Q2 Commentary (2009)
“The nine most terrifying words in the English language are, ‘I’m from the government and
I’m here to help’.” Ronald Reagan
“…all I hear about is the danger of an outbreak of high inflation. I’ll put my cards on the
table right away. I think the predominant risk is that inflation will be too low, not too high,
over the next several years.” Federal Reserve Bank of San Francisco President Janet Yellen
Ever since Ben Bernanke noted some economic optimism in mid-March by uttering the phrase “green shoots”, we have cautioned that perhaps the still very weak data only looked positive in juxtaposition with some of the horrific numbers of the post-Lehman period. Leading economic indicators and survey data moved up quickly and
appeared to bolster investor enthusiasm. Consumer Confidence surveys (from the Conference Board) jumped from the record lows of 26.9 in March to 54.8 in May. Institute of Supply Management (ISM) manufacturing and non-manufacturing numbers (considered a near-term economic barometer) rose from 32.9 and 40 to 44.8 and 47
respectively. Though many of these indicators and survey data may be skewed by financial market components, the bounce off of the lows reinforced the optimism of the horticulturists and fueled the continuation of the global rally from the March bottoms. The economic question will remain whether there is enough continued and sustainable improvement in housing and employment to warrant such increases in confidence.
The shift during the quarter in investor psychology was reinforced by data on housing and employment that, while still deteriorating, were clearly viewed as less bad and moving towards recovery. Housing starts appear to have stabilized around an annualized rate of 530K moving towards demand equilibrium while new and existing home sales also appear to have established a trough. Additionally, the most recent S&P/Case-Shiller home price index of national home values in May reported a year-over–year slowing in the rate of decline (though still down -18.1%).
In early June, the Labor Department reported that non-farm payrolls for May declined only 345K (since revised to -322K) a reading considerably better than consensus and off the depths of the average of a loss of 670K jobs in the November-March period. Additionally with jobless claims and continuing claims (more coincident indicators of the employment picture) showing signs of peaking and rolling over, the V-shaped recovery camp was becoming quite crowded. The Fed Funds futures market was even pricing in a 70% probability of the Federal Reserve actually raising rates in 2009!
The concurrent shift towards riskier assets was pronounced. For the quarter, the S&P 500 rallied almost 16%, moving into positive territory for 2009 (3.2%) and fully 38% above the 666 level of March 9. However, the strongest returns were found in the most aggressive categories. Indicative of this were the Auto, Casino, Consumer Finance and Real Estate industries which returned 98%, 74%, 132% and 74% respectively. These outsized returns brought the collective 2 year returns in these industries closer to -60%!The Russell 2000 index of small cap stocks and MSCI EAFE index of developed international markets rose 20.7% and 25.8% respectively yet trailed the massive 35% return for the MSCI Emerging Market index. The S&P/GSCI (commodity index) soared 25.6% led by the rise in Oil from $44/bbl to $70/bbl. Is the market discounting increasing global demand and the seeds of economic recovery?
Placed in a broader context however, housing and employment may be viewed quite differently. Housing starts are now off 75% from the levels of 2005; inventories of new and existing homes are still at levels of 10 months supply (and understated due to foreclosure moratoriums) fully 4 months above levels where pricing historically stabilizes; and the S&P/Case-Shiller index is now showing national house price declines of over 32% from peak levels and back to prices last seen in early 2003. As of March, fully 15 million homes now have mortgages that exceed the value of the property and we are on pace to see 3.5 million foreclosures in 2009 up from 800K in 2005. As the quarter ends, estimates are that over 13% of all home mortgages were delinquent or in some stage of foreclosure. Yet through early July, only 131.000 mortgages have been modified under the new Loan Modification programs. This need becomes more critical as scores of Option ARMs and ALT-A loans are scheduled for reset in early 2010 through 2011.
The employment data is even more concerning. The dogmatic views of many economists that employment is a lagging indicator seemed to buttress the recovery themefollowing the release of the May employment data. As this recession is not the typical manufacturing-inventory cycle, we fear that to be a dangerous and faulty assumption with employment more likely to be a leading indicator. In a highly-indebted economy, job losses and wage reductions are more likely to be followed by even more delinquencies and mortgage foreclosures. The subsequent release of the weaker June jobs data appears to have shifted concern back to this area.
In less than 16 months the unemployment rate has doubled from 4.8% to 9.5% representing over 14 million workers. We now expect this number to breach 11% by 2010. The U-6 rate of marginally attached workers (a broader measure that also includes underemployed and those who have ceased looking for work) has ballooned to over 16.5% and now represents 25 million people. The average workweek has now declined to an all-time low of 33.0 hours and a recent survey by Economist magazine estimates that 15% of workers have accepted pay cuts this year and scores of others have accepted unpaid leave. With the median duration of unemployment having jumped from 8.3 weeks to 17.9 in a little over a year, keeping one’s job is becoming the primary concern. In total the average weekly earnings have now declined at an annual rate of over 1.6% since March, a figure that was seen rising at a 5.2% rate as recently as 2007. The same Economist survey also indicates that 25% of employers will reduce or eliminate the 401K match to their employees. To the typical U.S. consumer already facing a weakened balance sheet and the additional burden of having to bear an increasing portion of healthcare costs, pressure on consumer spending continues to increase.
