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Follow The Leader

In past global recessions, the United States led the rest of the world to economic recovery with its shear economic strength.  This time, there is a very strong case that the larger emerging-market economies will lead recovery. These markets are typified by Brazil, China and India. These countries have sounder economic fundamentals than in the past, and million of domestic consumers to rely on in the face of slack foreign demand. This has led to an impressive rebound in stock and bond prices in these nations. As of this writing, the MSCI Emerging Market Stock Index is up more than 45% since the beginning of 2009.  It should be noted, however, that emerging market stocks were among the worst performers in 2008. The World Bank estimates that the global economy will contract 2.9 % in 2009, its worse performance since the 1930s. The good news is that the pace of decline is already moderating; it’s clear that a global recovery is underway, and is expected to take full effect in 2010. 

Why is it different this time?

Most emerging markets had little exposure to the global credit crisis that affected the US, Europe and Japan. This explains why developing economies as a whole have managed to avoid a decline in their economic activity. The World Bank projects that the economies

of developing nations will expand by 1.6% verses a decline of 4.5% in the industrialized world. This is important because emerging markets account for an increasing share of world output: 45% of the world GDP in 2008 verses 37% in 2000.

However, developing countries were not left unscathed by the collapsing world economies, having suffered some damage to their economics due to falling exports, declining commodity prices, and reduced capital inflows as a result of the global credit crisis. However, emerging markets were better prepared to weather the storm than in the past. Stable currencies, favorable trade balances, budget surpluses, and large foreign exchange reserves have given many countries room to weather an economic storm for the first time in history. Latin America and Asia have been able to stimulate domestic growth through lower interest rates and increased government spending. These areas have the added benefit of low household debt and limited debt in the banking and corporate sector, which will fuel the revival of consumer spending and business investment.

The “Good, the Bad and the Ugly”!

 It should be noted that not all emerging markets are participating in this economic revival. Most countries in Central and Eastern Europe are plagued by excessive leverage in their financial systems in addition to fixed exchange rates, large trade deficits and large budget deficits. On the plus side, there is recent news that several major European countries have started their economic recovery. The Wall Street journal reported on August 14^th that the GDPs of France and Germany showed positive growth in the 2^nd quarter.

The best of the best

Within the Latin American and Asian economies, three countries appear best positioned to lead the way in the global recovery: Brazil, India and China have solid economic fundamentals as well as several additional advantages. First, they were slower to liberalize their financial systems and therefore have been less affected by the collapse of the global credit markets. Second, they rely less on exports than the average emerging market country and have the ability to produce for their large domestic populations.

Many financial professionals group Brazil, Russia, India and China together, commonly referring to these countries as the BRICs. The BRICs comprised 22% of the world GDP in 2008, up from 16% in 2000. They also accounted for roughly 30% of global growth over that time period. It should be noted that the Russian economy is not in the same class as the others, due to its dependence on oil exports and the fragile banking system. While Brazil, India and China recovered fully in 2009, the overall Russian economy may struggle until 2010.

During and after the global economic recovery, we expect emerging markets to achieve much higher growth rates than developed countries. Developed countries such as the US will continue to be pressured by increasing budget deficits and higher trade imbalances. From an investment perspective, it is difficult to say whether the recent strong performance in stock and bond prices in these emerging markets can be sustained, given the volatility of the financial markets. However, the long term prospects suggest that they are an important piece of a well diversified portfolio.

What about US?  Is the worst over?

There seems to be no doubt that the US economy is improving. There is mounting evidence that the current recession is near its end, though the subsequent recovery will likely be fragile, with job losses continuing to mount for months, even after the GDP turns positive. The second quarter of 2009 may likely prove to be the final period of negative GDP. As we move into the second half the year, several key components of GDP are likely to show improvement. While the recession may technically be coming to an end, the ensuing recovery will not be in a straight line. Although the economy may have rebounded from its worst level, there are still questions about the timing, sustainability and magnitude of the recovery. There are a number of factors that need to improve for a sustained long term recovery, including:

• Continued improvement in the housing market: While the housing market is not exactly robust, the market for new and existing homes continues to improve.
• The labor market remains weak but is healing: There has been a clear downward trend in new jobless claims. Unfortunately jobs are still being lost and the official unemployment rate will likely move higher.
• The continued healing of the credit markets:  For an effective recovery, the credit markets need to continue to heal and make money available to business and consumer alike.
• Continued improvement in consumer confidence: Over the last 3 months indicators of consumer confidence have shown continual improvement.
• Business inventories: Business inventories have dropped to the lowest level in decades. As the economy shows signs of improvement, manufacturers will have to significantly build inventory to keep up with demand.

Although the downturn is largely behind us, the path to economic recovery will not be quick and easy. The myriad of stimulus programs are making some difference and could even provide a spark to ignite some growth.  Simply getting the domestic auto industry reopened for business in the 3^rd quarter should spark economic activity. Clearly the “Cash for Clunkers” program is having an impact. While consumer spending is down from previous years, we are saving more. Unfortunately, the Federal government’s effort to fill this void is creating massive budget deficits. We are mortgaging the future. 

We should be concerned that our fragile recovery could be derailed by increased taxes, increased regulations, health care reform, cap and trade, and protectionism.

Although some commodity inflation may continue to emerge such as we have seen with oil and copper, low capacity utilization, slow labor markets, and slow real-estate markets will keep core inflation low for the next year. One of the most intriguing and positive aspect of the current downturn is the increase in productivity growth. Businesses have cut payroll aggressively and although this has contributed to the rise in unemployment, it is very positive for corporate profits. 

Where do we go from here?

Stock markets typically anticipate economic recovery, looking months ahead. The major stock market rally that has continued since March of 2009 is in large part due to the improvement in expectations for the US economy. Companies seem to be in the process of transitioning back to managing their businesses with a view towards the future rather than doing all they could to conserve liquidity and rapidly downsize. Second quarter profits for most companies met or exceeded expectations. These markets moved in anticipation that with sales growth on the top line, bottom line profit will accelerate.

From an overall market perspective, we believe a number of risks remain, but other positive factors are having an influence. Monetary conditions remain very market friendly, valuations are still reasonable, and corporations are being more shareholder friendly. We are concerned that the current rally in the stock market may have gotten ahead of itself and therefore may stagnate and pull back slightly, but the intermediate and long term look good. In addition stock price movement has returned to more normal levels, with less extreme volatility. The bottom line is that it has become a stock picker’s market again.

Inflation remains an intermediate concern. Many economists believe that the massive amounts of stimulus and huge budget deficits will lead to a period of hyperinflation in the future.

For the near term we will add positions in cyclical industries such as Industrials and Materials while maintaining our positions in Energy. In addition, we will increase our exposure to emerging markets, including BRIC countries.

Corporate bonds, including high yield and convertible bonds, remain attractive for client portfolios. We will add positions as needed to balance out our clients’ asset allocation. If inflation does become a major factor, portfolios will be adjusted to take advantage of the opportunities available.

The Second Quarter and Year to Date:

During the second quarter of 2009, financial markets around the world rallied sharply from the lows of March 6. Nearly all major stock and bond indices rose, including the S&P 500, small cap, large cap, technology, developed markets, emerging markets, investment grade bonds, and high yield bonds. All of these gains reflected the belief that the US and global economies have averted a world wide systemic financial meltdown. In addition credit began to flow in the 2^nd quarter.

We are pleased to report that most client portfolios in aggregate beat the S&P 500.  In the second quarter we continued to overweight oil and gas; technology and emerging markets; convertible bonds; and high yield bonds. 

Thank you for the confidence you have in us.

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