Second Quarter 2006 Market and Economic Review and Market Perspective

Economic Review and Market Perspective*
July 25, 2007

Global stock markets continued to benefit from the growing world economy, shrugged off setbacks in Iraq, and provided a very profitable first half for the globally diversified investor. The performance was aided by a general lack of major global economic shocks so far in 2007. Nonetheless, the recent failure of two Bear Stearns hedge funds which invested heavily in sub-prime mortgages may be the tip of the iceberg. Other hedge funds have also begun to report losses in sub-prime mortgages so that a very painful resolution of this problem area may yet prove to be a shock to the U.S. economy. As noted below, we believe the economy is sound enough to handle this challenge.

Economic Review

By way of historical perspective, former Fed Chairman Alan Greenspan and the Fed successfully used interest rate cuts to prevent a serious recession at the beginning of this decade and a subsequent long series of rate raises to avoid an ensuing overheated economy. By halting rate increases last summer, the Fed engineered the current “soft landing,” or “Goldilocks” scenario, wherein the economy is not too hot and not too cold.

Meanwhile, during roughly this same time period, a symbiotic relationship has developed between primarily Western consumers (particularly U.S. consumers) and Asian export manufacturers (primarily, Chinese). The relationship has produced a “stable disequilibrium,” meaning a non-recessionary global economic regimen that is working despite unsustainable imbalances of such areas as the U.S. trade and budget deficits, low long-term U.S. interest rates, high commodity prices, especially oil and gas, and an undervalued Chinese currency. The outlook for most investments must be viewed in the context of this “stable disequilibrium” because it supports, at least for awhile, on-going low global inflation and real interest rates. These are the two essential ingredients for stable bond prices and stable, if not appreciating, stock and real estate values. Investors are closely monitoring the symbiotic relationship because it is showing early signs of breaking down due to increasing U.S.-China trade tensions, including growing U.S. trade protectionist sentiment and decreasing recirculation of U.S. dollars by Asian central banks.

Moving our perspective to the present, the second quarter’s abrupt move in interest rates was driven by evidence that the global economy remains robust, and that, while the U.S. economy is indeed slowing, it has been a soft landing, not a crash. As further evidence, the Index of Leading Economic Indicators has remained flat since early 2006 but has not deteriorated. Employment statistics have also remained solid. Jobs increased by 132,000 in June, ahead of expectations for 125,000. The prior two months were revised upwards by 75,000, bringing average monthly job growth in the first half to a fairly healthy 145,000. Additionally, the 4.5% unemployment rate remained near six-year lows. Growth in manufacturing orders and shipments continued to improve through April, from negative to flat, as did the U.S. Institute for Supply Management Survey (ISM), which improved to a relatively strong 56 in June (a figure above 50 indicates that purchasing managers believe business activity is expanding).

A key factor affecting the financial markets currently is inflation. Investors have been keenly interested in whether or not the high cost of energy would flow through to other goods and services. The CPI, less food and energy, has been moderating since up-ticks in the second half of 2006. In fact, the Fed’s preferred inflation gauge, the Core Personal Consumption Expenditures Price Index, has fallen back into the Fed’s comfort zone of 1-2% at long last. Looking ahead, this moderation of core inflation, coupled with current slow growth of the U.S. economy below its long-term potential, provides the Fed the luxury of lowering interest rates if needed to stimulate the economy.

Nonetheless, in news hot off the press, Federal Reserve Chairman Ben S. Bernanke on Wednesday indicated inflation remains the Fed’s biggest worry. In his semiannual economic assessment to Congress, he cited slowing productivity growth as potentially putting upward pressure on prices. Downplaying the favorable news of recent declines in the rate of core inflation, he testified “month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences.” Bernanke projected that inflation will edge higher over the balance of 2007.

