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Please take a moment to read this important information.
Before we get started, I would like to call your attention to our cautionary statements on the following slides. I will give you a moment to read it. It basically tells you that we are going to share opinions and estimates with you and that these should not be construed to be fact or any type of guarantee against market loss.
And some additional important information.
Here’s a quick preview of our discussion.
Most Americans likely share the same sentiment.
The LEI’s sharp recovery suggests that “double dip” in the U.S. is improbable.
It’s important to watch the LEI’s six-month rate of change in gauging the onset of a significant slowdown. This measure would have to move below zero to signal another slide into recession ahead — and it’s still well above that level.
August’s manufacturing purchasing managers index ticked up — a surprise compared to the consensus forecast for a decline. Historically, this measure has slumped below 50 prior to recession.
The consensus opinion of the 55 economists surveyed by the Wall Street Journal in its August poll was for a sustained, though restrained, economic recovery. Not a double-dip and not the “new normal” idea of very anemic GDP growth.
The Federal Reserve in its June “central tendency” GDP forecast sees a return to above-average growth in 2011 and 2012. (GDP growth has averaged around 3% in the decades since WWII).
The most recent data in these graphs show the percentage contributors to the +1.6% gross domestic product (GDP) growth in the second quarter of 2010. Consumer spending has held up; private investment has snapped back strongly; government spending has recovered; and, net imports have surged, subtracting significantly from GDP growth.
New job formation is recovering — but slowly.
Employment is the key to sustained expansion. Coming out of the last recession, the household survey — which provides information on the labor force, employment and unemployment — led the establishment survey — which is more often reported and provides information on employment, hours and earnings — and it may be doing so again. Putting numbers to it, the household survey has reported an average of 185,000 jobs/mo. created YTD, compared to the establishment payroll figure averaging 90,000 jobs/mo. New job formation is recovering — but slowly.
The unemployment rate is probably the highest-profile of economic statistics and it surges during recessions. Remember, however, that it has a history of peaking at the end of recession, or later, while the stock market has a history of bottoming before the end of recession.
Weekly initial claims for unemployment insurance have ticked higher in recent months, following a post-recession plunge. This trend of some “give-back” is typical of previous recoveries.
July housing starts ticked up after the slump that followed the termination of the government’s stimulus program that ended in April. The underlying trend since the March 2009 bottom is modestly encouraging. Homebuilding is presently running substantially below estimated new household formation.
The crux of the debate as to whether the economic recovery is sustainable or not revolves around consumer spending. That’s because consumer spending constitutes 70% of GDP. Following the post-recession bounce, will consumer spending revival continue? A common refrain heard in the media is that consumers are “feeling poorer.” This, and other arguments against a sustained recovery in consumer spending, are the subjects addressed in the next seven slides.
The simple observation here is that personal income and spending have been in recovery for two years — at approximately the pre-recession growth rate — following the sharp, recession-related correction of 2008. Because personal spending accounts for 70% of GDP, the rate of change in personal spending is key to the rate of change in GDP. Personal savings have surged from the lows of recent years. Restored household liquidity will drive spending, and, U.S. savers are providing, once again, a significant source of demand for U.S. Treasury bonds.
What’s driving the rising trend in consumer income? Rising wages and salaries, increasing hours worked and payroll gains, though modest, have driven rising aggregate employee compensation. A significant increase in government transfer payments — Social Security, Medicare and Medicaid and unemployment insurance payments — has also been a significant driver of rising personal income. Interest and dividend income and proprietors’ income have not recovered.
Rising savings and asset sales are reflected in this measure, which shows record high consumer cash balances compared to annual income in the last 15 years. It is simply not true that American households are “tapped out.”
Growth in consumer spending has principally been a function of income growth, which, in turn, is driven by job growth and wage gains. Whereas, historically, the wealth effect does not appear to have significantly affected growth in consumer spending.
Household debt compared to income is near record-high. However, this statistic is misleading. Because interest rates have declined so dramatically since the peak in 1980, households have the ability to service far more debt than they did in 1980. See next slide.
The Federal Reserve’s financial obligation ratio measures consumers’ fixed expenses compared to disposable income. This is a good all-in measure of the extent to which consumer debt drags on all other consumer spending. It has declined recently and, at 17.4%, means that households have 82.6% of after-tax income with which to make all other monthly purchases, including discretionary spending. This measure gives a very different and, in my opinion, a more accurate picture of consumers’ degree of leverage than the household debt-to-income measure presented in the preceding chart.
