The Outlook

In the developed world, banks with impaired balance sheets have curtailed lending, while over-leveraged consumers have cut back spending. The normal capital flows have slowed to a trickle, and the world’s central banks are now providing monetary stimulus to restore capital flows and create economic improvement. After bringing short-term interest rates down to their lowest possible levels, the Federal Reserve, other central banks and governments have initiated no fewer than 640 policy initiatives including tax cuts, industry rescues, housing subsidies, infrastructure programs and other stimulus programs. The United States has already committed to finance or backstop nearly $12 trillion, which is equal to 85% of Gross Domestic Product. It is clear that governments and central banks around the world will do whatever it takes to stimulate the global economic system to restore growth.

As we have written since last December, a select group of equity securities and corporate bonds will continue to be beneficiaries of these government initiatives. The areas of focus for equity portfolios continue to be agriculture, energy, materials, precious metals (particularly gold), healthcare, infrastructure, transportation and defense companies. In the corporate bond area, we remain focused on investment-grade issuers with an emphasis on maturities in the 1-4 year range.

In response to the economic crisis, a record supply of treasuries will be issued to pay for a mounting budget deficit which the Congressional Budget Office recently estimated at $1.84 trillion. In total, including refinancings, the U.S. Treasury will issue a record $3.25 trillion of debt for the fiscal year ending September 30th. This anticipated massive issuance along with the record debt is putting downward pressure on the dollar and is making U.S. treasury securities less attractive to foreign investors. The dollar index which tracks the U.S. currency vs. the Euro, Yen, Pound, Swiss Franc, Canadian Dollar and Swedish Krona has fallen more than 11% from its high this year reached on March 4th.

The United States is in the fortunate position of having its dollar as the reserve currency of the world and therefore its dollar debts can technically be discharged by simply creating more dollars. This solution is very tempting for it reduces the value of its debts in real terms, but the invariable result will be a devaluation of its currency. A devalued dollar weakens other nations’ competitive trade positions thereby forcing their central banks to create more of their currencies to offset the trade disadvantages of the weaker dollar. England’s monetary creation contributes to its weakening currency, is aimed at keeping its interest rates low and is intended to stimulate its economy. At the same time, the European Central Bank (ECB) is feeling similar pressure because the European economies have been contracting and their unemployment has been rising.

The developed nations are experiencing record and rising budget deficits leading to downgrades and the potential for additional downgrades. As a result, the cost of financing these deficits is rising. Standard & Poors (S&P) indicated that they may cut Britain’s AAA credit rating as debt heads toward 100% of GDP. Next year Britain’s debt will be 67% of GDP according to the IMF, the United States will be at 70% and the 16 nation Euro area will be at 68%. According to the Independent Institute for Fiscal Studies in London, rising debt costs will eventually crowd out funds available for roads, schools and hospitals.

Since there is no tangible asset backing any country’s currency, central banks are monetizing these deficits (printing money). This is contributing to raising the prices of vital and globally traded materials needed for economic growth and industrialization, such as oil and copper. We are also witnessing a continued increase in the price of gold which has appreciated over several years and is increasingly being viewed as a store of value.

In a difficult economic environment, it is critical to invest in needs first as any increase in consumption will initially go to the areas of greatest importance. Among these are food, energy, infrastructure, defense, healthcare and increased productivity. Investors should be best served by remaining disciplined in identifying undervalued assets in each of these areas. With respect to fixed income securities, we continue to emphasize the importance of shorter-term maturities among investment-grade issuers and will continue to be selective in the use of treasury securities.

The development of a two-tiered market should not be a surprise where the beneficiaries become standout investment opportunities irrespective of broader market returns. This is true in both equity and fixed income investments as evidenced by the experience of 1973-1980. This is an environment for thoughtful security selection in a more complex global environment.

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