In perhaps our first real world test of Keynesian economics, to the rescue has appeared our administration. If consumers cannot fill the vacuum of decreased demand, our government will. Total government stimulus in the form of increased benefits and reduced taxes now comprise almost 20% of personal income. Yet despite consumer spending representing almost 70% of GDP, we still experienced a contraction of 5.5% in total output in 1Q 2009 following the GDP decline of 6.3% in 4Q 2008. This represented the worst 6-month period for our economy since 1958.
We are noting, however, some longer term positives as consumers address the reparation of individual balance sheets. Future growth is made possible by foregoing present consumption to increase investment (assuming those monies are eventually recycled into investment by business). The U.S. savings rate has soared to a 16-year high
of 6.9% (from almost 0% as recently as the first quarter of 2008); consumer credit outstanding has contracted (for the first time on record) $63B over the last 18 months and the household debt service ratio, though still high, has declined back to levels first seen in 2003. Continued improvement in the consumer balance sheet along with a turn in employment and equilibrium in housing inventories are what we feel are needed for sustainable long term economic growth.
As we enter the 3rd quarter, we fully expect that we may see the balance of 2009 show positive prints in terms of GDP growth in the range of 1%-2% following a modest decline for the second quarter. Much of these gains will be as we anniversary very low residential construction and consumer spending figures that will be less of a drag on the tally (especially in Q4). Housing starts and business investment to replenish low levels of inventories (especially in the auto sector) will start to contribute less negatively. However, to generate a sustainable recovery, businesses must be confident enough to increase hiring which in turn is spurred by increased consumer demand due to job and wage growth. This will be the spiral that will need to be broken after the impact of the fiscal stimulus declines.
With current talk now moving to discussion of a third stimulus package amid the continuing onslaught of government intervention, it is worth noting that a recent WSJ/NBC News poll indicated that 24% of those surveyed expressed their primary concern to be the burgeoning U.S. National Debt. While rising unemployment was the foremost concern at 35%, there appears little question that growing fears of pronounced inflation contrasted by the minimal impact to date of the existing $787 billion dollar stimulus package (less than 15% of which may have even been deployed to date) has moved front and center in the minds of the public, investors and economists.
Indeed, with the national debt exploding to $11.5 trillion (this does not even include Social Security) or 80% of GDP, current budget deficit estimates of $1.85 trillion or 13% of GDP and the massive issuance of government bonds, 2009 has seen the 10-year U.S Treasury bond yield rise from just above 2% to almost 4% in early June. Inflation expectations as measured by Treasury Inflation Protected Securities spreads rose from almost 0% to 2% in June and many economists have expressed fears of eventual hyper-inflation. Polls, such as the one above, bear monitoring. It may be less actual inflation than inflation expectations that are most concerning. Expectations influence behavior and often not in the ways desired by policy makers as the recent rise in mortgage rates attest.
While we are sure that the inflation debate will rage on (in these pages as well) and may certainly be the most critical component to investing over the next decade, we simply cannot concern ourselves with it on the shorter term investment horizon. Capacity utilization rates of 65% will serve to keep business fixed investment constrained while unemployment levels that could potentially breach 11% will continue to present a major headwind to wage growth. Household net worth has declined by more than $14 trillion dollars since the peak in 2007, a figure equal to the annual Gross Domestic Product. It is fair to assume that both the consumer and the banking industry will continue to unwind credit amidst a more conservative approach to borrowing and lending. We may have permanently extinguished the securitization market and have witnessed credit being destroyed at a rate far faster than we have even been able to print money.
In our most recent commentaries we noted the exceptional attractiveness of fixed income and historically wide credit spreads afforded investors in high grade corporate, and especially lower-rated or high yield corporate bonds. The stabilization of the financial markets during the quarter allowed investors in these areas to be rewarded. Double-digit returns were achieved, competitive with the major U.S. equity averages. Though these spreads have since contracted by about 50%, they still offer historical attractiveness and we believe still represent solid value.
Consistent with the “less bad” recovery theme, earnings in the opening quarter of 2009 for the companies that comprise the S&P 500 index managed to meet the lowered expectations of analysts. We are now looking at full year estimates approximating $50 (down from $88 in 2006) and a modest rebound towards $60 in 2010. The equity markets may have already priced in much of a modest anticipated rebound in earnings but the
valuations are quite disproportionate. In the equity market, the focus should most certainly be on the safest and highest quality companies many of which failed to participate in the recent rally. We continue to see excellent values in high quality consumer goods and staples companies, healthcare companies and even the large integrated energy companies most of which are priced at their most attractive relative and absolute valuations in years. The companies that comprise the core of our portfolios remain in greater control of their own destinies with strong balance sheets, superior competitive positions and recession resistant business models.
As the economic downturn moves late into its second year, we remain encouraged by the operating and financial performance of our holdings. With dividend cuts and suspensions now almost as prevalent as increases, the indicated rate on the S&P 500 has been reduced by over 22% in 2009 after declining 3% in 2008. Dividends have
historically comprised almost half of the return in an equity portfolio and during the same 18-month period, none of our holdings have reduced their payout. In fact, our portfolio generated an increase in actual dividends paid in 2008 of over 11%. So far in 2009, almost 60% of our holdings have raised their dividend and before the year is over, we fully expect nearly all to have done so.