The most interesting action during the quarter occurred within the debt markets, which seemed to properly anticipate Bernanke’s hawkish stance on (fighting) inflation. The bond market reached an apparent consensus that the next Fed rate move is likely an increase. Anticipating the Fed Chairman’s comments and factoring in growing evidence that global growth is putting pressure on labor costs even in developing countries, and that factory capacity utilization is near all-time highs, bond investors aggressively reined-in duration, sending medium- and long-term interest rates significantly higher in late May and mid June.

In addition to the threat of increasing interest rates, the main domestic economic challenge is the weak U.S. housing market. U.S. homes sales, sales prices, and home building activity continued to deteriorate in the second quarter. Most economists agree that this has taken a toll on economic growth. The government’s final estimate of GDP shows first quarter real GDP growth to be only 0.7%. Furthermore, distress among the sub-prime mortgage-lending industry has affected some name-brand diversified financial companies, and the rise in medium- and long-term interest rates will only worsen the situation. Housing-related employment of construction workers and real estate agents has grown steadily since 1993 and now stands at about 1.1 million jobs more than its historic average (measurement based on historic share of total employment). Further, a vast number of other jobs related to such fields as household furnishings, appliances, and mortgage finance is also at risk indirectly. These job figures suggest the potential vulnerability of the U.S. economy to problems in the housing sector.

The strength of foreign economies has been a significant benefit for U.S. companies and the U.S. economy, which is transitioning to some degree from heavy reliance on consumer spending and housing toward export-oriented growth. Real GDP growth in developed foreign economies remains solid, fueling improved foreign company profitability, and emerging market economies are surging due to booming global demand for natural resources.

We are not too concerned about the recent jump in interest rates, which have since receded somewhat, and overall we remain optimistic. The best case for the global economy is occurring, namely a soft-landing in the U.S., a picking-up of the slack by other developed countries, and a continuation of stimulation of the global economy by the twin emerging economic giants, China and India.

Additionally, assessing the economic situation more broadly, “stable disequilibrium,” which has been a generally positive phenomenon, is probably nearing its final chapter. Indeed, it must ultimately end. It is important that the transition be gradual rather than abrupt.

Happily, there is evidence that an orderly transition is occurring. One good sign is increased economic activity in Japan and Europe. In conjunction with the on-going decline in the value of the U.S. dollar, which lowers the price of our exports to foreigners, these foreign economies are increasing their purchases of U.S. goods and services. The result is improvement of the U.S. trade deficit. Further, the increased foreign demand helps us achieve the soft landing and work through our housing and mortgage credit problems and is a benign way for unbalanced global economic forces to begin to unwind.

As an economic endnote mentioned a year ago as well, the long-term U.S. fiscal challenge of reducing deficit spending and bolstering the funding of Medicare and Social Security, while at the same time maintaining relatively stable economic growth, remains our biggest concern and eventually will overshadow the near-term analysis. Presently, this challenge is beyond our time horizon and can be put on the side burner.

Market Perspective

Investor sentiment is a key driver of markets. Particularly when valuations are reasonable and economic conditions generally supportive, as now, it takes on added significance.

Investor sentiment is a function of a number of factors, but an important one is the level of market volatility. Specifically, a low level of volatility is comforting to investors and produces a greater appetite for risk. The past five years are a good example. Volatility since the bear market of 2000-2002 has been quite low, and the current global bull market has featured a steady uptrend rather than a herky-jerky upward path. This low volatility environment has caused a multi-year move into risky securities as investors seek higher returns. The average emerging markets stock fund has returned 28.9% a year over the past five years, and the average small capitalization U.S. stock fund has produced a five-year average annual return of a lower but still impressive 15.4%. These returns compare with 10.2% for the much less risky Dow Jones Industrial Average of blue chip U.S. companies. The average junk bond has returned 10.4% a year over that same stretch, compared with 4.5% for the Lehman Brothers Aggregate Bond Index of investment grade bond returns.

