April 25th, 2010
Dear Friends and Clients: Q1 2010 Commentary from Andorra
“It was the best of times…it was the worst of times” (a quote from “A Tale of Two Cities” by Charles Dickens). This piece of Dickens’ quote is very telling and analogous to the current scenario playing out in the US economy and capital markets. Clearly there is a bifurcation that has developed from the “real economy” or what some call “Main Street USA” (still hurting by almost every measure) and the capital markets (the past year has been good to investors who did not abandon ship at market lows). Asset prices have partially recovered (non real estate assets that is) which has prompted many market watchers to be encouraged by a developing “positive wealth effect” and potential stimulative impacts this will have on the domestic economy. But on the balance “real” domestic economic activity, while picking up by many measures, still remains weak. The exact reason for this outcome is not fully clear but most likely can be attributed to government bailout measures benefiting members of the financial community (particularly big banks and financial companies) and not yet trickling down to Main Street. In short, the government sponsored liquidity effect has propped up asset prices and installed, while likely artificial, a base in the US economy that has not yet translated to meaningful job or wage growth.
It is no longer a secret that large US banks are hording massive piles of cash in an effort to rebuild their balance sheets due to pools of toxic assets. Politicians and pundits alike have poked, prodded, and tried to cajole banks into lending without much success. Recent feedback from businesses state that commercial lending had resumed but is still difficult to access and remains well below pre-bubble levels. Whether or not current bank reserves which have grown to historic levels will cover current and future bad residential and commercial mortgage debt is unclear. What is very clear is that banks are much more comfortable depositing newly created money (quantitative easing) at the FED than loaning out money to Main Street (according to the FED’s statistics as of March 21, 2010 banks have over $1.1 trillion dollars deposited at the FED). FED Chairman Ben Bernanke has acknowledged in public that banks hoarding cash is a problem with no clear solution. This begs the question: are banks concerned that future write-downs will continue and also be massive, and/or would banks rather sit on this money, wait for interest rates to rise and then begin to lend which will allow them to make much greater returns on their loan portfolios. Where interest rates have nowhere to go but up and banks typically begin lending again after economic activity has turned the corner, we believe it is a bit of both.
A passage from “Where are the Customers Yachts” which refers to bankers and how they deal with their clients:
“He says yes only a few times a year. His rule is that he reserves his yeses for organizations so wealthy that if he said “no”, some other banker would quickly say yes. His business might be defined as the lending of money exclusively to people who have no pressing need for it. In times of stress, when everybody needs money, he strives to avoid lending to anybody, but usually makes an exception for the United States Government”.
It is worth mentioning that the book “Where are the Customers Yachts” was originally published in 1940 by a man who had a brief career on Wall Street during the “Great Crash” of 1929. It seems that much of his experience nearly 80 years ago is still relevant today. The lesson that can be carried forward from this book is events do repeat themselves, while not always with regularity, and we should not forget the lessons of the past. Bankers are just people and can be prone to panics (the banks stopped lending as witnessed during 2009) and manias (the sub-prime lending bonanza when anyone with a heartbeat was approved for a home loan) which happen all too frequently over long periods of time.
What currently appears to be an economic recovery in the U.S. may prove to be lumpy and anemic which in our view rests on a three legged stool. In the developing world global growth needs to be strong and sustained (growth will be hampered in the developed world by continued deleveraging and boated government budget deficits for the foreseeable future), interest rates must stay at moderate levels that do not choke off “green shoots” in the economy, and future shocks to the financial system like the bankruptcy of Lehman must be avoided (but watch for high budget deficits to continue to provoke sovereign debt problems from the PIIGS, Portugal, Italy, Ireland, Greece, and Spain, which may make market nervous for years to come).
The emerging markets (NYSE:EM) or developing world (the usual BRIC economies of Brazil, Russia, India, and China, but may also include the likes of Taiwan, Korea, Chile, Indonesia, Poland, and Mexico which are also worth mentioning) will be relied upon to be a major source of global growth in the coming years. GDP growth in these countries is expected to be anywhere from 5%-10% in the near future (source International Monetary Fund “World Economic Outlook 2010”). EM economies have and will continue to benefit from relatively low debt levels vs. the developed world which has allowed them flexibility to internally stimulate demand while maintaining sustainable debt levels. Many of these countries, specifically Brazil, are resource rich and may benefit from a sustained recovery due to both high prices for natural resources and strong inflows of capital. This will continue to contrast with developed markets which will be boxed in by high debt levels and structurally high unemployment.
In the developed markets or developed world (primarily consisting of the U.S. and mainland Europe) GPD growth is expected to be between 1% to 3%, with a strong possibility of a GDP contraction for some of the PIIGS. As mentioned, unemployment continues to be a problem. Some have mentioned a “new normal” which might include much higher levels of unemployment (a structural shift) than we are accustomed to, which many see continuing for many years. Others point to inventory rebuilding and industrial production showing strong signs of recovery in the U.S. Industrial production has been improving with capacity utilization coming off record lows of June 2009 but current numbers are still at extremely low recessionary levels. This, coupled with many workers who are employed part-time and unable to find full-time positions (U6 running around 16-18%) and full-time workers currently experiencing furloughs, we expect the unemployment picture to remain difficult which will have spill-over effects to other sectors of our economy (state and local budgets will remain strained for many years).
Further US growth that was experienced during 2009 was strongly influenced by government stimulus measures and policy actions designed to prop up the financial and housing sectors. The results seems to be fairly good in salvaging the financial system but the housing sector is still on life support and is facing the expiration of tax credits and mortgage rates that are expected to rise. This coupled again with the previously outlined high unemployment rate and many workers who are experiencing furloughs or layoffs seems to set the stage for warning signs for the residential housing market. Participants in the mortgage business report bottlenecks at banks and financial companies unable to cope with the wave of foreclosures which may lead to a massive “shadow inventory” of unsold homes. While an artificial base may have been established in home prices, values in outlying areas could be in for another down-leg (or at the very least a “lost decade” of appreciation) and growth rates for “prime” real estate may be below trend for the foreseeable future.
Where does that leave us? The developed world is due for a slow recovery, EM economies are expected to post strong GDP growth rates and the U.S. consumer will go through a long deleveraging and recovery phase while trying to rebuild his or her household balance sheet. Our outlook for client portfolio’s on a “relative” basis is to underweight U.S. equity positions, within that asset class concentrate on U.S. based companies with strong international sales. Separately, strive to overweight international and emerging markets while avoiding companies with heavy exposure to Continental Europe. For fixed income look to shorten duration across the board and move to EM and International Bonds that will provide betters yields with a lower risk/return profile vs. developed markets. Inflationary risks are building on the demand side, not so much from U.S. led consumption but from the EM economies which will be strong consumers of raw materials in a world where large commodity players will able to exert more control over basic material prices going forward (see recent news stories on the new Iron Ore pricing scheme). As mentioned above, the PIIGS will have problems which at times will seem insurmountable. This may lead to periods of strength in the US Dollar vs. other currencies which will present as price weakness in non-US assets. This should be seen as an opportunity to further diversify away from dollar denominated assets into higher growth opportunities abroad. Our outlook is to remain vigilant in diversifying away from any overexposure to US assets which have had a tremendous run during the last year.