DFM Newsletters

ECONOMIC AND INVESTMENT FORECAST

May 2010

The U.S. Gross Domestic Product (GDP) grew at a 3.22% annualized rate for the 1st quarter of 2010, and most economists expect a continued strengthening of the economy.  Corporate spending on capital equipment and business software rebounded strongly during the 1st quarter, indicating a growing business confidence.  The Federal Reserve recently reaffirmed its commitment to exceptionally low short-term interest rates (currently at 0 - 0.25%) for an “extended period” and government stimulus programs will continue through at least the 1st quarter of next year.  Housing prices rose in nearly 60% of U. S. cities in the 1st quarter of this year as the housing market began to stabilize in response to the billions of dollars in federal spending.  However, price recovery remains elusive in some regions.  Retail sales were a little weak in April due to an early Easter, which produced strong sales in March.  Temporary employment, generally a precursor to full-time work, has increased, and jobless claims declined modestly during the 1st quarter.  However, the overall unemployment rate is expected to remain high while discouraged workers, who had stopped looking for work and had not been counted, return to the job market, and corporations remain cautious on new hires.  Labor productivity increased at a strong annual rate of 6.3% last year, which was an important factor in the 1st quarter’s strong corporate profits.  These earnings were anticipated by the stock markets, which have rallied over 70% from their lows in March 2009.  We expect this upward trend to continue, although at a slower rate with increased volatility.  Inflation in the U.S. remains muted.  However, the increasing budget deficit, now the highest percentage of GDP since World War II, as well as continuing government stimulus spending and higher energy and other costs will likely lead to higher inflation. 

The leading economic indicators for the developed world expanded in the 1st quarter at the highest rate in more than three decades.  This should provide a positive environment for U.S. exports.  Asian markets are projected to grow at a 7% annualized rate during 2010 and 2011 according to the IMF.  The largest emerging markets, the BRIC countries (Brazil, Russia, India and China), may grow even faster.  China recently raised mortgage rates and down payment ratios to reduce real estate speculation and lower inflation, as growth has approached double digits.  The sovereign debt crisis in Greece and its possible contagion to other southern European countries has resulted in diminished confidence in the EU, and is likely to result in higher interest rates in Europe as some developed countries attempt to fundamentally restructure their societies.  The dollar, which had significantly depreciated against the euro, is now recovering against the euro and is expected to strengthen over the next year, which will make our exports more expensive in that region.

For the past three decades, bond investors have benefited by a long-term decline in interest rates (as yields decline, bond values rise).  In contrast, over the last 10 years, equities failed to generate real returns (returns over the rate of inflation).  Many economists refer to this time as the “lost decade.”  We expect U.S. bond yields to rise and values to decline as inflationary pressures force interest rates higher next year.  Therefore, we will maintain short U.S. bond maturities and continue to look to closed-end funds, energy stocks and MLPs, and REITs for higher yields.  Fundamentally strong U. S. large-cap companies with solid dividends will also be attractive as alternative income investments.  In addition, emerging markets will continue to offer opportunities for positive equity appreciation.  We anticipate that small and mid cap U.S. equities will outperform. 

ECONOMIC AND INVESTMENT FORECAST

February 2010

The U.S. economy continues to improve as shown by the 5.7% growth in 4th quarter GDP.  This was the largest increase in over 6 years, although a portion of this growth is due to inventory re-stocking.  The Great Recession, which we believe ended last summer, was business-related rather than consumer-driven.  During 2009, business investments declined 17.9%, while consumer spending declined only 0.2%.  As a result, the consumer now represents over 70% of the U.S. GDP.  January unemployment (currently at 9.7%) declined 0.3% from December and 0.4% from its recent October high, a trend that is expected to continue throughout 2010.  Proposals to create jobs, reduce payroll taxes, and divert TARP funds to stimulate small business growth are all under consideration by the administration to enhance the recovery.  The Federal Reserve (Fed) indicated that it would keep interest rates low for “an extended period,” generally thought to be at least six months.  Low interest rates, easing credit, and existing stimulus programs should allow the economy to grow independently of government assistance by year end.  Unfortunately, the cost is the unprecedented U.S. budget deficit of $1.6 trillion and growing.

