THE ECONOMY
Individuals and corporations are saving and paying down debt while the US Government is increasing the amount owed at an alarming pace. This dynamic – the transference of debt from the private to the public sector – has many implications for our economy and capital markets.
We are drowning in red ink! The US deficit has risen to 10% of GDP while Government revenues last year fell by over $ 400 billion – the largest decline in 17 years. We are spending more as a nation than we are bringing in and the end result is a massive deficit with huge implications for our future.
We will not solve the problem of too much debt by taking on more debt. Taxes have to increase and spending for benefits has to be reduced. If we don’t do something now the interest on our Government’s borrowings will be enormous, not to mention the total amount we owe as a nation! Greece, Spain and Portugal are on the verge of not being able to pay back their borrowings. The US cannot end up in this position.
Morgan Stanley argues that inflation will actually increase US deficits since “Social Security, which accounts for one-quarter of federal outlays, is officially indexed and Medicare and Medicaid are ‘unofficially’ indexed.” These two programs will account for nearly half of all Federal outlays in the next decade. Immediate reform is needed in both programs for spending to come under control as the baby boomers retire and begin to collect benefits.
Our economy is only beginning to climb out of a very deep and dark hole. Fourth quarter GDP was exceptionally strong but will not continue if consumer spending is subdued and unemployment remains high. We expect GDP growth to taper off from the 5.9% level in the fourth quarter of 2009 and be sustained at around 2.5% to 3%. Economic growth will take two steps forward and one back for some time as housing gradually recovers and the employment picture slowly improves.
We cannot have a healthy and robust economy with a weak housing market. This past recession proved that home ownership drives much of the spending in the US and is the key to wealth creation among the middle class. It will take years before housing prices recover to 2007 levels but we have most likely seen the worst of it. Home prices have stabilized and are actually increasing at a moderate rate in most cities and states.
We now have six million Americans who have been out of work for six months or more. 2010 will come to a close with the unemployment rate around 9% and we expect that the rate will stay high for the next three or four years.
The Federal Reserve is working hard to keep interest rates low to insure recovery in the housing market and stimulate economic activity. However, interest rates can’t be where they are now – near zero – forever and it isn’t a question of if rates move higher but when.
Our economy is improving, albeit slowly, and the housing market is on the mend. By year-end interest rates will be higher as confidence improves, jobs are added and housing prices are stable. In the meantime, there will be setbacks. The stage is set for gradual interest rate hikes and a 5% yield on the 10 year Treasury note (vs. 3.7% today) is not out of the question.
THE STOCK MARKET
With all the grim news – too much Government spending, weaker than normal economic growth and rising interest rates- what can we expect for the bond and stock markets?
We won’t see another 60% advance in the stock market but that doesn’t mean we will test the March 2009 lows. We said in our last report that “the key to stability in the stock market is revenue growth and sustainable earnings growth”. This is still true. Eighty percent of the S&P 500 companies reported better than expected earnings growth for this past quarter. This was well telegraphed and expected so the market did not react, having already risen substantially.
Stocks will not move dramatically higher in 2010 as they did after March 2009 when the S&P 500 Index was at 666. The market just got too low and stock prices more than reflected the bad news in the economy. One year later expectations are still reasonable and stocks are neither cheap nor expensive. A return of 7% to 9% this year for the S&P 500 Index is possible if the economy and earnings continue to recover from recession lows.
The focus is once again on earnings growth and increases in shareholder value. Yes, there will be stock market declines as the economic recovery goes from fragile to stable, the Greek tragedy plays out and employment reports are less than would be hoped for. US balance sheets are very strong and companies responded well to the recession. Costs were cut immediately leaving corporate America’s companies in good shape with the exception of the banking sector. Sales in all sectors will pick up as the economy improves and profits will be strong for some time.
The stock market will follow earnings over time and if earnings grow so will the price of a company’s stock. The key to successful investing is to look to where earnings are most assured and expectations are reasonable, even if this means focusing on emerging markets and regions outside the US. Most of the US multinational companies derive more than half of their revenues from outside the US. Economic growth is strong in many foreign economies which means that earnings can grow even when growth in the US is slow.
What will work in this environment are companies with healthy amounts of cash, low debt and the ability to increase dividend payments and/or stock buybacks in addition to a reasonable and assured amount of earnings growth. These qualities, more than the economic sector or stock market outlook, will define an attractive company in 2010.
