Fiduciary Trust International

THE GLOBAL RECOVERY IS REAL AND IS HAPPENING

We have been consistently optimistic that the Fed and its fellow central banks could engineer recovery. They have. The November Department of Labor report on payroll employment shouts this message. Recall that in January the U.S. was losing jobs at a 700,000+ monthly rate; this latest report has the rate at -11,000. While Americans are still distressingly being laid off, the report suggests the U.S. economy is on the threshold of actually creating jobs. (CHART 1).

Bob Barbera, ITG’s Chief Economist, foresees the U.S. stepping over this threshold in March. The Household Employment report (a measure of jobs among smaller employers where most U.S. jobs are), shows jobs being created—227,000 of them.

Further confirmation of recovering employment comes from Department of Labor surveys: hours worked are now increasing; unemployment insurance claims are falling; and the overall unemployment rate fell slightly from 10.2% to 10%.

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 An Improving Picture Around the World

The improving picture has been the same around the world. Consider the Baltic Dry Index, a measure of shipping rates across all sizes of ships and routes. Shipping rates typically do not rise unless a shipper is willing to pay a higher price to meet increasing demand (CHART 2).  

Since we last wrote in September, equities, bonds and commodities have extended the post March 6 rally. Only the U.S. dollar and the yen weakened. Consider the following charts depicting the strong upward movement in markets between March and November 2009 (CHARTS 3, 4, 5). 

 

 

 

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The Recovery Is Not Without Risk

We could go on listing historic upward moves expressive of broad global recovery. Suffice it to say the Fed’s efforts have been paying off. Of course, their success may also be the breeding ground for problems:

1. Virulent inflation-at some point-is a distinct possibility and much in the commentators’ eyes.
2. Congress may well misstep with overly harsh regulation of financial firms, thereby curbing risk-taking and credit to deserving borrowers; jobs will be lost or not created.
3. With the mid-term elections less than a year away, along with the about-to-begin presidential election cycle, Congress may pander to ever-present protectionist interests. These, if expressed as more than token trade restrictions, could be serious restraints to recovery.

The U.S. Dollar Commands Attention

Lastly, the dollar deservedly commands much anxious attention. Will it collapse amidst worries over a runaway U.S. budget deficit? We think not. We believe that the over-arching self-interest of managing a gradual, measured adjustment of the U.S. dollar in recognition of the growing importance of the Chinese renminbi will likely prevail. Everyone suffers if the dollar moves sharply and suddenly lower. This would likely trigger higher U.S. interest rates, and a likely renewed recession that brings back sharp rises in unemployment in China and other emerging economies.

What, however, must not be ignored is the massive, profitable trade that low U.S. interest rates has encouraged. Borrowing in dollars to invest in securities issued in currencies likely to appreciate—the so- called carry trade--has been a no-brainer transaction for a long time. The amounts currently involved are massive.

We Are Watchful of the Fed Funds Rate

The unwinding of these trades may be abrupt should the Fed surprise the markets by raising the Fed Funds rate sooner than traders expect. We noted that on November 30 the Fed Funds futures market was pricing in an 18% chance that the FOMC would raise the Fed Funds rate to 0.5% at its June meeting. By December 3, the odds had risen to 42%. And by market close on December 4, following the U.S. employment reports that massively beat expectations, the odds rose sharply to a 68% chance of a 0.5% Fed Funds rate by July.

At the same time, an index of the dollar’s foreign exchange value, the DXY, had its best day of the year jumping +1.7%--a surge, which given the recent news and some of the fundamental trends, makes sense. These shifts in rates, if they occur, will also have a huge and likely adverse impact upon commodities because playing those markets with borrowed U.S. dollars will have become less profitable. The FOMC’s intention to hold the Fed Funds rate at "exceptionally low levels…for an extended period" may turn out to be somewhat less extended.

Can the U.S. Shake Free of a Ten-Year-Long Flat But
Volatile Market?

It is useful to take a long view from time to time. Given the widely recognized cyclical (for example, recession-induced unemployment) and structural (a permanent deficit arising from entitlements such as Medicare) pressures upon U.S. finances, can the U.S. shake free of the almost ten-year long, flat, but very volatile, market? Are we living through a cyclical recovery but remain in a bear market (CHART 6)?

These are questions we brood over. We are optimistic that the issues will get addressed by Congress. But, we are distressed that this may not happen until we are confronted with the prospect of real cost--that is, loss of confidence in the dollar and the unpleasant consequences that would follow.