A recovery in consumer spending will depend heavily on higher-income consumers. In the higher income brackets spending behavior is less a function of consumers’ having the wherewithal to spend more — they do. It’s more a function of their willingness and desire to spend.
July retail sales ticked up. The retail spending recovery remains intact.
While the first birth wave generation (broadly defined) is 117 million strong, their children’s generation — the echo boomers — are 125 million in number. This generation is still expanding. The leading edge of this generation has only recently begun entering the labor force. With each passing year, a greater number will be applying for jobs than the year before. This is significant because by comparison to most of the other developed economies — Europe and Japan — the U.S. is in an enviable position. Growth in the working population drives gross domestic product (GDP) growth. The U.S. has this large echo boomer population coming behind us — and they don’t. This fact is one reason why the U.S. will likely continue to be a magnet attracting foreign investment capital. And the echo boomers are the reason to anticipate a potential recovery in demand for new housing and autos.
In the top panel, you see actual measured Consumer Price Index (CPI) inflation. Note how food and energy have whipped the headline figure higher and lower over recent years, a direct result of crude oil’s wild ride from $20 to $140, back to $40 early last year and other changes in the last 10 years. On the other hand, note how the core figure has been in steady decline. The Fed focuses its attention on core. That takes me to the lower panel: the Federal Reserve’s latest “central tendency” forecast for core inflation measured by the personal consumption expenditures (PCE) deflator. Note that the Fed sees stable, low core inflation through 2012. By comparison to the trend rate over recent years, this outlook centered on less than 2% is, indeed, “subdued”, to use the Fed’s latest language.
First note the sentence from the Fed’s committee statement released on June 23, 2010, where they refer to resource slack. This is a reference to the “output gap” argument that inflation can’t return until actual demand for goods and services has reapproached productive supply limitations. Only at that point, states the theory, can companies hope to raise prices and can employees hope to get a bump in wages. How exactly to calculate the output gap is the subject of great debate among economists. The Fed’s capacity utilization statistic presented here is probably not a bad proxy, however. In the chart, note how inflation has, indeed, historically correlated with rising and falling capacity levels. The inflation “doves,” today, argue that because this recession resulted in record low capacity use, it’s highly unlikely that inflation will revive for quite some time — particularly since the prevailing view on the economy is for a slow, protracted recovery.
This chart is an analysis of the monetarist view that inflation is always a monetary phenomenon. Lagging money growth by three years results in the best fit with inflation, i.e., surges in money have resulted in inflation three years later. What’s interesting about this chart, though, is the link has been tight in certain periods, historically, but has been inconsistent in recent decades. And the relationship seemed to invert during the 1980s. The concern looking ahead, as you can see in the chart, is that year-over-year money supply growth hit 10% recently, which, according to the monetarist view, would drive inflation skyward. If it’s any comfort, the last episode you see here in which M2, a broad measure of household’s monetary holding, growth hit 10% (2004), the consumer price index (CPI) hit only 4%, and the core CPI remained stable at not much over 2%.
It’s important to distinguish between the Monetary Base and Money Supply. The Federal Reserve engineered an explosion in the former in order to restore confidence in the banking system and stimulate an economic recovery. For this policy action to result in inflation, a crucial next step is required: that banks actually start lending this newly available cash to households and businesses, whereupon it would start to show up in the Money Supply aggregates. In fact, this is the Fed’s desired outcome in order to stimulate spending. Thus far, this has not happened. The rate of year/year M2 growth, in fact, has declined in recent months.
This market-based measure of inflation expectations is not reflecting a general concern that prices will actually decline in the foreseeable future.
It looks like everyone’s budget might need some balancing.
The federal budget deficit as a percent of gross domestic product (GDP) has increased sharply from what had been a favorable position, but is forecast to subside in 2012 and 2013, according to the Congressional Budget Office’s (CBO’s) August 2010 10-year budget outlook update. Deficit reduction will depend critically on the strength of economic recovery. CBO is projecting a healthy recovery.
With the surge in federal budget deficits, the stock of outstanding federal debt compared to gross domestic product (GDP) is set to rise substantially, then stabilize, under the CBO’s August 2010 “baseline scenario.”
Under the CBO’s August 2010 “alternative fiscal scenario”, Federal debt rises radically.
This slide shows the Congressional Budget Office’s June 2009 long-term projections for total federal spending. Significantly, Social Security is not the problem, long-term, health care is.
