China, India, and Brazil: When Too Much Growth is Bad

On December 25 the People’s Bank of China (PBOC) hiked both the key 12-month lending rate (from 5.56% to 5.81%) and the 12-month deposit rate (from 2.50% to 2.75%). This marked the latest effort in the Chinese government’s year-long campaign to ward off inflation by cooling its overheated economy. Although these steps were widely anticipated, the Shanghai stock market immediately retreated and triggered selling in many other emerging-country stock markets.

The related issues of strong economic growth, rising inflation, restrictive initiatives implemented by policy makers, and a disappointing stock market have been building for a year and are not limited to China. A similar set of conditions has plagued the leading emerging countries of India and Brazil. At the beginning of the year, consensus 2010 GDP growth projections were 8.6% in China, 6.3% in India, and 3.8% in Brazil; economists currently estimate 2010 growth of 10.2% in China, 8.8% in India, and 5.5% in Brazil (The Economist, 1/2/10 and 12/18/10). Along the way, inflation and fears of asset bubbles have spread: inflation in China is currently running at an annual rate of 5.1%, in India at 9.8%, and in Brazil at 5.6%. In all three countries the governments and central banks have reversed the economic stimulus initiatives of 2008-09 and are now applying the brakes.

In a May 12 blog on International Stock Markets: Searching for Goldilocks, we highlighted the negative impact that these restrictive policies in China, India, and Brazil were having on their previously sizzling stock markets. Since May, the inflation threat has grown and clouds have continued to hang over these markets: The Shanghai Composite (CSEX) is down -15.1% for the year to date, the Brazilian Bovespa (BSPI) is off -0.1%, although the India BSE 100 Index has mustered a respectable 12.9% gain. For the same period, the S&P 500 Index has rallied 12.7% despite unimpressive GDP growth of about 2.8%.

At this point the consensus view, which we share, is that in early 2011 the policy makers in each of these 3 countries will escalate their war on inflation with additional measures, and the consequence could well be stalled or disappointing markets. There will be many investors who fear that the steps taken by the policy makers will be too little and too late, and the result will be destabilizing inflation and asset bubbles. Many other investors will be convinced that the policy makers will go too far and cripple economic growth. To the contrary, our view is that the policy makers will be able to pilot a soft landing, i.e. to cool their economies to healthy and sustainable growth with reduced inflation. We note that most economists predict modest slowdowns in 2011 sufficient to arrest inflation fears: the latest poll taken by The Economist forecasts slowing 2011 GDP growth to 8.9% in China, 8.6% in India, and 5.1% in Brazil. If our view is correct, then we expect a buying opportunity lies ahead for the stock markets of these leading emerging countries and the multinational companies that supply the rising demand of their mushrooming middle classes.

Growing Optimism for Global Equity Markets

Expectations that the global economic expansion will continue through 2011 is prompting Wall Street investment strategists to predict robust stock market gains next year.

The rosiest forecasts are for the markets of the leading emerging economies (China, India, Brazil et.al.), where economic growth is expected to be strongest. A mid December Bloomberg survey of stock strategists at UBS, Citigroup, JPMorgan Chase, Credit Suisse, and Morgan Stanley foresee, on average, a 30% jump in the emerging markets as a group. These same gurus also predict a 14% advance for the Stoxx Europe 600 Index even though the continent will likely continue to suffer from a sovereign debt crisis and government austerity programs that will further retard already sluggish economic growth.

Most notable is the rising optimism for the U.S. stock market as represented by the Standard & Poor’s 500 Index. The general view is that Congressional and Federal Reserve initiatives to accelerate economic growth will boost corporate profits and result in a 3rd consecutive positive year for this benchmark. A survey of 11 strategists by Bloomberg in December shows an average rise of 11% in 2011 for the S&P 500. Among the most optimistic are Deutsche Bank and Goldman Sachs with anticipated jumps of 25% and 20% respectively, whereas Barclays and BofA Merrill Lynch forecast advances of 15% and 14% respectively.

We wish our readers a happy and healthy holiday season and a profitable New Year.

Good reading: The Big Short

Good reading: The Big Short: Inside the Doomsday Machine by Michael Lewis (W. W. Norton, 2010), 264 pp.

In an immensely insightful, entertaining, and readable book, Michael Lewis chronicles the meteoric rise and catastrophic fall of Wall Street’s subprime mortgage market misadventure. This is a sorry saga of gargantuan greed perpetrated by unscrupulous Wall Street firms that in the end plunged the U.S. economy into the worst recession since the Great Depression and threatened a total demolition of the global financial system. Lewis’ vehicle is to spotlight a relatively small and obscure group of quirky investors who separately concluded that the U.S. housing market was a train wreck in the making. They recognized the opportunity for massive profits for those investors courageous enough and patient enough to bet against, i.e. short, the mortgage backed securities invented by Wall Street firms to feed their own avarice.

Lewis is highly critical of almost all the parties connected to the subprime mortgage market (including the mortgage firm executives and their sales forces, the rating agencies, American International Group and other insurance companies, the hedge funds, the U.S. Congress, the Federal Reserve, et.al.), but he reserves his harshest condemnation for Wall Street bond traders. This is a theme first developed 20 years ago by Lewis in his classic Liar’s Poker, which describes the Gordon Gekko investment world of the 1980’s. Once again Lewis reminds readers that the stock market may be the focus of media attention, but it was in the bond market “that it was still possible to make huge sums of money from the fear, and the ignorance, of customers.” Here, in this sparsely regulated and dimly lit cave of opacity and complexity, reptilian traders preyed on their naïve institutional investor victims: “An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons.”

In order for the Wall Street firms to exploit their customers, it was first necessary to dupe the rating agencies (Standard and Poor’s and Moody’s). In Lewis’ words, this was not much of a challenge: “Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain dead guys making high five figures a year the highest possible ratings for the worst possible loans.” The irony is that all of the major banks and investment houses on Wall Street eventually failed to recognize the risk involved in manufacturing toxic collateralized debt obligations (CDOs) and suffered fatal multi-billion dollar losses. Lewis asserts that were it not for the U.S. Government and the U.S. taxpayer “all of them, without exception” would have gone bankrupt.

Lewis provokes some interesting investment questions. Let us begin with the observation that it is not true, as some cynics claim, that investing is just another form of gambling in which the odds always favor the Wall Street house. Rather, investing involves the assessment of a security’s risk vs. reward with the understanding, often forgotten by professional investors as well as amateurs, that there is no free lunch on Wall Street. How could highly intelligent, trained, and compensated institutional investors abandon their homework and accept the soothing assurances of Wall Street traders that putting a rating agency’s lipstick on a bond pig suddenly made it beautiful? How could they commit such huge sums of money to recently invented collateralized debt obligations (CDOs) and credit default swaps (CDSs) when their risk and liquidity had not been tested over years of changing economic and market conditions? There seems to be no answer. Why did the Wall Street firms, overflowing with self-proclaimed geniuses, open themselves to such risk thus hastening their own demise? Lewis suggests it was because Wall Street was so busy gorging itself in a profit feeding frenzy that even the suggestion that it might collapse was tantamount to heresy. He adds that many of the top executives had not a clue as to how these new securities were constructed or what risk they entailed and/or they were lied to by their bond trading desks. This is a congenial if not convincing explanation.

The Big Short will not be, and was not intended to be, the comprehensive history of the great financial crisis of 2007-2009, but it is must reading for investors seeking an understanding of what went wrong. Readers will especially appreciate his lucid description of the nuances of the subprime mortgage market and his artful, if overly repetitious, explanation of the complexities of CDOs and CDSs. Most of all, Lewis brings to his narrative a provocative understanding of the driving energy of Wall Street and a gift for telling his story in a very entertaining way. The book is good reading.

U.S. Corporate Profits and Stock Prices

Our forecast for the U.S. economy, corporate profits, and stock prices in 2011 supports a positive if cautious outlook:

• The U.S. stock market’s rally since 3/9/09 rests on a solid foundation of rising corporate earnings.

• The market is not currently overvalued, and there is room for a further advance if the 2011 profit expectations of market strategists and research analysts are valid.

•  We caution that these 2011 earnings estimates underlying a further U.S. bull market advance rest on shaky economic ground. If the economic outlook deteriorates further, companies with excessive exposure to the U.S. and other developed countries may report earnings disappointments and suffer stock price declines. We recommend investors take a global perspective and emphasize markets in fast growing economies and the stocks of multinational companies in the developed countries that have strong business opportunities in these fast growing economies.