For the next few quarters, however, we believe the likely path of risk-asset prices—stocks and bonds—is upward. Non-returning cash is seeking a home, and the likely place will be in financial assets that provide yield and participation in cyclically recovering earnings. As long as inflation remains benign around 2%, this path can prevail. If, however, political expediency trumps sensible growth policies, the prospect of rising inflation coupled with slow growth—stagflation--will likely be the outcome. It is too soon to make the call.

While these forces compete, we continue to seek to exploit the opportunities we see in post-recession recovery earnings, and also with the much higher growth among emerging economies, while heeding the impact of the longer-term headwinds. 

We Are Placing Assets to Benefit from the "New Economy"

Unless some new turmoil appears, we expect global recovery to survive withdrawal of government stimulus programs and to gain momentum in coming quarters. We note that despite the epic recession, the world has grown dramatically in the past five years. This growth has created a "new economy," almost 70% the size of the U.S.

As we have written, this new economy resides in the emerging economies. In U.S. dollar terms, this growth equals new activity of $10.2 trillion. Expressed in terms of the percentage growth, the industrialized economies have grown 40%, while the emerging economies have grown 131% over this period.

The world has—and is—changing, bringing huge opportunities to portfolio investors who have the freedom to deploy assets anywhere. That said, managing risk is our paramount task and we do it with broad diversification across and within asset classes and geographies.

Mackin Pulsifer
December 5, 2009

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FIXED INCOME PERSPECTIVE

Ron Sanchez, CFA
Director of Fixed Income Strategies

AFTER STRONG DEMAND, CAUTION PREVAILS

High Demand Led to Declining Yields

Fixed income markets largely settled during the quarter as the economy continued to show signs of recovery and zero interest rates fueled demand for more yield. Fixed income markets have been the beneficiary of extremely strong demand throughout the year as evidenced by record setting inflows into mutual funds, both for taxable and tax exempt funds.

This demand has contributed to declines in yields for all non-Treasury sectors, including mortgages, corporate credit, emerging and municipal bonds. In addition, risk premiums, which measure the spread difference between various yield sectors and the risk-free Treasury market, have been stable in the most recent period, after declining sharply throughout the year. Chart 1 shows the spread effect on investment grade bonds as investors were willing to take more risk.

 

Bond Valuations Have Experienced Dramatic Recovery

The stellar performance of the broader fixed income markets resulted in valuations on many sectors to return to their longer-term ranges. While risk premiums for investment grade corporates have dramatically tightened (i.e. declined versus Treasuries), the tightening has not been uniform throughout the financial and industrial sectors.

For example, risk premiums on investment grade bonds in the industrial sector—which reached historic highs of 5.5% at the end of 2008—have experienced significant recovery to 1.69%. However, they still remain slightly elevated when compared to their 20-year pre-credit-crisis long-term average of 1.38%. Spreads of financial companies at 2.45% are still well above their long-term pre-credit-crisis spread average of 1.09% (after spiking to nearly 8.00% in March of 2009). Absolute yield levels on corporate bonds are near their all time lows.

At this point, we consider current valuations within the investment grade corporate bond market to represent fair value. We are looking to continue to add to the sector selectively in the short to intermediate maturity range, reflecting our more cautious view on the entire fixed income market.

Shorter-Term Municipal Bond Yields Hover Near Historical Lows

The performance year-to-date (January-November 2009) for the municipal market has been quite impressive in the absolute, and nothing short of extraordinary, for short- and intermediate-term maturities when compared to the returns in the Treasury market. Municipal bonds in the 5-year range began 2009 yielding 158% of Treasuries—it is rare for high grade municipal bonds to yield in excess of Treasuries.

Strong investor demand then drove municipal bond yields lower throughout much of the year. This caused municipal bonds to richen, with ratios reaching 63% of Treasuries in early December. With the 20 year average of the 5-year municipal bond ratio at 77%, we have moved from one extreme to the other.

Our Outlook on Munis is Cautious

Given the strong performance to date and the low absolute level of yields and rich valuations in the short- and intermediate-term maturities, we are taking a more cautious view of the tax-exempt sector. In addition, we believe credit fundamentals will continue to deteriorate at the state and local budget level over the next few years. We continue to focus our investments on the high quality segment of the market, including pre-refunded bonds and essential service revenue bonds, and seek to find value in callable bond structures with short final maturities.