Historically, the U.S. has had much higher top marginal tax rates than at present. The correlation between top tax rates and economic growth is not so clear. The U.S. has posted a 3% trend line GDP growth for many decades despite periods of very high marginal tax rates.
Since the 1960’s, total taxes paid as a percent of GDP has remained fairly constant under a wide range of top marginal tax rates.
Investors are looking for returns they grew accustomed to during past years.
Stocks still have a long way to recover just to re-take the pre-Lehman level.
Investors sold stocks and accumulated a record amount of cash. In the past, a surge in cash above normal levels has coincided with opportune market buy points. While a substantial amount of cash has flowed back out of money market funds over the past year, as of July 31, 2010, cash in money market accounts is still at a historically high level.
Earnings drive stock prices. Here you see the latest consensus 2010 and 2011 earnings forecasts (left axis) plotted against the S&P 500 (right axis).
Ned Davis Research, Inc. has created a stock market “cycle composite” based on daily stock prices going back to 1928. This pattern suggests a strong fourth quarter 2010 for the stock market.
With the plunge in bond yields (rise on bond prices), investors are wondering if we’re in a “bond bubble.” Here you see the record cash flows into bond mutual funds in recent months.
Ned Davis Research, Inc.’s 10-year Treasury bond price model suggests modest over-valuation of that bond as a result of the flood of cash into bonds.
Economists’ median forecasts are for rising bond yields over the next year and one-half. However, the distribution of their forecasts is wide for both 2009 and 2010. If the consensus view does play out it means there’s risk in long-dated bond prices as interest rates rise.
While the overwhelming sentiment among economists has been for higher bond yields, in the long-term context it appears that yields could drop even further.
Corporate, mortgage-backed, emerging market and CMBS bond yields have all declined in concert with the decline in U.S. Treasury bond yields.
This chart suggests that the U.S. dollar measured against a broad-based trade-weighted basket of currencies is in a gradual secular decline — which makes sense insofar as some of our trading partners’ economies, i.e. China, India, Brazil, are growing so rapidly. Our view is that continued strong U.S. economic growth by comparison to the rest of the developed economies will likely continue to attract large sums of foreign investment from those developing-economy investors.
Commodities have historically provided long-term returns comparable to stocks. Commodities have historically outperformed stocks during periods of rising inflation. In this example, commodities are represented by the S&P GSCI Total Return Index; stocks are represented by the S&P 500 Total Return Index; and bonds are represented by Barclays Capital Long-Term Treasury Bond Total Return Index.
Gold has trended steadily higher despite a higher $USD, as investors relentlessly seek a safe haven.
The U.S. DOE forecasts a resumption in demand growth for crude oil with global economic recovery.
Crude and the $USD have historically been inversely correlated, although crude has remained firm this year even as the $USD rallied, reflecting an expected continued healthy recovery in global demand.
To summarize, these are the key points.
Though many investors may share this sentiment, there are better investment strategies.
Here are the strategists’ 2009 sector recommendations from the Barron’s survey. They got more wrong than right.
Here are the strategists’ 2010 sector recommendations from the Barron’s survey. They favor the tech, industrials, materials and energy sectors — the sectors that outperformed in 2009. They least favor the utilities, consumer staples and telecom sectors.
Mother knows best.
The term asset allocation is our industry’s shorthand to describe the application of modern portfolio theory — diversify, optimize, rebalance. If getting this job done properly across a broad book of clients turns out to be too big of a job, then use an asset allocation fund — wherein you’re simply paying the manager to diversify, optimize and rebalance. The tactical asset allocation ideas that investors frequently hear from Wall Street “experts” have sometimes proven to be poor advice. In 2006, for example, the most favored recommendation among Wall Street strategists was that large-cap growth would outperform, led by the information technology and health care sectors. These turned out to be the laggards. In 2007, a similar story. In 2008, information technology missed again, while health care was one of the better performing sectors. Their calls in 2009 were, again, misguided.
Brigham Young Professor Israelsen has constructed a broadly diversified global balanced asset allocation model, the 7Twelve™ portfolio. How would this portfolio have performed through the stock market’s twin boom/busts of the last 10 years, assuming monthly rebalancing? See next page.
Professor Israelsen’s global balanced index, periodically rebalanced, suggests that MPT diligently applied over the past decade had the potential to produce strong results. The difference between his “Active” and “Passive” indexes is that the former is constructed using actively managed mutual funds, and the latter with index-based ETFs.
