“Once politics become a tug-of-war for shares in the income pie, decent government is impossible”– Friedrich Hayek
Mr. Hayek was right! One year ago I thought 2011 would be the year politicians tackled fiscal reform. After all, government policy has been the wildcard overshadowing global markets since the financial crisis erupted in 2008. Whether it was the rescue of too-big-to-fail banks or the massive expansion of the Federal Reserve balance sheet via quantitative easing I & II, government action has locked the market in a risk-on/risk-off trading range as investors have swung between hope and despair of real reform. Expectations that Congress and the Executive branch would reach a compromise and address the deficit ended unceremoniously in November with the failure of the “Super-Committee”. The classic debate on the role of government in resolving crises, a la Friedrich Hayek (free markets) and John Maynard Keynes (government intervention), has reemerged. Given that 2012 is an election year, I expect no meaningful progress until after November. Making predictions at this time is precarious as the outcomes will be based upon politics. Therefore, in this note I’ll highlight observations of items that could influence the investment environment during the coming months.
The US economy is entering the fourth year of a modest recovery with GDP forecast to expand around 2% as the headwinds of deleveraging remain. Market expectations, battered by fears of the European sovereign debt crisis, are so low any constructive development will be viewed favorably. Election activity, which is typically geared toward appeasing voters, should be good for equities. Bond yields are unattractive while stock yields look more appealing due to the Federal Reserve’s stated intention of maintaining low rates. Equities are inexpensive with the S&P 500 index trading at 12x projected earnings, and American businesses are lean and in solid financial shape.
Sectors that have been headwinds to the domestic economy, specifically housing, seem to be finding a bottom. Initial jobless claims have dipped below 400k. Consumer credit has begun to expand again following the significant contraction of 2009 yet hourly earnings and job growth need to strengthen in order to support continued consumer spending.
The situation in Europe is more challenging. It is unlikely the Euro survives as a currency with each of its current member nations. The cultural values of the Germans and Greeks are just different. As the world has seen, getting leaders of member nations to agree on a course of action which then needs to be ratified by individual parliaments is incredibly challenging. The European Central Bank (ECB) will play a prominent role in whatever reorganization of the currency transpires. The latest long term refinancing operation in December by the ECB injected 489 billion euros into the European banking system, doubling the size of the ECB’s balance sheet. It was quickly snapped up by European banks seeking liquidity so that the institutions could continue holding/purchasing European sovereign debt (QE III anyone?). The risks emanating from the euro zone are real and I will continue to monitor and make adjustments as the circumstances warrant.
After assessing these observations I find myself resolute in my investment discipline of the last 25 years: owning quality businesses that generate excess cash flow which is being deployed in shareholder friendly activities is the best way to navigate markets over the long run. Never underestimate the ability of a good management team to operate successfully when given the resources of cash flow and ingenuity.
In the fourth quarter I added positions in People’s United Financial (5% dividend yield), IBM (1.7% yield), Staples Inc. (2.8% yield), Deer & Co (2% yield), and Danaher (0.2% yield). I sold positions in PNC Financial, Illinois Tool Works, and Schlumberger. Generally speaking, stocks were purchased because of favorable growth characteristics/dividends, and those sold had disappointed (SLB, ITW) or I was repositioning sector weightings (PNC). I expect to remain active purchasing and selling stocks during the coming year as market volatility will likely remain high and I’m always focused on upgrading the quality of the businesses in which you are invested.
I wish you happiness and good health in the New Year. Thank you for entrusting Ayrshire Capital with the management of your money.
JM Sam Nevin, Jr.