Category: The Outlook

The character of the post-crisis US economy augers well for a period of continued low growth, low inflation, low interest rates and rising corporate profits. One of the reasons this period has been so challenging for investors is that we are operating in an economic and investment environment that is unprecedented.  While certain characteristics of this period are reminiscent of those past, there are critical differences as well.  Few investors have operated in an environment that enjoyed the prospects for reaccelerating US manufacturing growth along with expectations of continued low inflation and near zero interest rates for a sustained period of time.  The political dysfunction in Washington highlighted by the debt and deficit debate will likely continue to be a major distraction for investors until a long-term solution is established, but investors who take a longer-term view should be well rewarded.

The US economy is slowly but steadily improving, and that is more important in our view than the distractions often written about in the news media.  New technology in energy exploration and recovery along with decelerating growth in emerging markets is relieving pressure on commodity prices and providing an important stimulus for the US economy which is more than 70% consumer-spending driven.  This stimulus (in the form of lower gas prices and moderating food and heating bill inflation), along with low interest rates, is making homes and automobiles more affordable and tempering the negative headwind of consumer deleveraging that has been occurring since the financial crisis.  Lower energy costs are also making US manufacturers more cost-competitive and stimulating new manufacturing investment.

At the same time, structural headwinds discussed in this Outlook are keeping unemployment stubbornly high which is suppressing wage increases.  The combination of stable-to-falling commodity prices with stagnant wage rates is keeping overall inflation low and allowing the Federal Reserve to maintain its current accommodative monetary policy.  Most economic cycles are ended when rising inflation prompts central banks to raise interest rates to slow growth.  However, we expect low inflation to stay in effect for some time, creating the prospect for a prolonged economic expansion, albeit with lower growth than we were accustomed to in prior decades.  It is the unusual combination of these economic factors that make this cycle unique.

Many might assume that structural headwinds to more rapid economic growth would be negative for stocks because of reduced prospects for revenue growth.  However, a climate of low but steady growth, but also low inflation and lower interest rates (in contrast to shorter cycles of “boom and bust”) can, in fact, be favorable for equity markets, leading to gradual multiple expansion where investors are willing to pay higher prices for a given company’s earnings, cash flow and assets. This is particularly true in light of the relatively less attractive comparable offerings in cash and fixed income.

The Federal Reserve is likely to remain a major force in defining the current environment.  This view was reinforced by the recent nomination of Janet Yellen to become the next Chairwoman of the Federal Reserve.  The post-crisis policies of the Federal Reserve have been in reaction to and in anticipation of the structural impediments, and investors should expect Ms. Yellen to maintain a highly accommodative stance for as long as necessary for the Federal Reserve to meet its dual mandate of full employment and price stability.

Defining the Structural Impediments

Several structural headwinds are likely to prevent the US from achieving the 3-4% real growth rates experienced in the 1980’s and 1990’s, including high unemployment, wage stagnation and the need for consumers to deleverage.  While many will view these impediments as negatives for the market, the environment remains a positive one for equity investing, as described in this Outlook.  The following is a review of the key structural impediments facing the US today.

High Unemployment and Labor Market Issues

The US is experiencing chronic unemployment partially hidden by declining labor market participation rates and made worse by technology-driven productivity improvements.  This is a far more complex problem than the US Bureau of Labor Statistics’ (BLS) reported unemployment rate (known as U3) of 7.2% or 11.3 million people out of work would indicate. An example of the degree of the problem is that long-term unemployed (those jobless for 27 weeks or more) stands at 4.1 million persons or 36.9% of the unemployed.  The U3 measurement of unemployment understates the magnitude of the problem since it does not count those who have stopped looking for jobs as well as those forced to work part-time rather than full-time.  The broader measure, known as the U6 unemployment rate, totals more than 20 million people or 13.6%.

A fundamental issue is the mismatch between the skills needed for available positions and the skills available in the labor pool.  According to a new report by the Organization for Economic Cooperation and Development (OECD), the skill level of the American labor force has fallen dangerously behind its peers based on assessments of literacy, math skills and problem-solving.  The US needs to refocus its education system on the skills required to reduce the current level of unemployment.

Source: National Center for Education Statistics, “Literacy, Numeracy and Problem Solving in Technology-Rich Environments among U.S. Adults.”

 Other factors are also impacting the employment market, including the inability for US workers to move easily to other areas for a new job.  This had historically been a key advantage for the US in previous recoveries, but the collapse in the housing market made it more difficult for many workers to move to find employment because they were unable to sell their homes. Moreover, many companies were reluctant to hire new workers due to uncertainty regarding tax and fiscal policies.  Given the present rate of new job creation, it could take years to resolve the problem and return to acceptable employment levels.  The Federal Open Market Committee (FOMC) recently forecast that job creation would remain challenged, as the committee members are estimating it will take until the end of 2016 for the U3 unemployment number to return to a more normalized range of 5.2-5.9%, and this anemic rate of job creation could weigh heavily on Federal Reserve policy for a considerable period.

Wage Stagnation Issues

Further compounding the growth problem is the fact, that for most of the American population, wages have not grown in the past decade.  According to the Economic Policy Institute, during the period of 2002-2012 “the vast majority of wage earners has already experienced a lost decade, one where real wages were either flat or in decline.”  In fact, the real average hourly wages of workers with a college degree were lower in 2012 than they were in 2002 according to the BLS, and the college wage premium (the amount by which wages of college graduates exceed those of high school graduates) narrowed considerably. 

 

 

Consumer Spending Considerations

 

 

For those readers who are children of the depression or children of children of the depression, you remember the time when credit was used sparingly and usually for essential items and durable goods such as homes or cars.  Even after World War II, credit use, while rising, was measured and supported by large amounts of accumulated savings.  In the early-to-middle 1980’s, credit use began to accelerate, driving Gross Domestic Product (GDP) higher.  It was also around this time that the United States government lost its status as the world’s largest creditor nation and began the move to become the world’s largest debtor nation.  Debt use runs in both short and long term cycles, and will stimulate or slow economic growth.  When debt use is rising it tends to stimulate until such time that borrowers need to slow the use of credit and pay down the debt.   From the late 1990s up to the financial crisis in 2008, credit is estimated to have added 1.5% to GDP growth annually as people used their homes as ATM machines through the use of over $1 trillion of mortgage equity withdrawals.  At that time it was low interest rates and a flawed belief that housing prices would continue to rise that drove debt levels higher.

 

Since the financial crisis, debt reduction has been an important restraint on economic activity.  One area where this is manifesting itself is in the increasing use of debit card purchases.  The importance of this trend is that debit purchases do not add additional dollars to GDP, while increasing credit use does.  Under these circumstances, market participants can anticipate that economic growth in the US should remain muted by the loss of the rising credit that previously fueled the economy.

Source: Visa and MasterCard SEC filings.

 

Economic Consequences

In large part, to counter the structural issues described in this Outlook, the Federal Reserve has introduced a monetary policy not seen in investors’ lifetimes to stimulate the economy, avoid a severe recession or depression and buy time for the deleveraging process to work through the system.  As we have highlighted, this environment is distinct in its character, and therefore investors need to view this investment climate through a different lens than previously used on the US economy. There are some important economic consequences for the United States as described below.

 

Low Inflation for the Foreseeable Future

 

 

Several deflationary forces are at work in the US economy allowing monetary policy to remain highly accommodative and support the argument for a prolonged period of muted growth.  The Federal Reserve would not be able to maintain low interest rates or its quantitative easing (QE or money printing) program if the economy were experiencing inflationary pressures.  Among the forces suppressing inflation are lower energy costs, lack of wage growth and lower import costs.  US corporations and consumers have seen a reduction in costs as the energy sector has dramatically reversed decades of production declines leading to lower levels of energy imports.  It is estimated that for every ten cent decline in gasoline prices, US consumers benefit by about $13 billion.  Moreover, US manufacturers are paying less than $4.00/MMBtu for natural gas compared with $11.00/MMBtu in Europe and $16.00/MMBtu in Asia, providing a key manufacturing cost advantage versus their foreign competitors.  High unemployment and wage stagnation are also deflationary forces.  In the 1970’s, guaranteed cost of living adjustments (COLAs) for many employees drove up labor costs annually.   As noted above, the US has not experienced any wage pressures for nearly a decade and the supply and demand dynamics of the labor market will suppress upward wage pressures for some time.  Finally, the slowdown in the emerging economies, particularly China, is resulting in lower commodity prices, and therefore we are importing less inflation.  Lower energy prices and import costs are good for consumers and corporations because it increases their discretionary income.

