Economic and financial markets review
If the second quarter of 2009 was characterised by a strong rebound from oversold levels in risk assets, how to describe the third quarter? The theme certainly seemed to be that everything (equities, credit, gold, Treasuries, assetbacked securities) can, and did, synchronously rise in value. All this at the mere expense of the greenback, once more devalued against the majority of the world’s currencies. Conservative investors tend to view occurrences of largescale price appreciation across disparate asset classes as the exception, not the rule; we include ourselves in that list.
Recent improvements in incoming economic data in the US suggest that, over the coming quarters, the US economy will enjoy a burst in growth driven by the fiscal stimulus, a small rebound in business investment and an easing in the inventory rundown. We remain of the view that these factors are, by nature, temporary. The US consumer sector, despite one quarter’s small rise in retail sales (due to government handouts on an epic scale), has some serious problems to overcome. The crux of our view comes down to our assessment of the employment situation. The Federal Reserve may have been able to engineer a monetary miracle in avoiding the next depression, but there isn’t much it can do about irrational corporate behaviour.
Companies are continuing to shed workers at what, in past recessions, would have been an alarming rate. Consider some very stark statistics:
• There have been 21 consecutive months of payroll contraction in this recession
• September’s Household Employment Survey showed job losses of 785,000—the worst result since March (when equity markets hit their near-term low)
• The headline unemployment rate stands at 9.8 percent and the U-6 measure of unemployment, which captures labour underutilisation, continued to rise rapidly and stands at 17 percent
• The severity of unemployment continued to rise, with the average duration of joblessness at a record 26.2 weeks, and
• A record number of workers have been without a job for more than six months—36 percent of the total unemployed, or 5.4 million people.
Employment statistics such as the above, especially the rise in the long-term unemployed, point to a longer-term, structural picture of continued weakness in the economy, not just a cyclical dip in the business cycle. Those that are predicting the proverbial V-shaped recovery are doing so because that type of recovery has been the rule for the other post-war recessions. They may well accept the premise that this very severe recession was caused by a serious credit and banking crisis, but they are projecting a recovery that looks like a recovery from a ‘normal’ and healthy correction in the business cycle.
Under this cloud of uncertainty, we are apt to side more with the Federal Reserve. Most Fed officials have consistently erred on the cautious side of the debate when looking at the sustainability of economic growth absent the consumer spending and the credit creation element of the equation.
Fixed income markets
To date, we have seen a relatively stable environment for Treasuries and other high-grade sovereign issuers. We are rapidly approaching the end of the period of large-scale purchases in Treasuries, Agencies and Agency MBS (mortgage-backed securities) by the Fed. There is, therefore, considerable debate as to the direction of interest rates when the largest marginal buyer of these products can no longer be relied upon. In particular, there is uncertainty over how increased Treasury issuance to support fiscal largesse is going to be managed without the Fed as its primary liquidity source. To date, the increase in issuance has been absorbed by commercial banks using their excess reserves to buy the steepness in the yield curve, but eventually those institutions will begin to lend again—will that inevitably lead rates to rise? That is an ongoing question, but we have cast our vote in favour of caution (again) and chosen to remain at a shorter duration.
We had previously said that we didn’t think that the corporate bond market could continue in a straight line towards tighter spreads after such spectacular second quarter returns, but we clearly underestimated the desire to earn a return on assets greater than zero, regardless of risk considerations. We have continued to pare down corporate positions in favour of supranational and sovereign-guaranteed issues. We do not see impetus for any kindof immediate spread-widening event, short of a sharp correction in equities, in the near term—we are comfortable with our relatively defensive position going into the calendar year end.
As the year has progressed, headline economic and company data has continued to be reported with the best spin possible. Yet if one were to go one layer deeper behind most any data point, the green shoots suddenly disappear. Meanwhile, US companies reported earnings that were “better than expected”; however, when was the last time analysts correctly predicted earnings? It certainly didn’t occur in 2008, nor are they any closer for 2009. Looking at the most recent quarter (Q2 2009) companies (excluding banks) reported a 17.7 percent decline in sales and a 28.3 percent decline in earnings—hardly the numbers to support a strong conviction for risky assets. In addition, since there is no pricing power, nor the ability to grow sales, cost-cutting will certainly remain the focus for most companies. Cost-cutting will satisfy the markets for only so long; at some point, investors will start to ask for top-line growth.
Some forecasters, nonetheless, have stated that equity markets are cheap, but from our perspective, US equity markets remain expensive based upon dividend yield (2.30 percent), price to book (2.22x) and price-earnings (PE) ratio (19.93x trailing and 18.03x forward). In fact, on a forward PE basis, markets today are actually more expensive than they were in October 2007, before the credit bubble burst. The technical rally may carry the stock market further; however, the expiration of various government (cash for clunkers, first-time homebuyer tax credit, etc.) and central bank (Treasury and mortgage-backed securities purchases) stimulus programmes will very soon reveal the soft underbelly of the real economy, which will ultimately be reflected in the equity markets.
Longer term, however, we continue to see opportunities in the commodity and commodity-related investment space. Certainly, the positive supply/demand dynamics associated with the industrialisation of China and the emerging market story are well known at this point. In our opinion, the market continues to underestimate the ‘commodities as investment’ side of the equation. We envision strong returns over the next few years as investors flock to hard assets to protect themselves from the flat markets and global currency debasement. There are no free lunches in the financial markets and it is possible that by flooding the market with liquidity, policy makers could be creating difficult-to-manage long-term imbalances.
Accordingly, we are maintaining a healthy allocation towards physical commodities and resource-related shares. Specifically, we have an aggressive allocation towards gold and gold-related equities as bullion tends to outperform the market substantially during periods marked by financial instability and negative-to-low real interest rates. Additionally, we see tremendous opportunities in energy and diversified mining stocks. We recently trimmed substantial overweight positions into strength; however, there are some unique ideas we are exploring in the uranium and potash market. When we see signs of momentum turning positive, we will look to add to high-quality miners in these segments.
For more information about Butterfield Asset Management, visit www.butterfieldgroup.com