U.S. Stock Market Rally Supported by Economic Data and Corporate Profits

The 11.7% rally of the S&P 500 Index in the 4^th quarter through November 11 is part of a global stock market advance that includes Europe and the emerging economies. Most market observers attribute the gains primarily to developments in Europe, where policy makers have made progress in containing the sovereign debt crisis. Not to be overlooked, however, is the contribution made by encouraging economic data and strong corporate profits in the U.S. and by signs of ebbing inflation in some of the leading emerging countries, especially China.  

U.S. economic reports in October and thus far in November have been surprisingly good, especially in relation to the rising fears in September of an imminent and severe double-dip recession. Last week’s news, for example, reveals that small business optimism ticked up, consumer confidence indices rose, weekly initial unemployment claims continued to fall, mortgage applications rose, the trade gap narrowed, consumer credit expanded, and import prices declined. Despite a faltering Euro-Area economy, the U.S. economy continues to grow, although at an anemic pace.

U.S. corporate profits have also defied pessimists’ forecasts. Over 90% of companies in the S&P 500 have reported earnings so far this quarter, and over 70% have exceeded Wall Street estimates. International Strategy and Investment (ISI), a widely respected research firm for institutional investors, reports that S&P 500 earnings are running 5.8% above projections, and they are expected to be up about 18.3% year over year when the remaining companies report.   

We pointed out in our October 4 Outlook that global stock markets were “very oversold.” At the time, the markets reflected a recession-level collapse in economic growth and corporate profits despite a significantly more positive consensus forecast of economists. We view the market’s recent rally as only a partial adjustment to this oversold condition. During the last year, when S&P 500 profits soared about 18%, the S&P 500 Index rose only 4%. As a result, the P/E ratio of the S&P 500 Index based on consensus 2011 earnings estimates is now 13.1x, which is still below the past recession average of 13.7x. The consensus estimate of a further 7% profit advance in 2012 would further improve the market’s valuation.

Our conclusion is that if the U.S economy continues to avoid recession, as most economists expect, then the U.S market is still oversold.           

Global Economic Revisions

The sharp decline in global stock markets last week was in large part attributed by the financial media to economic warnings issued by the Federal Reserve and the International Monetary Fund (IMF). The reports spawned a rash of recession forecasts as markets tumbled. A closer look at the press releases of these institutions, however, reveals a far less ominous outlook of continued albeit more modest growth. 

Financial markets were well aware before last week that the U.S. and European economies were weakening and that there was a rising risk of further deterioration. It was the Fed’s language that startled investors. Their September 21 policy statement asserted that “there are significant downside risks to the economic outlook, including strains in global financial markets. ”This was a sterner warning than the Fed’s August 9 alert that “downside risks to the economic outlook have increased.” 

Investors evidently overlooked the positive growth forecast in the Fed’s statement: “The Committee continues to expect some pickup in the pace of recovery over coming quarters” and anticipates a gradual reduction in unemployment. Indeed, three members of the ten-member Committee believed the economy was not in imminent peril and voted against the Fed’s new “operation twist” policy on the grounds that they “did not support additional accommodation at this time.” 

In its semi-annual global economic report released last week, the IMF alarmed investors with the opening statement: “The global economy is in a dangerous new phase. Global activity has weakened and become even more uneven, confidence has fallen sharply recently, and downside risks are growing.” In the introduction, Executive Counsellor Olivier Blanchard pointed out that “fear of the unknown is high” and concluded: “In light of the weak baseline and high downside risks, strong policy action is of the essence.” 

The actual growth projections in the IMF forecast are more encouraging. Global GDP growth is expected to be 4.0% in 2011 with an additional 4.0% in 2012. The U.S. will avoid recession with 1.5% growth in 2011 and 1.8% growth in 2012. The Euro Area is projected to slip but remain positive: 1.6% growth this year will slide to 1.1% in 2012. The emerging and developing economies will continue to drive global growth with gains of 6.4% in 2011 and 6.1% in 2012. China and India will maintain their torrid pace with 2012 gains of 9.0% and 7.5%. 