 

 

Historically Low Interest Rates

 

Lowering interest rates is usually the first response by a central bank to slowing growth  and typically the economy responds fairly rapidly, often within two to three quarters. Even though the US already had relatively low interest rates at the start of the financial crisis, the Federal Reserve introduced a Zero Interest Rate Policy (ZIRP) to cushion the economy and stimulate growth.

 

 

Historically, economic recoveries in the United States have been led by the auto and housing sectors, and both have played a key role in aiding the current US recovery.  The housing and auto sectors are major beneficiaries of the ZIRP initiative which is allowing for a once-in-a-generation financing opportunity for consumers.  As the absolute yield level and the duration of record low rates are unprecedented, investors should not underestimate the impact of a prolonged period of low interest rates on the economy and on consumer behavior.  This policy discourages savings, fosters investment and promotes consumption.  As indicated in the charts below, mortgage rates are now at a level not seen since the 1950’s and auto financing rates can be obtained at very low levels.  Americans refinanced nearly $6 trillion of mortgage principal since 2008.  For every 1% reduction in mortgage rates, consumers will save $60 billion in annual interest payments, increasing their discretionary incomes meaningfully.  The rates to finance the purchase of an automobile are also quite attractive, which has helped the industry recover considerably since the crisis.  General Motors recently reported that it is running at the highest capacity utilization levels of any time in recent history with more plants scheduled to add a third shift to move to full production in the coming months. The proportion of GM’s North American plants operating at full capacity (53 percent) is more than twice the level of 2006 (26 percent), which was near the top of the previous cycle. Importantly, corporations have been refinancing higher cost debt at significantly lower rates and the savings on interest costs drop directly to the bottom line.

 

 

One of the uncertainties weighing on the markets in recent months had been the naming by President Obama of the successor for Ben Bernanke as Chairman of the Federal Reserve. In the post-crisis economy, this is a particularly important appointment as the Federal Reserve has employed aggressive and unconventional monetary policy to stimulate the economy in the face of the structural impediments and inadequate fiscal policy.  The next Chair will be the one responsible for managing a major transition to a more normal monetary policy.  It is important to bear in mind that the Fed’s balance sheet has grown from $900 billion to over $3.75 trillion over the past 5 years and at some point should be reduced.  Vice Chair Janet Yellen was recently nominated to replace Mr. Bernanke and is expected to be confirmed as the first woman to lead the Federal Reserve.  Ms. Yellen has been with the Federal Reserve for several years, and her background is well-suited for the challenges ahead.  One reason is that she has been instrumental in the implementation of the policies in place today.  Another is that her economic studies focused on the causes, mechanisms, and implications of unemployment which, as described above, remains one of the key issues facing the US.  The FOMC has previously stated that it would not reduce its accommodative stance until such time as the employment situation has demonstrated significant structural rather than cyclical improvement including the broader measure of U6 unemployment.

 

 

The two key elements of current monetary policy are the ZIRP and the printing of money (quantitative easing) which have been in place for far longer than many anticipated.  A close reading of the FOMC minutes over the past few years provides important insights into the members’ concerns about unemployment, deflationary forces and the slow growth trajectory of the economy.  The initial market expectation was that these policies would be relatively short-term initiatives.  Looking ahead, unless the economy’s growth meaningfully accelerates,  it is our expectation that any tapering of bond purchases will likely be measured, small in scale and quite possibly delayed for several months.  As we have written for several years, ARS would expect interest rates to remain low for an indeterminate period.  Unless there is a significant change in fiscal policy, present monetary policy will be required to remain in place.

Investment Implications

As we head into November, we are constructive on the potential for equity returns driven by price earnings multiple expansion resulting from the distinct characteristics of the prolonged, low-growth business cycle described in this Outlook. This view is further supported by other positive factors for corporations including record corporate profits, fortress balance sheets and increasing cash flows as well as corporate activity including mergers & acquisitions, share repurchases, and dividend increases. Due to some of the uncertainties surrounding the dynamics of the global economy and long term US fiscal and tax policy, corporations are generally investing cash for the most certain shorter-term economic results rather than investing where future uncertainties make commitments more difficult.  Taken in the aggregate, these factors create a favorable environment for equity selection as a combination of low interest rates and low inflation levels will tend to drive higher valuations for businesses with strong and stable growth characteristics.  The outlook for anemic yields on cash and fixed income investments presents a compelling case for capital to flow into equities.

Based on this Outlook, we are constructive on the equity markets and in particular on the following themes: America’s industrial and manufacturing resurgence; energy companies and the beneficiaries of the US shale gas development; the evolution of media consumption and the importance of proprietary content; growth in mobility and data; the financial, housing and auto recovery; companies with attractive and growing dividends; and companies with special situations or company-specific drivers.  Due in part to the challenges of the global economy, US small and mid-capitalization stocks have been strong performers  and are attracting continued interest as they often derive most of their revenues from within the US.   While the global economy is also in a low growth mode, those US companies with strong earnings growth should continue to be well rewarded.

The past few years have seen a significant shift in the trajectories of the major global economies.  After coordinated efforts to reflate the global economy following the 2008 crisis, the cumulative effects of monetary and fiscal policy have put the US at the forefront of a successful emergence from the financial crisis relative to Europe and Japan.  At the same time, China and the commodity-driven economies are struggling to rebalance their economies while maintaining acceptable growth rates. The US is undergoing a robust recovery in the housing, automotive and industrial sectors, making it an attractive market in which to invest.  Among the key factors driving US industry is the energy sector’s ability to dramatically reverse decades of production declines which is resulting in lower energy prices and giving domestic manufacturers a significant production cost advantage.  US corporate profits are also benefitting from lower capital costs and limited labor inflation, which are the same factors that are allowing the Federal Reserve to maintain its near-zero interest rate policy and creating the conditions for a potentially extended business cycle.  The current combination of benign inflation, low interest rates and rising corporate profits is conducive to valuation multiple expansion and is favorable for equity investing.

The divergences in global monetary and fiscal policies in recent years have impacted the respective recovery rates of the major economies, and in turn, the relative prices of currencies, equities and fixed income securities.  Although we continue to believe that interest rates will remain below historical norms for several years, it is notable that the Federal Reserve is now in the position to discuss the tapering of monetary stimulus as a result of a still fragile but improving economy.  In contrast, Europe continues to require a highly accommodative monetary policy to reduce unemployment, deficits and debt loads.  Japan recently implemented aggressive monetary and fiscal policies designed to reverse its decades-old deflationary economy.   China, now the world’s second largest economy, is attempting to stabilize growth at or above 7% while introducing much needed reforms, de-emphasizing fixed asset investment and rebalancing its economy between investment spending and consumption.

Despite a recovery that has been slower than those experienced in past cycles, the US is better positioned relative to other major economies with which it competes for capital.  Besides having the world’s largest economy, the US has many distinguishing characteristics, including the world’s most advanced and deepest capital market system, the most entrepreneurial and adaptive society, positive demographic trends, a good resource base (food, energy and water), a well-established legal system with respect for contract law and, for all its challenges, one of the most stable political systems.  Additionally, and somewhat counter-intuitively, the US is also a beneficiary of many of the challenges currently confronting other economies.  In the US, consumer spending accounts for over 70% of GDP, whereas exports account for less than 15%.  Therefore, the US benefits disproportionately from having a stronger currency that increases the purchasing power of consumers.  The relatively stronger recovery of the US economy has helped to strengthen the US dollar.  A stronger dollar combined with slower growth in infrastructure spending in China is helping to suppress the price of commodities, which represent the most volatile component of inflation.  Lower commodity inflation in turn is helping consumers and allowing the Federal Reserve to maintain an easy monetary policy.  Historically, divergences such as the one we are seeing today between the US and other major global economies have created some of the best investment opportunities for active investors.

The Interdependence and Interrelations of Global Economic Policy

In the period following the 2008 financial crisis, fears of a global depression caused governments and central banks around the world to develop a coordinated response.  The result was arguably the most extensive policy response in history with over 600 monetary and fiscal stimulus programs implemented.  Central banks created trillions of dollars in new currency and liquidity and these efforts were further supported by aggressive fiscal stimulus programs.  Five years later, the global economy is in a very different place and governments are even more focused on protecting their respective self-interests.  The following provides a brief perspective on the impact of the policy actions taken by the US, Europe, China and Japan in response to the unique situation in each economy.

