Issue 59 - February 17, 2010

Surprise, Surprise, Surprise

2010 has greeted investors with much the same story as 2009 ended – decent earnings reports largely driven by productivity gains combined with a steady and low interest rate policy. The economic news has also been consistent with the path set out in the 4th quarter last year with marginal improvements one month followed by marginal declines the next. This pattern however has been met with what appears to be wide scale disbelief among many pundits. Virtually every release is characterized as “unexpectedly”. Jobless claims are “unexpectedly” higher, housing starts are “unexpectedly” lower, wholesale inventories “unexpectedly” drop. The fact that we are trudging our way through a very modest recovery should not come as any surprise to anyone at this point. Are financial journalists in something of a conversational rut or have market strategists misinterpreted the equity market rally of 2009? Setting aside the rut theory for the moment, what would lead forecasters to be so surprised?

We commented in our year end newsletter that there were many in the financial community who held the belief that what we had gone through was a deeper than average recession which should give forth to a recovery propelled by pent up and replacement demand. We noted that history is on their side and they have cited the strong market recovery as evidence for the current case. However, we also noted that this economic episode was not driven by a traditional inventory correction; it was the result of a massive credit contraction which continues to this day. The market recovery, while welcome, held no particular deep inner meaning. Markets were simply monstrously oversold as a result of the liquidity crisis. But if there was wide spread belief in what we might call a “Field of Dreams” forecast – if we buy it, economic activity will come, then the current reality would certainly constitute both a surprise and a disappointment.

Deflationary forces remain our top concern. The most recent employment report was simply breathtaking in the scope of its revision. An additional 1.2mm souls were added to the 7.4mm who lost jobs in the December 2007 through January 2010 period. That is a 15% downward revision to what were already historic job losses. It means that the depth of the hole we must dig out of is that much deeper and it means that the juggernaut of deflation is in fact even stronger and more entrenched than we feared.

The Federal Reserve has to date accomplished a great deal. They have provided a respite of market stability through their myriad of programs and purchases, the majority of which have already wound down. They have also likely staved off a reckoning that would have simply swamped the market. There still remains years of deleveraging ahead of us. Assets such as commercial real estate are in the beginning throes of their market clearing process. A number of high profile properties including the winter Olympic Resort of Whistler and the 11,000 plus New York apartment complex of Stuyvesant Town and Peter Cooper Village, have recently been handed back to the lenders resulting in total losses for their equity investors. Now the headlines have moved to the global stage where the euro zone will be dealing the consequences of their own sub prime borrowers, this time on a sovereign level.

P.I.G.S. Matter

Portugal, Italy, Greece, and Spain are currently struggling with debt service burdens that are much too high in relation to their own GDP. Current headlines have focused on Greece in particular given the large, looming spring maturities and global markets have reacted poorly to the specter of a potential default. It is not the case that a singular default by any individual P.I.G.S. member would be so catastrophic. However a rolling series of defaults would be. If Greece fails then the worry will be why not the rest of the herd and that would portend one nasty meltdown across the euro zone. The seeds of the current crisis were laid almost 20 years ago during the birth of the Euro and are in the founding document, the Maastricht Treaty of 1992.

All participants won by merging their currencies. Major export economies such as Germany and France could enjoy direct access to all of their euro partners without absorbing the traditional currency risks and lesser economies gained unprecedented access to credit markets on the strength of the major member’s balance sheets and ratings. Just as artificially low rates in the US masked individual credit worthiness for a time, artificially high credit ratings in the euro zone replaced market discipline. Borrowing costs for the P.I.G.S. under their own individual credit ratings would have been a limiting factor along with volume. However when Greece gets to borrow as if they are Germany, things can get out of hand.

Two immediate challenges have surfaced. First, there is a provision in the Treaty which prohibits any one member from bailing out another presumably put in place to stem the second issue: the hazard of creating a run on expectations within the euro zone. If Germany were to step in on Greece’s behalf, then why should not Portugal expect the same treatment? In addition to monetary mechanics, there are major political issues at work as well.