 Supporting these forecasts of continued GDP growth this and next year is the consensus outlook of economists polled by The Economist. The U.S. is expected to grow 1.6% in 2011 followed by a modest rise of 2.0% in 2012. Euro Area growth will remain positive but slump from 1.7% this year to 1.0% next year. The widening gap between the developed and the emerging economies, so pronounced in the IMF forecast, is also reflected in the consensus outlook: China is predicted to slow only modestly from 9.0% to 8.6%, whereas economists foresee India’s GDP will rise from 7.9% to 8.2%. 

 In review, the broadly accepted, probable scenario projected by professional economists is that the U.S. and Euro Area will muddle through with the support of continued strong growth in the emerging economies. Even though the economists do not believe recession is likely, they acknowledge that the global economic outlook has dimmed, the risk of a further deterioration has risen, and a further reduction in estimates may be necessary. All eyes will focus on the policy makers to take decisive action to raise consumer and investor confidence and restore healthy growth.

U.S. Economy: The Good and The Bad

Investors over the past few weeks have been beset by a strong dose of volatility in both news reports and stock markets. Economists disagree on where the U.S. economy will go from this point forward and their forecasts seem to get increasingly divergent by the day. A recent Bloomberg article, “It’s the Dog Days of Summer, Shall We Take a Double Dip?: The Ticker,” discusses varying views on the likelihood of a double dip recession. The article enlightens both the optimistic and pessimistic sides of the issue. Their conclusion indicates that although the U.S. and global economies are clearly moderating, the consensus scenario is that recession will be avoided.

The Bad:

Polls conducted recently by the Wall Street Journal and USA Today reveal that the consensus on the likelihood of the U.S. entering another recession has risen to 30%, twice as high as a few months ago. Economists generally accept that U.S. growth will be slower and unemployment will remain inflated for a longer period of time than previously thought. On August 22, Citigroup, Goldman Sachs, and JPMorgan Chase cut their 2011 and 2012 GDP projections. Finally, the need to reduce government spending will handcuff legislators from adopting stimulus measures and the Fed has few tools left to jump-start growth.

The Good:

The consensus on the likelihood of entering another recession is still below 50%. Bob Doll, the chief equity analyst at BlackRock, states: “Stocks have fallen 15% or more in the past few weeks, but since the Great Depression there have been 30 market declines of 15% -- but only two of those predicted a recession.” Even with their reduced U.S growth outlook, Citigroup will projects a 20% stock increase over the next 12 months. The jobs picture is discouraging, but is still strong enough to avoid recession. To be sure, the 12-month data regarding new jobless claims has improved and bank lending conditions have eased. Credit flows, an indicator of reinvested savings, continue to be adequate. Corporations are generating strong profits and carry record cash holdings. Recessions are usually associated with having a negative bond yield curve (whose short-term rates rise above long-term rates), and right now the U.S. has the opposite. Schwab economists sum up these positives with the observation that the U.S. will avoid recession “due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.”

The slowing U.S. economy is expected to have only a limited impact on global growth. For example, Morgan Stanley recently cut global estimated GDP growth in 2011 to 3.9 percent from 4.2. The dramatic fall of world stock markets in the past few weeks, which we consider excessive, discounts a much greater than 0.3 percent drop in global growth. For a more in-depth view of Marietta’s opinions on this issue, please refer to earlier posted blogs “Clouds Gathering on the U.S. and International Economic Horizon” and “Financial Market Turmoil.”

Standard & Poor’s Downgrades U.S. Debt

Wild swings in the U.S. stock market escalated to unprecedented levels last week as the Dow Jones Industrial Average gyrated over 400 points on 4 consecutive trading sessions. Market observers agree that the principal catalyst of this turmoil was the decision by S&P to lower the U.S. Government’s credit rating from AAA to AA+. The downgrade and the market’s reaction raise important questions:

• Was the downgrade warranted?

• Will it have a lasting impact on the U.S. and global financial markets and economies?

