Fiduciary Trust International

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We have come a long way. From the U.S. equity market low on March 9, 2009, the S&P 500 rocketed 70.3% to the index high on January 19, 2010. Interest rates made good progress away from uncharacteristically low levels. It is a sign of the recovery that the yield curve has steepened versus a year ago; that is, the interest rates the Treasury pays on its longer-­term bonds have risen relative to its short­-term borrowing (Chart 1). The Fed has relentlessly kept the short rates low by aggressively deploying numerous initiatives designed to restart the flow of credit, and therefore of consumption and job growth.

UNEMPLOYMENT LEVELS ARE EXPECTED TO IMPROVE, YET REMAIN HIGH

What do ultra-­low short-­term rates mean? Ben Bernanke’s own words say it best, “The target for the federal funds rate has been maintained at a historically low range of 0% to 1⁄4% since December 2008. The FOMC (Federal Open Market Committee) continues to anticipate that economic conditions—including low rates of resource utilization, subdued inflation trends, and stable inflation expectations—are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”1 The large drop in short rates between March 2008 and March 2009 is testament to the Fed’s efforts.


1. Chairman Ben S. Bernanke, Semi­-annual Monetary Policy Report to the Congress before the Committee on Financial Services, U.S. House of Representatives, Washington D.C.; February 24, 2010.

But, Bernanke’s antiseptic phrase, “low rates of resource utilization,” means the Fed anticipates unemployment will likely remain well above historical levels. By the Fed’s own measure, the unemployment rate still will be between 8.4% and 8.8% in 2011, far above the 4.8% to 5% longer­-term historical average (Chart 2).




INCREASES IN PRIVATE COMPANY PAYROLL MAY BE OFFSET BY PUBLIC SECTOR CUTS

Reviving employment is the Fed’s focus. The Fed’s actions—along with the natural impulse of businesses sensing recovery to restock depleted inventories and necessarily to hire workers to do this—show private company payroll trends strongly improving (Chart 3). It will not surprise if jobs actually increase in the next few months as the chart suggests.
This sanguine outlook, however, must be tempered by the horrible condition of many state and local budgets which, by law, must be balanced by tax revenues, selling bonds or cutting costs, e.g., payrolls. Public sector employees have enjoyed the protection of well connected unions and the absence of market discipline (Chart 4). This will have to end, or major economies such as California will unavoidably face acute budget crises. Widespread public sector retrenchment can only aggravate the Fed’s bleak employment outlook.

EARNINGS GROWTH IS LOOKING POSITIVE FOR 2010

A year ago we noted the extraordinarily wide range of estimates of S&P 500 earnings for 2009, from $70 down to $40, expressive of the uncertainty about the duration and depth of the recession. By mid-­February this year, as the 4th quarter reporting season was about to begin, the estimates of S&P 500 earnings clustered tightly around $66 for the year.
 




Now, with the 2009 4th quarterly earnings reports nearly all in, analysts are far more optimistic about 2010, foreseeing companies earning $81.10, +22%.

The outlook appears justified given the numerous signs of global recovery at hand. Indeed, if the estimate is validated by actual experience over the coming quarters, the index is trading at 13.6x estimated earnings, which is quite reasonable relative to the long term and more so in the current low interest rate climate. Especially encouraging however, is that sales turned positive, indicating companies are selling more—in contrast to raising earnings by cutting costs and shrinking inventories.

SIGNS SUGGEST INFLATION WILL NOT RISE SHARPLY

The prospect of virulent inflation appearing in the next few years is much on investors’ minds. Analysts, economists and strategists are divided. Gold, widely seen as protection against debased currencies and therefore inflation, has jumped nearly 68% since September 2008 when the Fed and other central banks kick-­started their various rescue operations as Lehman and AIG imploded. Is the anxiety about inflation self­-feeding, unsubstantiated fear? Or, is there significant probability for sharply higher inflation in the near term? Several signs suggest not:

• Interest rate futures markets are not signaling so.
• There exists enormous unused manufacturing capacity along with hordes of low­-cost labor, especially in the BRIC countries. At home one measure of the unemployed plus the underemployed approaches 18%. 
• The mood of voters in the U.S. and Britain, which each face near­-term elections, is turning against higher deficits and public spending. 
• A global recovery is underway, which means public assistance programs will mechanically decline as incomes and tax collections rise. 
• Lastly, debt repayment by individuals and businesses is offsetting a sizeable part of the increase in borrowing by government. As of 9/30/09 (the latest data compiled by the Fed), private debt, including mortgages, consumer credit and loans to businesses, fell at an annual rate of $735.4 billion. This offset about 45% of the $1.6 trillion increase in local, state and federal debt. As the recovery proceeds and various emergency programs are wound down, the growth of government debt should also slow.