FundQuest analyzed 31,991 U.S. domiciled non-index mutual funds, both active and obsolete, in 73 categories for the period 1/1/80 to 2/1/10. Their conclusion: “We believe investors should seek to utilize a blend of both active and passive investing with the goal of optimizing their portfolios,” based upon their finding that actively managed funds, on average, beat their benchmarks in some categories whereas passive indexes, on average, beat their benchmarks in other categories.
The name refers to seven core asset classes with 12 underlying sub-assets. The 7Twelve Portfolio is constructed to generally follow the time-tested 60/40 guideline, but it uses eight sub-assets instead of one to create an overall equity exposure of about 65% and four fixed-income sub-assets instead of one to create a &quot;bond&quot; exposure of about 35%. All 12 sub-assets are index-based, exchange-traded funds and all are equally weighted. Each represents 8.3% of the 7Twelve portfolio. The fund is rebalanced annually to maintain the equal weighting.
Looking out five years, the IMF anticipates continued strong economic growth in these emerging markets.
The combined GDP of the four emerging markets, Brazil, Russia, India and China, has recently surpassed that of the U.S. and Europe, measured on purchasing power parity.
GDP per capita in these four leading emerging markets is still very low, suggesting substantial, long-term growth potential.
To summarize, these are the key points.
In 2006, the media often reported economic and stock market news with a negative bias. My opinion is that this is a systematic tendency on their part.
Important Information <ul><li>The views and opinions expressed are those of the speaker and are subject to change based on factors such as market and economic conditions. These views and opinions are not an offer to buy a particular security and should not be relied upon as investment advice. Past performance cannot guarantee comparable future results. </li></ul>
Important Information <ul><li>Performance quoted is past performance and cannot guarantee comparable future results; current performance may be higher or lower. </li></ul><ul><li>Results shown assume the reinvestment of dividends. </li></ul><ul><li>An investment cannot be made directly in an index. </li></ul><ul><li>Investments with higher return potential carry greater risk for loss. </li></ul><ul><li>Investing in small companies involves greater risks not associated with investing in more established companies, such as business risk, significant stock price fluctuations and illiquidity. </li></ul><ul><li>Foreign securities have additional risks, including exchange rate changes, political and economic upheaval, the relative lack of information about these companies, relatively low market liquidity and the potential lack of strict financial and accounting controls and standards. </li></ul><ul><li>Investing in emerging markets involves greater risk than investing in more established markets such as risks relating to the relatively smaller size and lesser liquidity of these markets, high inflation rates, adverse political developments and lack of timely information. </li></ul><ul><li>Fluctuations in the price of gold and precious metals often dramatically affect the profitability of the companies in the gold and precious metals sector. Changes in political or economic climate for the two largest gold producers, South Africa and the former Soviet Union, may have a direct effect on the price of gold worldwide. </li></ul>
Important Information <ul><li>Asset allocation/diversification does not guarantee a profit or eliminate the risk of loss. </li></ul><ul><li>The S&P 500 ® Index is an unmanaged index considered representative of the U.S. stock market. </li></ul><ul><li>The MSCI EAFE Index is an unmanaged index considered representative of stocks of Europe, Australasia and the Far East. </li></ul><ul><li>The Vanguard 500 Index is an unmanaged index considered representative of the companies in the S&P 500 Index. </li></ul><ul><li>The Vanguard Balanced Index is representative of the standard 60% equity, 40% fixed income allocation. </li></ul><ul><li>The S&P/Case-Shiller U.S. National Home Price Index is an unmanaged index considered representative of single-family home prices for the nine U.S. Census divisions. </li></ul><ul><li>The S&P GSCI Total Return Index is world-production weighted; the quantity of each commodity in the index is determined by the average quantity of production in the last five years of available data. </li></ul><ul><li>The Barclays Capital Long-Term Treasury Bond Total Return Index is an unmanaged index considered representative of long-term treasury bonds. </li></ul><ul><li>The Dow Jones Total Stock Market Index is an unmanaged index that measures all U.S. equity securities that have readily available prices. </li></ul><ul><li>Government securities, such as U.S. Treasury bills, notes and bonds offer a high degree of safety and they guarantee the timely payment of principal and interest if held to maturity. </li></ul><ul><li>U.S. Treasury bills are short-term securities with maturities of one year or less. </li></ul><ul><li>Long-term government bonds used in this illustration have a maturity of approximately 20 years. </li></ul><ul><li>The Consumer Price Index (CPI) is a measure of change in consumer prices, as determined by the U.S. Bureau of Labor Statistics. </li></ul>
“ I need some short-term stimulus.” Economic Data
Index of Leading Economic Indicators Economic Data “ The indicators point to a slow expansion through the end of the year. With inventory rebuilding moderating, the industrial core of the economy has moved to a slower pace. There appears to be no change in the pace of the service sector. Combined, the result is a weak economy with little forward momentum. However, the good news is that the data do not point to a recession.” The Conference Board August 19, 2010 Leading Economic Indicators (LEI) components: 1) average weekly hours worked, manufacturing; 2) average weekly initial unemployment claims; 3) manufacturers’ new orders – consumer goods and materials; 4) index of supplier deliveries – vendor performance; 5) manufacturers’ new orders, nondefense capital goods; 6) building permits – new private housing units; 7) stock prices, S&P 500; 8) money supply – M2; 9) interest rate spread; 10-year Treasury less fed funds; 10) index of consumer expectations. Source: Copyright 2010, The Conference Board. Data as of July 31, 2010.
