Prognosticating

Fall 2009 was the last time I brought you Prognosticating. Spring is here and perhaps it is a good time do it again. Previously, I mentioned that forecasting is potentially a futile exercise, but it is kind of fun. At the end of last year, I wrote a 3-piece blog essay titled Unprecedented that may shed some light on why I think ‘future tripping’ is often pointless. Basically, we have been talking about the end of the American empire since the empire started.

Below are some topics that often come up with clients. I have included comments from the Fall so you can see how these thoughts have progressed over time. Please take them with a grain of salt as the following disclaimer warns:

All estimates, opinions and views expressed are our own and constitute our best judgments as of the date of this podcast or email and may be subject to change at any time without notice. These opinions and views are made under conditions of great uncertainty and there is a good possibility that our judgments could be completely wrong. However, we hope for your sake and ours that we are more right than wrong of which there is no guarantee.

The PPWM Outlook Spring 2010

Economy Fall 2009 The global economy is nearing a trough in the business cycle marked by the early phase of a cyclical bull market in financial markets. Spring 2010 The global economy turned the corner. Economic growth returned in the middle of 2009 and has been stronger than expected. The U.S. is expected to grow in foreseeable future, but the rate of growth will be below 3%, which does not bode well for job growth. (Source: IMF WEO April 2010) The Depression sale is over in financial markets and with moderate economic growth we should expect moderate rates of return.

Stimulus Fall 2009 Coordinated global fiscal and monetary stimulus provides a positive environment for investors. Spring 2010 Fiscal stimulus will fade in 2010, but monetary accommodation is alive and well. While the Fed has stopped purchasing mortgages, interest rates are at historic lows. European central banks recently pumped more money into the EMU by purchasing debt of troubled governments. This a positive backstop for investors.

Rates Fall 2009 Global interest rates will remain low for a significant period of time as central bankers work aggressively to stimulate risk taking behavior and economic activity. Spring 2010 One year ago, the yield on a 10-year treasury note was 3.89%. Today, that same rate is 3.76%. (5/18/2010) Real estate has a long way to go to get banks out of the ditch. Unemployment is high. I don't see rates going anywhere for a while.

Commodities Fall 2009 We are in a long-term bull market for commodities, driven by new demand from emerging markets. Spring 2010 Asia is expected to grow at a rate of 7% for the next two years. Latin America, Emerging Europe, Middle East and North Africa are looking at 4%+ growth rates. This kind of growth underpins global demand for commodities. (Source: IMF WEO April 2010)

Moderate Growth Fall 2009 The developed economies will grow slower than emerging economies. Spring 2010 The U.S. is forecasted to grow at less than 3% over the next couple of years. Europe is expected to grow at a rate less than 1% and that may be optimistic. (Source: IMF WEO April 2010) Such growth rates are below the long-term averages.

Emerging Markets Fall 2009 Companies in the developed world that can sell products into the developing world are attractive. Spring 2010 The rapid economic growth in emerging economies provides opportunity for all sorts of companies -- heavy equipment, high tech machinery for manufacturing, energy infrastructure, consumer electronics, trendy global brands, entertainment, etc. The rise of the third world takes pressure off the Core to always be consumer of last resort.

Global Linkages Fall 2009 The rest of the world is geared toward selling consumer products to the U.S. consumer. They have a huge stake in the revival of U.S. consumption. Spring 2010 Understanding the global flows of money, goods and services is critical to understanding why countries like China would buy trillions of dollars of U.S. government and corporate debt despite our apparent mismanagement of those funds.

Consumer Fall 2009 The U.S. economy and the consumer are resilient and will be highly adaptive to the headwinds they face, despite opinions to the contrary. Spring 2010 When U.S. companies can shed millions of jobs to maintain profitability, governments can provide an effective safety net in the form of unemployment insurance to keep families in their homes, paying rents, and shopping at the corner store, it is no surprise that our economic system can take the blow it did, get back up and keep playing. This is why they call it mixed capitalism, and not capitalism. We have an enviable social safety net which makes are system more resilient shocks. Developing economies like China are emulating our system by building out a social safety net that will make them more stable, not less.

Inflation Fall 2009 When (assuming) the global economy starts growing robustly again, inflation will come back quickly. Spring 2010 Inflation is the symptom of excess money printing. Deflation is the result of excessive debt. Once markets have cleared and deleveraging has run its course, the forces of inflation will have their time in the limelight.

Unemployment Fall 2009 U.S. unemployment rates may not come back down in the near-term as the U.S. economy must make a tectonic shift from the hyper-activity of building automobiles, houses, condos, strip malls and office buildings – to doing something else – at least for the next 5 to 10 years. Spring 2010 Unemployment will be a nagging problem for years to come. When politicians tell you that they can make jobs, or that the one's policies are not making enough jobs, just nod and smile with skepticism. All the data of past experience suggests that unemployment in the U.S. will get back under 6% in no less than 5 years time. (Source: IMF WEO April 2010)

Deficits Fall 2009 The fiscal deficits of the U.S. government are unsustainable and highly problematic without serious sacrifices. Spring 2010 Greece is the canary in the coalmine, so they say. The drop in tax revenues due to the global financial crisis has exposed governments around the world. The resulting deficits raise the specter that bondholders, the lenders to governments, may not be paid back in full.