The downgrade was promptly supported by some conservative economists even as it was condemned by the White House and prominent financial leaders including Warren Buffett. Stirring the controversy was that neither of the other two rating firms, Moody’s and Fitch, reduced their top ratings. Moody’s sharpened its disagreement with its larger competitor on August 8 by emphasizing on its website its reasons for not reducing its rating (moodys.com).

We accept S&P’s own definition of the proper function of credit ratings; they “express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time” (standardandpoors.com). By this standard, the downgrade is dubious. The U.S. Treasury has affirmed clearly that its highest priority is to stand behind U.S Government debt and, with the raising of the debt ceiling by Congress and the President on August 1, there is no legitimate doubt as to its ability and determination to honor this pledge.

To justify its downgrade, S&P executives asserted that they were influenced by the messy, acrimonious struggle between Republicans, Democrats, and the Administration to reach a compromise. Here S&P is introducing criteria for a downgrade that is outside their own definition of the purpose of credit ratings. Congressional and S.E.C. investigations into S&P’s action have been launched, and in particular they will focus on whether S&P was motivated by a desire to influence politics. It is noteworthy that S&P is already under investigation by aggravated Euro Area governments for using sovereign debt downgrades to improperly impact political processes.

The initial fear of economists, policy makers and investors was that the downgrade would damage the U.S. economy by driving stock prices lower and bond yields higher. This has not happened. Key governments, including China, promptly declared last weekend that the downgrade would not impact their purchase of U.S. Treasurys. When markets opened after the weekend, investors increased their appetite for Treasury securities and drove yields to lows not seen since the crisis days of late 2008. For the week, the yield of benchmark 10-year Treasurys fell from 2.56% to 2.24%, while 2-year Treasurys dropped from 0.29% to 0.18%. Obviously, investors ignored S&P’s warning and, to the contrary, established unmistakably that in their view U.S. government securities remain the safest investment in the world. Last week’s trading also indicates that bond investors are shifting from credit agencies like S&P to credit default swaps (insurance premiums paid in the open marketplace by bond investors in order to protect against default) to determine the relative credit risk of sovereign debt. The role of rating agencies in sovereign debt markets is fading.

Will the downgrade of U.S. debt by S&P continue to roil global stock markets? We do not think so. Following three consecutive up days for U.S. stocks, it appears that the initial dramatic impact of the downgrade is already diminishing. If the bond market continues to ignore the downgrade, the stock market will likely follow. The real threat to the U.S. and global equity markets is an inability of U.S. policy makers to take decisive action on the issues of deficit reduction and job creation.

We think that S&P has acted unnecessarily and, given the fragility of the stock market and economy, irresponsibly. Fortunately, we do not think the downgrade will have a lasting impact.

Financial Market Turmoil

Recent weak economic reports coupled with the inability of European and U.S. policymakers to deal effectively with sovereign debt problems and adopt growth initiatives has eroded investor, consumer, and business confidence and rattled financial markets. We acknowledge that the global economic “soft patch” will likely be more severe and prolonged than we, and most economists, projected a month ago. Nevertheless, we do not think the U.S. and leading international economies will relapse into recession. The most probable scenario is a muted and delayed recovery that extends the expansion into 2013.

Predictions of gloom and doom, fanned for their sensationalist impact by some of the media, often ignore or underestimate the elements of strength and resilience:

• Surging demand in the fast growing emerging economies will continue to buttress growth.

• Lower commodity prices, especially oil and gasoline, have been a direct consequence of the soft patch and will boost consumer spending and corporate profit margins in the developed countries. In the emerging economies, lower commodity prices will reduce fears of inflation and asset bubbles, enable central banks to curtail restrictive policies, and improve confidence in their future growth.

• Lower interest rates in the U.S., another consequence of the soft patch, will reduce mortgage rates and other consumer borrowing rates, and will alleviate the financial debt problems of states and municipalities.

• Policy makers in Europe and the U.S. have been condemned by the media as “dysfunctional” and rebuked by financial markets. With the added pressure of voter discontent, the policy makers will feel a growing pressure to act responsibly and decisively. We think they will.

• If there are signs of a U.S. economic uptick, huge corporate cash reserves (estimated at $960 billion) will permit companies to hire workers, expand production, update technology and increase R&D budgets.

