A November NOT to Remember
December 7, 2007
From a historical perspective, November has traditionally been one of the best months for accruing gains in the U.S. stock market. This year, however, November turned out to be a real downer. The U.S. stock market lost ground in the month as traders reacted negatively to a growing list of issues. Not even the powerful rally that took place in the month’s final week could overcome the red ink. Given this performance, we feel it is a good opportunity to offer some insight regarding what we are currently thinking about the economy and the markets.
To begin, let us look at the U.S. economy. Heading into the final month of the year, the evidence suggests that the U.S. economy is decelerating. Consumer spending, the largest component of U.S. economic activity, is weak compared to prior years as households wrestle with higher costs of gasoline, food, heating oil and other essential goods. Retailers are already bracing for a weaker-than-hoped-for holiday shopping season. Businesses, with end-market demand declining and credit availability tightening, are being less aggressive with their capital expenditures. And the public sector, particularly at the State and local levels, is reducing spending as tax revenues decline. The only component of U.S. growth that is holding up well at this time is exports. Yes, the U.S. continues to import more than it exports, but for the past five months export growth has far surpassed import growth leading to a net positive contribution to U.S. growth.
Needless to say, with the U.S. economic outlook far from robust, corporate earnings forecasts are being revised lower and the job market may tighten. Given this backdrop, the financial markets expect the Federal Reserve to again cut benchmark interest rates at their next meeting on December 11th.
Unfortunately, the world we live in today is different than the one that existed just ten or even five years ago. As a result, the Fed’s decision is not clear cut. The biggest issue the Federal Reserve faces is inflation. Although the U.S. continues to consume the largest portion of the world’s natural resources, the pressure on the margin of supply is coming from the developing world, particularly China, India and Brazil. As these three major emerging markets have grown, so too have their middle classes and the demand for basic materials. Over the long run, this is a very encouraging development from an investor’s perspective given the greater number of end markets that become available for revenue growth. However, the transition is and will likely be painful. For many key global resources such as crude oil, copper, gold, or nickel, there is only so much that can be done in the short run to supplement supply. As a result, prices for these goods may very well continue to trend higher for the foreseeable future.
The Fed can do very little to prevent this from happening, unless they are willing to let U.S. economic activity meaningfully decline. Without consideration of this issue, the easy policy decision is to cut benchmark interest rates, but this parochial view of the situation could actually serve to exacerbate the problem. Ironically, the decade of the 1990s following the fall of communism in the Soviet Union and the expansion of free trade was largely deflationary for the world economy. Now, however, as this decade winds down, the trends are largely inflationary as incremental demand outpaces incremental supply. Coordinated monetary and fiscal policy along with less manipulation by governments around the globe in key basic materials may be needed to avoid an economic train wreck.
The second critical issue the Federal Reserve must consider is the U.S. dollar exchange rate. Over the past several months, the dollar has reached all-time lows against the Euro and multi-decade lows against the British pound sterling as well as many other trading partner currencies such as the Canadian dollar. Today there is growing talk of a collapse in the U.S. dollar. Although the probability of this event is not zero, there are many factors involved that are likely to prevent this situation from materializing. The number of variables that come into play when dealing with currency markets is beyond the scope of this discussion, but one key barometer for short term trends is the difference in short-term yields between the world’s major reserve currencies. With the outlook for the U.S. economy becoming less sanguine, global currency traders expect the absolute yield available on U.S. dollar reserves to decline while at the same time they expect non-U.S. dollar yields to remain stable, thus widening the yield differential in favor of non-U.S. dollar reserves. In plain English, global investors feel they are getting better yields in other currencies and are moving away from U.S. dollars. This trend is naively extrapolated by many commentators to continue forever. However, there are powerful medium and longer term issues that may prove this to be an unwise conclusion. Nonetheless, the Federal Reserve has to believe that the reduction in benchmark interest rates to help the ailing U.S. economy will offset the potential for even higher inflation if they accelerate the decline in the U.S. dollar.