The United States

“The economic recovery has continued at a moderate pace in recent quarters, despite the strong headwinds created by federal fiscal policy. Housing has contributed to recent gains in economic activity. Conditions in the labor market are improving gradually. CPI has been running below the Committee’s longer-run expectations.”
– Federal Reserve Chairman Ben Bernanke, 7/17/13

In recent decades, increasing credit levels helped to fuel spending and support economic growth. Going forward, the US will likely experience a more muted growth rate as a consequence of little or no wage growth for most workers, structurally high unemployment and private and public-sector deleveraging.  Due to the fragility of the economic recovery, some Federal Reserve officials worry that a premature withdrawal of stimulus from the system could be more damaging than an extended easy-money policy.  Because the US faces considerable structural headwinds which will prevent the economy from easily returning to its former growth rates (3-4%), ARS continues to believe that interest rates will likely remain historically low for a considerable period of time.

Even with the challenges described above, the US is further along in its recovery than much of the developed world.  Reflecting this divergence, the Federal Reserve has discussed beginning to taper its bond purchases over time while other central banks continue to see the need for aggressive stimulus.  Consequently, capital is flowing into US dollars which is helping to strengthen the dollar relative to other currencies.  The recovering economy is also lifting tax receipts and lowering the budget deficit, which is further supporting the dollar.  These trends are self-reinforcing, as a stronger dollar in turn benefits the US consumer-driven economy.  The highly accommodative monetary policies in other markets combined with the resilience of the US economy, low inflation and improving economic conditions should continue to attract capital in the coming quarters.

Europe

“The euro area still faces considerable challenges. The economy is still weak.  The Governing Council stressed that the monetary policy stance will remain accommodative for as long as needed.”
– ECB President Mario Draghi, 7/8/13

“As long as inflation remains subdued, [our] forecast for low interest rates will remain in place; this was unanimous; all interest rates are part of the statement; liquidity will remain abundant and stay ample as long as needed.”
– ECB President Mario Draghi, 8/1/13

Since taking over as ECB President in 2011, Mario Draghi has introduced monetary policies similar to those previously initiated by the Federal Reserve in an attempt to stimulate the European economy and offset the aggressive austerity initiatives that were being implemented by several European nations.  The Federal Reserve began its easing program nearly 2.5 years earlier, which explains in part why the US is ahead in its recovery.  It was only 12 months ago that Mr. Draghi issued his now famous “whatever it takes” statement to support the Euro and reduce fears of a break up.  While some progress has been made by European nations to spur a  recovery, political and structural challenges remain and several more years will be required to sufficiently reduce debt, lower unemployment and restructure individual economies.  Unfortunately for Europe, the relative attractiveness of the US economy is drawing capital to the US markets.  This is a form of monetary tightening on those nations experiencing capital outflows.  So it was not a surprise to hear Mario Draghi indicate that he was going to maintain a low interest rate environment for the indeterminate future to make the European economies stronger and to relieve pressure on the over-indebted southern-tier economies as Europe continues to play catch-up to the US.

Despite ongoing challenges, there is some evidence of a nascent recovery in the European economy, such as the recently improved purchasing managers index (PMI) readings that suggested a shift from contraction to expansion.  This may present an opportunity for select European-related investments as well as for US companies with significant exposure to Europe, although we will need to monitor closely for signs that improvement will be sustainable.

China

“China is in a phase when it must rely on economic transformation and upgrading to maintain continuous and healthy development. Through stabilizing growth, we can create room and conditions for restructuring and advanced reform.”   – Premier Li Keqiang, 7/9/13

“We need to prepare for all kinds of complicated and difficult situations as the domestic and international environment is highly complicated.”             

– According to an official statement from the Government, 7/30/13

 

Since 1990, China’s GDP has grown from $390 billion to $8.2 trillion reflecting one of the great industrializations in history as over 300 million people migrated from farms to cities.  However, a disproportionate amount of China’s GDP growth has come from government-led infrastructure outlays driving investment spending to nearly 50% of GDP—an unprecedented level for a major economy.  China’s government-led expansion fueled a major boom in commodity prices, and as China became the price-setter for commodities, it exported inflation to the global economy.  China’s rapid growth also brought challenges in the form of income inequality, corruption, environmental degradation and impairment of basic social needs.  The government now faces the difficult challenge of transitioning the economy from one which relied on exports and government spending, often debt-driven, to a more consumption-oriented one.  According to Premier Li Kegiang, China will focus on GDP, jobs and inflation.  It is taking some small-scale steps to stimulate and stabilize its economy including pumping $2.5 billion of cash into its banking system and announcing a review of the risks of local government debt.  Some of the top priorities for the government are preventing social unrest and fostering sufficient employment during this transition.

As part of the government’s 5-year plan, it mandated significant multi-year wage increases for workers, but as a consequence is reducing its low-cost competitive labor advantage versus other nations.  China’s environmental issues are increasingly at the forefront of both media headlines and leaders’ concerns, and the resulting regulation is leveling the playing field for developed-market companies that compete with Chinese manufacturers.  In short, China is willing to tolerate slower growth to achieve a more balanced set of policy goals.  If China’s growth can stabilize near its current target of 7%, it will still be a material contributor to global growth.  At China’s current size, 7% growth in dollar terms (estimated in excess of $500 billion) would contribute significantly more than a decade ago when China was growing in the double digits but from a smaller base. Moving forward,  the beneficiaries of China’s GDP growth will be quite different from those of the past decade.

Japan

“Japan faces structural issues – firstly, to extricate itself from deflation; secondly, to improve labor productivity; and thirdly, to maintain fiscal discipline. These threefold structural issues must be resolved simultaneously, and growth is a necessary condition for success.”

– Japan’s Prime Minister Shinzo Abe, 6/19/13

 

Japan has experienced two decades of deflation which has taken a toll on its leadership as evidenced by the fact that it has had 6 prime ministers in the last 6 years.  In response, Mr. Shinzo Abe has introduced an aggressive combination of monetary and fiscal policy in an attempt to weaken the yen to boost exports and to reflate the Japanese economy.  The “three arrows” of Abe’s economic policy are aggressive monetary easing, flexible fiscal spending and a growth strategy that would induce private investment.  The Japanese stock market has responded well to the policies, but it remains to be seen whether they will be sufficient to provide a sustained recovery.  These policies may in fact be too little, too late, as the half-hearted stimulus measures of the last 20 years have left Japan heavily indebted and vulnerable to higher interest rates.  Avoiding Japan’s deflationary experience of the last two decades is an important driver behind the thinking and policies of Mr. Bernanke and Mr. Draghi.

Reflecting on the challenges and recovery progress of the important global economies highlights the relative strength of the US today.  This is leading to a return of the US as arguably the most attractive opportunity for equity investment—a condition that we believe has the potential to sustain itself for a significant period of time.

US Corporate Profits and Valuations

We expect that US corporate profits will continue to increase over the next several years.  As highlighted in the chart below, US corporate pre-tax profits have risen from $903.5 billion in 2003 to $1.36 trillion in 2008 to almost $2.2 trillion today.  In past Outlooks, we have discussed the manufacturing renaissance that is taking place as evidenced by manufacturing pre-tax profits having grown from $131 billion in 2009 to $360.8 billion as of the first quarter of 2013.  With interest rates remaining at low levels US corporations have also been able to refinance debt at cheaper costs allowing managers to repurchase stock, reinvest in their businesses and drop remaining savings to the bottom line.  Although profit growth slowed in the second quarter, we expect that a gradual and non-inflationary expansion of the US economy combined with recoveries in other major markets will be supportive of profit growth over the intermediate term.  Importantly, low interest rates are making equities more attractive relative to fixed income, and so long as inflation remains contained, a persistent low-rate environment should be favorable for equity valuation multiples.

Corporate Profits (2003 – 2013)

The Energy Industry Loses a Pioneer

In our April Outlook, ARS discussed in detail the energy boom and its impact on the US economy.  We note the recent passing of George Mitchell, who was a pioneer in US natural gas fracking, exploration and development. Mr. Mitchell, the founder of Mitchell Energy (later sold to Devon Energy), was an important voice for sensible and environmentally responsible growth of US energy resources.  It was through the efforts of entrepreneurs such as George Mitchell combined with the increasing use of new fracking technologies that have allowed the US to reverse nearly four decades of energy production declines.  According to the NY Times, “fracking and other unconventional techniques have doubled North American natural gas reserves to three quadrillion cubic feet … These same techniques have been applied to oil and a well that would have produced 70 barrels a day using conventional drilling can produce 700 with fracking.”

Investors should not dismiss the intermediate and long-term impact of the energy revolution on the US economy.  In 2008, the US produced about 5 million barrels of oil per day but thanks to new technology, production has increased 50% to 7.5 million barrels per day, growing by 1 million barrels per day in just this past year.  This means that the US will be importing a million fewer barrels per day this year than last, reducing import costs by approximately $35 billion dollars and allowing those dollars to be repurposed toward more productive uses.  As oil and gas production has increased, the US industry has embarked on a massive, multi-year investment program to move oil and gas from where it is now being produced to where it is needed and the US reserve base has risen dramatically.