We are confident that global stock markets a year from now will be higher, and possibly significantly higher. In the near term, however, markets will likely continue to be volatile and highly sensitive to any new geopolitical and/or economic shock. In these circumstances, conservative investors should be more cautious until there is convincing evidence of economic recovery and markets settle down. More aggressive investors should look for bargains among industry-leading companies with strong balance sheets, experienced managements, positive earnings momentum, and attractive valuations.

The negative case for the global stock market has been highly publicized. On the other side of the ledger, the positive case includes:

• Corporate profits continue to grow and exceed estimates. Bloomberg reported on August 5 that over 75% of S&P 500 corporations have outpaced earnings estimates for the second quarter. Wall Street research analysts are predicting an 18% jump in profits in 2011 with an additional increase of 14% in 2012.

• Market valuations are very attractive. The U.S. market has already priced in a severe recession. The S&P trailing P/E ratio of 13.2x is 20% below the average since 1954 (Bloomberg). If the estimates for 2012 are even close to correct, the market looks even less expensive.

• The massive corporate cash reserves will fuel increased dividends, stock buybacks, and merger and acquisition activity.

Our major concern for developed country economies and markets is the expanding mood of crisis fatigue and despair among consumers and investors. Psychology is becoming increasingly important. Policy makers motivated by partisan political advantage and adamantly refusing to compromise have contributed significantly to this pessimism. Synchronized global policy maker cooperation and dynamic action was decisive in arresting recession impulses in 2008-09, and we expect that policy makers in Europe and the U.S. will once again recognize the need for leadership to restore economic growth and elevate investor confidence.

China Watch Update

Over a year has passed since we posted a blog “International Stock Markets: Searching for Goldilocks” (5/12/2010) in which we commented on the rising inflation problem in China and the damage it was inflicting on the Chinese stock market. More recently, on March 22, we issued a blog “China Watch: Is Goldilocks Waking Up” in which we pointed out that continuing stock market underperformance was a consequence of increasing concern among investors that the government would go too far and inadvertently cripple economic growth. We drew 3 conclusions:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.

• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.

• The “soft landing”would spark a strong stock market rally.

Fear of inflation and possible asset bubbles continues to be the central focus of investors and the Chinese government. Since the start of 2010 the People’s Bank of China (PBOC) has hiked bank reserve requirements 12 times, and on 4 occasions it raised the base interest rate. Nevertheless, inflation has risen steadily and is now, at 5.5%, above the government’s 4% target.

The latest important development was an article “How China plans to Reinforce the Global Recovery” in The Financial Times (6/23/11) authored by Chinese Premier Wen Jiabao. After touting the considerable strengths of the Chinese economy and the government’s achievements in promoting social reforms, implementing massive infrastructure programs, and sponsoring scientific and technology initiatives, he made remarkably confident statements regarding inflation:

There is concern as to whether China can rein in inflation and sustain its rapid development. My answer is an emphatic yes…China has made capping price rises the priority of macroeconomic regulation and introduced a host of targeted policies. These have worked…We are confident price rises will be firmly under control this year.

Investors in Chinese stocks interpreted the Premier’s confidence as a signal that the period of restrictive credit policies was over and China was headed for the desired “soft landing.” Since June 20, the Shanghai Stock Exchange Composite Index (CSEX) has rallied 4.1%, but is still down -10.6% since April 15 and over 50% from its peak in October of 2007. If the government can convince investors that it is correct in its claim that inflation can be kept below 5% and GDP growth over 8% for the foreseeable future, then the Shanghai market recovery has only just begun. The market’s P/E valuation, at 11.6 times estimated profits, is the lowest since the global financial crisis in November of 2008 and, according to research analyst estimates compiled by Bloomberg (6/27/2011), Shanghai index profits are expected to soar 32% in the next 12 months.

