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For the U.S. economy, 2010 marked the first calendar year of recovery from the 2008-09 downturn. While the recession officially ended 18 months ago, looking into 2011, the expansion continues to face dual headwinds.
To date, the recovery has been distinguished by a persistently high unemployment rate and lackluster job growth. Businesses have been cautious about adding to payrolls due to uncertainties associated with regulatory reform, potentially higher taxes and rising health care costs. Thus far, productivity improvements have enabled firms to cope with rising demand utilizing their existing work force, but sooner or later, businesses will need to hire additional workers to meet demand. We think monthly job creation can provide employment for 150,000 new workers.
While this may not significantly lower the unemployment rate, it will lead to an improvement in consumer sentiment. A higher level of confidence coupled with recently enacted payroll tax cuts and the improvement in household balance sheets that has occurred over the past two years should lead to increased consumer spending in 2011.
Housing has been an Achilles heel for the economy. At year end 2010, there were an estimated 4.3 million mortgages either in foreclosure or seriously delinquent. An additional 3.8 million homes were for sale, bringing the total inventory to 7.2 million homes after adjusting for bank-owned property. This represents 21 months of supply, which suggests a slow recovery in housing prices. Although further downside appears limited based on the magnitude of the price decline already, given the current supply hangover, and the precarious condition of many borrowers, we do not expect the housing market to improve significantly in 2011.
Despite the headwinds facing the economy, there are also bright spots in the outlook. Global economic growth has not been synchronized. The emerging economies of Latin America and Asia have been growing at roughly twice the pace of the developed world. . This trend coupled with dollar weakness has had a positive impact on a broad spectrum of businesses, including agricultural commodities, industrial metals, aerospace manufacturers, diesel engine manufacturers, petrochemical companies, and consumer goods manufacturers.
Capital spending, particularly on new equipment, has been another area of strength in this recovery. Businesses responded to the credit crisis and recession by instituting stringent cost controls. However, as demand has improved and revenue growth has turned up, corporate profits have also begun to recover. During 2010, a majority of U.S. companies reported positive earnings surprises and we anticipate corporate profit growth of 15% in 2011. Earnings growth coupled with balance sheet improvement suggests that businesses will invest in projects to increase capacity and improve productivity.
Interest rates are currently at or near historic lows as a result of the quantitative easing and monetary policy actions by the Federal Reserve. Low borrowing costs should provide a further incentive for capital investment. We anticipate that in early 2011, slow growth, low inflation, and an accommodative Federal Reserve policy will keep interest rates low. As the economic recovery takes hold and consumer spending improves, inflationary expectations may begin to surface, leading to increases in intermediate and longer term interest rates later in 2011.
Fiscal stimulus should also aid the economy in 2011. The tax compromise bill enacted in late 2010 provided an extension of tax cuts, a reduction in payroll taxes and tax credits for business capital investment. We believe that this stimulus could contribute at least a full point to 2011 GDP. While there are risks to the outlook, including pressure on state and local government finances, continued weakness in housing, and higher inflation, our crystal ball would suggest that the recovery will gain momentum in 2011, with the economy expanding at a 3 – 3.5% annual rate.
Recommendations for 2011:
Diversification making a comeback: From 2008 through the subsequent recovery, there have been high correlations between most asset classes. We expect that 2011 will see a more normalized market where asset classes and individual securities will move based on their own merits. With this in mind, we believe that strong active management should be able to create alpha (achieve high risk-adjusted returns) in 2011. We believe this not only for pure equity managers, but also alternative equity management styles such as long/short and equity market neutral, both of which lagged in 2010.
Be wary of bonds, but don't forget their benefits: Fixed income had a difficult fourth quarter as rising interest rates dropped most bond values. However, this rapid increase in interest rates will not likely continue. The quantitative easing of the Federal Reserve is a clear indication that they do not see inflation as an immediate concern. The Federal Reserve will likely keep the discount rate near zero, and a low discount rate would also likely keep short-term interest rates low. In addition, the quantitative easing should keep a lid on the ten-year treasury yield. So, while we are less favorable on bonds in the long-term, we expect any additional near-term rise in interest rates to be more gradual. Despite our outlook on bonds, they continue to be an effective tool to meet short term cash flow needs. In addition, bonds offer strong diversification to equities. While Weston has many tools at its disposal to diversify around equities, few of them offer negative correlation to equities like bonds do. The negative correlation would suggest that when equity values fall, that bond values rise, thus dampening the overall volatility of a portfolio. While we remain optimistic about the economy, we are ever-mindful of the laundry list of problems that our world still faces. The uprising in Egypt is a clear reminder that many parts of our world remain unstable. Therefore, we believe that it still makes sense to maintain a percentage of a portfolio in bonds as a layer of defense against another possible economic stumble.