Despite an anemic, subpar economic recovery, the Standard & Poor’s 500 Index has soared 74.9% since hitting bottom on March 9, 2009. The headwinds have been and remain formidable: weak consumer spending and confidence, sky-high unemployment and underemployment, a soggy housing market flooded by foreclosures, a troubled financial system that continues to restrain credit, and a nagging fear in business circles that Washington not only can’t remedy the problems but may make matters worse. On the other hand, the roster of positives boosting the market has evidently more than offset these negatives. These include strong corporate profits, low inflation and interest rates, a very accommodative Federal Reserve policy, an attractive market valuation coming off recession lows, and the relative lack of appeal of money market funds, bonds, and real estate.

In our view, the most important ingredient in the bull market recipe has been surprisingly robust corporate earnings. According to First Call, the trailing 4-quarter earnings per share (EPS) for S&P 500 companies rose from $62.85 as of March 31, 2009 to $79.05 on September 30, 2010, which is an increase of 26%. This includes an estimated 13% gain in year-over-year profits for this year’s 3rd quarter. Bloomberg reported on October 4 that more than 70% of S&P 500 companies have exceeded the average analyst profit projection for 4 consecutive quarters, which marks the longest streak since Bloomberg began tracking corporate earnings in 1993. We are convinced that positive earnings surprises and upward revision of future earnings estimates are the most powerful catalysts in lifting stock prices. The jump in earnings also keeps the market’s valuation attractive despite the huge run up in stock prices: the P/E ratio of the S&P 500 Index based on trailing 4-quarter earnings was 15.0% on September 30, which is close to the long term norm.

The key question now is whether 2011 profits will be strong enough to sustain the bull market. Clouding our optimism is that many economists are now predicting GDP growth next year to slow from its current sluggish rate. In The Economist’s latest polling of economists (10/23/2010), the consensus trimmed its 2010 U.S. forecast to 2.6% and predicted a further slide to 2.4% in 2011. We pointed out in our October 21 blog that in early October the International Monetary Fund (IMF) issued a similar 2011 GDP slowdown to 2.2% for developed countries as a group (the U.S. Europe, Japan, Australia, et.al.). As the IMF sees it, the economic recovery over the past 15 months has been driven by fiscal stimulus and inventory accumulation, and both are coming to an end. In the future, growth will have to come from consumption and investment, which in the developed countries are weak and not expected to improve much. A possible income tax increase in the U.S. and budget austerity programs in Europe would exacerbate the already meager 2011 prospects for growth.

There are two ways to measure 2011 S&P 500 profit expectations. A top-down forecast of market strategists, based on fundamental economic and financial market assumptions, is rosy: experts canvassed by First Call foresee a 14% advance, whereas the participants in Bloomberg’s poll anticipate a 9% rise. Even more optimistic is the bottom-up aggregate outlook provided by research analysts estimating company profits: 8,500 analysts tracked by Bloomberg expect a 15% increase. It is noteworthy that these 3 EPS estimates, which range from $87.34 to $95.95, are all above the pre-recession level of $86.20 reached in 2007. Also noteworthy is Bloomberg’s assessment that the S&P 500 is currently valued at 12 times projected income for 2011, which is “the cheapest level since 1988 (excluding October 2008 to March 2009 after New York-based Lehman’s bankruptcy), relative to reported profit from the past 12 months.”

Global Economic Growth: The Rabbits and the Tortoises

In an important October 6 address on the International Monetary Fund’s (IMF’s) latest world economic outlook, Director Olivier Blanchard focused on the current recovery’s most significant development:

“The world economic recovery is proceeding, but it is an unbalanced recovery. It is sluggish in advanced countries, and it is much stronger in emerging and developing economies.”

This is a theme we first identified in our April 4, 2009 Outlook, and at the time and in subsequent Outlooks and blogs we emphasized that this unbalanced growth would have important investment consequences. Chief among these would be the rising relative attractiveness of the emerging economies’ equity markets and the stocks of multinational companies positioned to provide products and services to the mushrooming middle classes in these economies.

Mr. Blanchard’s presentation is very useful in explaining the IMF’s view of the sources of this growth imbalance, in quantifying the extent of the gap in 2010 and 2011, and in providing policy options which would help to restore a healthier balance. From an investment perspective, his analysis supports our view that this gap is based on structural factors that will likely continue, and may increase, in the foreseeable future.

According to the IMF, there are three major impediments restricting growth in the U.S. and Europe: weak consumption as households struggle to improve financial security, depressed housing markets, and credit-constraining weakness in their financial systems. The IMF’s 2010 GDP growth forecast for these countries is a modest 2.7%. In sharp contrast are many emerging economies, “where excesses were limited and the scars of the crisis are few.” For these economies as a whole, the IMF predicts 2010 GDP growth of 7.1% with emerging Asia’s surging 9.4% growth rate leading the charge.

The IMF expects even more headwinds will buffet the U.S. and Europe in 2011 as the global recovery enters a new stage. The major drivers of growth dating back to the inception of the recovery were inventory accumulation and fiscal stimulus. As the IMF sees it, “the first one is coming to a natural end and the second one is being slowly phased out.” Going forward, consumption and investment must take the lead. The problem is that consumption and investment in most advanced countries “are still weak and will remain so for some time.” The IMF concludes that GDP growth in these countries will shrink from this year’s 2.7% to 2.2% in 2011. This slowdown will be too anemic to reduce stubbornly high unemployment rates, which in 2011 are expected to be around 10% in both the U.S. and Europe. 2011 GDP growth in the emerging economies will also likely slow, yet will still be a robust 6.4%.

The downward revisions in the IMF forecast are representative of reduced consensus predictions as the economic “soft patch” in the U.S. and Europe has continued into the fourth quarter. Lowered economic growth assumptions will likely result in reduced corporate profit growth estimates as Wall Street analysts direct their attention to 2011. We will explore this subject and its impact on global common stock strategies in a future blog.

For a transcript of Mr. Blanchard’s remarks, see www.imf.org/external/np/tr/2010/tr101006.htm

Review of the Third Quarter 2010

To the surprise of many investors, global stock markets rallied powerfully during the 3rd quarter, and in the process offset the losses incurred in the first half of the year. The Standard & Poor’s 500 Index advanced 10.7% and the Dow Jones Industrials rose 10.4%. Even more impressive were the gains of 20.0% in the EEM Emerging Markets ETF (which includes China, India, and Brazil among others) and 18.1% in the EFA Developed Countries ETF (which includes Europe, Japan, and Australia among others, but excludes the U.S.). Most bond holders also enjoyed positive returns, as did investors in gold and many other commodities. Losses in the quarter were sustained by investors who were short these markets and currency traders who bet on further gains in the U.S. dollar and/or wagered against the euro.

At the beginning of the quarter, a pervasive gloom and doom had settled over the U.S. and international financial markets. The U.S. economy had hit a “soft patch,” and some highly publicized forecasters warned of a coming double-dip recession. Europe was racked with sovereign debt headaches that threatened another credit crisis and battered Euro Area financial markets. The leading emerging markets (China, India, and Brazil) grappled with inflation fears, which provoked some pundits to predict that initiatives taken by the governments and central banks to slow their overheating economies might overshoot and plunge their countries into recession. As risk aversion spread, the S&P 500 Index corrected -16% from April 23 through July 2, and some key international markets suffered even greater declines. By early July, an overwhelming majority of technical analysts in the U.S. and abroad predicted more losses to come.

The expected decline never occurred. Global stock markets rallied in July, when strong quarterly corporate profit reports once again exceeded estimates. A further batch of disappointing U.S. economic data in August, however, rekindled pessimism and reduced the advance. As September loomed, investors braced for more dismal economic news and were reminded by the financial media that September is historically the worst performing month for the U.S. stock market. One indication of the growing pessimism was that $16.53 billion flowed out of U.S. stock mutual funds in August, which came on top of a $10.45 billion net withdrawal in July (Investment Company Institute). Inflows into bond funds soared despite historically low yields. Bearish investors were emboldened: by the end of August, the New York Stock Exchange short interest (shares sold in expectation of profiting from future price declines) hit a 52 week high.

The September “stealth rally” was triggered by a surprisingly solid U.S. employment report released on September 3 and then supported by economic news that further discredited forecasts of a double-dip recession. An increase in corporate merger and acquisition activity was also encouraging. Adding to the optimism were favorable developments in Washington. Action in Congress to provide incentives for small business owners to hire workers and talk of an extension of the Bush tax cuts boosted the markets. The Federal Reserve also contributed by announcing its readiness to provide additional monetary stimulus in November. As the rally gathered steam with further gains each week, the pressure intensified on short sellers to limit their losses by buying into the market. The September rally was historic: the 8.8% jump in the S&P 500 Index marked the best performance of this often-dismal month since 1939.