Index of Leading Economic Indicators Six-month percent change Economic Data Source: Copyright 2010, The Conference Board. Data as of July 31, 2010. Historically, the LEI’s six-month rate of change has provided a reliable signal for the onset of recession. Today’s reading remains well into expansion territory.
ISM Manufacturing Purchasing Managers Index (PMI) Economic Data Source: Copyright 2010, Institute for Supply Management; data as of Aug. 31, 2010. "Manufacturing activity continued at a very positive rate in August as the PMI rose slightly when compared to July. … New orders continued to grow but at a slightly slower rate.” Institute for Supply Management (ISM) September 1, 2010 Shaded bands indicate recessions. 25 35 45 55 65 75 Jan-60 Jan-62 Jan-64 Jan-66 Jan-68 Jan-70 Jan-72 Jan-74 Jan-76 Jan-78 Jan-80 Jan-82 Jan-84 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Index
Gross Domestic Product Growth Latest consensus forecast: sustained recovery Economic Data Sources: Bureau of Economic Analysis, data through June 30, 2010, last revised Aug. 27, 2010; Wall Street Journal survey taken Sep. 3-7, 2010.
Gross Domestic Product Growth Fed’s latest central tendency forecast Economic Data Source: Minutes of the Federal Open Market Committee meeting, June 22-23, 2010, released July 14, 2010. Sustained recovery through 2012 +2.5% to +2.8% longer run
GDP = C + I + G + Net Exports Contributions to percent change in real gross domestic product Source: Bureau of Economic Analysis, data through June 30, 2010, last revised August 27, 2010. Economic Data Percent change at annual rate (%) Percent change at annual rate (%) Percent change at annual rate (%) Percent change at annual rate (%)
Slow Improvement in Jobs Picture Economic Data 1 Temporary U.S. Census hiring in 2010 caused exaggerated volatility in the Total monthly change in payrolls. Private sector hiring is presented separately during that period. Sources: National Bureau of Economic Research, Bureau of Labor Statistics; data as of Aug. 31, 2010. -54 Total 1 +67 Private Sector 1
New Job Formation Household survey substantially outpacing establishment survey Economic Data The household survey led the establishment survey coming out of the 2001 recession. It may be leading again. YTD net new jobs : Household survey: 1,485,000 (185k/mo.) Establishment survey: 723,000 (90k/mo.) Source: Bureau of Labor Statistics, data as of Aug. 31, 2010.
Unemployment Is a Lagging Economic Indicator Economic Data Sources: National Bureau of Economic Research, Bureau of Labor Statistics; data as of Aug. 31, 2010. Clear bands indicate recession. 9.6% 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 12.0 Jan-60 Jul-61 Jan-63 Jul-64 Jan-66 Jul-67 Jan-69 Jul-70 Jan-72 Jul-73 Jan-75 Jul-76 Jan-78 Jul-79 Jan-81 Jul-82 Jan-84 Jul-85 Jan-87 Jul-88 Jan-90 Jul-91 Jan-93 Jul-94 Jan-96 Jul-97 Jan-99 Jul-00 Jan-02 Jul-03 Jan-05 Jul-06 Jan-08 Jul-09 Unemployment Rate (%)
Weekly Unemployment Claims Economic Data Source: U.S. Department of Labor, data through the week of Aug. 14, 2010. Weekly unemployment claims have turned higher following post-recession plunge. That pattern is typical of previous recoveries.
