20th century. This is no longer the case. China is the number one engine of economic growth with estimates for GDP to increase 9% to 11% in 2010. China owns roughly 20% of our government issued debt and we rely on them to buy our products. We are linked to China in many ways and more dependent upon them than many would like. US companies with the best growth profile are those that sell and export goods and services to the emerging economies where the middle classes are growing. The US economy has to rebuild where China has to build. We will witness commodity driven inflation as spending ramps up again in the emerging countries and there is always the risk that bubbles will be created just as they were in the US. Car sales in China are up over 40% this year and home sales are soaring. The government of China encourages spending and this demand will mean more revenue for American companies operating in China. American companies will look beyond our borders for revenue growth.
There are other risks on the horizon that could derail our modest recovery and erode confidence. The level of commercial mortgage defaults more than doubled in the second quarter compared to a year ago. This market is in the early stages of distress while the residential housing market is showing signs of stability. Banks hold about $ 1.3 trillion in commercial mortgages and half a billion dollars in construction loans. A good percentage of these loans will come due in the next few years. Commercial mortgage backed securities account for over 20% of the commercial debt outstanding and defaults in this area are rising. If this segment of the real estate market plays out like the residential market our banks and financial system could be in for another round of shocks.
Many of the stimulus programs are scheduled to wind down which poses another risk. How much of the recovery in the housing market and auto industry is related to government programs? Could we see another period of distressed home sales as stimulus support is withdrawn? Fortunately housing prices have fallen to the point where homes are more affordable than they were the first time around. Unemployment is likely to peak above 10% and companies will be slow to hire again which would further dampen spending and therefore corporate profitability.
Healthcare reform is a big question mark in terms of investor confidence and economic projections. Most everyone agrees that some form of healthcare reform is urgently needed. 85% of Americans have health insurance but the 15% who don’t are a drain on our economy and the well being of our country. The focus seems to be on the price of healthcare and rising costs. However, price is not the issue – utilization is! The amount of treatment and overuse of diagnostic tests is increasing and wasteful. Prices would decline materially if there were incentives for a healthy lifestyle, if doctors were paid not by procedure but by results and if tort reform were part of the package. This would reduce the number of prescriptions, surgeries and employer and individual costs for people who remain healthy. Healthcare reform won’t work on price alone. We have seen this with our Medicare system – the cost of which grows each year. If taxes are imposed to pay for healthcare reform without some means to reduce utilization we will end up with a very costly system that drains our resources. This will ultimately lead to rationing of healthcare.
We have plenty to worry about but the worst is behind us as a nation and globally. The stock and bond markets have rebounded-not to the highs in 2007-but to the point where many investors can open their brokerage statements without fear. A surprising number of US companies reported earnings above estimates in the second quarter. This was in spite of revenue declines suggesting that once the economy and global markets rebound profitability will follow. US corporations learned from past recessions. They have been more proactive in cutting costs – especially labor – and they continue to aggressively outsource other costly functions. This explains the reported productivity and margins at high levels compared to past recessions. Companies are also better at guiding Wall Street and investors to realistic earnings expectations to avoid surprises.
The key to stability in the stock market is revenue growth and sustainable earnings growth. There are only so many costs companies can eliminate and still operate efficiently. There will be jitters around this next quarter’s earnings announcements which will confirm whether or not there is meaningful revenue recovery. It is difficult to predict the stock market in the short-run and it is possible we will see an 8% to 10% decline as we go through this muted recovery, especially if some or all of the concerns listed above play out. Over the long term investors will focus on stability of earnings, quality earnings and will be better served in large, multi- national companies.
The past definition of international investing may not apply as the world’s borders disappear. Where a company is headquartered will matter less than where they generate revenues. Is Coca Cola a US company with over 50% of their revenues from outside the US? Yum Brands earns 50% of their revenues from emerging markets. This is more than some non-US companies. We have learned a painful lesson in this downturn – US and foreign stocks are highly correlated – meaning they move together. What really matters is which companies you hold in your portfolio and the composition and quality of revenues and earnings. It follows that if growth is higher outside the US then companies with revenues outside the US will do best. Investors, especially retired Baby Boomers, will gravitate toward those US multi-national companies that pay a dividend and have for many years or companies with very consistent earnings growth.
The best way to achieve superior investment results in a slow growth economy is to avoid companies with problems and invest in those with dependable earnings. Low quality, high risk investments have performed best in this market recovery since March for a variety of reasons, including short covering and a rebound from very low levels. This is typical after such a dramatic market decline. However, concern for risk and preservation of capital will be a factor in deciding which companies perform best for several years. Investors won’t forget such a dramatic decline in wealth any time soon.
The bond market has also recovered as a result of renewed confidence as well as low interest rates. Low quality and financial company bonds kept pace with the stock advances since March. The result is extremely low yields and very high prices for quality bonds. Dividend yields for many US stocks are now higher than bonds. The climbing deficit and fear of inflation is likely to drive interest rates higher, not lower, in years to come. Policymakers eased interest rates near zero to help shore up the economy and combat recession. The next phase will be a gradual increase in interest rates which will cause bond prices to fall. A bell won’t ring before this occurs – we will know rates have moved higher after the fact! This could erode recent profits in bonds.
Investors will have to stay nimble and be willing to take profits when the market rallies and invest on declines in this changing economic environment. The stock market will be choppy until we reach full employment and corporate profitability is restored. We mentioned in our note of January 2009 that “…emotional reaction to the markets will reduce returns significantly over time and result in the opposite behavior of what is rational and productive” We went on to say “if stocks recover from the 30% plus decline, which we expect, the returns will be very attractive indeed.” This is exactly what’s happened since March. Many investors missed this market rise for fear the world was about to enter a massive “Great Depression”. Ask yourself what lessons you’ve learned. Many portfolios were not rebalanced out of cash and into bonds and stocks. A disciplined asset allocation program is essential to preserving and building wealth.
Returns may be less than robust going forward as economic growth is muted and this may be a recession rally, but it does not mean that gains are impossible or the markets won’t be higher in years to come. There are many high quality companies that are still undervalued and plenty of investment opportunities as we adjust to the “new normal.” The economy will be restored to full health but there may be bumps in the road along the way.