IMF Forecasts Rebound from Global Economic Soft Patch

On June 17, the International Monetary Fund (IMF) predicted a rebound in global economic growth in the 2nd half of 2011 that should help to calm jittery equity investors. In an update to its World Economic Outlook, the IMF lowered only modestly its prior April forecast for 2011 GDP growth from 4.4% to a still-healthy 4.3%, and also predicted an acceleration in 2012 to 4.5%. The disparity in growth between the advanced economies (2012 GDP +2.6%) and the emerging and developing economies (2012 GDP +6.4%) is expected to continue.

For the U.S., the IMF anticipates anemic 2.5% growth in 2011 with only a slight bump to 2.7% in 2012. Nevertheless, Olivier Blanchard, the Fund’s Economic Counsellor, dismissed prospects of a retreat into a double-dip recession by labeling the soft patch as “a bump in the road rather than something more worrisome.”

The IMF also rejected negative economic scenarios for the leading emerging economies. Although rising inflation and subsequent restrictive central bank policies have spawned dire predictions of economic “hard landings,” the IMF expects continuing robust growth into 2013. China’s growth is pegged at 9.6% in 2011 and 9.5% in 2012, India at 8.2% and 7.8%, and Brazil at 4.1% and 3.6%.

Although optimistic, the IMF is hardly complacent. Their major concern, however, is not that the world’s leading economies will deteriorate on their own, but rather that governments and central banks will adopt ill-advised policies and abort a rebound.

Bond Market Considerations

At the beginning of the year, we alerted readers of our Outlook to be sensitive to the risks of investing in U.S. Treasury, corporate, and tax-exempt bonds. Our view rested on the historically low yields provided by these bonds at a time when the economic expansion was maturing and inflation was looming. We were also concerned about the U.S. government’s massive budget deficit and approaching debt ceiling deadline, highlighted recently by warnings of potential downgrades from credit agencies, and the very weak fiscal circumstances of many tax-exempt issuers. Our advice was to keep credit high and maturities short.       

                 

To our surprise, the yield on the benchmark 10-year U.S. Treasury note has declined from a high of 3.74% on February 8 to 2.95% on June 8, and corporate and tax-exempt yields have correspondingly declined. We attribute this drop in yields (and rise in prices) in part to growing uncertainty regarding the duration and severity of the current global economic “soft patch,” which has triggered an exodus from equities and a flight to the perceived safety of bonds in general and U.S. Treasury securities in particular. Another contributor to sliding yields has been the determined effort of the Federal Reserve to alleviate fears of inflation and keep rates low in hopes of accelerating economic growth.

Our forecast, shared by a consensus of economists, is that the “soft patch” will be relatively short and innocuous, as was the case with a similar “soft patch” at this time last year. A restoration of more healthy economic growth will most likely heighten inflation anxieties. We also expect the Federal Reserve’s “quantitative easing” policy (QE2) of purchasing Treasury securities to support low yields to expire in June and not to be extended.  Further, we expect worries about the U.S. government’s deficit to intensify as the debt ceiling deadline approaches. As a consequence, we reiterate our strategy of maintaining high quality and short maturities in U.S. bonds even though lower quality and longer-maturity bonds currently provide higher yields. We also suggest that readers consider the appeal of international bonds as an addition to U.S. bonds.

Our recommendation is echoed by Bill Gross, the celebrated manager of Pimco’s Total Return Fund, which is the world’s biggest bond fund. Gross, who according to  Bloomberg (6/9/2011) has outperformed 99% of his rivals over the past 5 years, eliminated U.S. government debt from his portfolio in February. Stating yesterday “I certainly don’t have any regrets,” he repeated his prediction that the 30-year bull market in bonds is over. Rather, he encouraged investors to consider the bonds of other countries with stronger balance sheets and half the debt. In particular, he cited the bonds of Germany, Canada, and Brazil, which have higher yields and he believes are safer credits, as “better opportunities.” 