The threat of a double dip recession combined with continued accommodation from the Federal Reserve to lower the yield (and raise the price) of bonds. The yield on the benchmark 10-year U.S. Treasury note fell to a near-record 2.51%, thereby continuing a decline dating back to April 5, when the yield peaked at 3.99%. This drop in yields took place even as the U.S. Treasury auctioned off a record $2.3 trillion of notes and bonds in the fiscal year ended September 30. Many companies took advantage of this opportunity to sell bonds at rock-bottom interest rates, and corporate debt was eagerly purchased by yield-hungry investors confronted with money-market funds yielding 0%. Most commodity investors prospered during the quarter. The CRB commodity price Index jumped 11% during the quarter, with spectacular surges in wheat (+30.4%), corn (+37.5%) and sugar (+48.6%). With much fanfare, gold topped $1300/oz. and closed September at $1307/oz. Notably lagging were energy prices: oil rose only 9% and natural gas fell -16.6%.

Currency fluctuations were surprising and significant. The U.S. dollar, which had risen 13.8% against a basket of currencies between January 1 and June 7, retreated 6.8% in the 3rd quarter. To the dismay of travelers planning trips to Europe, the euro ballooned 14.0% against the U.S. dollar following a 32.1% plunge from last November 25 through June 7. The continuing ascent of the Japanese yen, which rose a further 6.6% against the dollar, created consternation within the Japanese government and among investors in Japanese stocks. The government reacted by selling yen in the market in hopes of supporting exports and bolstering the slumping Japanese economy. Investors were disturbed: the meager 1.9% rise in the Tokyo Nikkei 225 stock market index during the quarter amounted to a miserable underperformance. Perhaps most noteworthy in the currency markets is what did not happen: the Chinese yuan inched up 1.3% against the dollar when many governments, especially the U.S., were demanding and expecting a sharp appreciation.

Roth IRA Conversions

This year provides a window of opportunity to convert a portion or all of an IRA to a Roth IRA. Until this year, the Roth IRA was available only to married couples making less than $160,000 or single filers making less than $100,000.

Since the IRA is a tax deferred and in some cases a tax deductible investment, the government requires a tax to be paid to convert an IRA to a Roth IRA. Talk to your tax advisor about what this additional tax may mean for you and your current income tax picture. Depending on the amount you decide to convert, you are adding the converted amount to your taxable income for 2010. There is an option to spread the tax impact over 2011 and 2012, but this is a decision you should reach with the input of your tax advisor.

 

Now may be a perfect time to convert, as 2010 finds many investors with a slightly lower taxable income than in the past several years. If you are optimistic about the capital markets, then now may be another reason to convert. It is best to convert when the balance of your IRA account is low.

Benefits of a Roth IRA over an Individual Retirement Account (IRA):

• Income tax –free withdrawals are available after a 5 year holding period.
• No Required Minimum Distributions such as those required by an IRA once the owner reaches the age of 70.5.
• At death, spouses can roll the ROTH IRA into their own Roth account and receive income tax free withdrawals. Non-spouse beneficiaries (children) must pull minimum required distributions but the income is income tax free.
• As long as an investor has “compensation” contributions can be made to a Roth IRA even after the owner reaches age 70.5.

Does a Roth IRA conversion fit my unique financial situation?

• Ask yourself the following questions:
• Do I believe that taxes are going up in the future?
• Do I believe that the stock market will go up between now and the end of my life?
• Do I have enough money saved for retirement that I will not need to pull money out of my Roth IRA for at least 5 years?
• Do I have a goal of leaving some money for my children at my death?
• Do I have some cash outside of retirement accounts that I could use to pay the tax liability associated with a Roth IRA conversion?

If you answered “yes” to all or most of the above questions, a Roth IRA conversion may be beneficial to your long term plans. The concept is to pay taxes today on a lower account balance, and this balance plus any investment appreciation in the Roth IRA can be withdrawn later in life without a tax consequence.

Conversion costs include:

• Tax liability.
• Trading costs to raise the cash and or invest the proceeds once conversion is complete.
• There may be custodial charges for the conversion.

What if the value of your new Roth IRA shrinks by the time you need to pay income taxes on the IRA conversion? What if you do not have enough money at tax time to pay the tax for the conversion?

• There is the opportunity to avoid the tax if you reverse the transaction before October 15th of 2011 and return the balance to your prior IRA.

This information is general in nature and is not meant as tax or legal advice. Consult your tax and/or legal advisor regarding your situation.

 

Global Growth Opportunities: India

We are impressed with the strength and future prospects of India’s economy, and we think its equity market is increasingly attractive. During the 2003-2007 global expansion, India’s robust GDP growth (which hit 9.1% in 2007) was driven by consumer demand arising from a mushrooming middle class. With only about 20% of the GDP dependent on exports, the economy was relatively isolated from the recent recession in the developed countries and enjoyed growth of 5.1% in 2008 and 7.7% in 2009. Now the economy is accelerating again: the World Bank estimates GDP growth will top 8% in 2010, with further gains of 8.7% in 2011 and 8.2% in 2012.

India’s astonishing growth, second only to China’s among the leading emerging economies, will continue to rest on the size, youth, and growing prosperity of its working class. The U.N. forecasts that the working-age population in India is expected to expand to 275 million, a rise of 46%, by the year 2025. An article in The Economist indicates that by 2020 three out of every ten new entrants to the global workforce will be Indian. Conversely, the working-age populations in the U.S and China are expected to grow by a mere 12% and 10%, and the working-age populations in Japan and Europe are expected to decline by -17% and -13%, respectively.

In addition to a burgeoning workforce, household incomes are also rising. In 2009, the IMF estimated India’s per person annual income at $1,031. At less than half the annual per person income in China and the other leading emerging economies, there is plenty of room for income growth without damaging productivity or international competitiveness. Multinational corporations, including those in China, are expected to increase outsourcing to India.

Challenges that may restrict long term growth include high inflation, inadequate physical and social infrastructure, and an ineffective and protectionist government. The Economist lists India’s inflation at 11.3% and their latest poll of economists predicts full-year 2010 inflation to be 11.4%. Recent trends such as moderating food and commodity prices, however, should reduce 2011 inflation to a manageable 5-6%.

A retardant to India’s current growth but a boost to future growth is a dilapidated infrastructure, which the government intends to upgrade with a $1 trillion investment between 2012 and 2016. To successfully implement these upgrades, India needs government reform. Historically, India’s democratic government has favored protectionism, complex labor laws, regulations that differ from industry to industry and has tolerated a lack of coordination among local government agencies. The 2009 election of Mr. Singh and Mrs. Gandhi is promising.

The investment implications of India’s rapid and assured future growth, coming at a time when the economies of the U.S., Europe and Japan are struggling, are manifest. The benchmark Sensex Index of India stocks rocketed 501% during the 2003-2007 expansion, and it soared 130% from the beginning of the global stock market rally on March 9, 2009 through September 12, 2010. In contrast the S&P 500 advanced a modest 67% and 63% during these two periods. We recommend investors focus on the stocks of Indian and other multinational companies which provide goods and/or services to the surging working class or which support infrastructure improvements.

IMF Rejects Recession, boosts 2010 Global GDP Outlook

Reflecting stronger global growth in the first half of 2010, the International Monetary Fund (IMF) on July 8 bumped its 2010 global GDP forecast from 4.2% to 4.6%, and restated their 2011 forecast of 4.3%. This upward revision supports the Marietta view presented in our July 5 Outlook that the global economic recovery will emerge from a current slowdown and enjoy a multiyear expansion.

The IMF projections, which reject currently fashionable predictions of a U.S. and/or global “double-dip” recession, also endorse our view that 2010 growth will be paced by the leading economies of China (10.5%), India (9.4%) and Brazil (7.1%); the U.S. (3.3%), Japan (2.4%) and the Euro Area (1.0%) will expand at a subpar recovery rate.

We pointed out in our Outlook the rising risk that the European austerity programs, the U.S. economic “soft patch,” and the efforts of the leading emerging economies to cool inflation will excessively slow growth. The IMF also expressed a similar concern regarding “how Europe deals with fiscal and financial problems, how advanced countries proceed with fiscal consolidation, and how emerging market countries rebalance their economies.” We continue to advise investors to remain vigilant and flexible.