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STRATEGIC ASSET ALLOCATION

Our Tactical Allocation Remains Defensive

We remain opportunistic, while balancing exposure to risk

• Equities remain underweight, but we maintain our long-term target for the U.S.
• We believe the inherent dynamism of U.S. economy will foster an evolution toward exports away from domestic consumption, leading to sustained domestic growth in the long term.
• U.S. companies have been distributing more cash to stockholders as company returns improve, making dividend yields more attractive.
• In our view, companies within the developed markets will experience slower growth vs. emerging markets due to a constrained lending environment and lower consumption growth.
• We maintain increased exposure to emerging markets; however, we are selectively selling holdings.
• Fixed Income continues to be underweight, with a focus on credit quality and risk management
• We continue to favor the investment grade corporate bond sector, but on a more selective basis with a focus on the short intermediate maturity range. This reflects our more cautious view on the broader fixed income markets.
• We remain cautious on the tax exempt bonds, especially inside of 10 years, due to the low absolute level of yields, rich valuations, and declining credit fundamentals. Considering the deterioration of state and local budgets, we are diversified within and outside of the municipal sector. We favor pre-refunded bonds and high grade essential service revenue bonds.
• Cash allocation remains overweight
• We have been cautious about chasing stocks in the post March 2009 rally and believe individual security selection remains critical.
• Higher cash levels provide the needed flexibility to be opportunistic, and to help protect against volatility.

 

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FIDUCIARY TRUST FORUM

Investing in the U.S. as the Global Recovery Takes Hold

Panel Members

• H. Penny Knuff, CFA, Managing Director, San Mateo
• Linda Krouner, Managing Director, New York
• Joseph C. Portillo, CFA, Managing Director, Los Angeles
• Ron Sanchez, CFA, Executive Vice President, Director of Fixed Income Strategies, New York

The participants in this quarter’s Fiduciary Trust Forum are senior portfolio managers from across the firm. They discuss their views on the opportunities and risks of investing in the U.S. on the heels of the strong 2009 market.

Q. Given the significant run-up in the S&P since March 2009, do you think that there is still upside?

LINDA: The cyclical areas of the market led the strong rally off the March 2009 lows as investors anticipated the economic rebound—several sub-sectors had extraordinary returns. Because a rally similar to that one is unlikely to repeat itself soon, we are selectively selling positions when we see opportunities to do so. In terms of buying opportunities, we are looking at companies that are tied to long-term secular growth themes in their respective sectors.

PENNY: We like investing in U.S. companies that are global leaders in their industries. Remember that at least 40% of the sales of the companies in S&P 500 come from markets outside the U.S. We believe that number will be even higher in 2010. Ideally, we like companies that have leading market share, expanding margins, free cash flow, consistent earnings growth and no debt. Many of these global leaders appear to be positioned to benefit from the significant growth in the emerging markets. Obviously, valuations matter. We want to pay a reasonable price for these high quality companies.

JOE: We believe that the domestic market has more upside potential, as long as we see continuing signs of economic recovery. The latest jobless data could indicate that unemployment may be peaking.

Q: Technology has been a favorable sector, both in good and bad economic times. What direction do you see the tech sector taking as we head into 2010?

JOE: Technology continues to represent a growing share of our GDP. We believe as business confidence builds, companies will look to invest in ways to increase efficiency, productivity and competitive advantage using technology.

Despite the sector’s performance year to date, valuations are not high by historical standards. For instance, global technology trades at about an 18% discount to its 1990-2008 historical average P/E ratio, excluding the tech bubble. In the U.S., tech trades at about an 8% premium to the S&P 500, which is below its average ex-tech bubble premium of 18%. Further, cost cutting and outsourcing has improved cash flow metrics for the sector—some estimate that free cash flow margins for many tech companies are running at 15% to 20%.

PENNY: I look for tech companies with specialized niches. For example, video conferencing equipment is experiencing a boom as companies continue to cut travel costs. This equipment provides cost effective ways of bringing people together which means quick, high ROIs. Also, voice recognition software, which is used in everything from phones to the medical transcription market to car navigation systems, looks like an attractive part of wireless communications.

Q. How have the changing patterns of the American consumer changed your views on investing?

PENNY: The U.S. consumer has become extremely focused on the value proposition- they want to pay a reasonable price for quality goods. We expect companies that sell desirable items at discounted prices to continue to do very well, as well as the ‘big box’ warehouse stores and retailers.

JOE: It appears that growth in the U.S. recovery will be subdued. It will take time for the U.S. consumer to deleverage their personal balance sheets. In spite of these likely headwinds, the U.S. consumer still loves gadgets and wireless mobility. Look at the success of third-generation (3G) wireless phones. They have combined wireless mobility with useful, easily downloadable applications, allowing users to customize their mobile experience. We believe there are still many attractive investments that benefit from these two dominant trends.