Investors continue to look to the past to predict the future. Einstein said the “definition of stupidity is doing the same thing over and over again and expecting the same outcome.” It is possible, and perhaps likely, that this recovery will not look like past recoveries.
What are some of the surprises we could see as we move away from the recession?
First, we may truly have a jobless recovery. Companies have increased productivity and have improved technology to the point where they may not need as many workers. Hiring may also pick up – but not in the US. BankAmerica announced additions to staff in China, not the US. It may not be smart to assume that a high unemployment rate means weak corporate activity. Our economy and corporate earnings could surprise us and show better than expected strength as the unemployment rate slowly declines. This would move stocks higher. We may still have a strong stock market in the face of relatively high unemployment – something not expected or seen in the past.
We may also be surprised by the pickup in consumer spending later in the year – from pent up demand in the US as well as foreigners buying our goods. It will not be wise to wait to invest until consumers are active again – other sectors of the economy may pick up the slack in the meantime and boost investor sentiment.
Investors are concerned which causes stock prices to fluctuate as moods shift from optimism to pessimism. Inflows to bond funds, even at today’s historically low rates, have been impressive and a massive amount of cash is still on the sidelines earning practically nothing. If investor confidence improves these funds could move quickly into stocks- another reason to stay invested and not bet against the market.
THE BOND MARKET
Bond prices will react negatively to higher interest rates. There is more risk in the bond market than the stock market if you believe interest rates are going higher as we do.
This fear of rising rates is in direct conflict with the recent flight to the safety of US Treasury issues which is typical when a country such as Greece threatens default on their bonds. We feel the concerns for Greece will be resolved, leaving the fear of higher interest rates – and then losses in bonds- foremost on investor’s minds.
Our country is very dependent on foreign investors to fund our deficit. China owns about 19% of our debt. They could decide to invest elsewhere or bring their surplus home to spend and if this happens we will have to raise our interest rates to attract other foreign investors. This could happen at the same time the rating agencies lower their opinions on our US Treasury obligations.
Corporate bonds are attractive from a quality standpoint because balance sheets are the strongest they have been in years. It makes sense to own bonds for diversification, but this may be one time – when rates are historically low – that holding some cash for future investments makes sense.
Tax exempt bonds are a different story. Taxes will most likely be raised to help reduce the deficit. If this happens, tax free bonds would become extremely attractive. Individual investors should look for issues where the interest coverage is strong or invest in a high quality, no load mutual fund. Higher interest rates, especially much higher, would impact these bonds as well but not as much because of the tax advantage.
STRATEGY
Today’s economic environment, political agendas and global competition make investing difficult. There are thousands of choices and conflicting reports to add to the confusion.
We think the economy and resulting headlines will cause concern and confusion for some time. However, corporate America is strong; earnings will continue to recover while unemployment remains high. Stock prices tend to follow earnings trends over time. It is hard not to get caught up in negative investor sentiment and the frightening reports we hear on the news.
This is not the time to look for home runs – stocks that will move sharply higher in the short run. The market won’t have another 50% move again unless we have another severe crisis in the economy and stock market decline, both of which are unlikely.
While investor psychology is improving it is doubtful we will see excessive risk taking and dramatic increases in “junk” – stocks that have been hit hard where the fundamentals are yet to improve. This is unlikely. “Junk” bonds moved higher in step with stocks as the economy recovered and they too may not be attractive.
Stocks of companies with high and increasing dividends, very little debt and steady earnings will do well. This argues for investment in larger companies. US multinationals, such as many consumer staples, industrials and technology stocks, are still world leaders. Stay diversified and resist the temptation to trade.
A bond portfolio with a shorter than normal maturity schedule and some cash makes sense today given the unusually low level of interest rates. As rates move higher, gradually add to high quality issues and extend maturities. The diversified bond portfolio should also include inflation protected bonds as there is risk inflation will rise in the next few years.
Any discussion of the economy and capital markets today is likely to be too simple. It is impossible to cover every risk and opportunity in depth. It is also dangerous to assume we have experienced a normal, cyclical economic downturn and the recovery will unfold according to past cycles.
We do know now that the global economy is one economy and we are no longer the dominant player. The US is mature, our population is aging and our corporations depend on spending and investing in other countries. As a nation we need to reduce our debt level and spending so we once again become the innovative, productive and leading country we once were.