Because the US has become a low-cost energy producer, the country has a decided advantage in manufacturing for those businesses that have a high energy cost component.  The consequence is that US manufacturing is expanding.  By way of example, over the past few years more than $100 billion in new plant investments have been announced in the US chemical industry alone.

Investment Implications

One of the defining characteristics of the lost decade in US equities was the industrialization of the developing economies and rapid pace of globalization which drove capital out of US stocks and into emerging markets.  It was the ability to recognize this shift that allowed some investors to outperform the US stock market from 2000-2010.  As described above, China is experiencing difficulties after this period of rapid growth, and the pendulum has swung back in favor of the US.  This transition is further enabled by the end of the commodity boom this past year as the US now imports less inflation. We have been asked how US companies will perform when China is slowing and Europe is struggling.  Our view is that the US economy is more than 70% consumer-driven and in many ways is benefitting from the lower inflation caused by current conditions in those economies.  Further, many US companies, especially small and mid-capitalization businesses that tend to rely more on domestic consumption than global sales, stand to be important beneficiaries.  In the context of a slowly improving economy, fixed income is less attractive relative to equities on a risk/reward basis.  Fixed income investor sentiment turned decidedly negative in June as evidenced by the $76.5 billion outflow from bond funds during that month.

The combination of factors described above leads us to a positive view of the opportunity for investors to benefit by investing in US equities which offer growth, rising dividend income or both.  As we head into the second half of the year, it is possible that we will see renewed focus on the significant political dysfunction in Washington; however, we expect any short-term disruption to be viewed as an additional opportunity for capital sitting in cash to be invested into equities.  We believe long-term investors should be well rewarded by owning companies benefitting from this outlook.

 

 

 

 

Throughout our 40-year history, the firm’s views on inflation, interest rates and corporate profits have been fundamental to shaping our Outlook and investment portfolios. Today, it is our view that the forces of disinflation remain powerful and have important implications for portfolio strategy. We continue to anticipate low interest rates for possibly several more years as the Federal Reserve targets for inflation and unemployment are not likely to be reached until at least 2016. Clearly macro concerns remain; however, there are distinct positive secular and cyclical trends taking place in the US today, and corporate profits, margins and market valuations should be strong for those industries and select companies that are best positioned to benefit.

These positive secular trends, which are important drivers of the Outlook, include:

For the past three quarters, ARS has expressed the view that event-driven or general economic concerns were masking several positives in the US and around the world.  The global economy has proven to be more resilient than many expected due to several factors including historically low interest rates and inflation rates, aggressive policy actions, and gradual improvement of several important economic indicators in the US (housing, unemployment and consumer confidence) and China (inflation and manufacturing). Further, there even have been signs of changing sentiment towards Europe, which has weighed heavily on the global economy the past few years, as yields in the most economically challenged countries have declined from crisis levels.  In recent months, central banks have embarked on a yet more expansive monetary policy at a time when the global business cycle is showing signs of reaccelerating.  Unlike previous business cycles where central bank policy was neutral to becoming restrictive as conditions improved, central bank policy is now designed to address the chronic unemployment problem in the developed world which has negatively impacted economic output.  There are several positive developments in the world’s second (China) and third (Japan) largest economies which should aid global growth this year.  These and other forces discussed in this Outlook have the potential to reverse the multi-year trend of fund flows from equities into fixed income. In recent weeks, two of the world’s most powerful institutions – the US government (the world’s largest borrower) and the Chinese government (the world’s largest lender) – have sent important messages to market participants that will have broad implications for investors in 2013 and beyond.  Since the introduction of its zero interest rate policy (ZIRP) and quantitative easing (QE), the Federal Reserve has made it clear that its policies are designed to favor borrowers (governments, corporations and homeowners) by devaluing the massive amounts of debt outstanding, while attempting to inflate asset values.  These same policies are negatively impacting lenders (bondholders), especially those living on a fixed income and pension funds that cannot meet their required rates of return.  The impact of the Fed policy is not lost on China, nor should it be on other investors.  To be more specific, China intends to increase its ownership of non-Chinese corporations by diversifying out of fixed income investments.  Since the US and China represent about 34% of global gross domestic product (GDP), the policies implemented and investments made by these two nations impact the rest of the world. With anemic and in some cases negative real rates of return on fixed income and a global economy that continues to grow, we may soon be in the early innings of a rotation of dollars from fixed income to equities.  For investors with the ability to differentiate between the headline stories and real economic activity, there are important investment opportunities as the global economy reaccelerates.

Short-Term Concerns Creating Long-term Opportunities

The uncertainty of the past two years had investors shifting out of the equity markets and flooding to the perceived safety of bonds ignoring the fact that many bonds were offering and still provide negative real rates of return (inflation adjusted) over time.  Investors have been worried about a range of issues from the US to Europe to China.  When pressed about concerns, investors cite one or all of the following topics which are frequently discussed in the media: the US fiscal cliff, the debt and deficit problems of the US and Europe, the slowdown in China in 2010-2011, the 20-year malaise of the Japanese economy and escalating tensions in the Middle East.  In 2013, one of the critical issues for investors to monitor will be movements in inflation as it is the low levels that allow developed nations’ central banks to maintain their aggressive monetary policies and for developing economies to focus on fostering growth. Short-term concerns regarding the US have created the very conditions for investors to reallocate to relatively undervalued US equities from bonds.  There are several large sources of assets (individuals, pension plans), a portion of which we believe will rotate out of cash or fixed income into equities.  In addition to a portion of China’s growing foreign exchange reserves which are being shifted into equity assets, there is in the US approximately $2 trillion of corporate cash, $3 trillion of money fund assets and large amounts of bond maturities coming due in the next several months.  Importantly, there is also more than $7 trillion held in FDIC insured accounts and the unlimited FDIC insurance coverage for non-interest bearing transaction accounts ended January 1st.  With the aggregate equity market capitalization of the US at approximately $16.6 trillion, a meaningful portion of these assets returning to equity markets in the pursuit of higher real returns as the global economy expands would have a significant impact on common stock prices.

Reflections on US Debt and Deficits

Our analysis of the Office of Management and Budget (OMB) report shows that as long as we are running $1 trillion deficits, the statutory debt limit (also know as the debt ceiling) will need to be raised by at least $1 trillion annually, and that will likely mean a fight in Congress each year unless a long-term deal is struck to reign in the deficits or the annual debt ceiling is eliminated.  Unfortunately for Americans, figures from the OMB show debt reaching $19.4 trillion by the end of 2015 with deficits declining from an estimated $1.326 trillion to $609 billion prior to the most recent fiscal cliff agreement. These assumptions do not take into account an increase in the deficits due to the extension of the Bush tax cuts for incomes of less than $400,000 (individuals) or $450,000 (joint).  The OMB had previously assumed we will be adding $3 trillion to our national debt.  Among the many troubling assumptions had been for interest rates on the debt in 2015 to average 1.9% with the additional $3 trillion issued at approximately 0.50%.  As a result of the recent legislation, the deficits will increase further unless there are significant cost reductions agreed to which we will not know until February or March when the Treasury will no longer be able to maneuver around the debt ceiling.  In light of recent developments, the analysis of the OMB projections makes it hard to see how many of these assumptions can come to pass.

Changes in Key Economic Figures 2002 – 2012 – 2015

For investors, there are four important implications. First, the solution to the deficit can best be achieved through a meaningful revamping of the receipts (tax reform) and expenditures (addressing entitlements) over the intermediate to long-term to get our fiscal house in order.  Second, the Federal Reserve could be forced to attempt to maintain its current interest rate policy to control interest costs for some years.  Third, bond investors will be challenged to achieve positive real rates of return in the coming years.  Fourth, ownership of businesses, equity investing, offers better relative value and improved prospects for building capital and protecting purchasing power over the longer-term.

The New Playbook for Central Bankers

“Central banks should consider more radical measures – such as commitments to keep rates on hold for extended periods and numerical targets for unemployment – when rates are near zero. If yet further stimulus were required, the policy framework itself would likely have to be changed.”  – Mark Carney, the next governor of the Bank of England 12/11/12

“The Committee currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”– Statement from the FOMC meeting 12/12/12

“I will direct the energies of my entire cabinet towards implementing bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment.” – Shinzo Abe, the new prime minister of Japan 12/26/12

With interest rates at historic lows for the foreseeable future and massive quantitative easing (currency creation) being implemented in many developed nations, central bankers are reinforcing the fact that they will do whatever it takes to avoid deflation.  Prior to the 2008 financial crisis, managing inflation was the cornerstone of monetary policy as bankers would raise rates to curb inflation and lower rates to stimulate growth and improve employment.  The new toolbox for central bankers in developed nations includes greater international cooperation, longer-term currency swap arrangements, zero interest rate policies, unprecedented amounts of currency creation and a rethinking of the policies that have been the norm for decades.  Because the developed world is undergoing the largest deleveraging in history with record deficits, austerity policies have required central banks to take it upon themselves to combat deflation and contraction.