Given the dramatically higher gains for the risky investments, the traditional price gap between shares of big, blue chip U.S. companies and those of smaller companies has shrunk, and the
difference in yield between Treasury and junk bonds is also far smaller than usual. In technical terms, risk premiums are very low. “We see a lot of investors willing to accept risk for very little return” beyond what they could get with a safer investment, says Steven Romick, manager of the $1.5 billion FPA Crescent Fund. In summary, low volatility feeds investor comfort with risk, some would say even complacency, but a jolt of volatility can quickly readjust risk premiums.

While it is not clear what events will occur to change investor sentiment and if the change will be positive or negative, the turbulence in the sub-prime mortgage market could do the trick. Waves of these dodgy loans will see their interest rates reset at higher levels over the next 18 months, likely leading to more foreclosures. That could mean more heavy losses for the hedge funds and others that bought bonds backed by those mortgages. In a worst case scenario, some worry, these investors’ souring bets could be big enough to rock the overall economy.

Second quarter market results provide evidence that a flight to quality may have started. For the first quarter in years, larger capitalization, growth-oriented styles prevailed over smaller capitalization, value-oriented styles. It is important to note that these relative performance comparisons have settled into long patterns of persistence historically until finally flip-flopping. It is possible we have reached a waypoint finally, which could mean large cap and growth might therefore outperform for a long time to come. We agree that large cap and quality growth issues now represent a safer bet, especially given the worst case scenario mentioned above.

Nevertheless, we don’t want to overstate the negative case and disagree with some recent headlines postulating high investor anxiety. Indeed, over the last 12 months, stocks have surged higher that nearly anyone forecast. Additionally, the duration of the current bull market is significantly longer that average. Yet, markets don’t turn on statistics; they and investor sentiment respond to economic events. As long as corporate profits keep rising and inflation and interest rates don’t soar, and as long as the world avoids a geopolitical crisis, global economic strength should keep any stock pullback temporary. Further, since the 2003 U.S. invasion of Iraq, when markets hit some heavy weather, stocks have bounced back strongly each time they faced trouble. The resilience has taken many investors by surprise but certainly should be reassuring to us at this time.

* Thanks and credit must go to the many sources for this writing, including Managers and PIMCO mutual fund families, the Wall Street Journal, and the Los Angeles Times.

