Much Less Bad!
Dear Investor –
Dare we say it? Can we officially proclaim that at the end of the second quarter of 2009, that we are safely past the brink? That we have successfully skirted – barely – the most dangerous economic threat in perhaps seventy-five years? Perhaps that the recession, begun officially in December 2007 may be coming to an end?
We’re not saying we’ve surmounted all our economic woes. Not close to it. Many of the systemic regulatory challenges we faced are still capable of recurring. As we all know from the recent market crisis it’s what we don’t have on the radar that truly wallops us. Yet while the critiques continue on Wall Street’s great bailout efforts, the fact remains that, heck…. it appears to have worked.
Back from the Brink. Indeed, the “green shoots of spring” we saw emerging back in March and April have steadily grown. The economy has not only stopped getting worse, areas have started to get better. This week’s GDP (gross domestic product – the output of goods and services in the US) figure for the second quarter, fell only 1% on an annual basis, far less bad than the -6.4% witnessed in the first quarter and the strongly negative growth experienced through much of 2008. Extremely tight money and lending – something that held a stranglehold on growth for many months – has begun to relax . This week, one member of the offical recession-calling entity -- the National Bureau of Economic Research – even posed the possibility that the recession will officially have ended in July. This the same week as June jobless claims numbers fell substantially from the prior month.
Key economic trends – inventories, retail sales, factory orders, shipping, and commodity prices are all turning in the right direction. Leading economic indicators are now up three months running. Housing, that monster that greased the wheels of economic agony, has clearly bottomed and begun its turnaround in many geographical areas. Housing prices may continue to languish for some time, but the signs of change are there. And the all important corporate earnings – well, let’s just say that companies are demonstrating greater profitability than they were expecting, albeit mostly on the backs of job cuts and increased productivity.
From a business sector point of view, both the financial and auto industries, huge beneficiaries of the government’s largesse, have clearly turned a corner -- witness the enormous success of the “cash for clunkers” program and Goldman Sach’s historic first quarter profits. We’re no longer terrified daily about major bank failures. Consumer, producer and commodity prices still remain low. So with all this generally good news, let’s turn, now, to a couple of areas in somewhat greater depth.
Housing and Real Estate. As our good buddy Dr. Paul Kutasovic points out in a recent report, all key indicators of the housing market released over the last few months show that the housing sector is bottoming and beginning to recover. Sales of previously owned homes have increased markedly for the third consecutive month, new-home sales were surprisingly strong in June compared with May, housing starts jumped 3.6% in June, and building permits have risen sharply. Moreover, while commercial real estate has sharply lagged the residential market, there has been a clearly improving trend in this key area as well. These are core economic areas – and essential to a sustained economic recovery.
Business Inventories and Investment – no fat left to cut. One of the key components of a business recovery is the ability to work through the inventories of unsold goods and components. Large inventories during a recession generally indicate businesses will cut production and labor, as reflected in the current high unemployment levels. The good news is that business inventories are at extreme lows. With the existing already-reduced labor force working at very high productivity rates (in this case another term for “overworked”), not to mention tremendous cuts over the last six months of equipment spending, businesses have no choice but to begin to spend. In addition, businesses have managed to maintain levels of profitability through these difficult times. Indeed, the business sector, through inventory rebuilding and spending on new equipment is well-positioned to drive the economy forward.
The Bad News – Jobs & Consumers. Unfortunately, the march to unemployment hasn’t begun to abate in earnest, although high monthly jobless claims are trending down since the beginning of the year, and June’s jobless claims figure was very promising. We expect the unemployment number to end near 11% -- which is hardly an accurate figure given the high additional percentage of those working part time or at reduced pay levels. With unemployment comes fear, increased savings, and restrictions on buying and consumption. Continued drops in housing prices contribute to people feeling poorer than in the past, and it may take some time before housing prices begin to rise again, particularly in the mid and upper range of homes. It all adds up to consumers, representing nearly 70% of GDP, who are still reluctant to spend.
