“You can’t escape the responsibility of tomorrow by evading it today”-Abraham Lincoln
A few weeks ago I had the opportunity to hear General Martin Dempsey, Chairman of the Joint Chiefs of Staff, speak in New York. When asked why he accepted the position given the treacherous geopolitical landscape he replied, “Why wouldn’t I? We’re at an inflection point in history and now is the time to make a difference.” His willingness to tackle the challenges facing our nation was refreshing. Wouldn’t it be wonderful if our politicians were as willing to confront our nation’s dysfunctional budget process which is creating heavier burdens to be paid tomorrow instead of offering lip service to whatever theme may get them elected today? They aren’t, yet the slow, choppy economic recovery that began in 2009 continues forging onward into the headwinds of deleveraging. In this quarterly letter, I’ll update the economic outlook domestically and internationally, my observations of what we can expect in the coming months, and the changes made in client portfolios.
Domestically, economic data on employment, capacity utilization, consumer confidence, and the leading economic indicators have all strengthened from the depths of the crisis in 2008. The Gross Domestic Product (GDP) has rebounded from the 4Q of 2008’s annualized rate of -8.9% to the most recently reported 4Q of 2011’s annualized rate of 3.0%. The economy has been assisted by aggressive Federal Reserve activity that has expanded the Fed’s assets from $869 billion in August of 2007 to $2.9 trillion in March 2012. The tripling of the Fed’s balance sheet has been successful in staving off a collapse of the US financial system and artificially depressed interest rates are buying time for overleveraged borrowers.
Internationally, the economic picture has been more mixed. Fear created by the Greek crisis spilled into other sovereign debt as borrowing rates spiked in Italy, Portugal, and Spain. The European Central Bank implemented a quantitative easing program of its own in December and again in February when it implemented a low interest loan program totaling 1 trillion euros ($1.3 trillion). The action alleviated pressure on European financial institutions to sell sovereign debt. Italian debt which had been under tremendous stress during the crisis with 10 year yields rising to over 7% saw its bonds recover and yields decline to 5%. Although the ECB’s loan program has been successful in the near term, it is important to remember that it and the Greek debt restructuring haven’t resolved the underlying issues in the Eurozone. The actions have only given member nations time to work out a sustainable restructuring of the Euro currency and member nation fiscal policies. If Euro GDP fails to grow more rapidly and member nation budget deficits aren’t brought under control, the crisis will return with a vengeance.
Emerging economies remain strong on an absolute basis, but are expected to grow more moderately in 2012. China continues implementing policies aimed at suppressing inflation but that also temper growth. China’s GDP is forecast to expand 7.5% in 2012, down from over 8% in 2011. Latin American nations are expected to experience GDP growth in the mid-single digit range, down from last year. Wage pressure is being felt in many developing nations, particularly Brazil, causing policy makers to walk a fine line between growth and inflation.
Looking forward, it is unlikely that any meaningful fiscal domestic issues will be addressed until the outcome of the elections is decided in November. The equity markets have advanced over 10% since the beginning of the year and almost 30% from last October’s lows. Stocks remain attractive on a fundamental basis but markets tend to zigzag so the upcoming quarter is vulnerable to sell-offs. The VIX index, a measure of market volatility, is also a helpful tool in measuring investor complacency. It is near its twelve month low which is usually a sign to be more cautious. The graph below shows the relationship over the last 12 months between the VIX and the S&P 500. The top line on the right is S&P 500 and the bottom line is the VIX index.
Fed policy continues to force investors into riskier assets, such as equities, as bonds continue to offer negative real returns. The US ten year treasury is currently yielding 2.2% while the latest CPI figure shows inflation running at 2.9%, generating a negative real return of 0.7%. I have purchased almost no bonds in the latest quarter and have favored yield oriented instruments like trust preferreds, MLP’s, and dividend paying blue chip stocks. I will be watching for an improvement in money velocity. The Fed’s aggressive use of quantitative easing has helped provide liquidity in recent years, but money velocity, a measure of real economic strength, has remained poor. Money velocity measures how quickly money changes hands in relation to GDP. It has fallen 16% since the crisis of 2008 and the Fed will have a difficult time deleveraging its balance sheet unless velocity improves. The Fed is currently walking a tightrope hoping velocity improves before inflationary forces push rates higher, thereby raising borrowing costs and adding to government budget pressures.
During the quarter I purchased shares of TJX Companies, Home Depot, and United Technologies Corporation in client portfolios. I added TJX because it is positioned to benefit from more value oriented shoppers. It has made great progress improving its international operations and margins are likely to expand. I added Home Depot because of its attractive dividend (2.5%) and its exposure to home remodeling and construction, should those markets continue to improve. United Technologies also has an attractive dividend (2.3%) and it provides exposure to the aerospace markets. Its pending acquisition of the Goodrich Corporation has the potential to be a transforming deal and I believe the opportunity is exciting. I trimmed client holdings in JP Morgan Chase & Company after the stock experienced a strong rally. I’m concerned that changes in the regulatory environment will make it more difficult for major money center banks, like JPM, to earn returns on equity and invested capital at the levels they achieved in the past. I’ll be looking to add smaller regional banks positioned to benefit from the pressure to consolidate that is another consequence of the heightened regulatory environment. I am focused on finding solid long term opportunities, while also keeping a wary glance over my shoulder for omnipresent risks.
In closing, I want to thank those of you who have been referring friends and associates to Ayrshire Capital. The trust and confidence you have placed in me is humbling and inspires me to work harder on your behalf. As always, please call anytime with any questions or comments. I look forward to our conversations.
JM Sam Nevin, Jr.
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