Housing Starts Gradually Recovering 1 Source: Joint Center for Housing Studies, Harvard University, March 2006. Sources: U.S. Census Bureau, data through July 31, 2010; Mortgage Bankers Association’s housing starts forecast dated Aug. 16, 2010. Annual Growth in Number of Households 1 (estimated) Housing Starts (actual) Housing Starts (estimated) end of buyers tax credit
Consumer Income, Spending and Saving Are Up Source: Bureau of Economic Analysis, data through July 31, 2010. Economic Data July savings rate = 5.9%
Consumer Income by Source Source: Bureau of Economic Analysis, data through July 31, 2010. Economic Data Rising hours worked, average wages and meager, but positive, payroll gains are driving employee compensation.
Consumer Liquidity is at a Record High Source: Federal Reserve, Bureau of Economic Analysis; data through July 31, 2010. Economic Data M2 = cash, checking, savings and retail money market funds. Aggregate household spendable cash equals 75% of annual disposable personal income … or, approximately nine months’ income.
Consumer Spending Versus Household Net Worth How significant is the negative wealth effect on consumer spending? Sources: Federal Reserve, Bureau of Economic Analysis; data through March 31, 2010. Economic Data “ Declining household wealth has a relatively small implied negative impact on aggregate consumption expenditures.” Federal Reserve Bank of Boston Paper No. 09-9, Nov. 13, 2009
Household Debt By this often-cited measure consumers are near-record leveraged Economic Data Source: Federal Reserve, data as of March 31, 2010, released June 17, 2010.
Consumers’ Financial Obligations Ratio Has Improved By this all-in measure consumers don’t appear to be over-leveraged Source: Federal Reserve, data as of March 31, 2010, released June 17, 2010. Economic Data The financial obligations ratio consists of estimated required payments on outstanding mortgage and consumer debt plus automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance and property tax payments divided by disposable personal income.
Personal Income and Spending by Quintile Most consumers don’t appear to be tapped out Economic Data Because income and spending are skewed to the upper brackets, the recovery in spending growth rides significantly on spending behavior in the higher brackets. Sources: Bureau of Labor Statistics. Consumer Expenditure Survey, 2008, table 45. Note: In the NBER’s Working Paper 15408 published October 2009, the top income decile (10%) accounted for 50% of 2007 total income, using a definition of income somewhat broader than the BLS’s.
Retail Sales Recovering 1 CAGR: Compound annual growth rate. Source: U.S. Census Bureau, data as of July 31, 2010. Economic Data CAGR 1 3/09-7/10 = 5.8%
GDP Growth Potential = ∆ Productivity + ∆ Labor Force Labor force to grow 0.8% per year through 2016 Sources: 1909 to 2004: U.S. Census Bureau, 2007 Statistical Abstract; 2005 to 2007: U.S. Department of Health and Human Services, National Center for Health Statistics; 2008: Bureau of Labor Statistics. U.S. Live Births 1909–2008 Economic Data Birth Wave 1 (1946 –197 6) 117 million Birth Wave 2 (echo boomers) (1977 –20 08) 125 million
Benign Inflation Expected to Continue 1 From the minutes of the Federal Open Market Committee meeting, June 22-23, 2010, released July 14, 2010. Source: Bureau of Labor Statistics, data as of July 31, 2010. Federal Reserve’s core personal consumption expenditures (PCE) inflation forecast 1 Economic Data
Inflation Versus Capacity Use The “output gap” argument 1 Source: Federal Open Market Committee’s statement released June 23, 2010. Sources: Bureau of Labor Statistics, Federal Reserve; data as of June 30, 2010. “ With substantial resource slack continuing to restrain cost pressures and with longer-term inflation expectations stable, inflation is likely to be subdued for some time.” 1 Economic Data
Inflation Versus Money Supply Growth 1 Source: Wikipedia Sources: Bureau of Labor Statistics, Federal Reserve; data as of April 30, 2010. The monetarist explanation of inflation operates through the Quantity Theory of Money, which states MV = PT. M is money supply, V is velocity of circulation, P is price level and T is transactions or output. Because monetarists assume that V and T are determined, in the long run, by real variables such as the productive capacity of the economy, there is a direct relationship between the growth of the money supply and inflation. 1 Economic Data
Money Supply Versus Monetary Base Economic Data Source: Federal Reserve, data as of May 31, 2010. The Federal Reserve has engineered an explosion in the Monetary Base — reserves that commercial banks keep on deposit at the Fed — in an effort to restore confidence in banks and stimulate the economy. M2 — which is a function of both supply and demand for funds — has not surged.