Review of the Second Quarter 2010

As the quarter opened, optimism regarding the global economic recovery helped propel equity and commodity markets to post recession highs. The International Monetary Fund (IMF), for example, raised its forecast for 2010 global GDP growth from 3.8% to 4.2% and reiterated its prediction of 4.3% in 2011 (see our April 23 blog “Global Growth Accelerating”). Other elements of the positive case for stocks, including strong corporate earnings reports, very low inflation and interest rates, and assurances from the Federal Reserve that they would continue their accommodative policy for an extended period, also fueled the rally. For the Standard & Poor’s 500 Index, the high water mark was reached on April 23, at which point this benchmark had soared 79.9% since the beginning of the rally on March 9, 2009.

For the remainder of the quarter, global financial markets were buffeted by relentless negative headline news emanating mostly from Europe and the U.S. The major focus was on the debt problems of Greece, Portugal, Spain and several other Euro Area countries, which generated fears of sovereign defaults, a Euro Area banking crisis, and a retreat into recession as governments turned to austerity programs to redress their budgetary woes. Nightly reports of the rampaging BP oil spill in the Gulf of Mexico and scenes of suffering wildlife and crippled local businesses contributed to the gloomy mood. Another headache was the heightened tension between South and North Korea, which raised the specter of a military conflict that might involve nuclear weapons. The final blow was a disappointing U.S. employment report in early June which, coupled with discouraging housing and other economic data as the quarter drew to a close, pointed to at least a slowdown (and maybe something worse) in the U.S. economy.

The aggressive, speculative, and unregulated pursuit of short-term profit by U.S. and international hedge funds exacerbated the severity of the May and June decline in equity and commodity markets. Armed with powerful computers programmed to react almost instantaneously, often with leverage, to the latest news release or to shifting price and volume patterns in financial markets, the hedge funds’ high-frequency trading strategies created unnerving market volatility (see our May 24 blog “Global Financial Market Turmoil”). On one memorable early May afternoon, runaway computers unleashed, in 15 minutes of spellbinding shock, a 700 point intraday plunge in the Dow Jones Industrial Average, whereupon the market recovered the entire 700 points in the next hour. The jump in market volatility in May and June heightened investor anxiety, which then seemed to feed upon itself. As the financial media, in heated competition for ratings, fanned speculation of a double-dip recession and a new bear market, pessimism became fashionable. By the end of June, the long-term positive case for stocks, which had dominated markets in April and was still arguably relevant, was completely eclipsed.

Another consequence of the computer-driven, hedge-fund trading during the quarter was the inter-connectedness of global equity, commodity, bond, and currency markets. An event in one country could quickly cause a chain reaction around the world. For example, each new indication of debt problems in Greece or Spain triggered a jump in these countries’ bond yields and declines in the euro and European stock markets, which led to an immediate rise in the U.S. dollar and U.S. Treasury prices and a plunge in U.S. stock prices, which prompted a decline in commodity prices and a selloff of stocks in the leading emerging economies of China, India, and Brazil. U.S. investors were forced to recognize that global economies and financial markets had become so intertwined that seemingly obscure events in far off places could profoundly impact U.S. stock and bond prices.

The Standard & Poor’s 500 Index slumped -11.9% for the quarter, and the EFA Developed Countries ETF, which consists primarily of Europe and Japan, plummeted -16.9%. The EEM Emerging Economies ETF declined -11.4% despite booming economic growth and healthy financial institutions in China, India, and Brazil. Also on the losing side was the CRB Index of commodity prices, which fell -5.4% paced by a -8.1% slump in oil prices. A notable winner was the U.S. dollar, which traded inversely to the U.S. stock market and rose 6.1% against a basketful of currencies. A flight to safety by risk-averse investors was especially beneficial to the perceived safe havens of gold and U.S. Treasury notes and bonds. Gold tracked the rise of the U.S. dollar (and decoupled from other commodities) as its price soared from $1115/ounce to $1244/ounce. The yield on the benchmark 10-year U.S. Treasury note dove from 3.83% to 2.94%, while its European safe-haven counterpart, the 10-year German government bond, fell to 2.59%.

Within the S&P 500 Index, 7 of the 10 industry sectors, representing 88% of the Index, posted declines ranging from -10.1% to -14.5%, and all 10 sectors had negative returns. The largest setbacks were in the economy-sensitive energy (-14.5%), consumer discretion (-14.0%), and materials (-13.2%), whereas the least impacted were the recession-resistant sectors of telecommunications (-0.5%), utilities (-5.3%), and consumer staple (-6.2%). Many individual stocks suffered plunges: 97 stocks were off 20% or more, and 24 of these stocks plummeted 30% or more. Size did not offer safety: the 23 largest companies (those with market capitalizations in excess of $100 billion), recorded an average loss of -12.3%. Apart from the S&P 500 Index, the Dow Jones Industrials were down -10.0%, the Russell 2000 Index of small company stocks shed -10.2%, and the NASDAQ Composite (mostly technology stocks) retreated -12.0%. Of the 24 international country ETFs we monitor closely, 19 were down more than -10.0%, 4 of the leading emerging economies (China, Hong Kong, India, and Singapore) fell single digits, and 1 (Chile) managed a 3.2% gain. There were few places to hide in either the U.S. or international stock markets.

China Indicates Confidence in Global Growth

On June 19 the Peoples Bank of China announced that it was removing the peg between the yuan (100 yuan = 1 renminbi) and the U.S. dollar (i.e. the currency would be allowed to fluctuate) following 2 years of a fixed exchange rate.

What is the importance of this change in policy by the Chinese government to Marietta’s investment strategy, which encourages investors to take a global perspective in general and favor the stocks of the leading emerging economies, including China, in particular?

• The announcement increases financial market conviction in the sustainability of the global economic recovery. The Chinese government originally put the peg in place during the 2008 global financial crisis to protect the Chinese economy against a further currency appreciation, which would increase the cost of Chinese goods sold abroad and decrease the cost of imported goods sold to Chinese consumers. In explaining their action, the Chinese policy makers stated that the global economy is “gradually recovering and the upturn in the Chinese economy has become more solid.”

• Global stock and commodity prices immediately responded positively. Led by a 3.1% jump in the Shanghai stock market, global stocks extended their current advance to a 10th consecutive session, which marked the longest rally in the MSCI World Index in 11 months. Oil, copper and other industrial commodity prices also rose (China is the world’s largest consumer of copper and ranks 2nd only to the U.S. in its demand for oil). The announcement also signals another step by Chinese authorities towards domestic demand and away from exports as the major engine of future economic growth. Stocks of U.S. and international companies that support the huge Chinese infrastructure programs or cater to the needs of the country’s mushrooming middle class rose dramatically the day of the announcement. The Indian, Brazilian, and most international stock markets also rallied.

• The announcement reduces international tensions, thereby diminishing the risk of trade wars that could retard seriously the global economic expansion. The timing of the announcement is also propitious, coming on the eve of this week’s G20 summit in Toronto.

• The announcement improves the U.S.-China relationship, which is key to the global economic outlook. In recent weeks U.S. congressional criticism has mounted that China is manipulating its currency and engaging in other unfair trade practices detrimental to U.S. industry and labor. The Chinese announcement should disarm demands for retaliatory action. In another gesture of good will, China boosted its holdings of U.S. Treasury notes and bonds by 2.6% to $900 billion in March and April (after reducing its stake by 6.5% from November through February). Renewed Chinese purchases will help the U.S. Treasury finance the huge U.S. budget deficit and assist the Federal Reserve’s policy to keep U.S. interest rates low until U.S. economic growth strengthens.

A cautionary note: Investors should not expect a dramatic and sudden jump in the yuan. The Chinese government will almost surely take a conservative and cautious approach, especially now that the U.S. and European recoveries are suspect. As a consequence, Chinese currency is likely to remain a topic of international controversy and the economic impact of the yuan’s appreciation will likely be gradual and limited.

Small Business Confidence Rising; ISI Remains Optimistic

We share the view of most economists that the major deterrent to a strong and sustainable U.S. economic expansion is the lack of healthy job growth. High unemployment and underemployment has dampened consumer confidence and spending, and is clearly having a serious negative impact on stock prices. The key to employment gains in this as in past economic recoveries will be small businesses. According to the U.S. Small Business Administration, its members represent more than 99% of all U.S. employers and have created 64% of all new jobs in the past 15 years. The problem is that small business owners have been very reluctant to hire in the current economic recovery.

