The second quarter marked a pause in the 18 month rally in the equity markets. International markets performed substantially worse than domestic ones, particularly when translated into U.S. Dollar terms. Much of this correction stemmed from the uncertainties in Europe and lackluster domestic indicators of economic activity.
The last three months have brought market participants to a point where many feel we are evenly balanced between economic decline and growth. That viewpoint is reflected in asset prices in both the stock and bond markets. We hold to our belief that growth will occur, albeit slowly, due to a very stubborn labor market in which unemployment remains high. Economic data aside, in the last three months financial markets have had to contend with the “flash crash,” a massive oil spill in the Gulf of Mexico and numerous austerity packages passed in Europe.
Economic activity as measured by the GDP grew at an annualized 2.7% rate in the first quarter of 2010. Although positive, this is a lower reading from the fourth quarter 2009 level. This figure has discouraged many since GDP growth following a recession is typically significantly higher; particularly with the massive stimulus efforts we have implemented in an attempt to spur growth. We note that history has shown it is common to have a temporary slowdown in growth after the beginning of a strong recovery and this may be exactly what we are experiencing.
Looking over the last year we see three good quarters of real growth in the GDP. According to Robert Schiller, in past recessions when GDP has reversed course and posted three or four quarters of gains (as it just has), it has never immediately begun to fall again. That record goes all the way back to 1947. When GDP starts moving upward after a decline, it usually doesn’t stop in its tracks.
Following the Greece fiasco, the EU passed a trillion dollar liquidity package intended to serve as a backstop to member nations that are having problems with their level of sovereign debt. Although heralded as a vital response to calm fears in the European markets, the fanfare was short lived and both sides of the Atlantic still view sovereign debt levels as monumental risks. The issue is simple: member countries of the EU have spent more than their tax base can support. Since the individual member countries do not have their own central banks, they do not have the ability to “print money” which debases the value of their currency and in turn reduces the true cost of debt. Quantitative easing (what economists call printing money) is only possible at the EU level and with so many governments involved, that is obviously a complex decision.
Adding fuel to the fire is the fact that austerity measures are being passed across the EU creating fear that the fragile recovery in the world economy could suffer due to the pullback of government spending. Again, if executed correctly we fall on the good side of the tipping point, but the risk does remain that execution is poor and a contraction follows. We are hopeful a healthy balance can be achieved, one in which investor confidence is supported.
BP’s massive oil spill adds immeasurable risk to our economy. First and foremost the direct economic losses from thousands of fishing and hospitality jobs are at risk as oil is causing tourists to cancel trips and the Government to close fishing areas. Secondly, the “drilling moratorium” as ordered by the executive branch, now deemed illegal by a Federal judge, risks thousands of jobs along the Gulf. Potential for further economic losses in areas such as real estate values, energy security, environmental restoration etc. are unknowns right now but will assuredly be large. For the environment and for the economy, let’s all hope that the relief wells currently being drilled by BP will succeed.
Although improving, job growth continues to be slow as companies stretch their workforce as much as possible. Manufacturing has picked up and companies are restocking inventories. However, they are achieving this via increased productivity as opposed to hiring new workers. Uncertainty regarding the new health care bill and future tax policy is preventing managers from knowing the true cost of employment and is thus contributing to the lack of large scale hiring. A strong consumer is paramount for a strong economy and consumers are made strong by employment.
Congressional leaders are in the midst of creating a new bill that if it passes, will be the biggest overhaul of financial institution regulation since the 1930s. Derivatives, bank proprietary trading, securitization and hedge fund registration are all issues that will be addressed. At present nothing has been passed but we expect a push to make it law before the next election. Regardless of the form, this bill will most likely mean more oversight, more regulation, and more government involvement in our financial system.
Finally, we mentioned in the last letter the need for the Chinese Yuan to appreciate relative to the Dollar. It appears this idea has finally gained some support from Chinese leadership. In a recent meeting the communist nation approved relaxing the ratio at which they have held their currency pegged to the Dollar. If this plays out it will make products that the U.S. exports more affordable in China and assist in balancing the current trade deficit. Our expectation is that the revaluation of the Yuan will be a multi-year process which will depend on the strength of the global recovery.
May 6, 2010 will go down in history as the day of the Flash Crash. The exact series of events which led to the short lived drop may never be known in full. We have long held the view that a share of stock represents a minority ownership position in a real operating business and should be bought and sold as such. We would cheer regulatory change that would “slow” trading down to benefit the long term investor. Debate on appropriate regulatory response is in full swing and no resolution has been reached at this point.
