April 2005: Keep Focused On What’s Important To The Financial Markets; GDP Growth, Corporate Earning
“If you can keep your head when all about you are losing theirs…”
Rudyard Kipling, first Nobel Laureate in literature (1907), poet and prolific author, wrote extensively on the issues of his time. Like a later-day investment advisor he extolled virtues of thrift, savings and investment. One wonders if he might have been thinking of the dilemma facing today’s investor when he penned the above famous opening line for his poem “If.”
The financial market climate ahead may well test investors’ fortitude and willingness to stay the course. World-wide, the investment market psychological backdrop is dimming noticeably. America’s seemingly endless demand for globally produced imported goods, China’s economic boom and the era of cheap money all seem to be peaking. Concerned about another asset class valuation bubble, knowledgeable real estate investors are cashing out; some even passing up the opportunity to reinvest in similar properties to defer capital gains taxes, instead paying the tax to the IRS and returning the after-tax proceeds to their partners.
As mentioned a few months ago in our year-end letter, 2004 will go into the books as a banner year when measured country against country by Gross Domestic Product (GDP) growth. 2005 is shaping up as a period of more normal, subdued economic activity, but nevertheless, a reasonable environment for further corporate profit improvement, albeit at a slower incremental pace than the year just ended.
As has become the media’s wont, the dark side of the equation garners the attention, making it difficult for us to distinguish important facts – facts with consequences – from insignificant ones. Much of this journalist hype of course is because bad news sells, but it is also due to news editors’ unwillingness to discern just which stories are worth relating.
In the U.S., our problems are well publicized: federal, state and local governments borrowing for non-investment, non-productive purposes, consumer balance sheets weakened by growing debt burden, and a high-cost uncompetitive manufacturing sector. The latter is one of the main reasons for our trade imbalances, the widening gap between cheaper imports and our relatively expensive exports. However, investors ignore the U.S. economy’s important positives at their peril. These long-term attributes continue to be 1) relative political stability and a broadly diversified economy; 2) a strongly financed banking system; 3) the world’s most sophisticated and liquid capital markets; 4) the planet’s lowest cost distribution system; 5) an entrepreneurial, mobile, educated work force, and 6) publicly traded corporations comfortably financed with relatively strong balance sheets. For equity-minded investors, the strengths continue to outweigh the weaknesses, still tilting the investment equation toward what we would describe as a “normal” equity-fixed income mix (i.e., an overall investable asset class allocation of roughly 60%-70% equities offset by 30%-40% fixed income for most investors). The time to bet against world-wide economic growth, the benefits of fuller economic integration, unfettered trade and increased globalization has not, in our opinion, yet arrived.
Inflation – The Fed Wakes Up and Smells the Coffee…
The long era of abnormally low interest rates is behind us. The most recent meeting of U.S. central bankers, the Federal Reserve Open Market Committee, ended with a watershed announcement. It was not that the Fed raised its Federal-funds rate target [for the seventh time] to 2.75%. Instead, for the first time since November 2000, the Fed explicitly acknowledged the growing risks of inflation. Having kept the monetary floodgates open with negative real rates for three years in order to promote economic growth – the most accommodative monetary policy since the 1970s – Mr. Greenspan and his colleagues have started to smell whiffs of inflation.
What's been brewing? Higher commodity prices, mid-$50 oil prices and a weaker dollar are starting to have an impact. The latter has boosted the price of imported consumer goods by over 4% from a year ago. A recent surge in wholesale prices also threatens to further pressure consumers’ wallets, as producers must either pass on increased costs or accept lower profit margins. The closely watched Consumer Price Index (CPI), used in adjusting social security and pension payments as well as labor contracts, for example, has ticked up 3% on a year-to-year basis.
But how well does this government inflation statistic reflect the reality we face? First, it's important to note that the CPI – with its many regional, seasonal, housing- related, "hedonic" and other adjustments – attempts to reflect the expenditure patterns of "average" urban consumers. As a result, individuals with a different mix of spending than those assumed in the CPI – for example, seniors spending 15-20% of income on health care rather than the 6% assumption – may have dramatically different "Personal Inflation" indexes than the published CPI.