Regarding the economy, there is another big shoe to drop. Municipalities are now making torturous spending cuts in programs and jobs with drops in mortgage, sales, and income tax revenue. These cuts will not only add to the unemployment rolls but also add to massive capital cuts. Sure, some of these will be offset by the enormous government stimulus spending, but their impacts will be real.
All told, the outlook definitely is brightening. On a bigger picture level, we see a continuation of positive economic trends going forward for many of the same reasons we saw back in March and April. Indeed, we may even see positive GDP growth for the first time in over a year by year’s end. And globally, investors might have reason to be more impressed. China and India have held up much better than expected, Europe has rebounded well, and even a commodity producer and exporter like Brazil is showing surprising solidity. We wouldn’t call the global economy “superheated”, but it is warm and heating up.
Heretical, perhaps, but what’s also interesting from our point of view is that the remaining economic challenges – unemployment and likely slow job growth, along with spotty real estate, struggling third world economies – may actually help prevent the economy from supercharging. We do not want the economy to grow too fast! A slow-to-moderate growth environment will probably be a much better foundation for sustained growth going forward and hopefully prevent reformation of dangerous bubbles. So the bad unemployment news – certainly painful to many – may actually help provide the basis for a prolonged, healthy recovery. Talk about irony.
Inflation, currently not an issue, will surely take more of a center stage as the economy strengthens. At the moment, however, we just don’t see it as an overriding issue.
So now, to the Markets. First off, even given the steep run-up in equity prices, we feel that the upside potential is significantly greater than the downside risk for equity investors. Yes, the markets may have gotten ahead of themselves and exhibit some downward or sideways movement, but the economic foundation is in place for a more sustained economic upturn.
A significant part of the market run-up invariably had to do with a bounce-back from an emotionally-based panic sell-off that led to the thirteen-year lows in March. Looking at a chart of the S&P 500 equity index, one can readily see the extreme turnaround that we observed was in formation back in mid March.
What surprised many, however, was the strength of that rally given the considerable lack of clarity and uncertainty that was still at play until recently. This once again confirmed the markets’ past history of rapid and remarkable recovery after a deep downturn. In this case, there remained very strong concern about the markets turning strongly downward again (as they did in July of ’07 and May of ’08). For most of our clients, caution was still the appropriate approach, and to some degree, remains so now.
All told, the combination of positive economic factors, reasonable stock prices, rising corporate earnings, and improved availability of credit amid an expansive monetary policy with limited inflation risk we feel bodes well for stocks for the foreseeable future.
What now? As our investors know, our investment approach has been one of cautious optimism. We’ve been moving slowly forward into the market as we have seen reduction in the economic risk. We feel now that the economic risks have abated sufficiently to begin to allow a return to historical allocations. This is not to say that we don’t see strong possibilities of temporary downturns as significant remnants of the deep recession linger – such as housing, unemployment, slow commercial credit. But the global economies have clearly not only pulled back from the brink, but are laying solid foundations for a more enduring recovery.
For the bond markets, government treasuries have been finally stabilizing, but the longer term prognosis is for a continued increase in interest rates. They are still expensive and subject to considerable risk. Bond spreads between higher yield and high quality corporate bonds have been narrowing with the growing confidence in the viability of companies. Short term yields and money markets continue to remain low with federal funds remaining at near zero interest rates. We expect those yields to rise. Intermediate term corporate bonds are becoming increasingly attractive from a risk basis.
As a result, while we will retain some caution, we will be stepping up our allocations in the broader markets and specific sectors over the next quarter as we move them closer to historical target allocations. We feel this will provide the appropriate balance of return and risk.
In summary, we feel that it’s now safe to say that we’ve been safely pulled back from the brink. Granted, many investors are still in trauma from one of the worst crisis in our lifetimes. Risk aversion is natural. Yes, we’re still quite a ways away from recreating a broadly healthy economy – some might argue reasonably that we haven’t had one of these even when times seemed good, and hopefully we will have learned enough this time to avoid the many excesses we’ve seen during the past two decades. Meanwhile, the markets almost always precede and economic revival, and we feel that this is the very case now.
To all, please enjoy the rest of the summer. Of course, please feel free to call with any questions or thoughts.
Good Harvest Financial Group