Austerity Fall 2009 Industrialized governments have made significant promises to their retirees that are significantly underfunded. Spring 2010 Austerity is perhaps the new buzzword for the media, pensioners and governments alike will need to face the reality that there is not enough money to fulfill all their dreams and promises. What’s new? We have been talking about reforming social security since the Advisory Council Report on Social Security in March 1975. Unions have been facing austerity for 30 years, but the economy seems to find ways to grow. Spain has defaulted 13 times since 1800. Greece has defaulted 5 times. (Source: Reinhard and Rogoff) Why is this time so calamitous?

Taxes Fall 2009 Higher taxes are on the horizon. Spring 2010 While not the only answer to global deficits and debt, higher taxes will play a role to reducing deficits and paying off the government debt bubble incurred over the last 20 to 30 years. During the 1990s, a bipartisan commitment to deficit and debt reduction provided a foundation for a vibrant economy. Pray that factious politicians can find common ground again. Let us be real – slower economic growth is the result of excessive debts built over a generation. Not because of lack entrepreneurial ingenuity. We will muddle through as history can attest, but we have now entered a time to pay the piper.

Real Estate Fall 2009 Financial markets still have significant negative exposure to commercial real estate assets that could be disruptive to economic expansion. Spring 2010 Commercial real estate prices may have stabilized taking the pressure off bank balance sheets and lowering the probability of a systemic risk event related to these debts. Residential markets, while seemingly on the mend, are stymied by shadow inventory, those bank repos not on the market, which means years, not months before the market can clear.

Bailouts Fall 2009 The government may to have to make additional capital injections into financial institutions in order to absorb future losses due to write-downs associated with commercial real estate (which have not yet been taken). Such injections may destabilize financial markets once again. Spring 2010 Something that will no doubt be studied by academics, the Private Public Investment Partnership (PPIP), Geithner's silver bullet to remove toxic assets from the banks balance sheets, never left the bullet chamber. Upon the government's announcement of the program, the so-called toxic assets rallied so much that the financial elite like PIMCO took a pass on the program. Originally slated for up to $1 trillion, the mere creation of the program deemed it nearly unnecessary. Where are those toxic assets now? Still at the banks but not as toxic.

Secular Bear Fall 2009 A multi-year bull market may take stock market indices back to old highs, but a return to the good old days like the 1980s and 1990s where indices rose 15-fold is probably not in the cards until the ‘structural headwinds’ mentioned above have been addressed. This may mean another decade of volatile markets similar to the 1960s and 1970s. Spring 2010 A term thrown around by market historians, secular bear markets are periods where returns for investors fall well below the average returns like the late 1960s and 1970s. Secular bull markets are periods when market returns are well above average, like the 1980s and 1990s. The Dow Jones rose 10-fold from 1982 to 2000. Today, it is still below the peak set in 2000. From 2003 to 2007 to Dow Jones nearly doubled, only to give back all those gains. Buy and hold? I don't think that is the best strategy right now.

Euro Spring 2010 The euro has been under significant pressure recently as the aftermath of the global financial crisis left the Greeks unable to make debt payments that came due. The EMU and IMF came to the rescue but not before the markets let us imagine a cascade of European defaults, the seizing up of global financial markets, the return of the Deutschemark and German nationalism, and the end of the Pax Europa. The media loves all the innuendoes with minute-by-minute coverage of disgruntled hoi polloi and Molotov cocktails, stoking the pandemonium. Despite the scary sound bites, the probable outcome is EMU will tighten its fiscal belts, impose austerity despite the political costs and emerge leaner and meaner at the end of the decade. Watch the prequel called the Asian Financial Crisis from 1998 when it looked like Korea and several others would default.

Wealth Destruction Spring 2010 At the end of WW II, much of Germany and Japan were destroyed, two of the biggest of the economies in the world at that time. (For further reading see Wikipedia Strategic Bombing WWII or the The Fog of War documentary film with Robert McNamara.) It is estimated some 60 million people died from combat, disease, starvation or genocide. The direct costs of the war, widely debated, are estimated at anywhere from $1.5 to $3 trillion in current U.S. dollars. Somehow, the global economy was back on track by 1948 even with U.S. debt at 120% of GDP, Britain’s at 260%, Germany’s at 217%, and Japan’s at 200%. (Source: Wikipedia, www.whitehouse.gov/omb, Ritsch 1996, Kudo 2006). Is wealth destruction a lower valuation on your real property at a point in time or the literal destruction of that real property? It is important to have the proper perspective on things to make good investment decisions. One-way to think about wealth is that is not destroyed except by natural disaster or war, it merely changes hands. Last year, Paul Krugman, a Nobel Prize winning economist, wrote a blog called 1945 where he made the point that the U.S. has been in a tough spot before and dealt with it. In response to criticism to his blog, he made another interesting point that people have ways of making analyses in hindsight that suggests the wind was always at the back of that Great Generation, so it was natural they would escape their predicaments. Today, has the wind stopped blowing, or is it always a headwind? I guess it is just how you look at things. I really doubt we are at the end of progress and wealth creation, or on the precipice of the new economic Dark Ages.

Investment Implications

As we have said before, we believe investors may need to be more proactive and nimble than they have been in the past. This may require considering new investments ideas, timing strategies and examining yield as an important slice of total return. We will continue to make investments in companies with exposure to basic materials (commodities) and emerging markets, either through the purchase of fixed income or equity instruments. In addition, we want exposure to investments that benefit from an improving global economy or can benefit from an inflationary environment. If you want specifics, we encourage you to contact us. These are our prognostications -- for now.

Jason McMillen, Chief Investment Strategist, PPWM

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If you would like to contact us feel free to email as at jason@portlandprivatewm.com or we can be reached at 503-595-1059.

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