The neighboring chart reflects price increases for select goods/services of importance to many individuals and families. Over the six years from 1999 to 2004, the national CPI increased at a compound annual growth rate of 2.5%. However, over the same period, average wage income increased at 3.3% annually, while single-family home prices went up over 6% and private college tuition increased 5.3% (and almost 8% at public colleges). Still, none of these increases approached the double-digit yearly rise in health care costs. For many individuals and families, these price increases are causing living expenses to outpace income growth, thereby pressuring household budgets. These trends underscore the importance of inflation “hedges,” like natural resources, in investment portfolios, to help protect the purchasing power of personal assets.
And what are the financial markets' expectations of inflation? Forward-looking indicators such as gold and other commodity prices have been signaling trouble ahead for some time. After a pullback last year, these indicators have turned up once again in 2005 and are suggesting that the Fed is at the moment behind the curve. The recent spike in 10 year Treasury note yields is further evidence of bond market inflation jitters. Another telling indication has been the steady climb in the "breakeven" level of inflation implied by Treasury Inflation-Protected Securities (TIPS) (i.e., the difference between the nominal 10-year Treasury yield and the TIPS yield). As shown in the chart above, TIPS prices are now embedding inflation expectations of 2.7%. With this breakeven rate less than the reported CPI, TIPS should provide a higher total return than conventional Treasuries. Should inflation expectations rise, allocations to TIPS (in tax deferred accounts) will provide investors with both an effective inflation hedge and good portfolio diversification.
The End of Fed Predictability
So in the face of overwhelming evidence, the Fed is now playing catch-up to reverse the effects of years of easy money. However, mounting inflationary pressures, coupled with a slowdown in productivity growth and a reduction in the economy's spare capacity have limited the Fed's maneuvering room. The days of “measured” 0.25% moves appear numbered; one or more 0.50% hikes seems likely, starting later this year.
Looking back, the Fed’s measured pace of rate increases has contributed significantly to keeping markets calm. In contrast to the severe and unpleasant reaction to Fed rate hikes in 1994, financial markets in recent years have seemed almost complacent, with stock market volatility today at 10-year lows. A consequence of this almost eerie calm, however, is that the relative risks of different asset classes have become progressively mispriced, as investors have chased higher yields (across all asset classes) in a world of low returns.
An end to Fed predictability may well lead to the return of greater stock market volatility. Looking forward, with monetary policy less certain, investors may return to demanding increased premiums to hold more risky assets – whether equities or fixed income securities. So for example, historically narrow corporate bond spreads relative to Treasuries will surely widen, and prices of emerging market securities could pull back. These trends are already unfolding, as investors also weigh the broader implications of recent corporate earnings shortfalls and debt downgrades, such as General Motors.
Mr. Greenspan’s Greatest Challenge
Few doubt that short-term interest rates are going higher, as the Fed siphons off the excess liquidity created these past 24-36 months. Of concern is whether the resulting tighter credit environment causes any indebted players to stumble or be spooked out of the capital markets. These market participants – highly leveraged hedge funds, large financial institutions involved in the “carry” trade (borrowing short and investing long), among others – depend heavily on cheap money and the booming structured credit market (e.g., credit derivatives, such as credit default swaps). As the cost of money rises, can unprofitable positions be unwound in an orderly fashion? While another spectacular hedge fund collapse is possible, and this year will be make-or-break for many hedge funds, the U.S. capital markets are extremely resilient. Nonetheless, even though a crisis may be averted, it’s likely to be a bumpy road ahead – highlighting the importance of broad diversification for investors.
