Q2 Perspective: Keep Calm and Carry OnJune 2011
Can the recovery survive the events of the past three months: jobs that would never return, unsold houses, gasoline surpassing $4 per gallon, the U.S. warned by Standard & Poor’s that it had something in common with Greece and Ireland, and uncertainty about how the European Central Bank, the International Monetary Fund, Germany and France will deal with increasingly probable sovereign defaults? In the background, China and India tightened the monetary screws on inflation to curb speculation in real estate and commodities. On top of these events, markets had to digest the widespread supply chain disruptions caused by the earthquake in Japan, the Mississippi River flooding hundreds of square miles of prime farming land, and the devastating tornadoes hitting parts of Missouri and Oklahoma. Lastly, in an echo from 2010, the Commerce Department reported that factory orders dropped 1.2% in April, slightly more than was expected.
Equity Markets Remained Undaunted
Through it all, the U.S. equity market registered a modest 6.5% decline between mid-February and mid-March. By the end of April investors had bid prices to a new recovery high. For the three months ended May 31, 2011, the S&P 500 had appreciated 1.35%. This month a slew of government data showed the economy to be slowing and equities declined 4.8% through June 15. Given all the upsets, this modest decline of 3.5% over the 14 week period (March 31, 2011 - June 15, 2011) in the face of such odds, strongly suggests that the global recovery will be difficult to stop (CHART 1).
The Progression from Recession to Recovery to Expansion Is Often Uneven
The recent soft economic reports suggest the path to expansion is not always smooth. In April 2010 for example, a slight “miss” in the quarterly GDP report, 3.2% versus the expected 3.4%, cracked confidence and sent stocks down 16%. Thereafter, the market climbed 33% to its April 29 high. A correction would not be unusual after the 101% advance from the recession’s March 9, 2009 low. We disagree with those who see another recession. Following the British government’s WWII exhortation, “Keep Calm and Carry on” makes sense.
Early Signals May Be Pointing toward Expansion
At major market turns, such as March 9, 2009, nearly every measure of economic activity looks bad, but also enticing to the discerning market observer. The threshold between recovery and expansion is harder to detect. One sign is the slowing year over year rate at which company earnings grow. In the quarter just reported, S&P 500 companies’ net income grew a respectable 17% versus this time last year. The year-over-year growth in the prior four quarters, however, showed off the snapback that often occurs at the end of deep recessions (CHART 2).
Another signal is that less cyclical sectors, for example food and health care begin to outperform when a recovery transitions to expansion. This recovery/expansion is no different. The materials, energy and industrial sectors were market leaders in the second half of last year; healthcare and consumer staples joined again by energy led this year through May 31.
Are Rising Commodity Prices Signaling Inflation?
Why have oil, copper and grain prices leapt this year? The core reason is that there is simply more demand as the world recovers from recession. Next, the entrance of India, China and Brazil as major economic players on the world stage over the past decade is absorbing massive amounts of industrial metals and oil to sustain growth.
Metals, such as silver, copper and tin, are up between 400% and 700% over the past decade responding to this new demand. Gold has risen 464% through June 14.1 Gold’s appeal rests upon a convergence of several trends: emerging market demand, low interest rates stimulating speculation, demand by small investors via ETFs and widening fear that the dollar is no longer a secure store of value. Gold, however, is simply a bet on the failure of developed nations to devise credible solutions to their seemingly intractable problems, led by runaway entitlement spending. We do not take this bet.
The Fed’s zero interest rate policy has diminished the dollar’s appeal but made levered commodity trading very attractive. This “carry trade” buying is no doubt a significant support for higher oil and metals prices. It is, however, a long-held truth that the cure for high prices is high prices. High prices attract new supply, suggesting commodity prices will likely revert to longer-term trends. New mines, however, take a long time to open, while expanding crops takes less time. There is lots of oil, and the political changes occurring among Arab states just might place supplies into friendlier hands. The high prices may also stimulate innovative techniques to use energy more efficiently and extract it from new sources.
1. Source: LME, Bloomberg. June 15, 2001 through June 14, 2011.
Conflating the threat to the dollar’s reserve currency status and preeminence in international transactions with the flight to gold is premature. Barry Eichengreen of UC Berkeley points out the inconvenient truth hovering above the anxiety, “There has been no discernable movement away from the dollar as a currency in which to invoice trade and settle transactions. The dollar remains the dominant currency in the foreign exchange market”2 accounting for 85% of all foreign exchange transactions according to the Bank for International Settlements. The day will come when transactions between Asian economies become so large that it will be efficient to settle transactions in renminbi. But this huge change also presupposes much greater confidence in the stability of the trading partners’ governments than exists today.