THE RECOVERY IS GLOBAL

Amidst the focus on employment, world trade among the G6 countries has been picking up, further confirming the recovery is global (Chart 5).


 
The chart, however, doesn’t do justice to the substantial increases from March 2009 through November. The latest data show exports up dramatically:

Japan      +36.3%                   Germany             +28.2%                  U.S.  +24.2%
Canada   +25.1%                    United Kingdom  +24.2%

These are impressive recoveries and another nail in the recession's coffin.2
2. Yardeni Research
  
Of unquestionably great future consequence for global growth was the January 1st launch of a huge regional trade agreement by China and the Association of South­ East Asian Nations. 90% of goods traded between these nations are now tariff­-free. The robust expansion of trade following NAFTA and the creation of the Euro Zone suggest the benefits this agreement will bring to the 1.9 billion people living in the area spanning Beijing to Wellington.

WE HAVE POSITIONED PORTFOLIOS TO EXPLOIT THE RECOVERY

We continue to believe an emphasis on global companies exploiting markets that are growing at multiples of what is likely in the U.S. will be highly rewarding. As noted, bonds offer less and less opportunity, and no doubt risk, as interest rates rise in coming quarters. Municipal bonds present particular risk and we are careful to avoid states and jurisdictions most likely to be downgraded. As recovery proceeds and tax revenues resume, beleaguered states such as California, however, may offer the venturesome appealing value.

For the time being, we do not foresee troublesome U.S. dollar weakness. Indeed, the dollar is again the safe harbor from the Eurozone storm. Despite high level Chinese mutterings about the value of their U.S. Treasury holdings, China would deeply wound itself with a sharp realignment of the Dollar/Renminbi exchange rate. Rather a steady incremental adjustment best sustains U.S. recovery and Chinese growth.

OUR OUTLOOK CONTINUES TO FAVOR EQUITIES

All in all, the outlook continues to favor equities, the financial asset that can best exploit the return to more normal long­-term relationships between a recovery in corporate earnings from the recession lows, interest rates, and somewhat higher inflation as business activity gathers steam. Indeed, more final demand from consumers and businesses is what the world needs to sustain the recovery and absorb overcapacity.

Mackin Pulsifer
Vice Chairman and Chief Investment Officer March 2010

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FIXED INCOME PERSPECTIVE

YIELD OPPORTUNITIES REMAIN SELECTIVE

A CHALLENGING STARTING POINT FOR 2010

Last year the fixed income market was the beneficiary of extraordinary demand as near zero interest rates on money market funds sent investors seeking higher yields elsewhere. This demand drove yields in many non­-Treasury sectors to historically low levels, pushing prices higher—making for a challenging starting point for 2010.

SELECT TAXABLE BONDS CAN OFFER YIELD OPPORTUNITIES

In spite of this environment, we do continue to find what we believe to be attractive opportunities in the primary market. Many corporations have demonstrated remark­able discipline in cutting costs and strengthening balance sheets. In fact, this rapid realignment of revenues and expenses stands in contrast to the challenges and fiscal positions of state and local governments.

Improvements in the investment grade corporate bond landscape led to a decline in yields from the highs experienced in early 2009. At that time, the yields were more than 95% higher (on a tax­-adjusted basis) to compensate investors for the higher perceived risk of these investments (Chart 6, Point A).


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Today, corporate bond markets have regained much of what they lost during the worst of the credit crisis, but intermediate-­term corporate bonds are still offering 26% higher yields (on an after­-tax basis) than municipal bonds of the same maturity range (Chart 6, Point B).

We see investment grade corporate credit fundamentals continuing to improve relative to municipal credit. The attractive valuations we see and the potential diversification benefits have led us to make a tactical increase in allocations to the corporate bond sector.

TAX­-EXEMPT BONDS STILL BENEFIT TAXABLE INVESTORS

Budget challenges and weakening fiscal positions continue to plague many state and local governments. While the general municipal environment is challenging, we are continuing to find select opportunities that we believe can provide solid tax­-free yields while keeping risk in check.

For example, we have increased our recommended exposure to essential services municipal bonds, such as water and sewer authorities, among others, as these are backed by more stable revenue streams. In contrast, we have reduced our recommended exposure to general obligation municipal bonds. We have also recommended callable debt—municipal debt with maturity targets of five or six years, that is callable in the next year or two— as a high­-grade investment opportunity that offers poten­tially higher tax­-free yields.

OUR OUTLOOK REMAINS CAUTIOUS

Highly­-focused security selection and broader diversification are important in managing through today’s low rate environment. We are seeking to balance these select yield opportunities with a focus on principal preservation and on lowering the price sensitivity of our clients’ fixed income portfolios. 
 
