Tuesday, May 24, 2011

Clouds Gathering on the U.S. and International Economic Horizon

There is a growing consensus among economists that the U.S. economy is slowing, and this revised outlook is being reflected in the stock and bond markets. A late April survey taken by the National Association of Business Economists, released on May 16, projected 2011 U.S. GDP growth of 2.8%, down from their early February forecast of 3.3%. The slowdown, first evidenced in disappointing 1st quarter GDP growth of only 1.8%, was also featured in The Economist’s recent cover article “What’s Wrong With America’s Economy” (April 30-May 6).
The reduced outlook for the U.S. economy comes at a time when doubts are also spreading regarding the strength of the international economies. In Europe the sovereign debt crisis has reached an ominous level: the austerity programs crafted by desperate governments in Greece and Spain are encountering increasingly belligerent popular resistance, and the policy makers at the European Central Bank (ECB), the International Monetary Fund (IMF) and leading Euro-area governments (notably Germany) have become more divided and intransigent in their failed effort to agree upon a remedy. Crippled by the economic consequences of the earthquake/tsunami/nuclear catastrophe, Japan has again retreated into recession. Within the leading emerging economies of China, India, and Brazil, intensifying inflation has forced governments and central banks to adopt ever stronger restrictive measures, which in turn has led to heightened investor fears of “hard landings.” In this perfect storm of economic concern, the Economic Cycle Research Institute (ECRI), a widely watched barometer of trends with an exemplary track record, issued on May 19 a statement that “there’s a downturn in global industrial growth in clear sight,” but added that they saw no sign of a renewed recession.
The response of global financial markets has been swift, and arguably excessive. Investors have suddenly turned cautious. In the midst of a flight to safety, the yield on 10-year U.S. Treasury notes plummeted from 3.59% in mid April to 3.13% on May 23. The U.S. dollar reversed a 4-month slide and in a three week period stretching from April 29 through May 23 rose 4.3% against a basket of currencies. On the other side of the coin, the prices of economy-sensitive commodities, which had soared for a year with only minor interruption, crashed: during this same three-week period, the CRB Index of agricultural and industrial commodities plunged -9.1%. Also damaged in this period were the international stock markets. As volatility rose to unnerving levels, the iShares MSCI ETF of developed countries (EFA) slumped -6.9% and the iShares MSCI ETF of emerging economies (EEM) sank a chilling -7.8%. The Standard & Poor’s 500 Index fared better with a more modest decline of -3.4%, but within the U.S. market there was a seismic rotation. Out of favor were many of the economy-sensitive, high-growth, low dividend, small and mid cap stocks that had led the market since the beginning of the bull market in March of 2009. Elevated to favor were many of the recession resistant, slow growing, high dividend, and previously underperforming mega cap stocks. Out were energy, materials, industrials, and information-technology stocks; in were health care, consumer staples, and utilities stocks.
If the recent economic developments and financial market trends persist and strengthen they will present a challenge to the consensus (and our) global economic outlook and investment strategy. Have we reached a point where it is necessary to alter our view of a healthy, if geographically unbalanced, multi-year global economic expansion extending through at least 2012 and abandon the growth-oriented equity strategies that have served us so well the past two years? At this point, we do not think so. The highest probable scenario, in our view, is that the global economy will experience a “soft patch” and choppy stock markets followed by a resumption of 4-4.5% economic growth fueling further market gains. We note that “soft patches” are a normal phenomenon of past economic cycles, and it would be very unusual for a cycle to last only two years.
It is not possible, at this juncture, to predict with conviction the severity or duration of a “soft patch,” but the prospect of a double-dip recession is quite low. There are many positive developments buttressing economic growth. The employment picture continues to improve gradually, consumer spending is resilient, corporate profits and balance sheets are very strong, interest rates are very low, exports are robust, financial institutions continue to strengthen and are more willing to lend, etc. Very important is that the outlook for inflation, which has been a major factor in igniting economic and market fears, is significantly improved by the recent sharp decline in commodity prices. Since the end of April through May 23, when the CRB Index retreated -9.1%, the price of crude oil dropped -14.2%. We expect a summer pick up in U.S. consumer confidence as gasoline prices fall, and relief from rising food and energy prices in the emerging economies may permit policy makers to back away from policies designed to slow their economies. The global equity strategy group at Citigroup on May 19 observed that the commodity price pullback indicates that a peak in inflation and interest rates is imminent in the key emerging economies of China, India, and Brazil, and predicted a 31% rise in emerging economy equities by the end of 2011.
Like the economy, there are also positive conditions supporting the U.S. stock market. Strong corporate profits continue to provide attractive valuations despite the large stock gains of the past two years. In addition, huge corporate cash positions should result in higher dividends, a pick up in stock buyback programs, and an acceleration in merger and acquisition activity. Further, interest rates are low and the Federal Reserve is implementing a very accommodative policy. Also worth noting is that a mountain of cash remains on the sidelines even though money-market funds yield little or nothing. The alternatives to stocks are not very appealing: bond yields are low and their prospects are limited by credit issues and the threat of future inflation. The real estate market is moribund and likely to remain so until well into 2012.
We currently encourage investors to exercise patience and adhere to long term asset allocation guidelines and norms. Conservative investors may chose to exercise a higher than usual level of caution to adjust for the more elevated risk in the economy and markets and to increase their comfort level in what may well be a choppy market. We also recommend that investors maintain broad geographic and industry diversification in their equity holdings, take a longer term perspective in the midst of heighted volatility, and monitor closely the fundamental progress of companies in their portfolio. This is a time when it is necessary to have a high level of confidence in the fundamental strength of portfolio companies. Above all, investors need to be especially vigilant and flexible.
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