On the economic front, the Naysayers (or “growth pessimists” as characterized by Professor Jeremy J. Siegel of the Wharton School), would have us conclude that the Fed’s tightening means the end of the current expansion. Fears of 1970’s-style “stagflation” abound, as the combination of sluggish economic growth and rising inflation threatens to return. We are monitoring economic developments closely. We remain cautiously optimistic that global reflation will prevent a relapse. Indeed, a more reasoned reading of the Fed’s tightening moves is that of a sensible policy response to a solidly based world-wide economic upsurge which needs to be taken off steroids.
Fed Chairman Greenspan’s accomplishments during his long tenure are many and well chronicled. Realigning U.S. and international credit markets to bring this recently unleashed liquidity under control will perhaps turn out to be one of his greatest challenges. If he can engineer a gradual readjustment upward in the structure of interest rates to more normal levels, the prospects of continued economic growth long-term will have been enhanced and renewed confidence in the dollar should result. The Fed’s move in the direction of a less accommodative money policy would seem on balance to be bullish for equity investors.
Aside from a possibly emerging real estate bubble, most other asset classes seem reasonably capitalized, but, as usual each offer differing prospects. In the U.S. equity markets, small companies now sell at virtual parity with large, “value” is priced closely to “growth.” International equities sell at a slight discount (i.e., 13x prospective earnings) to U.S. stocks (17x 2005 earnings). The natural resource sector (following a strong close last year and early 2005 relative gains) seems fully recognized. Our ongoing client portfolio rebalancing activities have adjusted for these changing dynamics in the capital markets, most recently reducing previously over-weighted exposure to small cap companies in favor of large in both domestic and international fund holdings. We will continue this realignment in the months ahead, as usual maintaining a fully invested stance throughout.
The Dollar’s Slide (Will Our Trading Partners Continue to Finance U.S. Profligacy?)
“We are in favor of a stable currency” intones Treasury Secretary Snow and other Administration officials; but do they really mean it? Probably not. However, to say otherwise would have serious financial market consequences. Cheapening the dollar is an insidious, stealthful way to export overseas the effects of our government deficit spending and trade gaps. Saddling others with appreciating currencies (e.g., the euro has risen in excess of 20% against the dollar over the last two years) forces counterpart countries to charge increased prices for their exports, thus becoming less competitive with the U.S. One view of this would be that this exacts a small amount of tribute from those around the world who benefit from our peace-keeping efforts reducing the burden on the U.S. Defense budget.
At the same time, we also rely on our trading partners, particularly China, Japan, the European bloc countries, etc. to buy U.S. Treasury bonds floated to cover our habitual deficits. But these countries need our purchase orders to generate revenue for their developing economies and growing workforces. This “virtuous circle” is at the heart of today’s dollar dilemma and Mr. Greenspan’s Conundrum… if we discipline ourselves too severely too quickly, the integrated world economic model, so carefully fashioned these past twenty years, may develop fissures with unknowable consequences. The better approach, at least from the American perspective, is to co-opt our partners, lock all interested parties into the loop and force each to participate in incremental compromises through which each works toward self-interested solutions. This hardball approach requires political stability through out all free market countries and the will, as well as policy continuity over time, to implement.
As long as our external liabilities are denominated for the most part in dollars, and the prices of the world’s necessary commodities continue to be quoted in greenbacks, America’s profligate ways will add fuel to this potentially inflationary fire, but probably not ignite it. If a gradual currency realignment process prevails in the months/years ahead, financial markets around the world will reflect these adjustments in an orderly way, but the dollar will remain under pressure. Beyond the fact that international stocks appear to be undervalued relative to domestic shares, unhedged mutual funds invested abroad may also benefit from continued dollar weakness.
U. S. Supreme Court Extends Creditor Protection To IRA’s
Stating that IRA’s will be shielded from claims by creditors in a Federal Bankruptcy proceeding, the Supreme Court has taken one more step to assure the safety of individual IRA’s. The way has now been cleared for many who were hesitant to roll-out retirement accounts from under large corporate umbrella plans to more personalized management arrangements. A wave of such roll-overs is expected to follow. The decision represents a very big win for individual investors.
Please do not hesitate to call us if you have comments or questions.
Sincerely,
James L. Joslin
President