The announcement on June 8 by the National Federation of Independent Business that their small business optimism index increased from 90.6 to 92.2 in April, which marks a 20 month high, is a very encouraging sign. 7 of 10 components in the index rose, led by a significant gain in expectations for business conditions six months down the road. Most noteworthy is that job creation plans registered the first positive reading in 19 months. Other positive responses include an improvement in profits, plans to increase capital spending, and an expectation of easing credit conditions.

A caveat is in order: even with April’s advance, the Index trails levels reached in past economic rebounds. On the other hand, a pick up in hiring led by small businesses would be a powerful antidote to the currently fashionable thesis that the U.S. economy is heading into a double-dip recession.

Separately, The International Strategy and Investment Group (ISI), highly respected and influential among institutional investors, has taken a strong stand against the prospects of a double-dip. On June 7, ISI distributed their forecast for U.S. GDP growth of 3.5% in 2010 with an additional 3.0% in 2011. Key to this forecast is their weekly survey of companies, which last week rose to a new high and indicates that “a powerful, broad-based recovery is unfolding.”

ISI is well aware of the headwinds: the Eurozone economy is likely to see a double-dip, U.S. tax rates are headed up, U.S. state and local budget cuts and tax hikes are likely, and they foresee a slowing in China real GDP to 7.5%. Despite these and other negatives, they cite continued strength in manufacturing, strong corporate balance sheets and profit growth, lean inventories, low inflation and interest rates, and an accommodating Federal Reserve in addition to their company surveys to support their positive outlook.

Global Financial Market Turmoil

We are troubled by the recent turbulence in global stock, bond, commodity and currency markets. Especially disturbing is the plunge and heightened volatility in the U.S. stock market. Nevertheless, we believe the current storm will pass through without serious negative impact on the global economic recovery and we continue to recommend that investors maintain discipline with a positive outlook for global equities.

A consensus of financial market observers attributes the turbulence to the highly publicized debt problems of Greece, Portugal and Spain and the clumsy, unsynchronized response to the crisis by the Euro Area governments and European Central Bank (ECB).  Our view is that the policy makers cannot afford the risks of sovereign bond defaults, which could well lead to a freezing of the European banking system reminiscent of the credit crisis conditions in the U.S. in early 2009. Europe has an even larger “too big to fail” banking problem than the U.S. Although a bailout of Greece and possibly other countries in the Euro Area is repugnant to many taxpayers, especially in Germany, we expect the finance ministers and the ECB will soon hammer out a solution sufficient to calm jittery markets.

An additional important factor exacerbating market upheaval is the aggressive and speculative pursuit of profit by U.S. and international hedge funds. Their trading desks are armed with powerful computers programmed to react almost instantaneously, often with leverage, to the latest news release or to shifting trading patterns in financial markets. The result can be a barrage of buy or sell orders in a chain reaction impacting stock, bond, commodity and currency markets around the world. For example, a recent worker protest in Greece against government austerity measures triggered a jump in European bond yields and a plunge in the euro and European stock markets, an immediate increase in U.S Treasury bond prices and a sudden drop in U.S. stock prices, a rise in the U.S. dollar and a sharp decline in commodity prices, and a selloff of stocks in the leading emerging economies of China, India, and Brazil.

Whereas hedge funds embrace heightened volatility as an opportunity to increase profits, long term investors are frightened by the risk to their portfolios and governments are alarmed by the destabilizing effects on their economies. Something must be done to prevent the hedge funds from converting financial markets into casinos and in the process driving serious, long term investors out of the markets. By some estimates, “high frequency” trading by hedge funds already accounts for more than 50% of U.S. stock market volume. Coordinated government regulation is urgently needed. We think that governments and regulatory agencies around the globe are finally recognizing the severity of the problem and will take appropriate remedial action. In the U.S., we expect the Securities and Exchange Commission (SEC) to finally wake up from its decade long stupor and incompetence.

As we emphasized in our Review of the Fourth Quarter and Year 2009, we are convinced that equity strategies based on a 6-12 month horizon are more often correct and easier to implement successfully than short-term, market-timing strategies. We share the view of U.S. Treasury Secretary Geithner that a slowdown in Europe will not be great enough to derail the U.S. and global economic recovery. That is, we continue to forecast a multiyear global expansion similar to but not as strong as the 2003-07 expansion, and we continue to think this expansion will be accompanied by a bull market in equities and commodities.

The current European upheaval may have limited economic impact, but it will have important investment consequences. The most debt-burdened European countries will be forced to implement budget austerity programs, which will damage the euro and retard economic growth. Some countries may well sink into a double-dip recession, although the crippled euro will provide a partial offset by benefiting export-oriented companies. The upheaval diminishes the attractiveness of European stock markets, which to us had very limited appeal prior to the crisis. U.S. exporters to Europe will be impacted negatively by a shrinking market for their products and services and a strong dollar will hurt their competitive pricing capability. On the other hand, the American economy will benefit from reduced commodity prices (especially gasoline), lowered inflation expectations, and lower mortgage and corporate borrowing rates. A weakened European economy and currency will similarly slow exports from China, India, and Brazil to Europe (Europe is China’s largest export market), but we see this as a positive. As we pointed out in our May 12 blog on international stock markets, the major problem here is that these economies are overheating, and their governments are reacting to the increased fear of inflation and asset bubbles by adopting restrictive policies. The consequence has been a painful retreat in their stock markets. Slower exports to Europe will cool these economies, reduce inflation worries, and possibly lead policy makers to move to the sidelines. This, in turn, could provide a green light to the leading emerging economy stock markets even as the European markets are flashing yellow.

We are not complacent regarding our positive outlook. Financial markets have been rocked by numerous unanticipated developments over the past 2 years and more may be coming. We remain vigilant and flexible.

Fed Watch

In recent Outlooks and blogs, we have emphasized the importance of Federal Reserve policy in influencing the direction of the U.S. stock market and the relative performance of industry sectors and investment styles. In particular, we have pointed out that in 1994 and again in 2004 the Fed reversed accommodative, anti-recession, low-rate policies and raised rates as economic recoveries gathered steam. In both cases, the Fed rate hikes abruptly halted powerful stock market rallies and led to rotational shifts in investor stock preference. We have also noted the negative impact thus far in 2010 on the prior stock market rallies in China, India, and Brazil as governments and central banks tightened credit in an effort to ward off potential inflation and asset bubbles.

To most Fed watchers, the question not whether the Fed will raise rates but when will they raise rates. For months the Fed has indicated its intention to keep rates low for “an extended period” even though the country has emerged from recession and the recovery has strengthened. At the end of 2009, we expected the Fed to raise rates late in the 2nd quarter or early in the 3rd quarter, by which time we anticipated that job growth would be the catalyst to trigger a change in Fed policy. In April, we subsequently pushed back our expectation to November when the Fed acknowledged economic growth, but stated its concern for the sustainability of the recovery and left in place its “extended period” language in statements regarding their interest rate deliberations. A Wall Street Journal survey of economists, disclosed in a May 12 article, finds that the consensus view in early April was for a hike in November, but now 42% expect the Fed to hold off on tightening until at least 2011. The WSJ attributes their shift in opinion to the European debt crisis, which “underscores the fragility of the global financial system and the risk, however small, of outside shocks derailing the recovery.” As a support to this view, on May 14 Chicago Federal Reserve President Charles Evans stated “I think the risks, obviously, with the global situation make things a little bit more uncertain than we were expecting…so, if anything, I am even more comfortable with my assessment that accommodation continues to be important.”

As the WSJ article points out, low inflation under 2% combines with the European turmoil to provide the Fed with room to keep policy on hold. We presume that the Fed prefers to avoid a rate increase in the politically sensitive months leading up to the national elections in November and thus welcomes this breathing space. On the other hand, the Fed is also painfully aware of the criticism of former Fed Chairman Greenspan and the Fed’s “too little, too late” rate raising policy coming out of the last recession, which permitted the creation of the housing bubble. We will monitor closely and comment on developments at the Fed in future blogs.

International Stock Markets: Searching for Goldilocks

Heading into 2010, we shared the view of a majority of international investors that the best performing stock markets this year would be China, India and Brazil. This expectation was based on the consensus forecast of economists polled in December by The Economist that these 3 countries would enjoy 2010 GDP growth of 8.6%, 6.3% and 3.8% respectively. In contrast, the major developed economies of the U.S., Europe and Japan were projected to experience anemic, subpar growth ranging from 0.6% to 2.4%. Since then, the economic performance of each of these leading emerging economies has exceeded expectations, and growth estimates in the latest poll of The Economist have been raised to 9.9%, 7.7% and 5.5% respectively. Nevertheless, the stock markets in these countries have been disappointing: for 2010 through May 10, the Shanghai Index (CSEX) has retreated -17.6%, the India Sensex (IBSI) is off -0.8% and the Brazil Bovespa (BSPI) has fallen -8.3%. In the much slower growth U.S., where 2010 GDP growth is currently pegged at 3.1%, the S&P 500 Index is down only -0.4%.