While a Threat for Emerging Countries, Lasting Inflation Does Not Appear Likely for the U.S.
Inflation is indeed rising in emerging countries. As the Financial Times reported, “With the rapid recovery of the past two years, many companies are running full stretch. HSBC says the output gap (the difference between actual output and maximum capacity) has disappeared in most East Asian economies, including China and in Brazil. Workers are winning pay increases and employers are passing on the costs. The UK bank says, `This creates the risk that in emerging economies inflation shocks turn into self-perpetuating inflation processes.’”3 Emerging market central banks are reacting by raising interest rates and restricting credit to blunt this toxic cycle. India has made some progress, while inflation has slowed in Russia and more recently in China. Brazil’s inflation, however, continues to move higher (CHART 3).
2 Eichengreen, Barry; Exorbitant Privilege, The Rise and Fall of the Dollar and the Future of the International Monetary System, Oxford 2011.
3 Analysis; The High Price to Pay, Stefan Wygstyl and Jonathan Wheatly, FT 5/31/11.
Inflation in the U.S. and the European Union Is Mitigated by Higher Savings, Cuts in Government Spending and High Unemployment
Inflation’s path in the U.S. and Euro Zone is moving higher but returning to a level that dispels the specter of deflation so evident last summer. How deftly Ben Bernanke disposes of the huge inventory of securities on the Fed’s balance sheet will determine whether or not inflation takes root here. Although $4 gasoline challenges this outlook, the wide output gap strongly suggests how difficult it will be for accelerating inflation to become established.
Public and private austerity makes virulent inflation taking hold problematic. Governments are beginning to spend less and people are beginning to save more. Americans especially are embracing belt tightening, saving at almost twice the rate they saved at during the ten years ended 2009 (CHART 4).
Governments are also cutting spending and shedding employees. The change in behavior—higher saving and public sector austerity—suggests that ongoing recovery will depend more upon net exports and investment than on rising consumption, the engine in earlier recoveries. This is possible, but with consumption such a preponderant part of the U.S. economy, exports and investment are unlikely to meaningfully accelerate expansion from its current tepid pace.
In sum, the mix of a high savings rate in the U.S., moves to cut government spending and the still large amount of idle labor are formidable headwinds to “inflation processes” taking root.
U.S. and European Economies Will Need to Confront Debt and Deficit Issues
The United States is about to hold its quadrennial debate about its future; a debate already underway in state houses, city halls and around kitchen tables. The focus will be upon sorting out economic priorities and preserving adequate revenues for government services paid for by higher taxes, less consumption, greater investment and less debt. In Europe, the European Stability Mechanism will be in place, and we trust it will be the forceful institution to manage Greece and other bankrupt economies back to sustainable health. If we and the Europeans again just “kick the can down the road,” bond investors will lose patience. Standard and Poor’s growl about U.S. finances will become true.
Broad Forces that Sustain Growth Are Present throughout the Emerging Markets
Multiple drivers of growth are intersecting in the emerging markets—productivity of labor, productivity of capital and demographics—most of which are not robust in Europe, Japan or the U.S. This potential is also the investment challenge because emerging markets periodically become overcrowded and overvalued. That, however, does not deny the opportunity offered when investors skillfully enter—and periodically take profits—in these more volatile markets.
Our Outlook for Growth Remains Positive
Fiduciary Trust is fortunate to be associated with Franklin Templeton’s local asset managers who manage investments for Brazilian, Chinese, Korean, Japanese and Indian investors from offices in the financial capitals of these countries. Their research is an important resource for Fiduciary Trust clients, both for the "bottom up" information on specific companies, and for the local market perspective. Although we are somewhat cautious today and have trimmed emerging market exposures, the growth potential is clear. It is fashionable to be gloomy, but we believe the opportunities presented by a dynamic U.S. economy, China hastening its development march toward domestic consumption and Japan rebuilding from a ten-year slump are indeed enticing.
FIXED INCOME PERSPECTIVE
Renewed Demand Benefitted Bond Investors
Receding Credit Concerns Helped Buoy Bonds
Bond prices rallied overall during the second quarter, driving bond yields down to their lowest levels of the year. Two factors worked in favor of bonds during this time: 1) Investors became more risk-averse due to worries over a slowdown in global growth, with the re-emergence of debt woes for some European countries and the impact of the tsunami in Japan; 2) Inflation fears subsided, partly in response to commodity prices retreating from highs earlier in the year.