Finally, let me address the 800 pound gorilla in the room—sub-prime mortgages. Beyond the negative impact the end of the U.S. housing boom is having on the real economy, the central issue creating significant uncertainty at this juncture is the apparent inability of anyone to get a handle on the true magnitude of the problem. The good news, according to data compiled by the Bank of England and published in the Financial Times, is that sub-prime and slightly less risky “Alt-A” mortgage securitizations represent just a fraction of the total value of the world’s capital markets: (In billions)ASSET CLASSVALUE%Global Equities50,600$ 34%Global Bank Deposits38,500 26%Government Bonds30,000 20%Investment Grade Corp. Bonds10,000 7%Corporate Bank Loans6,100 4%Mortgage Backed Securitizations5,869 4%Other Securitizations3,531 2%Sub-Investment Grade Bonds800 1%Sub-Prime Mortgage Securitizations700 0%"Alt-A" Mortgage Securitizations600 0%Sub-Investment Grade Bank Loans500 0%Total Global Capital Markets147,200$
What has trapped many of the world’s money center and investment banks is that they were essentially playing all three sides of the credit market trade. Specifically, bankers not only originated the mortgages through aggressive lending standards, they also securitized the loans thereby generating more capital to lend, and then they provided credit to hedge funds and other investors to leverage their purchases of the sub-prime mortgage-backed securities the originating banks were selling!
This “triple whammy” is the real crux of the problem. As investors attempted to unwind their positions, there were few if any ready buyers, thus creating the need to mark down the value of the securities. The banks in turn experienced more delinquencies on their loans to the investors . Then banks needed to raise capital reserves, but there was limited funding available to them to do so. Because this game was being played for so long and across much of the industry, it will likely take quite some time before the problems are completely resolved, and that may very well mean still more asset write-downs and charge-offs in the near future and perhaps beyond.
So, with all of that said, where do we stand? We believe the world is fundamentally in transition to one that is less U.S.-centric. This trend will likely be with us indefinitely and will likely occur in phases, ebbing and flowing. Through the transition there will likely be times of content and times of discomfort but, with the proper cooperation of the world’s leading economic officials and some wise policy decisions at the country level, the end result can very well be greater prosperity for all across the globe.
How have we modified our strategic thinking?
1. We are thinking globally in all asset classes. In previous eras, a U.S. investor sought international assets for the diversification benefits. Today, international investments will also be an important consideration in deriving absolute portfolio return. We are thus likely to adjust long-term strategic assets allocations for your respective portfolios.
2. We are studying a number of macro trends that will play out over the next several decades. In particular, we are looking first at key sectors such as energy, healthcare, basic materials, transportation, and consumer goods. We are then examining regional trends that may present opportunities, like development of Sub-Sahara Africa.
3. We are evaluating the feasibility and potential to use structured overlays to manage downside risks in several volatile yet important asset classes, thereby attempting to insure against disaster scenarios.
How are we investing new cash and what modifications are we making to portfolio holdings currently?
1. We are looking to “take profit” in markets and asset classes that have performed exceedingly well in the recent past but may offer limited immediate upside and are vulnerable to a correction. One example is emerging market stocks.
2. We are trimming stock allocations back to policy targets and emphasizing multi-national large cap stocks that are benefiting from non-U.S. economic growth.
3. We are raising cash reserve levels to buy selective stocks and bonds that are suffering undue negative sentiment.
4. We are continuing to expand holdings in global commodities, precious metals and foreign real estate trusts.
5. We are realizing losses for year-end tax planning and reinvesting the proceeds in the same or new securities to benefit from the improved valuation.
Of course every client situation is different and we will look to optimize each of your personal portfolios.
In closing, let me reiterate three key points. First, we are patient investors, not traders. This is an extremely important distinction. Patient investors focus on the total return potential for their investments over the time frame they intend to cover. Traders on the other hand are evaluating their results in much shorter time frames. True, a good trader can make for a highly successful long-term investor if he or she strings together one great performance after another. While this is feasible, few traders in reality have ever accomplished this feat, and even those who have done so experienced long periods of under-performance. The point is, bad months and quarters happen from time to time, but that does not mean the appropriate action is to sell everything at the first sign of trouble.
Second, we build multiple asset class portfolios so that the ups and downs of one type of investment can be mitigated by offsetting performance elsewhere in the portfolio. Such was the case in November with bonds, commodities and precious metal investments providing solid performance to mitigate the weakness in stocks. We have highlighted the benefits of asset allocation in the past and once again it has helped stabilize overall results. True relative performance is not as sexy as absolute (meaning always positive) performance, but preventing big declines does enhance the compounding of gains which over time creates additional wealth.
And third, we like to be contrarian thinkers. This simply means that we look at the conventional wisdom priced into financial markets and attempt to dissect where the collective thinking could be wrong. History shows that truly great returns can be earned by taking a correct view opposite the masses and being positioned to profit as the crowd comes around to the right way of thinking.
I realize these comments are quite extensive, but the issues having an impact on the world’s capital markets and real economies are complex so we err on the side of full discussion. As always, we are available for discussion specific to your investment portfolio.
Jack E. Payne, CFA
Chief Investment Officer