Why is this happening?

The problem with the stock markets of China, India and Brazil is that their economies are too hot. That is, accelerating growth is giving rise to fears of excessive inflation and asset bubbles. In China, for example, the government recently announced that April year-over-year consumer prices rose a more-than-expected 2.8%, producer prices jumped 6.8%, and property prices soared 12.8%. Consumer prices in Brazil are projected to rise 5.2% in 2010, and India inflation could top 12%. In response, the central banks in these countries have initiated policies designed to cool their economies. Some observers think the steps taken by the policy makers are too little and too late, and the result will be the dreaded inflation and asset bubbles. A contrary opinion is that the central bankers will be excessively restrictive and cripple economic growth. It is normal in the economic cycle for governments and central banks to reverse stimulative polices in the aftermath of recessions as recoveries gain strength. It is also normal for investors to question the outcome of a change in policy, and there is ample historical precedent in the U.S. and abroad of investors pulling back to wait and see if the policy makers are able to pilot a soft landing.

At the opposite extreme are the economies of Europe and Japan, which are too cold. Growth outlooks for these countries were weak at the beginning of the year, and the future now appears to be even bleaker. The highly publicized debt problems of Greece, Portugal and Spain will surely lead to austerity measures that will further retard growth, and quite possibly push the countries back into recession. Italy, Ireland and even Great Britain also have severe deficits that will require government action. The massive holdings of these countries sovereign bonds held by the leading banks of Germany, France, and Switzerland could spark a further crisis if the debt laden countries are unsuccessful in implementing adequate austerity programs. The consensus foresees 2010 Euro and GDP growth of only 1.1%, and we suspect that this gloomy assessment may be revised downward. It thus comes as no surprise that for 2010 through May 5 the Euro Area (FTSE Euro 100) stock index suffered a -9.6% decline. As for Japan, we expect another year of very modest growth (2.0%) and debilitating deflation (-1.0%).

Positioned comfortably between the too-hot Asian economies and the too-cold Euro Area and Japan, the U.S. economy is providing a propitious environment for common stocks. Favorable employment, consumer spending and manufacturing data indicates that the recovery is picking up steam, and the 2010 GDP growth outlook is now above 3%. Corporate profits have been above Wall Street expectations, and research analysts are raising significantly their 2010 earning estimates. On the other hand, growth has not been so strong that inflation forecasts have become ominous and, of great importance to investors, the Federal Reserve has repeatedly expressed its intention to keep interest rates at a historically low level “for an extended period.” To be sure, the major headwinds buffeting the U.S. stock markets thus far in 2010 have emanated from Asia, South America and Europe.

What lies ahead? Can investors anticipate a change?

We think the policy makers in China, India and Brazil will successfully guide their economies to a soft landing, and will then halt their restrictive measures in order to usher in long-term sustainable economic growth with controlled inflation. The Economist’s latest poll supports this view: consensus 2011 GDP forecasts for China, India and Brazil are 8.1%, 8.0% and 4.5% respectively. We expect the governments and central banks to complete their braking activities some time in the next 6 months, and investors will likely anticipate this green light and restore bull markets for the duration of a multiyear expansion. It makes sense that investors will migrate back to these geographic areas where growth is greatest once government and central bank policies are no longer threatening.

We are less positive regarding the stock market prospects of the developed countries over the next year. Japan and the Euro area will simply not have sufficient growth to attract investors. On the other hand, some of Europe’s leading export-oriented companies, aided by the weak euro, deserve investors’ attention. We expect the U.S. stock market, which has rallied for 14 months without a 10% correction, to stall, or possibly retreat, when the Federal Reserve signals its decision to gradually restore long-term norm interest rates from the current recession lows. There is much debate as to when this might occur, but most Fed watchers believe it will be within the next 9 months. We think the Fed may wait until after the November election, by which time job growth and a stabilized housing market will put the recovery on firmer footing. We further expect the Fed to alert investors of a new tightening policy several months in advance by eliminating the “extended period” language in statements regarding their interest-rate deliberations. Worth noting is that 1-2 years into the past 2 recoveries from recession, in 1994 and again in 2004, the Fed commenced to hike rates, and on each occasion stock market rallies abruptly halted as investors turned more cautious.

We remain convinced that investors who take a global perspective will be amply rewarded.

Global Growth Accelerating

In yet another indication that the global economic recovery is gaining momentum, the International Monetary Fund (IMF) has again raised its projections (see our January 28 blog). On April 21 the organization bumped its 2010 global GDP forecast from 3.9% to 4.2% and reiterated its prediction of 4.3% in 2011

The IMF continues to emphasize that the expansion will be lead by the leading emerging economies of China, India and Brazil with growth increases of 10.0%, 8.8%, and 5.5% respectively. The IMF also continues to anticipate sluggish growth in the Euro Area (1.0%) and Japan (1.9%) but they are becoming more optimistic regarding the U.S. with GDP growth raised from 2.7% to 3.1%.

The IMF forecast is supported by a consensus of economists that the latest monthly polling by The Economist foresees modest 2010 GDP growth in the Euro Area (1.2%) and Japan (1.9%), slightly higher growth in the U.S. (3.1%) and robust growth in China (9.7%), India (7.7%) and Brazil (5.5%). Worth noting is that these economists anticipate a broad-based as well as a multiyear expansion. The consensus expects positive 2010 growth in 38 of the 42 countries included in the survey (negative growth is projected for Greece, Spain, Hungry and Venezuela) and additional gains in 2011 for 40 of the 42 (Greece and Venezuela are the exceptions).

Review of the First Quarter 2010

Global stock markets in the U.S. and abroad weathered a temporary setback in January and early February and then rallied to extend beyond one year the new bull market. In its best 1st quarter since 1999, the Standard and Poor’s 500 Index rose 4.9%. This marked the 4th consecutive positive quarter without a correction in excess of 10% and increased to 72.9% the advance dating back to March 9 of last year. Despite fears of inflation and central bank tightening in China, India, and Brazil, the ishares Emerging Markets ETF (EEM) rose 1.5%, which increased its advance from last March to 111.0%. Although Europe was plagued with sluggish growth and a sovereign debt crisis, the ishares Developed Countries ETF (EFA) was up 1.3% for an overall gain of 76.6%.

The catalysts for the early quarter’s correction, which amounted to declines of -8.1% for the S&P 500 Index, -12.9% for the EFA, and -14.7% for the EEM, originated in China and Greece. In January, the Chinese government, concerned that strong economic growth would accelerate rising prices for real estate and food, introduced curbs on excessive bank lending. Alarmist speculation from some China watchers that the Chinese policy makers were about to prick a bubble economy triggered profit taking. The inflation contagion spread quickly to the Indian and Brazilian markets, where fears mounted that interest rate hikes by their central banks might choke economic growth. The storm passed quickly and all three markets recovered, but inflation clouds were still visible on the horizon as the quarter came to a close.

If the problem in China, India, and Brazil was that their economies were too healthy, the problem in Greece, Portugal, and Spain was that their economies were too sick. Many of the Euro area governments resorted to huge budget deficits to fight the recession, but national debts measured as a per cent of GDP were most worrisome in these countries. Although there was widespread agreement that a Greek default was unacceptable, the crisis was exacerbated by fierce worker resistance to belt tightening measures proposed by the Greek government and ugly bickering among Euro area governments as to who would finance a solution to the problem. As European stock markets trembled and the euro dropped like a stone, government leaders, the European Central Bank (ECB), and the International Monetary Fund (IMF) finally worked out a compromise. By the end of March, European stock markets recovered and the euro stabilized, but the potential for debt headaches down the road persisted.

Despite high unemployment, anemic consumer spending, a weak housing market, humongous federal deficit projections, and unseemly, vicious partisan squabbling in Congress, U.S. stock investors focused on positive developments. Driving optimism in the U.S. stock market upward were fresh data showing economic recovery, strong and above-expectation 4th quarter corporate profit reports, and comforting statements by the Federal Reserve that inflation was under control and an accommodative policy would be maintained for “an extended period.” An indication of investors’ confidence was that the best performing S&P 500 industry sector was consumer discretion (+11.8%) followed by industrials (+9.3%). On the bottom rungs of the ladder were the relatively conservative telecommunications (-2.5%) and utilities (-2.9%). In their optimism, investors preferred low-quality stocks, and their appetite for many of the big blue-chip stocks was meager: suffering declines were Exxon Mobil (-1.8%), Microsoft (-3.9%), AT&T (-7.8%), Pfizer (-5.7%) and Coca-Cola (-3.5%).