Despite the headlines, municipal bonds aren't all junk: Municipal bonds were hit the hardest in the fourth quarter as headlines prompted investors' concerns over the ability of cash-strapped municipalities to meet their obligations. We agree that municipal bonds require more scrutiny than ever before, but here are a few of the reasons why municipal debt should not be deserted:
- Debt service payments, on average, currently make up only 4% to 5% of a municipality's operating budget(8). In most states, bondholders have preference to revenue. Furthermore, a bond default would severely impact a municipality's future ability to access the capital markets. For these reasons, bond payments would likely be the last payment cut. - General obligation bonds have taxing authority - taxpayers, not bondholders, are likely to feel the most pain in the months and years ahead.
- The historical default rate of municipal bonds is extremely low. The annual default rate for all credits is 1/3rd of 1%(8). It is likely that default rates will rise in the coming years, but we do not believe there is a high probability of massive defaults.
- The historical pay-back to bond holders of a municipal general obligation bond in default is close to 100%. Unlike corporations, states and towns cannot just liquidate. In most situations, municipalities in default will stop paying interest while re-organizing, and then will not only resume interest payments, but will satisfy any unpaid interest payments. - Unfunded pensions and rising health care costs are often highlighted as reasons to be concerned about municipal debt. However, both of these problems are not large budgetary issues today, but rather are issues that will face municipalities in 10 to 15 years. Today's problem is based on the recent recession, which cut tax revenues, on average, by 12%(8). The improving economic conditions should increase tax revenues and help alleviate these near term pressures.
Look for quality: High risk assets, such as REITs and small cap stocks had a very strong 2010. Meanwhile, higher quality, high dividend paying stocks had more modest gains. We believe this has created an opportunity in blue chip equities. Large cap growth stocks are currently trading at a forward P/E ratio of 14.6, while their 20 year average is 21.2(9). Small cap value stocks are trading at a P/E ratio of 14.0 versus a 20 year average of 14.1(9). Based on historic multiples, it would appear that large cap growth stocks are in much better position today than small cap value equities. Large cap growth stocks not only have attractive valuations, but they also typically have easier access to cheap capital and greater exposure to the rapidly growing emerging economies. Therefore, on a risk-adjusted basis, this is one of our most preferred asset classes in 2011.
Footnotes:
(1) Source: Center on Budget and Policy Priorities
(2) Source: JP Morgan's Guide to the Markets
The views expressed here are those of Weston Financial Group, Inc. and are subject to change based on market and other conditions. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is neither representation nor warranty as to the current accuracy of such information, nor liability for decisions based on such information. Past performance is not a guarantee of future results.
It is important to remember that investing entails risk. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. As with fixed-income investments, municipal bond's prices fluctuate in response to changing interest rates and are also subject to interest rate risk, credit risk and market risk. Credit and market risk includes the risk that an issuer of a bond will be unable to make interest and principal payments when due. Short selling involves the risk of potentially unlimited increase in the market value of the security sold short, which could result in potentially unlimited loss in portfolios employing this strategy. The value of a portfolio will fluctuate based on market conditions and the value of the underlying securities. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio.
All material presented herein is believed to be reliable. Investment recommendations and opinions expressed in these reports may change without prior notice.
You can also read our past periodic market and economic commentary articles by going to the Suggested Reading Section on our web site: www.westonfinancial.net.
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Several Washington Trust Wealth Management professionals were recently designated as 2011 FIVE STAR Wealth Managers. The list of 2011 FIVE STAR Wealth Manager is an elite group, representing less than five percent of the wealth managers in Rhode Island. We are proud to have Washington Trust Wealth Management well represented on this list. Congratulations to Russel Burgess, Gary Friedmann, Mary McGoldrick, Robert Salmonsen, L. Peter Sheehan, Barbara Williams Rogean Makowski and Laura Ward for recognition as 2011 FIVE STAR Wealth Managers.
The FIVE STAR Program, managed by Crescendo Business Services, LLC of Eagan, Minnesota, works with prominent city and regional magazines and business publications to present the "FIVE STAR Award" to professionals in many industries throughout the United States. A third party survey was administered, by mail and phone, to approximately over 51,000 high-net-worth households and to over 2,200 financial services professionals with in the Rhode Island area The evaluation was based on nine criteria, including customer service, integrity, knowledge/expertise, communication, value for fee charges, meeting of financial objectives, post sale service, quality of recommendations, and overall satisfaction. For more information on the FIVE STAR Award Program, please click here.