We point out that many factors need to be considered in evaluating the appropriateness and desirability of international bonds, and currency fluctuations will have a significant impact. Investors who want to control risk should favor intermediate-maturity, attractive-yielding sovereign bonds of countries with strong economies and currencies. We are currently reviewing portfolios on a client by client basis, and we strongly advise other readers to seek professional assistance in diversifying their bond holdings by taking a global perspective.                                                                                                                  

Clouds Gathering on the U.S. and International Economic Horizon

There is a growing consensus among economists that the U.S. economy is slowing, and this revised outlook is being reflected in the stock and bond markets. A late April survey taken by the National Association of Business Economists, released on May 16, projected 2011 U.S. GDP growth of 2.8%, down from their early February forecast of 3.3%. The slowdown, first evidenced in disappointing 1st quarter GDP growth of only 1.8%, was also featured in The Economist’s recent cover article “What’s Wrong With America’s Economy” (April 30-May 6).

The reduced outlook for the U.S. economy comes at a time when doubts are also spreading regarding the strength of the international economies. In Europe the sovereign debt crisis has reached an ominous level: the austerity programs crafted by desperate governments in Greece and Spain are encountering increasingly belligerent popular resistance, and the policy makers at the European Central Bank (ECB), the International Monetary Fund (IMF) and leading Euro-area governments (notably Germany) have become more divided and intransigent in their failed effort to agree upon a remedy. Crippled by the economic consequences of the earthquake/tsunami/nuclear catastrophe, Japan has again retreated into recession. Within the leading emerging economies of China, India, and Brazil, intensifying inflation has forced governments and central banks to adopt ever stronger restrictive measures, which in turn has led to heightened investor fears of “hard landings.” In this perfect storm of economic concern, the Economic Cycle Research Institute (ECRI), a widely watched barometer of trends with an exemplary track record, issued on May 19 a statement that “there’s a downturn in global industrial growth in clear sight,” but added that they saw no sign of a renewed recession.

The response of global financial markets has been swift, and arguably excessive. Investors have suddenly turned cautious. In the midst of a flight to safety, the yield on 10-year U.S. Treasury notes plummeted from 3.59% in mid April to 3.13% on May 23. The U.S. dollar reversed a 4-month slide and in a three week period stretching from April 29 through May 23 rose 4.3% against a basket of currencies. On the other side of the coin, the prices of economy-sensitive commodities, which had soared for a year with only minor interruption, crashed: during this same three-week period, the CRB Index of agricultural and industrial commodities plunged -9.1%. Also damaged in this period were the international stock markets. As volatility rose to unnerving levels, the iShares MSCI ETF of developed countries (EFA) slumped -6.9% and the iShares MSCI ETF of emerging economies (EEM) sank a chilling -7.8%. The Standard & Poor’s 500 Index fared better with a more modest decline of -3.4%, but within the U.S. market there was a seismic rotation. Out of favor were many of the economy-sensitive, high-growth, low dividend, small and mid cap stocks that had led the market since the beginning of the bull market in March of 2009. Elevated to favor were many of the recession resistant, slow growing, high dividend, and previously underperforming mega cap stocks. Out were energy, materials, industrials, and information-technology stocks; in were health care, consumer staples, and utilities stocks.

If the recent economic developments and financial market trends persist and strengthen they will present a challenge to the consensus (and our) global economic outlook and investment strategy. Have we reached a point where it is necessary to alter our view of a healthy, if geographically unbalanced, multi-year global economic expansion extending through at least 2012 and abandon the growth-oriented equity strategies that have served us so well the past two years? At this point, we do not think so. The highest probable scenario, in our view, is that the global economy will experience a “soft patch” and choppy stock markets followed by a resumption of 4-4.5% economic growth fueling further market gains. We note that “soft patches” are a normal phenomenon of past economic cycles, and it would be very unusual for a cycle to last only two years.

It is not possible, at this juncture, to predict with conviction the severity or duration of a “soft patch,” but the prospect of a double-dip recession is quite low. There are many positive developments buttressing economic growth. The employment picture continues to improve gradually, consumer spending is resilient, corporate profits and balance sheets are very strong, interest rates are very low, exports are robust, financial institutions continue to strengthen and are more willing to lend, etc. Very important is that the outlook for inflation, which has been a major factor in igniting economic and market fears, is significantly improved by the recent sharp decline in commodity prices. Since the end of April through May 23, when the CRB Index retreated -9.1%, the price of crude oil dropped -14.2%. We expect a summer pick up in U.S. consumer confidence as gasoline prices fall, and relief from rising food and energy prices in the emerging economies may permit policy makers to back away from policies designed to slow their economies. The global equity strategy group at Citigroup on May 19 observed that the commodity price pullback indicates that a peak in inflation and interest rates is imminent in the key emerging economies of China, India, and Brazil, and predicted a 31% rise in emerging economy equities by the end of 2011.