An interesting and noteworthy development in the 1st quarter was that the gain in the U.S. stock market was accompanied by a rise in the dollar. Since early 2008, the dollar and stock prices had exhibited a pronounced inverse relationship, and for both to move up together was seen by many investors as a positive sign that recession fears had subsided. Commodity prices usually fall when the dollar rises, and the CRB Commodity Index declined 3.5% during the quarter. On the other hand, gold gained $15.50/ounce to $1115.50/ounce and oil rose from $79.36/barrel to $83.76/barrel.

The bond market was relatively calm during the quarter: the yield on the benchmark 10-year U.S. Treasury note started the quarter at 3.84%, never rose above 3.88% nor fell below 3.56%, and ended the quarter at 3.83%. Thirsty for yield, individual investors continued to pour money into investment-grade and high-yield bond mutual funds despite the huge borrowing needs of the government and expectations that the Federal Reserve will push interest rates higher later in the year. As a result, the spread between U.S. Treasury notes and corporate bonds narrowed to levels not seen since late 2007. An ominous development in March was that both investment-grade and high-yield “junk” corporate bond issuers increased significantly their issuance of new bonds, thereby indicating their view that yields will most likely rise (and prices fall) in the future.

Good Reading: Lords of Finance

Good reading: Lords of Finance: The Bankers Who Broke The World by Liaquat Ahamed (Penguin Press, 2009), 505 pp.

For investors tracking the ongoing efforts of governments and central banks to battle recessionary pressures and engineer a global economic recovery, we recommend strongly Ahamed’s informed and captivating Lords of Finance. The book focuses on the largely successful efforts of the central bankers of the U.S., England, France and Germany to restore economic and currency stability following the chaos of World War I and their subsequent policy mistakes that helped bring on the Great Depression. These bankers were men of sharply divergent backgrounds and personalities, and they were committed to the sometimes conflicting interests of their respective countries. Nevertheless, they managed at critical moments in the 1920s to coordinate policies, overcome the obstacles thrown in their path by the politicians, and weather one crisis after another. The glue that held them together was a near-religious faith in the gold standard, which they managed to restore after World War I and to maintain for a tumultuous decade. Ironically, the author argues that it was their slavish adherence to this inflexible gold standard that ultimately triggered the Depression and in the process tragically ruined their careers and reputations. For the author, who is no fan of the gold standard, the heroes of the book are John Maynard Keynes, the brilliant and controversial English critic of these central bankers, and Franklin Roosevelt, who rejected the insistent advice of his economic advisors and took the U.S. off the gold standard at the depths of the Depression in 1933.

Readers will enjoy and profit from Lords of Finance even if they are not sophisticated in economics or historians of the Great Depression. Ahamed, whose background includes a stint at the World Bank, patiently and expertly explains the formation of the Federal Reserve and its inner workings through the 1920s and 1930s. He also provides a clear explanation of the gold standard with its benefits and limitations, and places the economic and currency crises within a broader political and social historical context. Readers will also appreciate the ability of the author to paint personality portraits of the major protagonists. The book is a useful antidote to the currently fashionable thesis that seismic economic events, such as the Great Depression, are the consequence of largely impersonal and unavoidable political, social and demographic trends.

In a very instructive epilogue, Ahamed compares the Great Depression with the 2008-2009 global economic and financial crisis. Although he acknowledges the two events share many of the same characteristics, he concludes that the differences outweigh the similarities. His major point is that The Depression was the consequence of the misguided policies of politicians and central bankers; modern policy makers, enlightened by the errors of their predecessors, are now pursuing a contrary set of policies that will result in a more favorable conclusion.

The book deserves its accolade as the Financial Times and Goldman Sachs 2009 business book of the year.

Laning Addresses Investment Symposium

At an investment symposium held on Tuesday at the University Club of Milwaukee, Marietta portfolio manager Bruce Laning presented the positive case for a multiyear global economic expansion and a further, if bumpy, rise in equity prices. He pointed out that the U.S. recovery will likely be modest, due in large part to sluggish consumer spending and continued bank credit issues, whereas prospects for the leading emerging economies are much brighter. He concluded that diversification is now very important and urged attendees numbering about 50 to take a global perspective in structuring their portfolio.

Threats to Global Economy and Markets

The blood pressure of the investment community has been elevated several notches in recent weeks as threats to the global economic recovery have surfaced. Stock markets around the world have slumped with unnerving volatility, even though a consensus of economic forecasters have reassuringly continued to project a solid if not spectacular global recovery in 2010 and the latest batch of corporate earnings reports have been well above analysts’ expectations. Creating additional palpitations has been a sharp drop in commodity prices and a corresponding rise in the dollar as risk-averse investors have responded with a flight to safety.

The Economist (February 13-19, pp. 13, 70-72) provides an excellent, succinct overview of the dangers confronting the world economy and offers pragmatic recommendations to government and central bank policy makers. In its cover article, the magazine emphasizes the gulf between the troubled U.S., European, and Japanese economies “where there are few signs of strong private- demand growth,” and the leading emerging economies of China, India, and Brazil, where there is “strong growth in domestic demand and scant spare capacity.”

The challenge for the policy makers in the developed countries is to engineer growth even as they are forced to come to grips with massive budget deficits. The problem is especially vexing for European leaders, who are under pressure to formulate a rescue plan for Greece and, possibly, for Portugal and Spain as well. We think the European Union will successfully if grudgingly provide a solution that will calm jittery currency markets, although the remedy may result in painful austerity for the indebted countries and political fallout for those governments, notably Germany, that may be called upon to finance a bailout.

In sharp contrast, the Chinese, Indian, and Brazilian governments are concerned that rapid growth will trigger inflation and create asset bubbles. Policy makers here are taking steps to rein in growth, which in turn worries some investors that their braking activity will become excessive and produce a slowdown that endangers the global recovery. The focus is on bank lending restrictions imposed by the Chinese government since the beginning of the year. We share The Economist’s view that “for all the market’s worries, there are few signs that it [the Chinese government] will tighten too much too fast. A slowing is possible, but a serious stumble seems unlikely.” We also note a recent article in The Wall Street Journal (2/8/2010), which reports that last week Citigroup, Bank of America Merrill Lynch, Goldman Sachs, and J.P. Morgan Research all issued reports touting upside expectations in emerging markets this year.

Although we think these threats to the world economy and equity markets will eventually be resolved without calamity, we also acknowledge that investors should not become overly sanguine. We will continue to monitor closely these international developments and we remain flexible. We also alert clients to expect market volatility until these matters are resolved.

Today is the 10th Anniversary of Marietta Investment Partners

Today, Thursday, February 4th, Marietta Investment Partners is celebrating it's 10th anniversary. We thank our clients for their support though the challenging and, at times, difficult last decade, which included two brutal recessions and two bone-crushing bear markets. We remain dedicated to serving our clients and we are confident the next decade will provide satisfying investment returns.

Five Star Best in Client Satisfaction Award

In 2009, Milwaukee Magazine surveyed Milwaukee-area consumers, financial services professionals and subscribers to identify financial advisors considered to be the best in providing client satisfaction. All 3 of Marietta's portfolio managers were among the 7% of the area's wealth managers to be honored.

Stronger Global Growth Expected

On January 26, the International Monetary Fund (IMF) hiked its 2010 global GDP forecast from 3.25% as of last October to 3.9%. This projection is now above our year-end forecast of 3.5%, which in turn is slightly above the 3.2% year –end estimate issued by The Economist. The IMF continues to endorse the consensus view that 2010 growth will be driven by the emerging and developing economies (+6.0%, with a further acceleration to 6.3% in 2011), whereas the advanced economies will remain sluggish (2.1% in 2010, with a rise to 2.4% in 2011).

The IMF’s revised 2010 growth projections for individual countries are close to those in our January 4, 2010 Outlook.

 

Source: IMF staff estimates; www.imf.org

The IMF report is in many respects encouraging:  economies are accelerating more quickly than expected, equity markets have recovered faster than expected, stability has been restored to credit markets and commodity prices have rebounded. A possible concern lies in the IMF’s 2010 inflation forecast:  an expected inflation rate of 1.3% in the advanced economies will provide central banks in these countries with considerable flexibility is setting monetary policy, but the 6.2% forecast in the emerging and developing economies may trigger restrictive policies.