As one might expect, the energy sector was hard hit following the Gulf oil spill in late April. Almost every energy stock from service companies to oil producers have suffered as investors sold the energy index in one fell swoop, throwing the good out with the bad. We believe there is a real risk that the government moratorium which bans drilling for 6 months could convince all 33 deep water rigs currently in the Gulf to leave for other countries. This would do damage to a vast number of other companies that support the Gulf drillers. There are 3,600 structures in the Gulf that produce oil and gas which provide 31% of domestic oil and 11% of natural gas production. If the moratorium lasts too long we may force the industry into a steep decline and our dependence on foreign oil will grow even larger.
Economic and political uncertainty has certainly led markets lower this quarter. The psychology of many investors and certainly of the major media outlets is depressed and fearful. As we’ve shown in this letter, there are a number of legitimate factors, both political and economic, that support a gloomy outlook. Losing money is on everyone’s mind right now, but simply because the media is fearful and economic numbers have slowed it does not mean a double dip recession is a certainty as some have concluded.
What’s not in the headlines is that analysts are raising earnings estimates for U.S. companies at the fastest rate since 2004 and valuations after this correction are even more attractive than they were 6 months ago. According to Bloomberg, during the first quarter “the proportion of S&P 500 companies that raised their profit outlooks reached 8.6% … compared with 3.4% that lowered forecasts, according to data compiled by Bespoke Investment Group LLC. That’s the second-highest level of companies increasing their projections since 2001…” Not only that, but 28% of S&P 500 companies either increased or initiated a dividend in the first 6 months of this year and amazingly only 1 company has lowered its dividend in 2010! When dividends are rising like this it is a strong signal that companies are strong and confident about their future.
U.S. Government and high quality bonds are again en vogue, as one would expect in turbulent times. The uncertainties mentioned above have driven investors to the safe haven of Dollar denominated government debt. The yield on the 30 year Treasury dropped to 3.89% at quarter end from 4.63% at the beginning of the year. While this may sound trivial from a yield perspective, this move equates to nearly a 13% increase in price and signals that bond investors believe there is a greater risk of deflation as opposed to inflation. Agency bonds (Freddie Mac, Fannie Mae, etc.), now backed by lines of credit at the Treasury, have held their ground and performed well. We have been participating in the new Agency issues coming to market with step-up coupon structures that are designed to protect investors from an increasing interest rate environment. While there is little room for these structures to appreciate in price due to their callable nature, at this point we are content to earn an above market yield and to have short effective durations.
The investment grade portion of the corporate bond market has performed well in this correction, which is a healthy sign. We can remember when the credit crisis was in full bloom in late 2008 that prices on investment grade bonds fell precipitously and created tremendous buying opportunities. In the current market, prices of corporate bonds have increased, but not as much as the Government market. The difference between Government and corporate yields (called the spread) has thus widened, which means the market is pricing in additional risk on corporate bonds. This is a welcome reaction since it leads us to believe the correction is temporary and based on emotion as opposed to a real liquidity event or default risk.
The municipal market has also held firm, but the unending media reports of default risk in this sector have kept a lid on prices. Tax free yields relative to taxable equivalents have crept back to well over 100%, which we view as attractive. It is important to understand the credits you buy since there is a wide disparity in the health of various state and local budgets. We are comfortable with the credits we buy and continue to believe there are structural issues that will support municipal prices going forward. Although we have outlined our rationale before, it is worth noting that the issuance of the “Build America Bond” program is gaining traction. This is essentially a stimulus program where municipalities issue taxable bonds and the U.S. Government subsidizes their interest payments. In many cases the issuers are choosing to issue taxable bonds to the exclusion of tax free bonds. This has, and we believe will continue to, decrease the supply of tax free bonds. At the same time, we believe income tax rates will inevitably rise. The health care bill alone will levy a 3.8% tax on investment income over a certain threshold. However, municipal bond income is exempt from this tax. We believe the demand for tax free bonds will increase when tax rates rise, thus creating a supply/demand imbalance that will support municipal prices. We have been buying longer dated maturities in this space for several months now, and doing so by selling bonds with very high premiums, low yields, and short maturities. In some cases we have been able to reinvest the proceeds into bonds with longer maturities and double the yield.
This quarterly letter is not intended to be a farmer’s almanac whereby we predict the specific occurrence of distant future events. It is meant to summarize the current situation in which we now find ourselves and to funnel the ocean of financial and economic data into an easily consumed glass.
The stock market is always trying to predict the short-term economic future and right now it’s saying that future is bleak. We understand its pessimism, but find that valuations are quite attractive and if your time horizon is measured in years rather than months, there are opportunities available. We plan to invest accordingly.