Market Outlook September 2009

In July we wrote: “I have often said, CASH IS KING. Well, with interest rates falling well short of the expected inflation rate, one will actually lose buying power if invested in cash or even many of the Treasury Bonds.” With Money Market interest rates well below 1% we believe parking money in these instruments is akin to putting money in a jar and hiding it in the cellar. It is reasonably safe but not going to do much for you. Fixed income investors, in our opinion, typically show a depth of knowledge beyond that of the typical equity investor. To that end, the Fixed Income investors, by their actions, are showing us that credit spreads are expected to widen, which is bearish for the equity markets.

The bulls say:

Investments in U.S. Treasuries are “reward-less risk” and believe that the historic, extreme risk aversion wave that swept the world actually mis-priced the treasury asset class and believe that the case for corporate bond and equity investment can be based on the following data points: 

• The yield curve has turned from an inverted slope to a sharp positive slope, which historically has marked the beginning of an economic expansion.   

• The FED is committed to using all of their tools to reinvigorate the banking system and the economy. Don’t fight the FED.  

• Bulls are not believers in runaway inflation at this stage in the recovery.    

• Bulls believe that the economic expansion in Asia, Central America and India will resume. 

• Bulls feel that markets where economic expansion is expected to dwarf that of the U.S. are also excellent places to find value.  The equity markets of China, India and Brazil would be examples of where most see value.  

• Bulls believe that income taxes must rise in the future and that the current administration will support higher tax and spending measures.  As such, they believe that the preferred asset class for higher-rate taxpayers is municipal bonds. They also think that an economic recovery will help to stem the credit deterioration of municipalities and that over time, credit quality can actually increase.

The Bears say:

The enormous dosage of monetary stimulus that continues is greatly adding to the Federal deficit which is creeping up from 41% of GDP into the 50% area and eventually projected to hit 56% of GDP. No one knows where America loses its reputation for financial integrity but if we keep this up we are about to find out. In the past couple of weeks; fixed income investors, by their actions, are showing us that credit spreads are expected to widen which is bearish for the equity markets.

• 6 straight months’ consumer credit scores have declined (a record).

• The Congressional Budget Office (CBO) estimates the federal deficit will grow to 1.4 trillion in 2010.

• The CBO assumes that the Federal Government can refinance debt in 2011 with rates 250 basis points lower than current rates. With debt climbing and assumption that asset valuations are growing, the bears say the CBO is doomed to repeat the mistakes of the homeowner; taking on debt they can’t afford under the assumption of perpetually lower interest rates and perpetually rising asset classes. Can anyone say “CRASH”?

• If investors demand higher interest rates to compensate for the risk associated with huge chronic deficits, the impact on the government’s financing, and the economy as a whole could be devastating.

• Higher governmental debt means weak dollar.

• Commercial Property outlook is terrible: rising vacancies, falling rents, dropping prices, balloon notes coming due, and no financing available. It will get worse before it gets better.

International

With a projected weak dollar countries with sound governmental financial management will benefit. Brazil comes to top of mind. Brazil is currently experiencing; a housing boom, strong currency, and strong economic headwinds. China, which is our nation’s 3rd biggest customer, and largest foreign creditor, has been injecting their own stimulus. Many believe that their style of government has given them the ability to spend their stimulus dollars more wisely than the U.S. They have also begun to reduce their exposure to U.S. debt. In June alone, they sold 25 billion dollars worth of U. S. debt. Prior to the meltdown, China’s GDP had been north of 9% and is projected to hover in the 8% range for 2010. The biggest challenge for the Chinese is how to stimulate jobs in the higher wage areas of manufacturing. This relies heavily on demand from the U.S. As you can see, we are in a more synchronized economic cycle with the Chinese than ever before.
The economic recovery underway abroad appears to be ok until late 2010. Then if the consumer from the U.S., China, Brazil, and other countries does not start to spend, the recovery could experience a relapse. The cautious U.S. companies are aware of this possible scenario and thus have demanded from suppliers lower minimum orders which lead to more frequent shipments and demand for delivery with shorter notice. This bodes well for countries closer to our shores in South America rather than China and Asia.

A bit of trivia:
Did you know that in order to get the current deficit down from 7% of GDP to 3% GDP the U.S. government will have to cut its spending by 700 billion dollars?

Did you know that every 1 point increase in the household savings rate takes 115 billion dollars out of our economy? Back in my freshman year at Texas A&M my economics professor said that the push by the Reagan administration to increase household savings was a good idea for the individual but bad for the country.

Bottom line:

There is a case to be made for both bullish and bearish stance in the market. We at Alamo Asset Advisors believe there is money to be made in both scenarios. We are focused on international investing, domestic trends such as cyber crime, and energy demands for the future.
We remain bullish over the next 12 months with ‘normal’ pullbacks in the market. We are more cautious both domestically and abroad in the 2nd half of 2010. Our clients will see more focus and more exposure to international markets going forward. We have multiple partners in the fixed income arena and will be focused on finding value in the bond markets going forward.