Monday, June 15, 2009

May 2009 Market Update (posted to our blog two weeks after sending to clients)

"Inflation and deflation in this levered world coexist nearly side-by-side.”
Bill Gross, PIMCO founder and co-CIO

Any review of today’s investment markets must include significant conversation on the subjects of both inflation and deflation. Deflation is defined as a continuing decrease in the prices of goods and services, such that consumers greatly slow their purchases as they wait for cheaper prices. Investors want to sell assets in a deflationary environment because they believe the future price will only become less. Inflation is the opposite condition, whereby buyers seek goods and services that are increasing in price. Investors want to buy assets in an inflating environment, as they believe the future asset price will increase.

Debt is an important consideration as it relates to inflation and deflation. In a period of deflation, debt magnifies the losses of the investor, while in periods of inflation debt magnifies gains. Too much debt can cause deflation, as borrowers are forced to sell assets to pay down debt and those sales cause the asset prices to decrease in a deflationary spiral. This is exactly what happened in the Fall of 2008.

Governments worldwide, led by the U.S., are trying to “reflate” the markets to fight deflation. Key steps include record low interest rates, spending stimulus programs, central bank asset purchases, financial institution support and direct investment in industries such as autos. Without these steps the problem of deflation could have become deep and prolonged. Most experts today feel that the risk of such a deflationary “depression” is now very minimal.

So here we are on May 28, 2009 (S&P 500 closed at 907) with asset prices significantly above the lows reached on March 9, 2009 (S&P 500 closed at 676). The fact that the S&P 500 is 34% higher in less than a three month time period tells us that the reflation efforts by governments have enjoyed some good success. However, there are many issues for investors to be concerned with going forward.

One key issue is how and when governments will withdraw their support of the markets. If support is withdrawn too soon or too suddenly, an economy that is recovering could dip back into recession (thus the concern this might be a “W recession” of down-up-down). If support is withdrawn too late or too slowly, inflation can heat up. Certainly policy will not be handled exactly right.

Markets have begun to reflect some of these concerns. The interest rate on the 10-year U.S. Treasury Note is 3.7% today, compared to 2.3% at December 31, 2008, as markets begin to wonder if the program of Federal Reserve “quantitative easing” will have sufficient Fed buying of Treasuries to keep rates low. The average 30-year mortgage rate nationwide has increased to about 5.4% after recently being below 4.75%. The U.S. dollar, which rose significantly as the safe haven currency while the world sold risk-based assets, has declined about 10% since March 9th (versus a basket of foreign currencies).

At the same time, deflation risks are still present. An important risk is that imposed by the low percent-of-capacity at which economies are operating. In the U.S. an April decline in manufacturing industrial production marked a total decrease of 16% since its late 2007 peak even though the total decrease in U.S. real GDP from the top in 2007 to now is still less than 3%. In countries such as Taiwan and Singapore the circumstances are much direr as they have seen their real GDP decline by over 10%, thus crossing the line into official depression.

A recent U.S. consumer confidence indicator showed a sizeable increase, and the markets responded positively. Looking behind those numbers reveals that much of the increase in consumer confidence comes from a big increase in the “expectations” portion of the measure. This sets up a possible disappointment for consumers if those expectations of an improving economy aren’t sufficiently realized and risks a further future pullback in consumer spending.

So we have a world economy that is in somewhat of a tug-of-war between deflation and inflation. Government policymakers will have to do the almost impossible task of handling policy in a fashion to avoid fueling too much of either. Markets are encouraged by the reflation steps taken so far, but they show their concern about where things are headed by a significant increase in interest rates. Consumers are beginning to show signs of improving sentiment, but their fragile psyche could be damaged easily by signs of additional economic weakness.

The markets have come a long way since the lows of early March. Our portfolios have been rewarded with high levels of returns in emerging market equities and high yield bonds. These are two asset classes we have shifted more money into over the past six months. Much can still go wrong, and we are still of the opinion that our April reduction in large company U.S. stocks in favor of quality bonds was the right type of portfolio insurance. At present we are making no additional changes in client portfolios, but are evaluating a variety of possible holdings including those that protect against U.S. dollar weakness and inflation.

We also continue to update client wealth plans so that we can evaluate client goals and how they are affected by these challenging markets. Further, in those specific client situations where it makes sense, we are using the low stock market levels to model and recommend high-end planning techniques such as Roth IRA conversions and wealth transfer tools like Grantor Retained Annuity Trusts (GRATS).