Issue 67- January 10, 2011


2010 Year in Review

Curiosity of the Federal Reserve

Popular wisdom held at the end of 2009 that the economy was recovering well according to script as evidenced by a strong Q4 2009 GDP report. Market strategists held that the economy had achieved escape velocity and began to layout a variety of exit strategies by which the Federal Reserve could begin to drain excess liquidity. Productivity driven corporate earnings were expected to improve the employment picture which would in turn lend a hand to the moribund housing market. Domestic equity participants would be rewarded with solid if not spectacular returns and developed international and emerging markets would be responsible for the heavier lifting in diversified portfolios.

The earning expectations did by and large deliver but the follow on effects, employment in particular, did not. The strong returns of the winter and spring gave way to double dip disappointments and we finished the second quarter virtually on the lows of the year.

Concerns surrounding the Euro and potential sovereign defaults manifested first in Greece in the spring. The success of the common European currency led to profligate borrowing by what had historically been non investment grade nations much as we saw here in the US by under qualified borrowers. This lack of credit discrimination has proven to be the Achilles Heel of the Euro. Credit standards and leverage ratios of participating countries were roundly ignored as a practical matter as there was no ultimate authority. Meanwhile, the banks of France and Germany and to a lesser extent Spain used the bonds of these former high yield nations as cheap capital such that a default of any magnitude could begin the cascading effects of bank failures just as we saw in the US in the fall of 2008. The unthinkable had once again become a possibility in this continuing global credit unwind.

Enter the Federal Reserve in late August to lay out a plan not of draining stimulus as was hoped, but to use new and innovative and unproven ways to add even more liquidity. Enter the second round of quantitative easing known as QE2. This approach had a number of specific goals. The first was to lower longer term rates even further in an effort to assist housing. Yet the choke point in housing was neither rates nor liquidity but negative equity. Lowering the 7 year US Treasury 25 basis points would do nothing to help the 40% of current mortgage holders who were being laughed out of their local banks for lack of qualifying metrics.

Second, it was thought that further downward pressure on rates would weaken the dollar and thus improve the lot of our exporters. However, it was the third goal of the program that has proven to be the most controversial. Could another round of Quantitative Easing sufficiently inflate asset prices, equities in particular, in such a way as to serve as a wealth narcotic encouraging consumers to go out and spend, spend, spend? Stock prices would wag the dog of equity valuations which would (hopefully) catch up as the economy continued to recover. Equity investors were treated to a blistering rally as QE2 became the official policy in November. The overall plan has not gone precisely according to plan. Bond investors have seen rates rise especially in the longest maturities as inflation worries have seeped back into the market consciousness and the dollar has modestly strengthened versus the Euro as the debt crisis rolled over Ireland and was heading southward to Portugal and Spain.

On the face of things we ended 2010 much as we had 2009. Popular wisdom holds that the economy is recovering and that equity investors will be well rewarded with solid if not spectacular results. But the contextual flexibility shown by nearly 100% of these strategists is worth noting. Last year they were bullish on the economy because the Federal Reserve was going to be removing stimulus. This year they are equally bullish not for the same reason but for the exact opposite! They expect the Federal Reserve to continue to inject liquidity and inflate assets indefinitely. This strikes us as curious.

Complacency & Fragility

2011 will mark three years since the financial crisis struck. In the intervening period a tremendous amount of repair has taken place across a broad array of institutional and individual balance sheets. However, all of this mending has taken place upon a backdrop of government support in the forms of massive liquidity injections and low global interest rates. This reality poses two uncomfortable questions: what is the real organic growth rate in the economy and how far along are we really in the deleveraging and healing process? Watching and reading the financial talking heads in the fourth quarter was like watching some reruns of programs and articles that had been produced long before 2008. There was precious little mention of anything but the strength of corporate balance sheets and the overall cheapness of stocks. Inconvenient data readings were roundly dismissed. The challenges facing the US and global economy are real and very much still with us and we hope that as we navigate 2011, markets are able to strike a balance between the appreciation of what has been accomplished and what still lies ahead.

Employment and housing go hand in glove. There continues to be great expectations that the current strength in corporate balance sheets will translate into job growth as it has historically. But economic history has not been in the habit of repeating itself in this cycle. This deep financial recession did not give way to a “V” shaped recovery and the tremendous productivity and technological enhancements of the past few years have allowed businesses of all sizes to create what was previously thought to be unobtainable operating efficiencies and leverage. As the organic economy improves, businesses will continue to hire, but it is unlikely that the historic formulas for growth translating into employment will hold true this go around. This has significant implications for the housing market especially one which is in such dire need of a catalyst. As we noted in our November newsletter, 40% of current mortgage holders are unable to refinance into more attractive terms largely due to negative equity. The recent run up in rates as a consequence of the QE2 program flies directly in the face of those who are hoping to accelerate the accretion in their home equity. QE2 has inflated stock market values but this has come at the expense at least to some degree of wealth held in real estate. In terms of building consumer confidence, this seems like a poor bargain.