Back to Market Reviews



		Economic Review and Market Perspective* July 25, 2007

		Global stock markets continued to benefit from the growing world economy, shrugged off setbacks in Iraq, and provided a very profitable first half for the globally diversified investor. The performance was aided by a general lack of major global economic shocks so far in 2007. Nonetheless, the recent failure of two Bear Stearns hedge funds which invested heavily in sub-prime mortgages may be the tip of the iceberg. Other hedge funds have also begun to report losses in sub-prime mortgages so that a very painful resolution of this problem area may yet prove to be a shock to the U.S. economy. As noted below, we believe the economy is sound enough to handle this challenge. Economic Review By way of historical perspective, former Fed Chairman Alan Greenspan and the Fed successfully used interest rate cuts to prevent a serious recession at the beginning of this decade and a subsequent long series of rate raises to avoid an ensuing overheated economy. By halting rate increases last summer, the Fed engineered the current “soft landing,” or “Goldilocks” scenario, wherein the economy is not too hot and not too cold. Meanwhile, during roughly this same time period, a symbiotic relationship has developed between primarily Western consumers (particularly U.S. consumers) and Asian export manufacturers (primarily, Chinese). The relationship has produced a “stable disequilibrium,” meaning a non-recessionary global economic regimen that is working despite unsustainable imbalances of such areas as the U.S. trade and budget deficits, low long-term U.S. interest rates, high commodity prices, especially oil and gas, and an undervalued Chinese currency. The outlook for most investments must be viewed in the context of this “stable disequilibrium” because it supports, at least for awhile, on-going low global inflation and real interest rates. These are the two essential ingredients for stable bond prices and stable, if not appreciating, stock and real estate values. Investors are closely monitoring the symbiotic relationship because it is showing early signs of breaking down due to increasing U.S.-China trade tensions, including growing U.S. trade protectionist sentiment and decreasing recirculation of U.S. dollars by Asian central banks. Moving our perspective to the present, the second quarter’s abrupt move in interest rates was driven by evidence that the global economy remains robust, and that, while the U.S. economy is indeed slowing, it has been a soft landing, not a crash. As further evidence, the Index of Leading Economic Indicators has remained flat since early 2006 but has not deteriorated. Employment statistics have also remained solid. Jobs increased by 132,000 in June, ahead of expectations for 125,000. The prior two months were revised upwards by 75,000, bringing average monthly job growth in the first half to a fairly healthy 145,000. Additionally, the 4.5% unemployment rate remained near six-year lows. Growth in manufacturing orders and shipments continued to improve through April, from negative to flat, as did the U.S. Institute for Supply Management Survey (ISM), which improved to a relatively strong 56 in June (a figure above 50 indicates that purchasing managers believe business activity is expanding). A key factor affecting the financial markets currently is inflation. Investors have been keenly interested in whether or not the high cost of energy would flow through to other goods and services. The CPI, less food and energy, has been moderating since up-ticks in the second half of 2006. In fact, the Fed’s preferred inflation gauge, the Core Personal Consumption Expenditures Price Index, has fallen back into the Fed’s comfort zone of 1-2% at long last. Looking ahead, this moderation of core inflation, coupled with current slow growth of the U.S. economy below its long-term potential, provides the Fed the luxury of lowering interest rates if needed to stimulate the economy. Nonetheless, in news hot off the press, Federal Reserve Chairman Ben S. Bernanke on Wednesday indicated inflation remains the Fed’s biggest worry. In his semiannual economic assessment to Congress, he cited slowing productivity growth as potentially putting upward pressure on prices. Downplaying the favorable news of recent declines in the rate of core inflation, he testified “month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences.” Bernanke projected that inflation will edge higher over the balance of 2007. The most interesting action during the quarter occurred within the debt markets, which seemed to properly anticipate Bernanke’s hawkish stance on (fighting) inflation. The bond market reached an apparent consensus that the next Fed rate move is likely an increase. Anticipating the Fed Chairman’s comments and factoring in growing evidence that global growth is putting pressure on labor costs even in developing countries, and that factory capacity utilization is near all-time highs, bond investors aggressively reined-in duration, sending medium- and long-term interest rates significantly higher in late May and mid June. In addition to the threat of increasing interest rates, the main domestic economic challenge is the weak U.S. housing market. U.S. homes sales, sales prices, and home building activity continued to deteriorate in the second quarter. Most economists agree that this has taken a toll on economic growth. The government’s final estimate of GDP shows first quarter real GDP growth to be only 0.7%. Furthermore, distress among the sub-prime mortgage-lending industry has affected some name-brand diversified financial companies, and the rise in medium- and long-term interest rates will only worsen the situation. Housing-related employment of construction workers and real estate agents has grown steadily since 1993 and now stands at about 1.1 million jobs more than its historic average (measurement based on historic share of total employment). Further, a vast number of other jobs related to such fields as household furnishings, appliances, and mortgage finance is also at risk indirectly. These job figures suggest the potential vulnerability of the U.S. economy to problems in the housing sector. The strength of foreign