From the comments above, it is clear not only that the mindset of central bankers has changed, but there is a willingness to break free from the old methods and to aggressively work to stimulate their respective economies. To date, monetary policy has carried much of the burden as global fiscal policy has not been sufficiently stimulative.  At the forefront of unconventional policy is Ben Bernanke of the Federal Reserve who has been the most aggressive in implementing tools including the recent open-ended QE 3 program, and now he is being joined by others such as Mark Carney and Mr. Abe as illustrated by the quotes above.  This past July, the ECB’s Mario Draghi made his now famous pledge to do “whatever it takes” to preserve the Euro.  In Japan, Mr. Abe is pressuring the Bank of Japan (BOJ) to target a 2% inflation rate from the current 1%, and launch a program of “unlimited” quantitative easing to fight the more than decade-long deflation and to weaken the yen to boost exports.  In addition to monetary initiatives, Mr. Abe is planning to introduce large-scale fiscal stimulus.  Japan has had 5 recessions in 15 years and now has gross public debt to GDP of 236% with little to show for it.  The market has responded in anticipation of proposed actions by Japan as evidenced by the weakening of the yen.  The proposals by Mr. Abe also call into question the independence of the BOJ and will be closely watched by others.  The actions of the US and Japan may force the ECB and European governments to respond with additional measures as the strengthening of the Euro raises the price of exports and negatively impacts the competitive position of European companies.  We are reminded once again of the interconnections and interdependencies in the global economy.

Impact of Global Monetary Policy on China

“With foreign reserves of $3 trillion in hand, we will not sit back and watch the assets depreciate with the third round of quantitative easing. We must inject it into the real economy and make our contribution to global prosperity. An increase in overseas investment by Chinese companies is an inevitable trend.”  – Chen Deming, Commerce Minister of China (November 2012)

Although China may be concerned about its contribution to global prosperity, much of the concern stems from its ability to export to the rest of the world as it remains the world’s leading exporter.  In order to serve its long-term interests, China will work to secure the resources it needs to meet its goals.  While central banks are working on a new playbook, China has developed its own focusing on strategic overseas acquisitions.  It is not interested in receiving little short-term return on its fixed income investments and risking significant loss of purchasing power over the longer term.  The comment from the Minister of Commerce provides critical insight into the nation’s current plans to reduce its foreign reserves by investing in non-Chinese companies that will support its long-term priorities and achieve a sustainable level of growth.  There are several recent examples of this strategy including the China Investment Corporation’s (CIC) acquisition of the 10% stake in the company that owns London’s Heathrow airport.  CIC was established in 2007 to invest some of China’s foreign exchange reserves.  In perhaps its largest overseas acquisition to date, CNOOC, the China National Offshore Oil Corporation, received approval from the Canadian government to acquire Nexen, a Canadian oil and gas company, for $15 billion.  In addition, PetroChina purchased a stake in the Browse liquefied natural gas project in Australia for $1.63 billion.  These acquisitions are consistent with the government’s 5-year plan to 2015 which has identified seven strategic emerging industries which serve as a guide for political and economic policies.  These are energy conservation and environmental protection, new information technology, biotechnology (medical and agricultural), high-end manufacturing (aviation, rail, smart grid, machinery), renewable and alternative energy, new materials in support of emerging industries and new-energy vehicles.

As the world’s second largest economy and one of the most important contributors to global GDP growth (estimated to be between $420 billion and $560 billion), China has recently announced a once-in-a-decade leadership transition, and we are beginning to see some important areas of focus—reducing corruption and rebalancing its export-dependent economy. At this stage of its industrialization process, China has to carefully balance growth programs (fiscal stimulus) with managing inflation (monetary policy), while working to migrate another 300 million people to cities from farms over the next 20 years which is a key initiative to increase domestic consumption and living standards.  Similar to other rapidly-industrializing countries, China experienced several policy missteps in recent years leading to a rapid rise in inflation in 2011, and government officials will be working to avoid a repeat through more effective monetary policy and tighter controls around housing and improved lending standards. China is adjusting to its own version of the “new normal” which means that 10% or greater GDP growth may be a thing of the past, and the new expectation should be in the 5-8% range.  The significant decline in inflation from a high of 6.5% last year to around 2% last month has paved the way for a much more positive outlook for 2013.

Investment Implications

During the past 16 months over 325 stimulative policy initiatives have been implemented around the globe, including interest rate reductions, tax rate cuts, lower reserve rate requirements and quantitative easing initiatives.  The two key issues that have driven our investment thinking over the past few quarters have been the anticipated improvement of leading economic indicators (driven by these stimulus initiatives and lower inflation) and the massive monetization by central banks.  It has been our belief that the combination of these two forces has been underestimated by the markets as the focus of the media continues to be on negative headline issues.  ARS research will continue to identify those companies whose businesses are well positioned to increase earnings, free cash flow and assets in an economy that is expected to improve but nevertheless exhibits fits and starts due to the multitude of competing global forces.  Our research has identified several companies that we will be adding to portfolios in early 2013.  As we wrote in recent investment outlooks, ARS continues to favor the following areas:

Beneficiaries of the Revitalization of Industrial America:  A sea change for US industry and corporate America (about which we have written for six months) is underway.  Wage increases from overseas competitors, low natural gas prices and, for the first time in many years, increasing oil and natural gas production in the United States are contributing to a resurgence in US manufacturing and its competitiveness.  The current low interest rate environment also gives companies access to historically low-cost capital to finance expansion and pursue shareholder-friendly policies such as return of cash through dividends and share buybacks.  New technologies such as 3D printing are providing companies with the opportunity to bring elements of manufacturing back home. Apple and Ford have recently announced new US manufacturing initiatives which serve as excellent examples of the opportunities for US companies.

Select Media and Technology Companies: Internet traffic continues to swell and is expected to grow by a factor of four in as many years.  Mobility, cloud computing, machine-generated information and internet video are among the underlying drivers of internet use.  Data center companies and owners of wireless spectrum will be key beneficiaries as businesses and consumers demand access to data anytime and anywhere.  We also see opportunities in the media industry, which we believe is approaching an important inflection point as content companies (producers of original programming), are set to benefit from the emergence of novel distribution outlets.  High-quality content owners will benefit from an expanding customer base that can be serviced at negligible incremental costs, positioning them to benefit from the disruptive era in video distribution that is occurring.

Energy and Strategic Resource Opportunities: Equities in this sector rebounded in the third quarter after being hurt by several compounding factors over the past 12 months.  ARS believes that many of these factors are temporary in nature, but together they conspired to drive energy company valuations to the lowest levels in a decade when measured by valuations of cash flow and/or reserves, with several companies in ARS’ portfolios trading for less than 4x cash flow from operations.  These companies are well-positioned to benefit from a cyclical recovery in the US and the developing world as well as growing secular demand for energy in the developing world and expected increasing US reliance on natural gas in the coming decade.  The attractive valuations also make the mid-sized exploration and production companies appealing acquisition candidates to strategic buyers.  Importantly, some companies have shifted the emphasis of their capital deployment from purely long-term growth projects to a balance of growth and return of free cash flow to shareholders which we expect to be well received in the coming quarters.

Financials: Several forces have combined to lead us to add financials selectively to portfolios.  While US and European banks made headlines with trading losses, fines and regulatory issues in 2012, there continue to be opportunities to buy businesses at attractive valuations of earnings and tangible book value.  Several of these investments remain particularly well positioned to benefit from a continued recovery in the US housing sector and improvement of the US economy.

Dividend Growers:With interest rates at historic lows, investors should look to benefit from the attractive dividends currently available from select corporations with strong balance sheets and policies of raising payouts over time.  We note that S&P 500 companies have increased dividends each year from $196 billion in 2009 to an estimated $281 billion in 2012 for an increase of 43%.  Recent legislation has removed fears of dividend income being taxed at ordinary income rates as the new level will be up to 23.8% depending on the tax bracket.

Beneficiaries of Currency Devaluation: After a period of consolidation, 2013 should be another constructive year for gold prices, as efforts to devalue currencies are ramping up. The recent announcements by Japan to depreciate their currency may trigger another round of currency devaluation, and gold has tended to be a standout performer during such times.  The open-ended nature of the new QE initiatives makes the upside for gold quite different from recent years when these programs had a defined end.  We believe that gold and undervalued mining companies with growth potential, low production costs and strong cash flows should have continued representation in ARS client portfolios.