In the municipal bond market, heightened credit worries caused a sell-off of municipal bonds, which began in late 2010. In fact, municipal bond mutual funds, often used as a broad measure of demand, experienced over $38 billion in total net outflows in the fourth quarter of 2010 and the first quarter of 2011, representing the largest net outflows in a two quarter period since 1990.1 By the middle of the second quarter, however, the pace of this sell-off moderated as concern over widespread government defaults receded and the pace of state tax collections continued to show improvement.
The fiscal restraint that is being discussed at the federal level in the U.S. is also occurring at the state and local levels, as states and cities have cut back on spending and borrowing. These spending cutbacks have resulted in a significantly lower volume of municipal bonds being issued. In fact, after hitting a record high for the year 2010, the volume of municipal bonds issued year-to-date has declined to the lowest level in 11 years, and is less than half of the volume that was issued during this timeframe last year (CHART 1).
As we move into the second half of the year, we anticipate a slight improvement in the economy, coupled with an increase in municipal bond supply as most states will eventually finalize their 2012 budgets. We expect that these actions will lead to modest upward pressure on yields.
While confidence has presently returned to the market, we believe that current risk/reward valuations are unfavorable. Many states are facing ongoing fiscal challenges and will undergo a meaningful reduction in aid from the federal government. We remain vigilant in the management of both credit and interest rate risk, and are positioning portfolios with a defensive bias toward capital preservation and a focus on high quality bonds with intermediate-term maturities.
Ronald Sanchez, Director of Fixed Income Strategies
1. Source: Investment Company Institute, Net New Cash Flow for Municipal Bond Funds.
STRATEGIC ASSET ALLOCATION
TACTICAL SHIFTS REFLECT OUR BIAS TOWARD MULTINATIONAL FIRMS IN THE U.S.
- Our allocation recommendation to equities remains overweight, with an emphasis on U.S. large-cap companies that are well-positioned to benefit from a continued global recovery.
- We have reduced our recommended exposure to preferred stocks and added the proceeds to U.S. large-cap stocks. Rising earnings, and in many cases dividends, add to their relative appeal.
- Small-cap stocks are generally more volatile and cyclical than large-cap stocks, and we have tactically reduced our recommended small-cap exposure, adding the proceeds to cash.
- We are not ready to restore an overweight recommendation in emerging markets because we believe a number of factors—including monetary tightening, a diminishing labor cost advantage and, in China’s case, growing demand to revalue the currency upward—have temporarily narrowed the potential advantages of investing there.
- Our recommended municipal bond allocation remains underweight as we see the overall level of interest rates as unattractive and are finding better relative value in other fixed income sectors.
- We are seeking select opportunities in essential service revenue bonds, higher coupon callable bonds trading at premiums and government-guaranteed housing bonds.
- We are recommending an overweight allocation to both investment-grade and high-yield corporate bonds due to their improving credit fundamentals and for the additional yield potential they offer over U.S. Treasuries.
- Our cash allocation recommendation has increased slightly due to our more cautious view toward U.S. small-cap stocks.
FIDUCIARY TRUST FORUM
PERSPECTIVE ON FIXED INCOME
INVESTING IN A POST-CREDIT CRISIS ENVIRONMENT
During the 2008 financial crisis, the Federal Reserve’s goal was to stimulate and reinflate the economy by injecting an extraordinary amount of capital into the economy, which resulted in near zero short-term interest rates. With the second round of government monetary stimulus (quantitative easing) scheduled to end on June 30, 2011, our Fiduciary Trust Forum panel members discuss fixed income investing in today’s post-credit crisis environment.
Q. With five consecutive quarters of positive GDP growth in the U.S., inflation concerns have been dominating headlines. What is your view?
RON: We believe inflation risks are a greater concern abroad than in the U.S. Core inflation bottomed in the U.S. during the third quarter of 2010. If no unforeseen events present themselves, we believe the core inflation rate will end 2011 in a very low range of 1.5% to 2.0%.
ERIC: Bond investors always worry about inflation. While we are nervous by nature, we believe the Fed’s view, that domestic inflation is mostly transitory and not at a level that will be persistent for the long term, is correct.
This view stems from the belief that the increasing prices of essential commodities, such as oil, are acting like a tax and are taking money out of consumers’ hands which tends to slow the economy. This can work to keep inflation from taking hold, as long as wage increases do not accompany these price increases. At this stage, where unemployment remains high, we believe that wage increases will present themselves very slowly as the economy continues to grow, create jobs and absorb excess labor.
Q. Do you believe the stage is set for interest rates to increase?
RON: It appears that we are on the cusp of sustainable growth in the U.S. economy. If the current pace of the recovery continues, we expect the Federal Reserve to start raising the federal funds rate from the present 0.25% beginning sometime between the first and second quarter of 2012. We believe that interest rates will begin to gravitate modestly higher during the second half of this year.