“ You’re in luck, in a way. Now is the time to be sick — while Medicare still has some money.” Economic Data
Actual and Projected Federal Budget Deficit Baseline scenario Sources: Actual: Bureau of Economic Analysis through Dec. 31, 2009; Projected: Congressional Budget Office (CBO), Budget and Economic Outlook: An Update, August 2010, Baseline Projection. Economic Data Y/Y ∆ GDP (%) Deficit/GDP (%) Projected Projected (dotted line) 2009 Deficit (E) = $1.4 trillion 2010 Deficit (E) = $1.3 trillion
Actual and Projected Federal Debt as a Percent of GDP Baseline scenario Sources: U.S. Office of Management and Budget data through Dec. 31, 2009; Congressional Budget Office’s (CBO) Budget and Economic Outlook: An Update, August 2010, Baseline Projection. Economic Data Projected (dotted line)
Actual and Projected Federal Debt as a Percent of GDP Source: Congressional Budget Office, Federal Debt and the Risk of a Fiscal Crisis, July 27, 2010, Alternative Fiscal Scenario. Assumptions include: 2001 and 2003 tax cuts extended, Alternative Minimum Tax (AMT) indexed for inflation, Medicare payments to physicians rise over time, taxes remain at ~19% of GDP. Economic Data Note: The extended-baseline scenario adheres closely to current law, following CBO’s 10-year baseline budget projections through 2020 (with adjustments for the recently enacted health care legislation) and then extending the baseline concept for the rest of the long-term projection period. The alternative fiscal scenario incorporates several changes to current law that are widely expected to occur or that would modify some provisions that might be difficult to sustain for a long period.
Congressional Budget Office Long-Term Spending Projections Source: Congressional Budget Office (CBO), The Long-Term Budget Outlook, June 2009. Extended-Baseline scenario. Medicare and Medicaid Social Security Other Federal Noninterest Spending Economic Data Actual Projected
Top Tax Brackets and GDP Growth Sources: Bureau of Economic Analysis; Tax Policy Center. Data through Dec. 31, 2009. Economic Data On Earned Income (right axis) On Capital Gains (dotted, right axis) Reagan Clinton Bush Bush Carter Nixon Johnson Kennedy Kennedy Johnson / Nixon Reagan “ read my lips” Bush II
Taxes as a Percent of GDP Fairly constant in recent decades despite changing top marginal rates Source: Bureau of Economic Analysis. Data through Dec. 31, 2009. Economic Data
S&P 500 — Earnings Drive Stock Prices, Estimates Rising <ul><ul><li>1 Estimated 2010 and 2011 bottom-up S&P 500 earnings per share (left scale): for 2010, $81.12; for 2011, $95.06, as of Aug. 31 2010. </li></ul></ul><ul><li>Source: Thomson Baseline, data through Aug. 3, 2010. Reuters and Thomson Financial survey of consensus estimates. </li></ul>Market Data 2010 1 2011 1
10-year U.S. Treasury Bond Yield Forecasts Most economists expect rising bond yields 1 Wall Street Journal , survey of 54 economists taken Aug. 6-9, 2010. 2 Median forecast. 3 At Aug. 12, 2010. Market Data Distribution of Forecasted Bond Yields — 54 Economists Surveyed 1 Current 3 3.10% 2 4.05% 2
Gold Lately ignoring $USD strength; reflecting relentless demand for safe haven Market Data Source: Baseline. Data as of June 30, 2010.
Crude Oil Rising post-recession demand forecast Market Data Source: U.S. Department of Energy, Energy Information Agency, International Energy Outlook, May 2010, reference case. 1 BRIC = Brazil, Russia, India and China. Actual Estimated
Crude Oil Historically inversely correlated to the $USD; reflecting rising global demand outlook Market Data Source: Baseline. Data as of June 30, 2010.