Opportunistic use of Cash: Because business cycles have tended to be shorter in the current environment of near-zero interest rates and fluctuating inflation, it can be prudent to periodically hold higher cash balances in accounts, particularly during times of greater market complacency and lower margins-of-safety in company valuations.  As importantly, it provides the buying power to be opportunistic to purchase shares of companies at attractive valuations.

For our clients and readers, the team at A.R. Schmeidler wishes you a happy, healthy and prosperous New Year.

AR Schmeidler is pleased to announce that Gregory S. Markel has joined our team as a Portfolio Manager and Research Analyst. With 24 years in the business, Greg is an experienced and respected investment professional having worked for several well-known asset managers including FrontPoint Stadia, State Street Research & Management and Fidelity.  He has a B.A. from Brown University and an M.B.A. from The Wharton School at the University of Pennsylvania. Please join us welcoming Greg to our firm. 

AR Schmeidler is pleased to announce the launch of our new website.  The new website offers easy access to current and past editions of the Outlook, as well as information about our firm’s history, investment philosophy, process and investment professionals.  Please visit our website at www.arsinvestmentpartners.com.

In our July Outlook, ARS expressed the view that many of the concerns of the global economy had been discounted to a meaningful degree by the markets, and that the pervasive focus on these issues was masking several positives in the US and global economy.  The economy has in fact shown more resilience than many expected, and the equity markets went on to post strong returns for the third quarter.  Significant challenges remain and will be with us for some time; however, at present, these challenges are balanced by several offsetting positive factors, including historically low interest rates, relatively low inflation, continuing monetary creation and the gradual improvement of several important US economic indicators, including housing and manufacturing indices.  In addition to the cumulative effect of global monetary and fiscal stimulus, we also see important structural improvements in the US economy, which we discuss in further detail below.  The Outlook calls for a low growth environment for both the US and global economy, and our research continues to target companies with the opportunity to increase earnings, assets and cash flows against this backdrop.

The magnitude and duration of the Federal Reserve’s policy in support of the economy is unprecedented in the monetary history of the United States.  The actions resulting from the September Federal Open Market Committee (FOMC) meeting provide investors with yet another indication that US economic and employment growth may be muted for several more years.  The Committee decided to keep short-term interest rates at near zero percent and stated that it anticipates that exceptionally low levels are likely to be warranted at least through the middle of 2015.  The FOMC will then have committed the United States to a minimum of seven years of historically low short-term rates.  When combined with the introduction of the third round of quantitative easing (QE), the Federal Reserve has made an open-ended pledge of its balance sheet to support its statutory mandate of maximum employment and price stability.  In what has been perhaps its strongest statement yet, the Committee told the markets that a “highly accommodative stance will remain appropriate for a considerable time after the economic recovery strengthens.”   This is a point reiterated on October 1st by Chairman Bernanke at the Economic Club of Indiana.

Several other central banks have also undertaken unconventional actions due to concerns about their respective economies.  Mario Draghi of the European Central Bank (ECB) delivered a strong message to the markets that the ECB stood ready “to do whatever it takes” to support the Eurozone economy through an aggressive monetary policy.  Furthermore, the Bank of Japan announced another $128 billion of quantitative easing bringing its total to over $1 trillion.  The scale and scope of these actions seemed unimaginable just four years ago and speak volumes about the economic challenges facing the global economy.

These actions have potentially played a role in boosting confidence, enhancing liquidity and bringing down certain interest rates; however, they are not without critics.  Ever-present with quantitative easing is the threat of inflation and competitive currency devaluation.  This concern was summarized by the Finance Minister of Brazil in a recent speech stating that the US QE initiatives are creating significant problems in currency management and might spark a “currency war”.  Aggressive monetary policy also takes pressure off the legislators and administrators to enact sound and responsible fiscal policy.

This Outlook addresses the impact of monetary and fiscal policy on interest rates, inflation and global growth prospects and the implications for investment portfolios.  Also included is an update on some of the positive secular changes taking place in the US that are balancing some of the obvious challenges, including most notably the pending fiscal cliff.

Central Bank Policy in the Absence of Sound Fiscal Policy

“In order to restore confidence, policy makers in the euro area need to push ahead with great determination with fiscal consolidation, structural reforms to enhance competitiveness and European institution-building.”
– Mario Draghi, President of the European Central Bank

“Monetary Policy, as I said many times, is not a panacea.  We’re looking for policy makers in other areas to do their part.  We will do our part, and we will try to make sure that unemployment moves in the right direction.  But we can’t solve this problem by ourselves.”
– Ben Bernanke, Federal Reserve Chairman

In the absence of effective fiscal policy and economic restructuring efforts by the developed nations, the central banks’ responses have needed to be sufficiently reflationary and forceful on their own to offset the economic contraction.  This is particularly true for Europe as many nations’ problems are growing worse each day.  At present, social unrest is rising as a record high 11.4% unemployment rate in the Eurozone has fed increasing discontent with the additional sacrifices being demanded as the price for further financial aid. These deleveraging and restructuring efforts are

destined to fail if the policies employed promote further contraction.  Additionally the politicians responsible for such policies will not be reelected.  Central bankers have recognized the need to buy time while they wait for fiscal and economic policies to be implemented to address the many imbedded structural issues preventing a sustainable recovery.

From the time he assumed responsibilities as President of the ECB from Jean Claude Trichet, Mario Draghi has consistently utilized unconventional monetary policy which reflects both the degree of the challenge and his MIT-orientation towards solving problems proactively.  From the introduction of the LTRO (Long-Term Refinancing Operations) last year to his bold statement this past August about keeping the Euro intact through QE and other initiatives, he has managed the political and economic issues deftly, but the coming months will test his skills as he attempts to promote a fiscal union.  Mr. Draghi’s actions along with signs of economic stability have bought time, but now Europe needs policy makers to become action-takers to resolve the crisis.  We believe that we have reached an important inflection point because policy makers are running out of time to address pressing needs.  This position was recently supported by IMF’s Christine Lagarde who warned against the possible excesses of austerity and suggested stimulative initiatives also be enacted.

While many may view the recent announcement of additional QE from the Federal Reserve as more of the same, the open-ended nature of this program makes it quite different.  As a student of the Great Depression and of the Japanese economy in the 1990’s, Mr.  Bernanke is of the belief that central bank response in each case was neither sufficient in amount nor duration.  The announcement of QE3 indicates that the Federal Reserve recognizes that its first two QE programs were not sufficient to move the needle on unemployment.  Many US politicians and some economists have criticized the use and the value of QE3 as well as expressed considerable concern about the inflation that could result.  The Federal Reserve is willing to accept higher inflation if it would be accompanied by rising employment and a strengthening of the housing market.  The Committee views food and energy inflation as transitory.  Mr.  Bernanke is focusing on increasing employment which would reduce the federal deficit by increasing tax revenues and lowering unemployment insurance costs.

The chart below provides the Federal Reserve’s assumptions for interest rates, inflation rates and unemployment rates extending several years and highlights the challenges facing the United States economy.  It is this data and these projections that influence the Committee’s policy decisions. 

One of the unfortunate consequences of the actions of the Fed is that they allow politicians to delay making the difficult fiscal policy decisions needed to address the structural problems of the US.  According to a recent Gallup poll, the approval rating for Congress hit a 38-year low with only 10% of Americans approving of the job Congress is doing.  Without stimulus from the Federal Reserve, the US might still be mired in a recession, and every politician’s job would be at risk, which sadly seems to be the prerequisite condition for action.  With the pending fiscal cliff almost upon us, policy makers cannot ignore the problem any longer.  The business community has been emphatic with congressional representatives about removing obstacles hindering growth. Immediately after the election, the winner will need to work with Congress to reach a compromise, something it has not been willing to do up to now.  A failure to orchestrate a compromise would result in higher taxes and lower government spending, leading to slower economic growth and an even greater burden on the Federal Reserve.

Investment Implications

Over 270 stimulative policy initiatives have been implemented around the globe during the past 12 months including interest rate reductions, tax  cuts, lower reserve rate requirements and quantitative easing initiatives.  The two key issues that have driven our investment thinking over the past several months have been the anticipated improvement of leading economic indicators (driven by these stimulus initiatives and lower inflation) and the massive monetization by central banks.  It has been our belief that the combination of these two forces has been underestimated by the markets as the focus of the media continues to be on the negative headline issues of Europe, China and the US.