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STRATEGIC ASSET ALLOCATION

OUR TACTICAL ALLOCATION HAS SHIFTED TOWARD EQUITIES

WE EXPECT EQUITY YIELDS TO BENEFIT PORTFOLIOS

U.S. and global equities offer attractive yield opportunities with potential for growth

• We believe the potential for total return is strong among higher yielding U.S. and international equities.
• The benefit of yield is important, and we are therefore recommending a tilt in stock selection toward firms that pay generous current income and others that we believe are likely to restore their dividend payment as business improves. 
• With the economic recovery now more firmly established, smaller companies, particularly in the U.S., have been attracting greater investor attention, prompting us to slightly increase our tactical target for U.S. Small Cap. 
• As a result of these tactical shifts, our recommended cash position is approaching our long­-term strategic target.

• Our strategic view of emerging markets as an important source of global demand growth has not changed; emerging markets have led world equity market returns.
• Tactically, we are reducing our 12.5% guidance exposure to 10%. In our view the trade is crowded, and becoming more so. We see this as an opportunity to shift client capital to U.S. Large and Small Cap which we believe have lower valuations and strong gain potential from here.
  

• We have not changed our 25% recommendation for municipal bonds vs. last quarter; however, with widespread, acute state and local government budget deficits, our focus is on shorter­-term maturities with quality ratings of AA or higher.
• We believe carefully selected corporate bonds within a five­ to seven­ year range remain attractive, and we are maintaining our recommendation to have a 5% weighting in the taxable bond category.
  

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FIDUCIARY TRUST FORUM: GENERATING INCOME IN TODAY'S LOW RATE ENVIRONMENT

Near zero yields on Treasuries and low yields on municipal bonds pose a challenge for many income-seeking investors. Our Fiduciary Trust Forum panelists discuss how they are finding income for clients in today's low-rate environment.

Q: Should investors change their expectations about income potential?

Rob Bridges, Managing Director: Clients have adjusted their expectations regarding income as interest rates have declined for more than a decade. However, if investors can adopt the idea that income can come from investment areas they may not have relied on in the past, I believe the income gap can be narrowed.

Pascal Wirz, Managing Director: In terms of dividend income, several years ago the tax rates were lowered to 15%, making dividend stocks very competitive with bonds on an after-tax basis. As a result, we set out to create equity portfolios dedicated to producing higher than normal yields. This effort was successful, and has become even more valuable for clients today as bond yields are at record historical lows.

Steve Dutka, Managing Director: To me, it’s more about investors understanding their risk profile, rather than changing their expectation about income. Following the market volatility that most investors experienced over the past two years, I think today the biggest risk to an investor is to be fearful of equities, and to abandon them in favor of a purely fixed income focus.
In my experience, a blend of income and growth makes for a better approach—actuarial tables show that a 65 year old today has about a 70% chance of living another 20 years, so most investors will need to make sure their portfolio can beat inflation and can see them through these years. In an exceptionally low rate environment like this, I like to augment income with high dividend paying stocks that provide both income and the potential for some long-­term price appreciation.

Q: How are you supplementing income in client portfolios?

Karen Fang, Managing Director: Outside of tax­-exempt bonds, we have found several interesting opportunities that can boost income in client portfolios. These have included high­-grade, short-to-intermediate-­term corporate bonds, preferred and convertible preferred issues, as well as stocks with attractive fundamentals and dividend yield.

Rob: We are looking toward high quality, dividend paying stocks to play an income role right now. An interesting observation though is that companies, like consumers, have been facing challenging times. Last year 804 U.S. companies reduced or omitted dividends, resulting in $58 billion lost due to dividend cuts in 2009. However, another 1,191 U.S. companies either increased or reinstated dividends, suggesting shareholders are very important to the management teams of well­-run companies.

Steve: Today the overall yield on the S&P 500 is about 2%. Using a more income­-oriented strategy to select stocks, we seek to get above a 3% expected yield, helping to offset the lower yields on bonds. The income potential of stocks can be significant—since 1926, 43% of the S&P 500 returns came from dividends, and there have been three or four periods of time, including in the 1970’s, where that percent­age was as high 70%.

Pascal: We are also finding REITs (Real Estate Investment Trusts) are distributing high and relatively steady dividend streams, as their structure requires them to distribute 90% of their income to investors. Royalty trusts, generating income from the production of natural resources such as coal, oil, and natural gas, have also been offering higher yield opportunities.

Q: Where are you finding high quality investments?