economies has been a significant benefit for U.S. companies and the U.S. economy, which is transitioning to some degree from heavy reliance on consumer spending and housing toward export-oriented growth. Real GDP growth in developed foreign economies remains solid, fueling improved foreign company profitability, and emerging market economies are surging due to booming global demand for natural resources. We are not too concerned about the recent jump in interest rates, which have since receded somewhat, and overall we remain optimistic. The best case for the global economy is occurring, namely a soft-landing in the U.S., a picking-up of the slack by other developed countries, and a continuation of stimulation of the global economy by the twin emerging economic giants, China and India. Additionally, assessing the economic situation more broadly, “stable disequilibrium,” which has been a generally positive phenomenon, is probably nearing its final chapter. Indeed, it must ultimately end. It is important that the transition be gradual rather than abrupt. Happily, there is evidence that an orderly transition is occurring. One good sign is increased economic activity in Japan and Europe. In conjunction with the on-going decline in the value of the U.S. dollar, which lowers the price of our exports to foreigners, these foreign economies are increasing their purchases of U.S. goods and services. The result is improvement of the U.S. trade deficit. Further, the increased foreign demand helps us achieve the soft landing and work through our housing and mortgage credit problems and is a benign way for unbalanced global economic forces to begin to unwind. As an economic endnote mentioned a year ago as well, the long-term U.S. fiscal challenge of reducing deficit spending and bolstering the funding of Medicare and Social Security, while at the same time maintaining relatively stable economic growth, remains our biggest concern and eventually will overshadow the near-term analysis. Presently, this challenge is beyond our time horizon and can be put on the side burner. Market Perspective Investor sentiment is a key driver of markets. Particularly when valuations are reasonable and economic conditions generally supportive, as now, it takes on added significance. Investor sentiment is a function of a number of factors, but an important one is the level of market volatility. Specifically, a low level of volatility is comforting to investors and produces a greater appetite for risk. The past five years are a good example. Volatility since the bear market of 2000-2002 has been quite low, and the current global bull market has featured a steady uptrend rather than a herky-jerky upward path. This low volatility environment has caused a multi-year move into risky securities as investors seek higher returns. The average emerging markets stock fund has returned 28.9% a year over the past five years, and the average small capitalization U.S. stock fund has produced a five-year average annual return of a lower but still impressive 15.4%. These returns compare with 10.2% for the much less risky Dow Jones Industrial Average of blue chip U.S. companies. The average junk bond has returned 10.4% a year over that same stretch, compared with 4.5% for the Lehman Brothers Aggregate Bond Index of investment grade bond returns. Given the dramatically higher gains for the risky investments, the traditional price gap between shares of big, blue chip U.S. companies and those of smaller companies has shrunk, and the difference in yield between Treasury and junk bonds is also far smaller than usual. In technical terms, risk premiums are very low. “We see a lot of investors willing to accept risk for very little return” beyond what they could get with a safer investment, says Steven Romick, manager of the $1.5 billion FPA Crescent Fund. In summary, low volatility feeds investor comfort with risk, some would say even complacency, but a jolt of volatility can quickly readjust risk premiums. While it is not clear what events will occur to change investor sentiment and if the change will be positive or negative, the turbulence in the sub-prime mortgage market could do the trick. Waves of these dodgy loans will see their interest rates reset at higher levels over the next 18 months, likely leading to more foreclosures. That could mean more heavy losses for the hedge funds and others that bought bonds backed by those mortgages. In a worst case scenario, some worry, these investors’ souring bets could be big enough to rock the overall economy. Second quarter market results provide evidence that a flight to quality may have started. For the first quarter in years, larger capitalization, growth-oriented styles prevailed over smaller capitalization, value-oriented styles. It is important to note that these relative performance comparisons have settled into long patterns of persistence historically until finally flip-flopping. It is possible we have reached a waypoint finally, which could mean large cap and growth might therefore outperform for a long time to come. We agree that large cap and quality growth issues now represent a safer bet, especially given the worst case scenario mentioned above. Nevertheless, we don’t want to overstate the negative case and disagree with some recent headlines postulating high investor anxiety. Indeed, over the last 12 months, stocks have surged higher that nearly anyone forecast. Additionally, the duration of the current bull market is significantly longer that average. Yet, markets don’t turn on statistics; they and investor sentiment respond to economic events. As long as corporate profits keep rising and inflation and interest rates don’t soar, and as long as the world avoids a geopolitical crisis, global economic strength should keep any stock pullback temporary. Further, since the 2003 U.S. invasion of Iraq, when markets hit some heavy weather, stocks have bounced back strongly each time they faced trouble. The resilience has taken many investors by surprise but certainly should be reassuring to us at this time. * Thanks and credit must go to the many sources for this writing, including Managers and PIMCO mutual fund families, the Wall Street Journal, and the Los Angeles Times.

		Back to Market Reviews