Globally, central banks are trying to restrain excessive government spending, which is inflationary, while stimulating economic growth.  The Fed realizes that moderate inflation will likely increase housing and stock market prices, thereby creating wealth, which will raise consumer confidence and spending, and thus aid economic recovery.  Alternatively, too much inflation can lead to a weaker U.S. dollar and a wage price spiral.  We believe the Fed sees inflation as a lesser problem than deflation and will allow prices to rise significantly before withdrawing liquidity and raising interest rates to insure a sustainable recovery.  Conversely, some economists expect the Fed to begin to tighten credit as early as this spring as part of “normalization” of Fed lending.  The 4th quarter 18.1% increase in U.S. exports took most economists by surprise, reflecting the difficulty in projecting the uneven global recovery.  Some euro-zone developed countries, Spain, Portugal, and especially Greece, are struggling with large budget deficits, and questions have been raised concerning their ability to finance new debt.  In contrast, emerging economies with rising middle classes, such as China, India, and Brazil, are expected to continue to grow at a healthy rate.  It is important to note, 2009 was the first year that overall consumption in emerging economies as a group surpassed the U.S., a major economic trend.

The U.S. stock market, which has not had a significant correction in nearly a year, is currently experiencing increased volatility as uncertainty over the global recovery, continued high unemployment, the unclear funding of government deficits, and the size and timing of tax increases/decreases make investors uncomfortable.  A 10% or greater correction over the next few months is certainly possible before the stock market continues to increase with an improving economy.  With the volatility expected in the next six months, a well-diversified portfolio which includes emerging market fixed income and equity investments, income-producing energy stock and MLP investments, and dividend paying multinational corporations is appropriate for most investors. 

ECONOMIC AND INVESTMENT FORECAST

November 10, 2009

The U.S. economy continues to struggle, even as the housing market appears to have bottomed out. Credit conditions are improving, interest rates are low, and 30 year fixed rate mortgages are below 5.0%.   Although most economists and Fed Chairman Bernanke believe the recession has ended and a double dip is unlikely, the recent Commerce Department 3rd quarter Gross Domestic Product (GDP) of 3.5% was not as encouraging as first perceived.  Personal consumption expenditures rose 2.36%, but 1.66% of this was due to the one-time Cash for Clunkers stimulus program.  Other positive contributors to GDP included inventory replenishment and government spending.  Surprisingly, net exports were a slight detractor despite the weak dollar, which makes our goods and services less expensive overseas.  Consumer spending, which accounts for approximately two-thirds of GDP, was weak, and we believe will remain so until the consumer feels more financially secure.  Unemployment, now 10.2%, is not predicted to decline significantly until the 2nd quarter of 2010.  Although consumers will gradually return to spending, an increasing amount of their purchases will be through the Internet, from which neither the Federal government nor most states currently collect taxes.  Recently, there has been some talk in Congress about a Value Added Tax (VAT) to replace the existing cumbersome income tax system, although implementation in the near future is highly unlikely.  With or without a health care plan, tax increases are expected at the federal, state, and local levels.

Fed Chairman Bernanke believes that Fed policy in 1932 played a significant role in causing the Great Depression.  He has repeatedly expressed his determination not to make the same mistakes of raising interest rates or reducing liquidity too soon.  We expect 2010 U.S. GDP to fluctuate between 2.5% and 3.5%, and about the same for developed European countries.  This is well below the International Monetary Fund (IMF) forecast of 9% GDP growth for China and India.  Inflation represents a potentially serious long-term problem given the unprecedented monetary stimulus and the deteriorating financial situation at both the federal and state levels.  Although the Federal Reserve has been downplaying inflation, the Labor Department reported that the Consumer Price Index (CPI) rose in September.  Commodity prices are also rising, with oil and metals up over 50% since the beginning of the year.  Import prices have risen 6 out of the past 7 months as the weak dollar has caused the price of almost everything we import to rise.

U.S. corporate profits have been higher than anticipated as a result of cost cutting and employee layoffs earlier in the year.  We expect corporate revenue growth to provide positive earnings surprises next year which, coupled with a continued influx of cash from the sidelines, should continue to drive stock prices higher.  Investments that benefit from inflation should produce the best returns next year, including basic materials (energy, gold), REITs, as well as equities.  We especially like emerging economies due to their young demographics, rising middle classes, and robust economic growth rates.  Over the next several years, emerging markets will likely dominate and drive worldwide growth.