2011 will be an exceptionally challenging year for those who direct state and local finances. Everyday we read several articles which decry the plight of the municipal bond investor, but most of these treat the Municipal market as if it were one common credit. The modern municipal market however is made up of thousands of individual issuers whose credit worthiness runs from high yield to AAA. We are now witnessing its transformation from a monolithic asset class to a differentiated credit market. The difference in quality between a Texas School District supported by the Permanent Fund of Texas, and one issued by the Philadelphia School District with no credit enhancement is real and should be priced that way. There will certainly be defaults this year and perhaps more than we have seen historically. However capital markets are in the business of pricing and trading risk appropriately. As this process continues, we will undoubtedly be presented with opportunities to add to holdings with quality names at attractive levels.

The Euro Zone and the P.I.G.S could well dominate the news in the early part of the year. The ECB will strive to find ways to provide sufficient liquidity to those nations in search of solvency. We saw in 2010 credit demands overwhelm first Greece and then Ireland. Greece had taken itself to the brink by its own government profligacy while Ireland was done in by its own banks that extended credit far beyond what its own GDP could support. The ECB is looking to float a number of bond offerings that would supplant the needs of the individual states, but it is unclear what type of demand exists for promissory notes issued by an entity with no taxing authority and no clear call for repayment. The fiscal discipline required to get the Euro back on sound footing has been rolled out in both Greece and Ireland, but it is far from clear if the terms are in fact too draconian to be ultimately successful. It is also far from clear if the Euro will allow its weakest members to remain within the confederation despite the fact that there does not currently exist any path for expulsion. History will also play an important role in the evolution of the Euro. Those older members who played a part in the establishment of the common currency did so with an eye to centuries of conflict. The younger leaders of today are perhaps more fortunate in that time has passed and they may be able to show both more flexibility and discipline when it comes to writing the next chapter of the Euro Zone.

US stocks ended 2010 on a very strong note propelling the S&P to gain 15% and seeing the Nasdaq index return to highs last seen prior to Lehman’s failure in September of 2008. Bonds meanwhile were treated rather poorly in the latter part of the year only to finish up more or less unchanged for the entire 12 month period. The enthusiasm and complacency that surrounds the US stock market now is striking. The vexing problems of high structural unemployment and further weakening of an already ravaged housing market seems hardly the foundation onto which to launch yet another run at a “V” shaped recovery. This is not to say that we are not optimistic as to a recovery, simply that the single-mindedness of the bullish sentiment does not seem properly sober in light of all that remains to be done. Remember that all of the liquidity that has been fire hosed into the market remains relatively dormant and the velocity of money has not shown any meaningful signs of picking up despite the best efforts of the Federal Reserve. Tremendous slack remains in the economy and wishing it to not be so does not make it true. Consider that in addition to further individual deleveraging, state and local government, which comprises 13% of GDP and 15% of overall employment, will surely be contracting for the foreseeable future.

2011 is likely to be another year of ups and downs as markets try to interpret the economic tea leaves for signs of strengthening organic growth. As we begin the New Year, the market is very much dependent upon those signs ringing true. There is very little room for disappointment at this juncture. We will continue to recommend resilient portfolios that feature high quality assets with a strong income component.

Wishing you all the Best in 2011 –

Jen & Patsy


In this Edition

  • Curiosity of the Federal Reserve
  • Complacency & Fragility

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln
/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward

58 - 12.29.09
2009-The Year in Review/ 2010 - The Year of "The Exit"/ Deflation or Inflation?/ 4 Cylinder Economy/ Rates and Returns

57 - 11.04.09
Banks-Back to the Future/ Navigating the Tsunami/ TARP 3.0/ Implications

56 - 09.15.09
Are We There Yet?/ The Beginning? The Present/ The Journey is the Destination

55 - 08.04.09
A Transformation is not a Recovery/Not All Economic Data is Created Equal/
Smallest, Lowest, "Shortest"

54 - 06.24.09
Aftershocks/ Fragility/
Inflation and the Fed

53 - 05.29.09
A Brave New Road to Recovery/ Vehicle Choice/ Speed Limits

52 - 04.07.09
The Things We Know/The Things We Don't Know/Savings and Sensibility

51 - 03.25.09
The Correct Problem/ The Need for Speed/ No Good Deed Goes Unpunished

50 - 03.05.09
Rebuilding Credit/ Under Repair/Problems Persist/Big Chore

49 - 01.12.09
The Year in Review/ The Path Forward/ 2009

48 - 12.15.08
An Old Fashioned Swindle/ Who,What, Why, & How/ The Lure/ Getting Back to Fundamentals

47 - 12.05.08
Unwinding/ The Past/ The Present/ The Future.

46 - 10.07.08
History/ Changing Hands/ Dominos/ The Road Block.

45 - 07.02.08
Black Gold/ The Federal Reserve, The Banks, & The Earnings/ Moving Forward/ The Recovery

44 - 06.03.08
Shallow Waters/ Odds and Evens/ Changing Times

43 - 04.09.08
Q1 2008/ The Call/ The Response/
Investing Opportunities

42 - 02.27.08
Credit Hangover/ Busy Banks and Brokers/ Insurance Cleanup
Risk vs Reward

41 - 01.02.08
2007-Year in Review
2008 - Outlook



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Market Highlights



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