ARS portfolios have benefited in recent months from the gradually improving economic trends, as well as particular portfolio initiatives.  We have been transitioning our China growth exposure from steel-related infrastructure investments to power and energy investments which are reflective of an economy entering a more advanced phase of industrialization.  We have also added investments in companies with rather unique competitive positions whose business activities are dependent on the global economy.  A third initiative has been to add to high-conviction holdings that the market had temporarily mispriced, including select financials, gold and energy securities.  Finally, we continue to find opportunities in special situations such as spinoffs.  As we wrote in recent investment outlooks, ARS continues to favor the following areas:

Beneficiaries of the Revitalization of Industrial America:  A sea change for US industry and corporate America is underway.  Wage increases from overseas competitors, low natural gas prices and for the first time in many years increasing oil and natural gas production in the United States are contributing to a resurgence in US manufacturing and its competitiveness.  A recent Boston Consulting Group report suggests that the US now has a competitive cost advantage over the UK, Japan and Germany, and that its disadvantage versus China is narrowing.  Key beneficiaries include energy-intensive manufacturers, users of energy feedstocks (such as chemical, fertilizer and manufacturing companies), pipeline companies and transportation companies, among others.  The current low interest rate environment also gives companies access to historically low-cost capital to finance expansion and pursue shareholder-friendly policies such as return of cash through dividends and share buybacks.

Select Media and Technology Companies:  Internet traffic continues to swell and is expected to grow by a factor of four in as many years.  Mobility, cloud computing, machine-generated information and internet video are among the underlying drivers of internet use.  Data center companies and owners of wireless spectrum will be key beneficiaries as businesses and consumers demand access to data anytime and anywhere.

We also see opportunities in the media industry, which we believe is approaching an important inflection point as content companies (producers of original programming), are set to benefit from the emergence of novel distribution outlets.  High-quality content owners will benefit from an expanding customer base that can be serviced at negligible incremental costs, positioning them to benefit from the disruptive era in video distribution that is occurring.

Energy and Strategic Resource Opportunities: Equities in this sector rebounded in the third quarter after being hurt by several compounding factors over the past 12 months.  ARS believes that many of these factors are temporary in nature, but together they conspired to drive energy company valuations to the lowest levels in a decade when measured by valuations of cash flow and/or reserves, with several companies in ARS’ portfolios trading for less than 4x cash flow from operations.   These companies are well-positioned to benefit from a cyclical recovery in the US and the developing world, as well as growing secular demand for energy in the developing world and expected increasing US reliance on natural gas in the coming decade.  The attractive valuations also make the mid-sized exploration and production companies appealing acquisition candidates to strategic buyers.  Importantly, some companies have shifted the emphasis of their capital deployment from purely long-term growth projects to a balance of growth and return of free cash flow to shareholders which we expect to be well received in the coming quarters.

Dividend Payers: With interest rates at historic lows and quite possibly set to stay there for longer than many anticipate, investors should look to benefit from the attractive dividends currently available from select US corporations with strong balance sheets and their policies of raising payouts over time.  Moreover, we expect companies to consider special dividend distributions before year-end.

Beneficiaries of Currency Devaluation:Currency devaluation or debasement occurs when governments manage debt service and other obligations through monetizing or printing currency.  During such periods, as the purchasing power of fiat (paper) currency declines, tangible assets and productive businesses tend to maintain their relative values to society and appreciate in currency terms.  For this reason, gold has tended to be a standout performer during times of currency debasement.  We believe that gold and undervalued mining companies with growth potential, low production costs and strong cash flows should have continued representation in ARS client portfolios.

Financials: Several forces have combined to lead us to selectively add financials to portfolios.  While US and European banks continue to make headlines with trading losses, fines and regulatory issues, the news flow and negative sentiment towards the industry is offering potential opportunities to buy quality businesses at unusually attractive valuations of earnings and tangible book value.  Several of these investments are particularly well positioned to benefit from a recovery in the US housing sector and a cyclical improvement in the US economy overall.

Opportunistic use of Cash: Because the business cycles have tended to be shorter in duration in the current environment of near-zero interest rates and fluctuating inflation, it can be prudent to periodically hold higher cash balances in accounts, particularly during times of greater market complacency and lower margins-of-safety in company valuations.  As importantly, it provides the buying power to be opportunistic to purchase shares of attractive companies at compelling valuations.

The Importance of Taking a Balanced View of the US

Elections bring to light many of the differences in beliefs about social and economic issues, and this election is being described as a choice between two different views for America.  Rather than focus on the choice and the differences, this is meant to provide a balanced view of the short and long-term concerns and opportunities that exist today and why, in the face of the many challenges, the US remains uniquely positioned for the future.  Elections are often divisive and this one certainly seems to be.  While many politicians are focused on getting re-elected, unemployment remains stubbornly high and a growing number of unemployed are giving up and leaving the work force.  What should be the top priority, creating jobs, is being put on hold.  The looming fiscal cliff is not being addressed and likely will not be until after the election.  Finally, businesses are putting hiring and spending on hold until they have greater clarity regarding taxes and regulations.

Against this backdrop, there are several near-term positives as well.  One of the least discussed and appreciated advantages of the low interest rate environment is that it is allowing the system to finance its current and longer-term needs at record low costs.  The three biggest beneficiaries are housing, financial institutions and corporations which are critical drivers of the economy.  Housing has been gradually improving, the financial institutions are in much better financial shape than just a few years ago, consumers have been reducing their debt burdens and industrial America is experiencing a resurgence. The US is taking advantage of its tremendous energy resources, our technology industry remains one of the most innovative in the world, and manufacturing is regaining its competitiveness as cost differentials close with developing nations.

The long-awaited recovery in the housing sector has been understated by many but is critical to our economy.  Home building has traditionally played a key role in helping to lift economies out of recessions as slowing growth leads to falling mortgage rates, in turn making homes more affordable and leading to greater demand and ultimately an increase in construction jobs.  The recession following the financial crises of 2008 was a key exception.  Heavy excess supply including “shadow inventory” of repossessed homes held by the banks was a significant overhang on the market making new homes less competitive.  This led to a decline in housing starts from over two million prior to the financial crises to a 65-year low of fewer than 500 thousand units in 2009.  According to the Census Bureau and JP Morgan, housing starts have averaged approximately 1.5 million per year since 1947, driven by growth in population, household formation and GDP per capita.  From 2009 through 2011, housing starts remained below 600 thousand, more than two standard deviations below the long-term average.

This period of below-trend building while the population and number of households have continued to grow has slowly brought supply and demand back into balance.  Vacancy rates and new and existing home inventories are down and the cost of owning a home relative to renting is approaching a 40-year low as rents continue to rise while mortgage rates continue to drop.  As a result of these factors, the Case Shiller Home Price Index recently turned positive, and housing starts have climbed back to 872 thousand on an annualized basis.  Importantly, each incremental 250 thousand housing starts is estimated to generate up to one million jobs, which would provide a significant boon to consumer confidence and spending and which is not currently anticipated by the financial markets.  An additional benefit of home price appreciation should be to strengthen the collateral values and hence the balance sheets of the banking system, potentially contributing to a virtuous circle in the economy.  Moreover, the US housing recovery is somewhat insulated from factors impacting the international economy, and is providing an important offset to weakness in other parts of the globe for the benefit of the US.

Longer term, the US is well positioned relative to other nations even with our debt, deficit and employment problems.  It remains the leading country in innovation, and through innovation companies are able to transform industries from secondary to leadership positions.  Five key US advantages should give people cause for optimism:

Demographics: A significantly better demographic profile over most developed nations and in a few years over China as well

Natural Resource: Abundant food, energy and water resources relative to other nations

Culture of Innovation: Arguably the most innovative and entrepreneurial culture in the world

Capital Market System: A capital market system that is one of the world’s most advanced and liquid as the US dollar remains the world’s reserve currency

Worker Productivity: A workforce that remains one of the most productive in the world

These are all key ingredients which foster growth.  It is easy to focus on the many challenges, but there is a reason the US remains home to many of the best and strongest corporations in the world.  It also remains the country of choice for foreign students to come for their education.  Finally, the US is the nation that many people will risk their lives to come to for a chance at a better life.  This is not to suggest that the United States does not have its flaws, but rather it enjoys many advantages that are frequently overlooked.  The United States can mobilize faster than virtually any other nation to resolve any difficulty it confronts when it acts with a sense of urgency and common purpose.

Investors are appropriately concerned about several factors today, including the European crisis, a soft patch in the US economic data, the pending US fiscal cliff and a cyclical slow-down in China and other developing markets.  These concerns are significant but have already been discounted by the markets to a meaningful degree, and we believe that the pervasive focus on these issues is masking several positives in the US and global economy.