Germany is the implicit economic leader of the euro zone. Germany provided the majority of the payments into the EU during the cold war and they alone bore the cost of German unification. If Germany rides to the rescue this time, they will not do so without substantial concessions or conditions. This could potentially re-write the terms of control over the ECB and the fiscal policies of the wayward nations. Whatever the immediate solution, a substantial adjustment to spending and taxation could not be far behind. Again we find ourselves looking at yet another deflationary drag on global growth.

Leverage vs. Debt

One genuine surprise of 2009 was the strong outperformance across equity asset classes of lower quality companies. Those with lower returns on equity, higher leverage, and smaller relative market capitalizations were the belles of their respective balls. This struck us as not just curious but reckless. Why would investors be focusing on the junk when the good stuff was trading at such steep discounts? We have seen this phenomenon abate in the past few months as quality has begun to asset itself. In hindsight, the enthusiasm around these names may have simply been a trading opportunity as opposed to an investment. In any case, relative values are critically important at this juncture in the market and discriminating portfolio managers will be emphasizing those companies with the strongest balance sheets and revenue streams.

Consider that even if interest rates remain low for the foreseeable future, debt service simply can not go any lower than it is today. This stands in stark contrast to the past three decades, where the grinding down of interest expense has been a reliable and powerful tailwind to all manner of business. This has been particularly true in the case where the economy was attempting to rise out of a recession. Those businesses which find themselves in a position of having too much debt are in much more vulnerable positions than in the past. They are getting no relief on their current debt service. They may or may not be able to maintain their current credit lines and even if lines remain open, they will certainly not enjoy the same generous terms that might have been available previously. In the case where they are forced to sell assets to pay down debt, buyers are highly advantaged in the negotiations. This too should serve to further widen the relative value along the credit spectrum.

With an economy on a slow healing trajectory, there is yet another factor which will serve to discriminate the winners from the losers even among those with better balance sheets and that is operating leverage. Operating leverage is not debt (financial leverage). Operating leverage allows companies to increase earnings at a faster pace than revenue growth. The magic is having the rate of expense growth be less than the revenue growth. This is in part what we saw in 2009 where expenses were slashed. However, we did not witness much in the way of revenue growth. Earning targets were eclipsed with productivity gains only. The bull case for equities lies in the strong improvements in productivity having set the table. Modest revenue improvements will turbo charge earnings.

Financial leverage or debt is a horse of different color. There is nothing wrong with debt, but in a world were we are deleveraging we are in effect taking horsepower away from those companies which have relied on leverage to enhance their earnings. This is the antithesis of operating leverage. In the current competitive world, those who can grow their earnings with modest revenue gains will be again be highly advantaged relative to their indebted peers.

Going Forward

In a world which continues to deleverage and battle deflation and in which governmental supports are being wound down, portfolio composition is critical. We continue to believe that global deleveraging is a multi year process and as such we will continue to emphasize high quality, essential service municipals as the anchor to portfolios. Investments in those bonds in 2008 and 2009 featured rates that are simply unobtainable now. The additional 2-3% of income that those bonds provide over current shorter term bonds will be invaluable over the next 5 to 7 years. High quality equities should be able to distance themselves from their lesser competitors, but their road is likely to be extremely uneven although positive in the net. Low overall rates will also help to provide the best possible backdrop for restoring equilibrium. The declining pace of job losses should not be extrapolated into instant job gains and this is by far the most painful part of the recovery. Businesses will hire when they see a pick up in demand, however recent productivity gains will not be abandoned. Where we once may have needed 3 people, 2 might suffice now and 1 might be all any business is willing to agree to initially. We should not be surprised if the job recovery is long and shallow.

No investment backdrop is ever perfect and the current situation is far from that. But if we understand what the primary challenges are and we invest accordingly, we should be well rewarded over time.

Best Wishes,

Patsy and Jen

• Surprise, Surprise, Surprise
• P.I.G.S. Matter
• Leverage vs. Debt
• Going Forward