Corporate Earnings Season

The corporate earnings season is fully underway and we are tracking closely the results on a company-by-company basis. We have combed through the S&P 500 Index and the S&P 400 MidCap Index and have selected 134 stocks that meet our criteria for inclusion in client portfolios. We have similarly screened over 440 international stocks that trade with American Depositary Receipts (ADR’s) and have market capitalization of at least $1 billion, and have identified 116 stocks that merit close attention. In coming days and weeks we will review carefully the revenues and earnings progress of the 250 companies in our “universe,” together with the CEOs' comments on business conditions and future expectations. We will also monitor the response of research analysts and the reaction of the markets. Our review will have a direct and immediate bearing on our purchase and sale of stocks in client portfolios.

Most U.S. corporate 4Q2009 revenues and earnings’ comparisons with a year before will show considerable gains in part because the economy continued its recovery from recession in the 4Q2009 and in part because the 4th quarter of 2008 was the trough in corporate earnings during the recession. For the S&P 500 companies, aggregate earnings per share are expected to climb from $12.42 in the 4Q2008 to $17.57 in the 4Q2009, according to mean estimates of Wall Street research analysts measured by First Call. Although expectations are high, corporate CEOs are experienced and adept at guiding these estimates of research analysts, and typically 65-70% of S&P 500 companies “beat the street.”

China and Brazil Watch

In our January 4 Outlook, we contrasted the accelerating economic strength of China, India, and Brazil with the struggling U.S. and European recoveries. Fresh evidence of Chinese prosperity is the surprising surge in both exports and imports in data released overnight. Another indication may be found in today’s Financial Times in an article “China lenders eclipse U.S. rivals.” The article reveals that all 7 of the world’s top valued banks (ranked by bank share price to book value) are Chinese or Brazilian, and concludes the data “reflect growing [investor] confidence in emerging markets, particularly China and Brazil.” In 2000, 5 of the top 6 highest valued banks were American. To highlight the contrast among economies, another article on the same page of the Financial Times, “Lingering doubts over recovery keep European inventories low” reveals that European business executives continue to have very low confidence in their own economic future. To be sure, the latest The Economist poll of forecasters (1/9/2010) foresees an anemic 1.4% real GDP growth for Euro area in 2010.

Review of the Fourth Quarter and Year 2009

Amid further evidence of global economic recovery, many of the trends dominating financial markets since early March were extended through the 4th quarter. The U.S. and international stock markets rose, including gains of 5.5% in the Standard & Poor’s 500 Index, 6.7% in the EEM Emerging Markets ETF, and 1.1% in the EFA Developed Countries ETF. Most commodity prices continued their ascent, including a hike from $70.61/barrel to $79.36/barrel in the price of oil and a pop from $996/ounce to $1,100/ounce in the price of gold. The yield rose (and price fell) on the benchmark 10-year U.S. Treasury note and the interest rate on most money-market funds remained at or below 1.0%. A notable new development was a December rally in the dollar against major currencies, which may be attributed to surprisingly positive U.S. economic data suggesting that the recovery might be accelerating. An immediate consequence of the dollar’s bounce was to reverse partially the upward surge in commodity prices, and in particular gold, and to reduce the relative attractiveness of international investments.

Despite an early year plunge in global equity markets, 2009 will be long remembered for the dramatic and unprecedented bull market that commenced in early March and continued without a significant correction for the remainder of the year. For the S&P 500 Index, this rally measured 64.8% and, in the process, the Index offset its -25.1% decline earlier in the year and left a satisfying 23.5% gain for 2009 as a whole. Many investors failed to match the performance of this standard benchmark, and some investors participated minimally or not at all. The Investment Company Institute’s (ICI) reports to the Federal Reserve show that for 2009 through November there was a net outflow of $4.127 billion from stock mutual funds and that as of December 29 there was still $3.293 trillion tucked away in low-yielding money market funds. According to Hedge Fund Research, the average hedge fund returned 19% to investors in 2009. Morningstar’s data on mutual fund performance also indicates that few fund managers shifted strategy in early 2009, with the result that many of the best performers in 2008 were among the worst performers in 2009, and vice versa.

Some of the keys to successful equity investing in 2009 were:

• The old Wall Street adage don’t fight the Fed was especially relevant in 2009. Governments and central banks around the world initiated massive and unprecedented stimulus packages in late 2008 and early 2009, yet stock markets in January and February suffered a cascade of selling culminating in a brutal capitulation in early March. Investors who ignored the pervasive gloom and doom and exercised patience in waiting for the beneficial impact of the stimulus policies were rewarded.

• It’s always darkest before the dawn. We cannot remember a time when it was more pitch black than in early March, when the S&P 500 Index was off 58% from its October 2007 high. Nevertheless, in late March a consensus of economists predicted an economic recovery in late 2009 and 2010 (see our April 1 Outlook). Some investors understood that the stock market is an anticipatory mechanism, which historically has bottomed about 6 months prior to the end of past recessions, and increased their commitment to equities in the 2nd quarter. They were richly rewarded.

• In our view, equity strategies based on a 6-12 month horizon are more often correct and easier to execute successfully than short-term, market-timing strategies. From late March through the end of the year the financial media hosted a parade of gurus who incessantly questioned the sustainability of the rally and promoted the view that a sharp correction was inevitable and immanent. On the other hand, we pointed out in our October 1 Outlook that successful market timing requires not one but two correct decisions, and that it is especially difficult to execute in the midst of an upward moving market supported by economic fundamentals. There never was a correction greater than 7% in the S&P 500 Index, and many market-timer investors either bought back their shares at higher prices or ended up sitting on the sidelines as the bull market rolled on.

• In a bull market, be bullish. There was a widespread belief in the early stages of the rally that a majority of investors, shocked and damaged by the devastating bear market, would favor defensive blue chip stocks in any market rally. To the contrary. Historical evidence is that following recessions and bear markets, those equity investors still active in the markets are driven by bargain opportunities and/or the promise of cyclically driven growth. This was true in 2009. The top-performing industry sectors in the S&P 500 Index were the economy sensitive materials (+43.3%), consumer discretion (+38.3%), information technology (+35.5%), and energy (+27.4%). On the lower end of the ladder were the defensive sectors of consumer staples (+13.8%), health care (+13.1%), utilities (+6.4%), and telecommunications (+2.4%). The big and presumably safer Dow Industrials (+18.8%) lagged.

• Investors need to be willing to take a global perspective. By the 2nd quarter it was already evident that the leading emerging economies (China, India, and Brazil) were weathering the global recession far better than the leading developed countries (U.S., Europe, and Japan) and also would provide stronger and more assured growth in an eventual global economic recovery. It was thereby reasonable, and correct, to expect these emerging economy stock markets to outperform significantly the developed country markets (see our April 1 Outlook). In 2009 the EEM Emerging Markets ETF soared 66.2%, whereas the EFA Developed Countries ETF rose 23.2%.

In the 2009 bond market, it was a good year for corporate bonds, and especially low-rated “junk” bonds, but a miserable year for investors in U.S. Treasury securities. Going into 2009, when the recession storms were howling, fears of a multiyear deflation were widespread, and the global credit crisis threatened almost all leading financial institutions, money flowed into super safe U.S. Government securities. The resulting decline in yields was also a consequence of unprecedented measures taken by the Federal Reserve to stabilize economic and credit conditions. As of the last trading day of 2008, 90-day Treasury bills yielded a paltry 8 basis points, 2-year Treasury notes yielded 77 basis points, and the benchmark 10-year Treasury note yielded a near record low 2.21%. We pointed out in our January 6, 2009 Outlook that the yields on shorter term bills and notes were too low to have investment appeal, and the yields on longer maturity Treasury securities would likely rise (and prices fall) when the recovery we anticipated later in 2009 set in; we recommended high quality, intermediate-term corporate bonds. As it turned out, U.S. Treasury securities suffered their worst total return year since 1978, as indicated by the 3.84% yield on the 10-year note at the end of 2009. In contrast, yields declined (and prices rose) for most corporate bonds as economic recovery improved corporate credit and diminished concerns for maximum safety.

Among the major beneficiaries of global economic recovery in 2009 were commodity prices, which also surged in response to a massive decline in the dollar from early March to the end of November. For the year as a whole, the commodity price index (CRB) jumped 23.5%, which included a 77.9% pop in the price of oil (from $44.6/barrel to $79.36/barrel) and a 26.5% rise in gold (from $869.7/ounce to $1100.0/ounce).