Like the economy, there are also positive conditions supporting the U.S. stock market. Strong corporate profits continue to provide attractive valuations despite the large stock gains of the past two years. In addition, huge corporate cash positions should result in higher dividends, a pick up in stock buyback programs, and an acceleration in merger and acquisition activity. Further, interest rates are low and the Federal Reserve is implementing a very accommodative policy. Also worth noting is that a mountain of cash remains on the sidelines even though money-market funds yield little or nothing. The alternatives to stocks are not very appealing: bond yields are low and their prospects are limited by credit issues and the threat of future inflation. The real estate market is moribund and likely to remain so until well into 2012.

We currently encourage investors to exercise patience and adhere to long term asset allocation guidelines and norms. Conservative investors may chose to exercise a higher than usual level of caution to adjust for the more elevated risk in the economy and markets and to increase their comfort level in what may well be a choppy market. We also recommend that investors maintain broad geographic and industry diversification in their equity holdings, take a longer term perspective in the midst of heighted volatility, and monitor closely the fundamental progress of companies in their portfolio. This is a time when it is necessary to have a high level of confidence in the fundamental strength of portfolio companies. Above all, investors need to be especially vigilant and flexible.

IMF Supports Marietta Global Growth Forecast

On April 11, the International Monetary Fund (IMF) issued its semi-annual World Economic Outlook, which forecasted global GDP growth of around 4.5% in both 2011 and 2012. This prediction is in line with the 4+% estimate in our January 4 and April 4 Marietta Outlooks, and supports our view that the recent dramatic events in Japan and the Middle East will have only a modest negative impact on the global economic expansion.

The existence of a growth gap between the leading emerging economies and the advanced economies has been a prominent feature of Marietta’s economic outlook and investment strategy since the inception of the global economic recovery in early 2009. More recently this was the subject of our October 21, 2010 blog Global Economic Growth: The Rabbits and the Tortoises. The IMF shares our view that this gap will extend for the foreseeable future. We concur with the IMF’s 2011 and 2012 GDP projections of 9.6% and 9.5% for China, 8.2% and 7.8% for India, and 4.5% and 4.1% for Brazil. In sharp contrast, the IMF forecasted significantly lower growth for the advanced economies of the Euro Area (1.6% and 1.8%), Japan (1.4% and 2.1%), and the U.S. (2.8% and 2.9%).

For the past two years, Marietta’s central investment thesis has been that a multi-year economic expansion would give rise to a multi-year bull market in global stocks, and the best returns would be provided by the stocks of companies that participate heavily in those economies where growth is highest and most assured. The latest forecast by the IMF buttresses our conviction.

Especially noteworthy is the IMF’s discussion of what needs to be watched and what could go wrong. Highest on their list are rising inflation trends exacerbated by soaring industrial and agricultural commodity prices. IMF Chief Economist Olivier Blanchard asserts that at this point “they appear unlikely to derail the recovery,” but adds that inflation pressure is likely to build further as growing production comes up against capacity constraints, with large food and energy price increases raising pressure for higher wages (IMF Survey Magazine, 4/11/2011). The response of central banks to combat inflation with restrictive policies will likely slow economic growth. In other words, there is a growing threat of stagflation. We at Marietta will be watching closely.

China Watch: Is Goldilocks Waking Up?

Almost a year has passed since we issued a blog “International Stock Markets: Searching for Goldilocks” (May 12, 2010). Here we pointed out that recent steps taken by the Chinese government and central bank to cool their economy and tame inflation had halted the sharp advance of Chinese stocks in 2009. Some investors feared that the policy makers’ initiatives would prove to be too little and too late, resulting in an inflation spike and asset bubbles. Others were concerned that the government and the central bank would become excessively restrictive and cripple economic growth. We offered three views:

• Chinese stocks would continue to languish (at best) as long as inflation continued to rise and policy makers continued to impose additional restrictive measures.
• Eventually the government and the central bank would be successful in piloting a “soft landing,” i.e. they would slow the economy and usher in a period of healthy and sustainable growth with reduced and controlled inflation.
• The “soft landing” would spark a strong stock market rally. 