CINDY: This course of action has been well telegraphed by the Fed, so broadly speaking this should not be too problematic or disruptive to the markets. In terms of long-term rates, we believe we will end the year with rates above the current low levels. This is based on our expectation for moderate economic growth above 2%.
Q. With the U.S. hitting its $14 trillion debt ceiling, how will fixed income investors be impacted?
RON: Our expectation is that legislators recognize the current path is unsustainable and will act prudently to address the debt limit issue, although we expect negotiations will likely go down to the wire. We believe the political climate has shifted and the prospects for meaningful fiscal discipline are improving.
CINDY: If actions are not taken, the markets will begin to punish the U.S. for not having a plan, or for having the wrong plan. The ramifications would likely be a weaker dollar, higher rates and slower growth than what we are calling for.
ERIC: The debt limit is a short-term issue, while the debt itself is a longer-term issue. Ultimately this means that job #1 is to get the U.S. financial house in order. In the late 70s double-digit wage-push inflation demanded bold action on the part of the Fed to break the back of inflation, and very assertive monetary policy was the answer. In the early 80s when the economy stalled, the extremely high marginal tax rates were lowered, and the economy boomed for the greater part of a decade.
We believe the Fed has largely done its part, and this next phase will require a host of policy responses from state and local governments. This could mean tax reform at the corporate and at the individual level, and austerity at every level of government—but not too much too fast.
Q. How are you navigating the municipal bond environment as state and local governments cope with their deficits?
RON: Clearly there have been challenges, but there have also been opportunities. During the recession, Washington sent states extra money to cover rising Medicaid costs and help them weather the downturn. This federal assistance for states, which has been enormously helpful in allowing states to avert some of the most harmful budget cuts, will largely be gone by June 30, 2011.
Now, we are seeing the effects of state deficits trickle down to the local levels. The challenging part is that the degree to which costs are shifted from state to local governments will vary from state to state, county to county and city to city.
CINDY: We therefore believe that some local level governments will be stressed, and anticipate that these stresses will continue to lead to some credit deterioration beyond the usual suspects of lower-rated or non-rated projects, healthcare, and real estate related credits.
ERIC: The great opportunity here is for investors who can look beyond negative headlines for the asset class and identify individual issuers with strong credit profiles. We have been investing in bonds with very good fundamentals while also positioning portfolios to have less exposure to areas we believe will be most subject to stresses.
Q. How has the municipal bond landscape changed for investors since the credit crisis?
RON: It is important to understand that the municipal market is not homogenous. It is characterized by its enormous size, diversity and the complexity of its many issuing authorities. Since the crisis, the complexity has increased significantly as it now takes an enhanced level of due diligence and bottom-up credit research to analyze the creditworthiness of securities. For example, the strength and enforceability of the borrower's legal obligation to pay, its capacity to generate the needed revenues, and its ability to adapt to adverse circumstances must be analyzed in every case.
ERIC: Another layer of difficulty has been the demise of bond insurers. These insurance companies offered an additional layer of credit protection since they guaranteed debt issued by municipalities. Today, just 5% of newly-issued bonds carry insurance, down from 50% four years ago. Insured bonds previously had the highest credit rating by all of the major credit rating agencies and made municipal bonds more of a commodity, hence, enhancing their liquidity. Now, the onus lies entirely with the investor to make bond selections from issuers they believe are creditworthy and secure.
CINDY: All of this means that targeted security selection has become a crucial factor in the ability to achieve a portfolio’s objective. It takes significant research capabilities to identify bonds with the characteristics we are looking for and that meet our criteria. Our research and analysis allows us to filter out less desirable bonds and identify those bonds that best achieve our quality, duration and sector views.
Q. Where are you finding opportunities today?
RON: In the current market environment we are underweighting general obligation bonds, particularly at the local level. Our focus remains on essential service revenue, government guaranteed housing bonds and higher coupon callable bonds trading at premiums. Given the steepness of the yield curve, we find the six to eight-year maturities particularly attractive.
In the taxable bonds sector we continue to underweight U.S. Treasuries in favor of those sectors that we believe will benefit from improving economic growth. We are overweight corporate bonds, both investment grade and high-yield, for their improving credit fundamentals and the additional yield they offer over U.S. Treasuries.
This communication is intended to provide general information. The information and opinions stated are as of June 15, 2011 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.
Vice Chairman and
Chief Investment Officer
Ronald Sanchez, CFA
Director of Fixed Income Strategies
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