Conclusions <ul><li>Economic data: </li></ul><ul><li>Most economists believe that global economic recovery will continue despite the sovereign debt crisis and U.S. slowing. </li></ul><ul><li>The unemployment rate might trail economic recovery. </li></ul><ul><li>Consumers’ savings and liquidity have risen substantially. </li></ul><ul><li>The “negative wealth effect” may be over-estimated. </li></ul><ul><li>Significant skew in income; spending is relevant to economic recovery. </li></ul><ul><li>The U.S. economy is positioned to potentially continue its +2½% to +3% long-term trend rate of growth. </li></ul><ul><li>Inflation is subdued and has the potential to remain so for at least a few years. </li></ul><ul><li>The CBO projects massive budget deficits lasting two years. </li></ul><ul><li>Higher marginal tax rates don’t automatically equate to recession. </li></ul><ul><li>Market data: </li></ul><ul><li>Still significant cash on the sidelines. </li></ul><ul><li>Fund flows heavily weighted to bonds. </li></ul><ul><li>Stocks are attractively valued on estimated earnings. </li></ul><ul><li>The U.S. dollar is mid-range. </li></ul><ul><li>Commodities have historically provided equity-like returns. </li></ul><ul><li>Gold and crude oil both strong despite $USD rally . </li></ul>“ It’s just a correction. The fundamentals are still good.”
“ Winning is crucial to my retirement plans.” Investment Strategies
Wall Street’s Call for 2009 1 Published Dec. 22, 2008. 2 Retailers 3 Health care equipment 4 Semiconductors For illustrative purposes only. Barron’s 2009 Forecast 1 Survey of 12 stock market strategists sector picks and pans for 2009 Big Miss Good Call Wrong Wrong Big Miss Investment Strategies Missed Wrong Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Utilities Blackrock + - + + - - DB Private Wealth - + + + - Neuberger Berman - + - + + Oppenheimer Funds - + + U.S. Trust - + + - + + Wells Capital Management + - - + + + - Citigroup + 2 - + + 3 + 4 + - Goldman Sachs - + + - JP Morgan + - + + - - Merrill Lynch - + - - + - - + Morgan Stanley + - + + - - - + Strategas - + + + - - - - Net (+/-)l -2 +5 -2 -1 +9 -4 +4 -3 +2 -3 Actual 2009 Sector Return (Rank) +39% (3) +11% (8) +11% (7) +15% (6) +17% (5) +17% (4) +60% (1) +45% (2) +3% (10) +7% (9)
Wall Street’s Call for 2010 1 Published Dec. 21, 2009. 2 Media For illustrative purposes only. Barron’s 2010 Forecast 1 Survey of 12 stock market strategists sector picks and pans for 2010 Investment Strategies Only six out of last year’s 12 strategists returned for this survey. Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Utilities Blackrock - + + + - U.S. Trust - - + - + + + - Putnam - + + - Morgan Stanley + 2 - + + - Wells Capital Management + - + - + + + - Prudential - + - + + + - BofA Merrill - + + - + - Barclays - - + + + Goldman Sachs - + - + + - - JPMorgan - + + + - Citigroup + + - + - ISI Group - + + - Net (+/-) -2 -4 +4 0 -1 +7 +8 +5 -2 -8
Modern Portfolio Theory “ Your mother called to remind you to diversify.” Investment Strategies
Modern Portfolio Theory = Asset Allocation Asset allocation and diversification do not guarantee a profit or eliminate the risk of loss. Source: Riskglossary.com Modern portfolio theory was introduced by Harry Markowitz with his paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance . Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Modern Portfolio Theory Diversify Optimize Rebalance Investment Strategies
Asset Allocation — Emerging Markets Looking out five years — International Money Fund’s (IMF) 2014 GDP growth rate forecasts Investment Strategies Source: IMF, World Economic Outlook — October 2009.
Asset Allocation — Emerging Markets BRIC’s share of global GDP has surpassed the U.S. and Europe Investment Strategies 1 BRIC = Brazil, Russia, India and China. 2 E.U. = 27 countries using the euro currency Source: IMF World Economic Outlook, October 2009
Asset Allocation — Emerging Markets BRIC’s GDP per capita — growth potential from very low base Investment Strategies Source: IMF World Economic Outlook, October 2009. BRIC = Brazil, Russia, India and China. E.U. = 27 countries using the euro currency.
Conclusions <ul><li>Investment strategies: </li></ul><ul><li>Wall Street strategists don’t always systematically add value. </li></ul><ul><li>Global diversification with rebalancing provides support for modern portfolio theory (MPT). </li></ul><ul><li>Potential for long-term economic growth in emerging markets. </li></ul>“ I’m looking for a hedge against my hedge funds.”
And Don’t Believe Everything You Hear <ul><li>A study by Media Research Center of a year’s worth of economic coverage on ABC, CBS and NBC found more than twice as many stories and briefs focused on negative aspects of the economy (62%) compared to good news (31%). </li></ul>Source: Media Research Center, “Bad News Bears,” October 2006 “ We were wondering if now would be a good time to panic?”
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