LINDA: In my opinion, next year could be harder on companies. Most have been good at cost cutting, and in many cases earnings have been better than expected relative to the extremely low expectations in the wake of the financial crisis. For the market to continue to perform we need to see end demand start to pick up; so, we are going to be 'waiting for demand' and we hope that demand is not as elusive as Godot. 

Q: Healthcare has been a high profile topic. Is this an area where you see opportunity?

LINDA: Healthcare has been stymied by uncertainty over Obama’s health insurance reform, but we believe this is one sector where the U.S. has and should maintain a global competitive advantage. The U.S. has the best research and development, the best medical schools and the highest reimbursement system. There are high barriers to entry in almost every sub sector, making it difficult for others to compete.

JOE: We look for firms that are finding innovative solutions for long-time health care issues such as reducing healthcare costs or treating life-threatening diseases like cancer or HIV. We believe that companies that make specialized but highly necessary equipment should see growth. Hospitals have and will likely continue to find ways to buy them, despite the still tough economic environment.

We also like global pharmaceuticals; they are surrounded by pessimists as healthcare reform legislation poses a potential threat, and we believe the positives are not fully priced in. With the largest populations getting richer and living longer, health care becomes more important in general—in our view, investors should not bet against this long-term demographic trend.

Q. How do you see U.S. firms adapting to lower consumption here at home?

JOE: U.S. consumers will likely take a while to gain more confidence, so many U.S. companies will have to find earnings abroad. We, therefore, are attracted to global leaders who can benefit from improving demand in China, Brazil and India.

PENNY: Merger and acquisition activity is on the rise globally. Many companies want to control the quality of their supply chains so they are becoming vertically integrated. Others merge to expand their pipelines or product offerings. Shareholders also benefit from synergies and cost cutting, boosting earnings.

LINDA: You must remember that companies have done better than consumers. Large companies that have been squirreling away cash can expand substantially through merger activity—it’s in some cases the only way to grow their earnings right now.

Q. How can investors benefit from the weak U.S. dollar?

JOE: Multinational corporations with good exposure to overseas revenues have traditionally been a good way to benefit from a weaker dollar. We believe that companies with a high level of overseas sales, such as consumer product manufacturers or food conglomerates, are usually good ways to play a weaker dollar.

RON: The dollar has experienced an ongoing valuation adjustment which has been orderly. We do not believe this will lead to a dollar crisis. We expect that the dollar weakness relative to the euro and Japanese yen is most likely complete, but that the dollar may continue to weaken over time relative to high yielding, commodity driven economies, and faster growing peripheral economies such as Brazil, and non-Japan Asia.

PENNY: The U.S. has many innovative companies that can have the potential to benefit from the growth in countries like India and China. For example, the global agribusiness is looking for ways to make existing land more productive. Companies that focus on crop protection or harvesting productivity are interesting investments.

Q. Where are you finding income, while keeping risk in check?

RON: As yield opportunities have diminished over the past year and the Federal Reserve continues to keep short-term interest rates very low for an extended period of time, we still see some opportunities in the investment grade corporate bond market—but on a very selective basis.

In general, we are not in favor of reaching for yield by extending out maturities to the very long end of the yield curve or down the credit quality curve. We do believe there are opportunities in structured bonds. These are bonds issued that have a call feature; investors are compensated by incremental yield in return for the embedded call option. For example, we favor bonds that have a 5 year final maturity with a call feature in 3 years.

On the tax-free side, we believe high-rated municipal bonds tied to specific revenue streams should continue to offer much better yields than cash with a relatively modest amount of principal risk.

LINDA: There is also good dividend income available among many stocks right now. We are seeing this specifically in the energy, consumer staples, health care, and, to some extent, in the technology sector. Since we expect fundamentals in most of these sectors to be quite good, assuming continued economic recovery, we believe that dividends for larger high-quality companies in these sectors should be quite secure.

PENNY: As substitutes for fixed income investments, we are investing in cheap, high-quality companies with a history of increasing dividends. Many equities are offering 4%-5% yields and are trading substantially below the market. These stocks primarily are income-producers but, the bonus, over time, could be some appreciation in the stock price.

 

This communication is intended to provide general information. The information and opinions stated are as of December 5, 2009 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.

Fiduciary Trust Company International is a member of the Franklin Templeton Investments family of companies. 

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