Since our “Goldilocks” blog, Chinese inflation has continued its ascent from 2.8% last May to its current 4.9%. In response, the Chinese government has responded with a succession of interest rate hikes and bank loan restrictions, and Premier Wen Jiabao announced recently that the highest priority of government was to reduce inflation. Our forecast for Chinese stocks was lamentably correct: since the end of 2009, the Shanghai Composite Stock Index (CSEX) has retreated -11.3% and the exchange traded fund for Chinese stocks traded in Hong Kong (FXI) is off -1.4%. For the same period, the S&P 500 Index has risen 14.7%.

We think the Chinese policy makers are making progress and will be able to pilot successfully a soft landing. We also continue to expect this soft landing to renew the bull market in stocks dating back to March of 2009. We are not alone in these forecasts. In a March 15 report issued by Deutsche Bank titled “Turning Bullish on China,” Chief Economist Jun Ma argues that “recent developments are increasingly supportive of our view that year-over-year CPI inflation will likely peak in June at around 5.8%, then fall to around 4% in December.” He expects the policy makers to take their foot off the brake and considers the risk of a hard landing to be minimal. He concludes with the prediction that in the next twelve months the Chinese stock market will “rise about 25% from its current level.”

If Chinese inflation peaks in June, will the Chinese stock market anticipate this development and rally before the data confirms the fact? Is this already happening? Since January 25, the Shanghai market (CSEX) has gained 8.6%, whereas the S&P 500 Index has slumped -0.9%. We are very aware that anticipating events that do not materialize, or are delayed, can be very painful, but is it better to be too early than too late?

We are continuously reviewing Chinese stocks to identify the most attractive candidates to participate in a renewed stock market advance. Our focus is on companies that would benefit from the government’s massive infrastructure projects and/or would prosper from the rapidly rising demand for goods and services by the mushrooming middle class.

Current Challenges to the Global Economy and Stock Markets

Recent developments in the Mideast and Japan convey scenes of human misery and loss of life that are sad and disturbing. The question for investors is whether they also constitute so serious a challenge to the global economic expansion and stock market advance that a substantive change in strategy is required. As alarming as these momentous events are, we do not think that they will tip the global economy into recession and trigger a new bear market. At this point, we advise clients to maintain their long-term commitment to global equities and ride out the storm.

The global economy entered 2011 with considerable momentum. The leading emerging economies were expanding above their sustainable long-term growth rates, the U.S. economy was accelerating towards a healthy 3.5% or higher GDP growth, and the Euro Area was weathering better than expected its sovereign debt woes and austerity budget imperatives. In our view, it would take a severe jolt to reverse this momentum. On the other hand, the twin threats are real. Oil at $100/barrel is already elevating global inflation fears and could retard international and U.S. growth, and in the near term the Japanese economy may slip from our previous forecast of 1.3% growth in 2011 into a modest recession. Nevertheless, we continue to anticipate global growth this year in excess of 4%. Further, we expect reconstruction in Japan will provide a boost to global growth later this year and in 2012.

We expect markets to remain volatile in the immediate future, but at this stage we do not anticipate a significant and lasting decline. Predictions of what will happen next in the Mideast and Japan are difficult, and even more threatening storm clouds may materialize quickly. A further jump in oil and gasoline prices resulting from violent political confrontations in the Arab world will roil global financial markets. Additional setbacks in the earthquake, tsunami, and nuclear power catastrophe in the world’s third largest economy will add even more turbulence to already fragile markets. There is also the possibility of a new geopolitical calamity or natural disaster.

Consequently, our optimism is wrapped in caution. Clients should be concerned but not alarmed, remain vigilant and flexible, and maintain a longer-term perspective.