Karen: Today’s relatively reasonable valuations on some high quality companies are benefitting income­-seeking investors. That said, we are not reaching for the highest yielding stocks—we are reaching for high-­quality companies that meet the parameters with which we invest. The majority of these companies also happen to have a strong history of consistent dividends and annual dividend growth.

Steve: The quality bias in the companies we buy looks to be paying off. Some of these “steady eddies” have been well­-positioned to support stable dividend yields, in some cases paying yields upward of 3% to 4%.

Rob: We have also included preferred stocks as part of our overall allocation strategy, and these have been yielding 6% or 7% in some cases. Although preferred dividends do not all qualify for the same favorable tax treatment as dividends on common stocks, we believe these are an important income alternative in a portfolio, given that yields on short­-term bonds are so incredibly low.

Q: Are you finding certain sectors to be particularly advantageous?

Steve: What’s been interesting in this market is that we are finding the old rules no longer necessarily apply—yields can be found across many sectors and in places you wouldn’t expect. It used to be that financial stocks contributed 20% of S&P earnings; today it is only about 12.5%. Many sectors are actually paying a higher yield than financials right now, which is a departure from their growth­-orientation of the past decade. We have also found opportunities for yield in the telecom sector—in fact some telecom stocks are paying yields over 6% right now.

Karen: In addition to the sectors that Steve mentioned, I would add industrial, energy and healthcare. Globally, we are seeking to find well­-positioned companies with strong management, healthy balance sheets and steady cash flow characteristics that are also paying good dividends. An added advantage to uncovering opportunities across sectors is that we are able to build more diversified portfolios.

Rob: It’s noteworthy to mention that some traditional dividend­-paying sectors, namely utilities, healthcare and telecom, lagged the market last year. However, we are looking favorably toward these sectors which offer the potential for above average yields and the possibility for improving relative performance in 2010.

Q: How do international stocks compare to U.S. stocks in terms of dividend opportunities?

Pascal: Dividend yields in non­-U.S. markets vary, but many countries offer reasonably secure yields that are noticeably higher than those available in the U.S. market. Consequently, we are growing our global content, and are finding this diversification can prove valuable in many ways.

Rob: One aspect we watch for as we look for yields outside of the U.S. is variability in dividend payouts from the same firm. We find that some of the developed foreign companies tend to decide on their dividend payouts based on the year they are having. In the U.S., there’s typically a pattern of four similar quarterly dividend payments; companies reevaluate dividends once a year, usually deciding to either maintain the amount or go up a bit. Over time, dividend streams from foreign firms may turn out to be as smooth as in the U.S., but we have to be careful about assuming the same predictability we see from U.S. firms.

Q: Are there risks associated with using stocks for income in a portfolio, and how are you keeping risk in check?

Pascal: Being an alternative to bonds, high yielding stocks are subject to the same risks as bonds—they may suffer when interest rates start to rise. They typically also under-perform the overall equity market in a strong bull market. In a crisis, companies may have to cut dividends and the yield is not as reliable as that of a bond portfolio. In the recent crisis, many companies did cut their dividend payouts, but it is worth noting that some continued to raise them throughout the crisis.

Thus, although dividends may appear more unreliable, they actually provide an upside to the income stream as many companies may raise the dividend payout over time. In that regard, in recent years companies with excess cash have often used it to repurchase shares rather than boosting dividends. It now appears that the trend is reversing, and that increasing the dividends is becoming more the norm.

Steve: The bias of the firm is to look toward strong, well­-run companies. Many times these are the ones that also pay higher dividends.

Rob: Looking down the road a bit, it’s possible that higher tax rates may put some downward price pressure on income­-producing stocks since it’s natural that a higher­-taxed dividend may lower investor demand for these stocks.

Similarly, if inflation levels increase, income-­producing stocks may be compromised vs. growth stocks as investors look to growth stocks to outpace inflation. These are issues we’re watching, but we don’t expect them to be problematic in the near term.

Q: Are you more optimistic or less optimistic about the potential for generating income in the future?

Rob: The amount of cash companies have today suggests dividends will be well­-supported. In fact, many high-­quality companies have recently paid out special dividends—one time returns of cash to stockholders—as their balance sheets are strong and they have the cash to support these payments.

Karen: We see good news on two fronts for income­-oriented investors: first, the economy is slowly improving, and as business strengthens we expect many companies to be in a position to increase their dividends; second, with the expectation of rising interest rates, supplementing income with stock dividends, REITS, convertible preferred stocks and other instruments outside of tax­-exempt bonds will likely be supported by bonds stepping back into their traditional income-­providing role.

This communication is intended to provide general information. The information and opinions stated are as of March 7, 2010 unless otherwise indicated, and do not represent a complete analysis of every material-fact concerning any industry, security or investment. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether information in this newsletter may be appropriate for you. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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