“The truth does not change according to our ability to stomach it”
-Flannery O’Connor
Since the financial crisis of 2008 the Federal Reserve has been working to satisfy its dual mandate of maximizing economic growth while also curtailing inflationary pressures. A first round of Quantitative Easing was followed by QE II, yet still the strength of the recovery is tepid. Chairman Bernanke, in his most recent press conference following the Fed’s Open Market Committee meeting said “We don’t have a precise read on why this slower pace of growth is persisting…Maybe some of the headwinds that had been concerning us – like weakness in the financial sector, problems in the housing sector, balance sheet and deleveraging issues – some of these headwinds may be stronger or more persistent than we had thought.” As investors, we need to navigate the challenging domestic and international issues understanding that policy makers have fewer levers to pull without elevating the risk of inflation. In this note we’ll review the pace of the recovery-to-date as well as the pillars on which the economy is built: the consumer, corporate earnings, and government spending.
After a strong start the economy began to show signs of stumbling in April & May. GDP estimates for 2011 that began the year around 3.9% were reset to 2.9% by early June. We disagree with those who solely blame “external factors” like disruptions in the supply chain caused by the Japanese earthquake, or higher gasoline prices for the slowdown. (Remember, QE II was initiated last fall after signs of a slowing recovery.) Instead, we concur with Mr. Bernanke’s candid comment during his June press conference in which he cited the economic headwinds created by overleveraged consumers and deficit laden governments. While QE I & II have helped treat problems that arose from the financial crisis, economic growth along with austerity measures are fundamental to resolving the underlying issues of overburdened government budgets and consumers.
We are monitoring the progress being made eliminating economic headwinds by evaluating consumer balance sheets and the willingness of politicians to enact fiscal discipline. Job growth, personal debt, and disposable income are among the most important gauges of consumer health. Consumer debt has started to rise again, but remains below the peak reached in 2008. Employment and disposable income must expand in order to support consumer spending. Housing, which is a core component of individual wealth, is establishing a base. There were only 323,000 new homes sold in 2010, down from 1,283,000 in 2005 at the height of the bubble so any recovery in this sector will be helpful.
Governments around the world cannot defer budget imbalances any longer. Whether it is a crisis in the Eurozone led by Greece, or tough negotiations preceding a vote to raise the US debt ceiling, the need to address fiscal imbalances in government budgets is unavoidable. We doubt the plan passed by the Greek parliament on June 29th will address the core issues in that dysfunctional nation. Instead, we believe another round of reform will be necessary. Problems associated with a weak Eurozone are likely to persist for the foreseeable future.
In the United States we are quickly approaching August 2nd, the date given by Secretary Geithner on which the US debt ceiling will be reached. Congress is working toward a goal of reducing the federal deficit by $4 trillion over the next ten years. To date, Congressional leaders and the White House have agreed to savings of only $1.2 trillion. What wimps! Last year’s commission on the budget deficit led by Alan Simpson and Erskine Bowles created an excellent blueprint and Congress needs to gain the intestinal fortitude to enact many of the measures. Recent statements by Congressional leaders indicate a compromise may occur in time for the US government to avoid default. Activity on the state level is very interesting. Governor Christie has attacked the political third rail of union benefits. Other states like Wisconsin and New York are also addressing bloated labor benefits. We believe that addressing government deficits has the potential to brighten the longer term outlook for the US economy and drive equity markets higher, but we need leaders willing to lead to accomplish this goal.
The strongest leg of the economic stool is the private sector. Corporate earnings have rebounded from the recession of 2008/2009 and companies have been building cash balances. In the last year, 20 companies owned in client portfolios increased cash dividends an average of 33%. Earnings increased 45% and are forecast to increase 23% in 2011. Top performers year-to-date include Praxair, Sigma Aldrich, Costco, Henry Schein, and Williams Partners. Our investment in financial stocks has been the greatest drag on performance as the risk of greater regulatory oversight, combined with low interest rates, have hurt results. We sold our investment in Cisco Systems in the quarter and also eliminated our remaining holding in Corning. Neither had met our expectations on a consistent basis.
We believe this is a stock picker’s market. We intend to focus on adding stocks in client portfolios that are generating distributable cash flow, stable/expanding returns on invested capital, and that are run by management teams with a record of demonstrating shareholder friendly activities.
We will not buy turnaround companies that have yet to show signs of a turn. We believe doing so creates the risk of buying a “value trap”. We intend to increase investments in businesses that benefit from expanding global trade. We also intend to increase our investments in businesses that benefit from a frugal consumer. People can defer spending only so long before the replacement cycle begins to kick in. We are also mindful that the risk of inflation has risen and this makes us wary of buying longer term bonds at current market rates.
Thank you for entrusting me with the management of your money. It is with great professional satisfaction that I recognize every long term client has joined Ayrshire Capital Management LLC. If you know of others who would benefit from Ayrshire Capital’s services please let me know and I’ll be happy to arrange an introduction. I invite you to visit our new offices and please call or email if you have any questions or comments.
Sincerely,
JM Sam Nevin, Jr.
Managing Partner