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Economic Soft Patch Causes Equity Market Correction - CitizensTrust
In our second quarter 2010 commentary, we discussed our opinion of “cautious optimism” for the U.S. equity markets given a business-led smokestack recovery and strong signs provided by leading economic indicators both in the U.S. and abroad. We also suggested that the equity markets after almost an 80% run from the March 2009 U.S. market bottom were overbought and, in the shorter-term, were due for a correction.
Indeed, we got the correction as expected with about a 15 1⁄2 % downdraft from the peak of the S&P 500 in late April. The problem for most investors (including professionals) is that these corrections tend to feel long and extremely painful especially if you are looking at your portfolio on a daily, weekly or even monthly basis. These are the times when investment counselors refocus clients on their accepted risk profiles and see if they have changed and also refocus clients on their original goals’ which are hopefully based on more than a month or quarter’s returns. At CitizensTrust, we focus on the business cycle and its four phases - decline, trough, expansion and peak.
No matter what phase the cycle is in, it rarely moves in a straight line. There are deviations and volatility along the way and also potential issues that could derail an investment thesis which have to be constantly evaluated. Our focus continues to rely on leading indicators. We still believe that the U.S. and global economies are in the expansion phase of a business up-cycle that began in June of 2009. In earlier commentaries, we have indicated “cautious optimism” concerning the expansion phase which typically lasts about five years. We also indicated that we believed that we were in a cyclical bull run within a longer-term secular bear market. We hoped that the run would be similar to that experienced from 2003 to early 2008 (another expansion phase).
The alternative would be a jagged roller coaster ride of up and down moves which are typically difficult periods for investors.
On the negative side, we saw a distinct softening of leading economic indicators in the second quarter that included a recent decline in weekly U.S. leading indicators, average jobless claims now stuck between 450,000 and 475,000, and a sudden rise in bond spreads (corporate bond, 2 year swap, Libor-OIS); which together indicated a slower rate of growth for the U.S. economy than we saw last quarter when these indicators were all moving in a positive direction.
Given the slowdown from higher growth levels domestically which is especially affecting the U.S. consumer as seen with a weakening in retail sales, the next questions are whether there is evidence of a global slowdown and, if so, does this portend of a “double dip” recession where we revisit the lows of the markets back in late 2008 and early 2009.
The short answers to these questions are there has been evidence of a slowing of growth internationally but not of the magnitude to make us believe this is a prelude to negative growth rates in GDP or a “double dip”. Rather, it looks like a “soft patch” which is a period of slower growth within the longer-term expansion phase of the business cycle. In an expansion phase, growth and recovery rarely occur in a straight line. International evidence included a slowdown of growth in Europe as a result of austerity measures and fundamentally weak economies in Southern Europe. In addition, growth in China slowed as a result of self-imposed limits on construction and business lending meant to slow property speculation and growing signs of inflation. For example, Shanghai new home sales were down 57% in the first half of 2010 and Chinese vehicle sales were down 18% from their 2009 peak this June. Finally, the Baltic Dry Index (a measure of non-oil related global trading) has declined markedly of late, signaling a slowdown in the shipment of goods between countries.
Soft Patch, Not a Double Dip
Although there has been a definite slowdown, we do not believe that the global economy is headed for negative growth - a double dip recession. This extreme view has been postulated by many pundits based on the negative news reported above. Nevertheless, there is also a spate of positive items which suggest the global economy truly bottomed in June 2009 with no revisit of the crisis of 2008 and early 2009. First, manufacturing activity has remained strong as seen with impressive new orders for manufacturing equipment. This indicates that our thesis on a business-led smokestack recovery is still intact.
In addition, the IMF lifted their forecast of global growth to 4.6% from 3.9% predicted in January based primarily on strength in emerging markets with a focus on China, India and Brazil. While Southern Europe remains weak and implementing their own austerity measures to control government debt in the face of weak GDP, major European economies such as Germany and France are faring much better. Also on the positive note, Timothy Geithner, President Obama’s Treasury Secretary, indicated that the maximum federal capital gains tax rate next year would be 20% (up from 15% but well below the 40% or so feared by the markets). He also recently indicated a similar small rise for taxes on dividends’ which is again smaller than many feared.
The Chinese slowdown (from 11.9% GDP growth in the first quarter of 2010 to 10.3% in the second quarter) portends a “soft landing”. The Chinese sought to control growth which was bringing about signs of unacceptable levels of inflation in both real property and commodity prices. Of note, the country can rapidly reignite growth if it is deemed to have slowed too much through policy (reducing or eliminating restrictions) if necessary. In addition, world money supply remains high, the yield curve is still steep, and inflation is not an issue with U.S. capacity utilization at 74%, well below the 80% average.
Although U.S. GDP growth will likely slow from the 3% plus rate expected at the start of 2010, it should remain positive. This means a “recovery” albeit not as robust as previously anticipated earlier this year. In the U.S., the markets are focused on both the creation of jobs domestically and the stabilization and recovery of the domestic housing market.
With only about 593,000 private payroll jobs created so far in 2010 (after a loss of 8.4 million jobs since the slowdown began in 2007) and the unemployment rate now averaging 9.5% due to a drop-off in those seeking employment, the job scene has weakened. At this point, job creation does not appear that it will become robust absent additional stimulus through growth initiatives. A rise in U.S. factory capacity utilization to the 80% plus level from 74% currently would ignite job growth given robust productivity numbers that likely cannot be extended much further. Sales of existing homes were down 30% month- over-month post the end of government stimulus. We believe that supply and demand for existing homes which stands at 8.3 months nationally has to normalize to the 5-6 month level and must include “shadow inventory”. This likely means a bottom sometime next year or in 2012.
The bottom-line is that we remain cautiously optimistic with a bit more emphasis on the “caution” side given anticipated slower growth from the U.S. and increasing reliance on emerging markets to take up the slack. We will continue to focus on those indicators providing a view on what is going to happen rather than those depicting the present or past and will make adjustments to allocations and holdings accordingly.
Like equities, the fixed income markets remain volatile as well. So far this year, U.S. Treasuries have continued to surprise, as investors flee European sovereign debt, anything energy - related and many financial names. Yield spreads began to widen in late April, and then more or less hit a plateau in June. It would appear those who had predicted the bond market’s demise may have been wrong - or just incredibly early.
We continue a fairly conservative approach, but we have loosened up a bit to take advantage of a still- steep yield curve. Of late, we have used more of a “barbell” approach to bond portfolios - buying bonds at the shorter and longer ends of our yield-curve comfort zone. The barbell approach tends to outperform during flattener environments and sometimes during parallel yield-curve shifts. We attempt to keep durations in the 3-year range for taxable accounts, and slightly longer for tax-free portfolios.
For taxable clients, we continue to favor California municipal bonds. On the bright side, the state’s cash-management techniques may have bought it a few months’ leeway, while state tax revenues have trended upward this year, though not in a straight line. At the end of the day - and possibly toward the end of the summer - we expect California to strike a new budget, meet its obligations and at least maintain its current debt ratings. Individual municipalities may not emerge so fortunately, however, as they see less local revenue and fewer dollars coming from Sacramento. In May, for instance, the state grabbed $1.7 billion in redevelopment funds from local entities, putting more pressure on municipal and county governments. Thus, CitizensTrust continues to scrutinize our portfolio holdings to insure capital preservation.
Hiring!
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Looking for Capital!
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• New mass-market high-quality wine, run by highly experienced wine maker / distribution team