ECONOMIC AND INVESTMENT FORECAST

August 13, 2009

It has become increasingly evident that the U.S. economy is gradually improving, albeit at a slow and uneven pace.  Recent improvement in new and existing home sales, better than expected durable goods orders, higher prices for basic materials, and the strong bear market stock rally seem to have convinced consumers that there is a light at the end of the tunnel.  Consumer sentiment now stands at a 15 month high.  However, the economy is still weak from the effects of deleveraging, wealth destruction, credit tightening and increasing unemployment.  Industrial capacity utilization dropped to a record low of 65% in May.  Unemployment, a lagging indicator, will likely peak at approximately 10% before beginning to decline in the first half of 2010.  Although there is now adequate liquidity in our economic system, restricted credit is still a problem.  Car Allowance Rebate System (Cash for Clunkers) has been successful in stimulating new auto sales and will positively impact 3rd quarter retail sales and GDP.  However, U.S. consumers have recently increased their savings rate, which essentially takes money out of the system and slows the recovery.  Some economists think the savings rate will reach 10% to 11%. Nevertheless, we still anticipate that the recession will end in the second half of this year.  With respect to inflation, the Fed recently commented “substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”  Therefore, we do not expect any short-term interest rate hikes in the near term.

The stock market, which was substantially underpriced in early March due to panic selling and fear of an economic depression, has rallied strongly.  The S&P 500 Index is up 13.2% year to date and is up an impressive 48.7% from March 9th.  Although we believe that the stock market is now due for a pause, we still expect some modest gains in the remainder of the year.  There are issues, however, that can derail the economic and stock market recovery:  higher state and federal income taxes, higher payroll taxes, increased regulation and the enormous budget deficit.  Corporate earnings have been unexpectedly strong this past quarter as productivity has increased with workforce reductions.  It is unlikely that there will be further cost reductions, and prospects for top line revenue increases are limited.  This being said, cash has begun to leave its low yielding safe haven and enter the market. The cash level is still abnormally high at about 40% of the S&P 500 market value, which likely means the market has further to rise.

The strongest economic growth will likely take place outside the U.S. as well as outside developed countries, as the emerging countries expand their economies.  The U.S. GDP is now only 23% of the global GDP, and the U.S. accounts for only 36% of world stock value.  Although we believe that the U.S. economy will grow modestly in 2010, some emerging economies are expected to grow 2-3 times faster than the U.S.  We see opportunity in these emerging markets as well as investments that benefit from expanding economies and inflation, such as energy, gold, and real estate.

ECONOMIC AND INVESTMENT FORECAST

May 1, 2009

The panic and fear of a deep and prolonged recession experienced by many people last fall began to gradually dissipate toward the end of March.  The combination of a recession and restrained credit created a steep economic decline in the 2008 4th quarter GDP (-6.3%) with similar results forecast for the 2009 1st quarter.  Unemployment continued to rise through the first quarter, especially in the construction and financial areas, as companies quickly cut expenses for fear of what might lie ahead.  As unemployment is a lagging indicator, it is expected to peak at about 10% later this year before beginning to decline in 2010.  The accompanying collapse of the stock market last fall along with the drop in home prices made all consumers feel considerably less wealthy and less secure.  However, we believed, as expressed in our January Economic and Investment Forecast letter, that this 10th recession since World War II was just another cyclical slowdown following extreme leveraging in the economy, exacerbated by the housing collapse and resulting credit crisis.  Also, as previously expressed, we still believe that this recession will end in the second half of this year and it appears that Federal Reserve Chairman Bernanke agrees, as he recently mentioned “green shoots”, while sifting through economic data.

The stock market reinforced our belief that this recession might not be as severe or prolonged as initially forecast.  The S&P 500 Index rallied 20% from its November low in the last few weeks of the year.  After an expected volatile first quarter, the S&P 500 Index established another low in early March.  Since then, the S&P 500 Index has rebounded steadily and is up 29.7% from its March low.  The Nasdaq has had positive returns for the past 8 weeks, volatility has diminished, corporate bond yields have declined, mortgage rates are low, the TED spread (the difference between the 3 month T-bill interest rate and the 3 month Libor) has narrowed to about 100 basis points, and consumer confidence is beginning to rise.  We expect a pause in this rising market during the summer as the P/E ratio of the S&P 500 Index is approaching 14, which is currently considered fair value.  So far, this has been a terrible decade for stocks.  The S&P 500 Index is down 40% since January 1, 2000.  As a result, several widely-respected Wall Street sages have called this a buying opportunity of a lifetime even if the March lows are re-tested.  We expect strong sustained growth across all categories as the cycle of performance evens out and we enter a new bull market with what is expected to be solid economic growth in 2010.

