The Economy
New York Times opinion writer and Princeton economist, Paul Krugman recently deemed our current economic circumstances prospectively as the third “Great Depression” in U.S. History. These were harsh words, but they were echoed in part by other prominent bearish prognosticators and permanent pessimists. Talk of double-dip recession and other forms of negative economic forecasts have recently pervaded the media and public sentiment. The economic recovery, which probably started about a year ago, has not lived up to its promise. Economic growth, although positive, has been subpar when compared to past recoveries. Most importantly, employment growth has been weak and the unemployment rate has hovered near 10%, a historically high number. Most forecasts for the last half of 2010, rather than seeing acceleration, are predicting a slowing of growth and stagnation in employment. The stock market has reflected much of this, retreating sharply over May and June and declining about 7% for the first half of 2010. All of this accounts in part for the gloom.
I am always skeptical of analysis which sees things in only one way. The economy is certainly facing significant head winds and public policy has been somewhat directionless, but there is still enough positive news. The economy is growing, not declining. We have come a long way since the financial and economic debacle of late 2008. Employment growth is positive, and unemployment, although high, has stopped accelerating. Corporate profits are healthy and profit margins widening. The housing market, while still in the doldrums, appears to have bottomed and has even improved in several markets. I wrote in a recent newsletter about the “New Normal,” a phrase coined by PIMCO funds, depicting a secular trend of low economic and income growth. I think it still holds. We are in a new age of protracted demographic and fiscal challenges. This will probably produce a long period of slow economic growth, high unemployment, and underperforming financial markets. However, I don’t think we are headed into a “Great Depression.” The pessimists see it one way and only one way. The U.S. Economy still is dynamic, flexible, and resilient. We are in difficult times that differ from most of our experiences. However, we are not at the gates of economic Armageddon.
The Markets
The first half of 2010 was marred by poor performing stock markets in both the U.S. and most of the world. After the promise early in the year of a more buoyant economic recovery, the stock market plummeted in May and June. For the U.S., May saw the worst stock market performance for the month of May since 1940. Overall, the S&P 500 was down 7.6% in the first six months of 2010 and the Dow Jones Industrial Average declined 6.3%. The precipitating cause for the decline was the debt crisis in Europe, in which Greece and several other countries in the European Union seemed poised for default. This weakened the euro and threatened all of Europe’s economies and banking institutions, as well as the European Union itself. The repercussions were felt around the world, including the U.S. At the same time, the U.S. economic recovery seemed to slow or even stall. A new pessimism emerged, pushing stock markets into decline.
The major European powers have taken short-term steps to address these issues and for now have assuaged the markets. The markets will react positively if these steps are successful. Deep seeded, more profound problems are evident and need to be resolved. However, this is not the environment for either an economic or stock market debacle. For the near future, I believe modest but positive returns can be achieved in stocks, as we experience neither nirvana nor doom. Focus should be on risk aversion and income generation. Many of the major U.S. company stocks fit this bill and have not performed well in the past year and a half since the stock market bottomed. As a result they are cheaply valued. They are also paying high dividends. These include stocks like Exxon, Wal-Mart, Johnson & Johnson, AT&T, Verizon and many big drug companies. They may present the most attractive opportunities, both because of their cheap value and because their dividend yields in some cases exceed their bond yields. International stocks also carry some promise. Battered by uncertainty and falling currency values, they now seem ready for a turnaround. Emerging markets continue to grow economically and may hold the best prospects, but risk there is heightened and prudence is warranted. Overall, I have cautious optimism regarding selective stocks and stock markets, with the emphasis on “cautious”. I think the pessimists have overstated the case.
The bond market moderately advanced in the last quarter and has provided some positive gains for 2010. Interest rates have fallen across the spectrum of the yield curve, as the Federal Reserve has held to its zero interest rate policy and the economic recovery has remained muted. Disinflation has also supported bond prices. The producer and consumer price indices have trended down toward 1%. In fact, some analysts have predicted outright deflation.
The U.S. Treasury market has proved particularly strong, as nervous world-wide investors have flocked to U.S. dollar denominated bonds. This trend was exacerbated by the debt crisis in Europe. The ten-year U.S. Government bond has dropped below 3% and the three month U.S. Treasury bill has held around 15 basis points. In this environment, investment grade corporate bonds, mortgage backed, and municipal bonds have also benefited. They reflect the same steep yield curve structure (long-term rates are substantially higher than short-term rates) as treasurys. The high-yield bond market (junk bonds) was negatively impacted by the increased uncertainties of the last few months, pushing the spreads on high-yield bonds significantly higher than either treasurys or investment grade corporates. Foreign bond markets were also hurt as the dollar strengthened.
It is hard to conceive of interest rates going much lower than they currently are — although a deterioration of the economy and deflation could shift the yield curve down even further. Nevertheless, the risks are mostly one sided: that interest rates will rise. The big question is “when”. Given the current economic environment, the answer seems to be, “not anytime soon.”
The best bond opportunities are in shorter-to intermediate-term high quality corporate and municipal bonds. With the latter, credit quality has become more important than at any time that I can remember. State and local finances are shaky and many public entities are facing financial crises. Credit risks have increased. On the other hand, federal and state income taxes are on the rise, making the tax free income from municipal bonds that much more attractive. Therefore, opportunities exist in municipals if one is careful about the credit quality of bonds. With the higher spreads on high-yield bonds, these too present possibilities. Some high-yield bond funds are now yielding near double digits and are worth exploring. In the foreign bond markets, the best values are in the bonds of the hard currency countries like Australia and Canada and the developing countries of Asia. Yields are higher in these bonds and there is potential for currency appreciation.
Commodity markets have mostly moved sideways through much of the past few months, reflecting more supply and demand situations than any trend. Gold has risen to all time highs, then backed off. Longer- term trends of economic and financial market uncertainty warrant some commitment to broad-based commodities, gold, and energy. In today’s environment, with the threat of disinflation or even deflation, these commitments should be modest.
Summary
Pessimistic prognosticators and less than buoyant economic news have created a downbeat national mood. This sentiment has befallen financial markets, as the stock market experienced two straight declining months and was down for the first half of 2010. There is much to be concerned with in the economic outlook. Protracted and profound economic problems confront us. Nevertheless, I believe some of the forecasts present a far too gloomy picture. I believe our fundamental economic resiliency will keep the economy growing, albeit at very modest rates. We are facing a transitional and transformative time. However, opportunities do exist in financial markets. Given the very low level of interest rates, I believe that reasonable returns can be realized in risk bearing securities. The best opportunities are in many large U.S. company stocks and selective corporate, high-yield, municipal and foreign bonds. Gold, other precious metals and energy related investments also have attraction due to continued uncertainty and the potential threat of long-term inflation. Risk and uncertainty pervade all aspects of financial markets. More than ever, risk deserves our attention and respect.