The Obama administration, Congress, and the Federal Reserve are in the process of providing more than a trillion dollars to stimulate economic growth.  We believe that this massive influx of capital will ultimately re-ignite inflation.  As Chairman Bernanke is a student of the Depression, it is unlikely that he will raise interest rates to control inflation until he is confident the economy is on solid footing.  Interestingly, low interest rates combined with inflation could result in rising home prices.  Although we expect the economic recovery to raise the value of the entire stock market, growth stocks are likely to remain the top performers for the next several months before value style investing takes hold.  Foreign, especially emerging markets, should also do well.  For families with fixed pensions, TIPs (Treasury Inflation Protection Bonds) will be an attractive hedge against eroding purchasing power.

ECONOMIC AND INVESTMENT FORECAST

January 2009

2008 was a miserable year for both the U.S. economy and the U.S. financial markets. Although most people were aware that the U.S. consumer was overextended and the economy was slowing, partially due to rapidly increasing energy costs, few, if any, experts forecast the severe impact on the financial system.  The highly leveraged consumer, struggling under a mix of heavy debt, meager inflationary income growth, and a budget largely consumed by health care, gasoline, and other rising costs, finally reduced spending.  The collapse of home prices together with the failure of complex derivatives of sub-prime mortgages held by financial institutions around the world became the catalysts for a severe recession.  Inflationary concerns turned to deflationary worries as our financial system began the painful process of de-leveraging.  As fear replaced greed, financial institutions, burdened with now unmarketable sub-prime mortgage derivatives on their balance sheets, greatly restricted credit.  This resulted in further slowing the U.S. economy despite the Federal Reserve’s increase in liquidity and the Bush administration’s huge stimulus package (TARP).  Wall Street financial institutions Bear Stearns, Lehman Bros., and Merrill Lynch filed for bankruptcy or were merged away by year end.  It wasn’t until late 2008 that we learned that, according to the National Bureau of Economic Research, the U.S. economy had been in recession since December 2007.  Unemployment continued to rise as corporations reduced costs fearing lower revenue.  Consumers held onto their money fearing job losses and home foreclosures.  This downward trend could continue for at least several more months.  Unemployment could reach 8-9%, and the GDP could decline by up to 5% for the first half of 2009 before stabilizing. 

However, many economists now predict that the positive effects of massive international stimulus, low energy costs, lower mortgage rates, and new stimulus programs initiated by the Obama administration should gradually turn the U.S. economy back to positive growth in the second half of this year.  As with the beginning of the recession, the end of the downturn in the economy will not be confirmed until well after the actual event.  It is expected that the U.S. economy, which led the world into this slowdown, will begin recovery well ahead of most developed countries.

This past year was the worst for stocks since the 1930s, and the financial markets experienced unprecedented volatility.  The low for the stock market in 2008 was on November 21st, with the Dow down 51.9% from its high just over a year earlier.  The S&P 500 Index ended 2008 down 38.5% and the MSCI EAFE (foreign) was down 45.1%.  There was no place to hide as virtually all equity categories worldwide were affected.  Although stocks staged a rally in December, continued economic weakness eliminated most of that gain and stocks may test the previous lows before rebounding.  Historically, the U.S. stock market has begun to advance approximately six months prior to the end of a recession, and following every recession but one since World War II, stocks have recorded strong gains in the following year.  Whether or not any of these scenarios occur this time, there are currently many large U.S. companies (or mutual funds that hold them), with attractive dividends and potential for strong gains in the next several years.  Stocks in emerging economies and basic commodities also have excellent potential when the worldwide economies begin to recover.

Investment grade U.S. corporate bonds, international bonds, and U.S. treasury inflation protected securities (yes, we believe that inflation will return within 1-2 years) are also attractive.  The massive cash hoards now on the sidelines (the highest level since 1990) will likely begin to move in a series of waves back into the financial markets over the next several months.