In the United States, the decline in oil prices has led to lower gasoline prices, which is a significant stimulus (non-taxpayer funded) for a consumer-driven economy and is being augmented by lower electric utility bills resulting from the decline in natural gas prices.  In recent years, we have repeatedly seen that approximately two quarters after a peak in oil prices, the US economy has begun to improve.  Most recently, oil prices peaked in February and have since fallen by more than 20%—a benefit that is filtering through the US economy as we speak.  Moreover there has been a fundamental change in the US energy sector which is having a major impact on the competitiveness of the US industrial base.

In Asia and other developing markets, energy and other commodity prices have come down considerably, providing stimulus to its economy.   Importantly, lower inflation has given China the policy room to once again prioritize growing employment over fighting inflation, and China has already implemented multiple reductions in bank reserve ratio requirements and interest rates.  Other developing nations are also benefitting from the lower inflation pressures and are acting to stimulate their economies as well. These monetary and fiscal stimulus measures began a few quarters ago and should start to have a positive influence on the global economy in the second half of this year.

In other words, falling inflation and stimulative fiscal and monetary policy represent a material change from the rising inflation and tighter fiscal and monetary policy that we saw last year.  A comparison of these important macro factors impacting the global economy today versus late 2011 through early 2012 is presented on the following page:

Comparison of Macro Factors: 2011-1H 2012 vs. Today

We remain sensitive to the structural problems that exist in the global economy which we address in this Outlook.  However as a result of the negativity in the media, longer-term investors now have the opportunity to purchase world class companies which we refer to as the crown jewels of the global economy at particularly attractive prices. While we expect modest support from fiscal policy outside of the US, central banks will feel compelled to take the lead in addressing the unemployment, debt and deficit problems, albeit reluctantly, with aggressive action with respect to still lower interest rates and ultimately currency devaluation. Attractive valuations combined with a resilient economy in the US and a cyclical pick-up in the developing world should create a more constructive investment outlook in the coming quarters.

In addition, our bottom-up research has been focused on new opportunities consistent with the six focus areas identified in our April Outlook— America’s industrial resurgence; the mega-trends of mobility, data and content; high dividend payers; the beneficiaries of currency devaluation; financials; as well as energy and strategic resource companies. During the quarter, ARS implemented changes in portfolios to reflect ideas our research team identified with new positions initiated in mobility, data, content and high dividend payers, while reducing exposure to selected materials companies in the supply chain for steel production. The following pages provide detail on the impact of policy paralysis in Europe and the US, the changes occurring in China’s economic program, followed by a discussion of the potential for a second half cyclical improvement and the investment implications for investors.

Policy Paralysis Forcing the Central Banks’ Hands

The failure of governments in the developed nations to provide the fiscal policies necessary to adequately support growth in the face of a synchronized global slowdown has forced central bankers to step up monetary policy initiatives.  Although there have been over 200 fiscal and monetary stimulus initiatives implemented globally in the past ten months, the most significant have come from the central banks.  Last month, the Federal Reserve announced it would expand Operation Twist, its program of purchasing long-term bonds by selling short-term bonds in order to lower longer-term interest rates. At the time of the announcement, Ben Bernanke, the Chairman of the Federal Reserve, indicated that he was ready to take additional action if needed. On July 5th, global central banks again took aggressive and decisive action.  The European Central Bank (ECB) and the People’s Bank of China (PBoC) moved to counter the economic slowdown by cutting interest rates, and the Bank of England (BOE) expanded its asset-purchase program (“quantitative easing” or printing of currency). These announcements took place within an hour of one another.  One reason for these actions is to encourage the banks to increase their lending to stimulate growth.  As many investors hope for some form of coordinated central bank action to jumpstart the global economy, the more likely course of action is a series of reactive policy initiatives, whereby nations respond with policies that are in their own best economic interests, particularly to expand exports to counteract their slowing domestic economies.  As we have previously written, such actions by one country to improve its competitiveness will cause other nations to respond with a counter action to regain any lost ground which will lead to further competitive currency devaluations.

Complicating matters for central banks is the massive monetary disequilibrium that is evidenced by capital flight from the periphery of Europe to Germany, the UK and the US, which has created record low interest rates for the 10-year bonds of the US and Germany.  During the second quarter, Greece and Spain saw record capital outflows into safe-haven assets such as German bunds, the Swiss franc and the US dollar and treasuries. Investor sentiment has been so negative that the German 10-year bund reached a record low yield of below 1.2% this month. With Spanish 10-year bond yields approaching the 7.5% level, the large yield differential between the Spanish and German debt is a symptom of the real and perceived differences between the German economy and many of the other nations in the eurozone. This monetary disequilibrium is forcing countries with large foreign reserves to reconsider their choices for how those reserves are deployed, as further discussed later in this Outlook.

European Update

The political dysfunction of Europe has prevented governments from effectively addressing the debt and deficit challenges with suitable immediate and longer-term solutions. Last month, the European leaders met for the 20th European Union (EU) Summit since the start of the financial crisis. While this meeting was more productive than others and some progress was made in temporarily lowering borrowing costs for Spain and Italy, in strengthening the banking system and generally improving confidence that the problems are being understood, there is much that remains to be done.  Each meeting of the EU highlights the need for not only a monetary union, but also a more fully integrated banking, fiscal and political union as well.  However, the major historical and cultural differences among the European nations do not auger well for meaningful structural solutions in the short-term.

Today the periphery member countries require a dramatic restructuring of their economies to remain economically viable within the union.  Realistically, a restructuring will require the wealthier EU nations, who have been the primary beneficiaries of the euro, to bear much of the costs.  To date however, the more fiscally-sound EU nations, led by Germany, have continued to benefit from the ability to export goods to the periphery in exchange for euros, but have not addressed the impact that the single currency and forced austerity is having on the weaker members.

Unemployment in Europe was recently reported at over 11%, and this poor employment data highlights the slowing global growth currently taking place. Slower growth has been a catalyst in the recent market pullback although some retracement was to be expected after several months of gains earlier in the year. The unemployment problem is made worse by the austerity programs being forced on the peripheral nations causing social and political stresses. This has placed tremendous pressure on the incumbent political leaders making the implementation of the needed reforms increasingly difficult.  In France, François Hollande won the recent election on a platform of growth reforms and anti-austerity which was a message that was welcomed by many in the indebted nations.  Hollande’s win changed the working dynamics among European leaders as his predecessor had aligned with Germany’s Angela Merkel to push an austerity platform to address the deficit problems.  He will be a significant force in shaping the solutions to the European crisis going forward.

It is quite possible that it will require a meaningful slowdown or even a recession in Germany itself driven by faltering exports before the German people come to appreciate that weakness in the peripheral nations has negative repercussions for their own economy.  For now, the actions needed to be taken by the political leadership will most likely result in the presiding party losing in the next elections.  Fixing the problems of Europe and the US without growth initiatives will not work in our opinion, but only

lead to lower living standards and increasing social stress, which is not a recipe for re-election.  It is clear to all the parties involved in the European crisis that a major restructuring is required in the peripheral countries. It is also becoming increasingly clear in the developed world that austerity alone will not provide the solution. Therefore, leaders must work to delicately balance the need for the immediate growth initiatives favored by France, Italy, Spain and Greece with economic restructuring and accountability demanded by the Northern European nations.

The Impact of Partisan Politics on the US Economy

It would be unfair to criticize the political dysfunction of Europe without addressing the work of the two parties here in the US.  The failure of Washington to put partisan issues aside to address the economic needs of the United States is shameful.  It would be beneficial if the politicians stopped running for office for just long enough to focus on the critical issues facing the nation today—including creating a path to sustainable growth for the world’s most dynamic economy.  Job creation, the fiscal cliff, the federal deficit, entitlement program costs and tax reform should all be priorities. Businesses and consumers need clarity on many of these issues in order to have the confidence to make effective investment and spending decisions, which in turn drive growth. Without sound fiscal policy, the burden has fallen on the Federal Reserve to use monetary policy to stimulate growth particularly over the past few months when US economic data has begun to show signs of slowing. However, the benefits of monetary stimulus only go so far, and ultimately greater visibility from a sound long-term fiscal plan will be required.

While the pending fiscal cliff is clearly a concern, we suspect that it has been the softening trend in US economic data that has had the bigger impact on markets. Therefore we see the potential for a more constructive investing environment if the economy begins to show signs of stabilization. Already we are seeing some positives including the slow improvement in housing markets, the continued resurgence in industrial America, the gradual return of manufacturing jobs to the US driven by higher wage inflation overseas and lower US natural gas prices and the overall new abundance of energy resources.  Of particular note is the benefit to corporations and consumers of the lower cost of energy which has the same effect as a direct stimulus program or tax refund by putting incremental dollars into the pockets of consumers—a key benefit to an economy that is 70% consumer-driven.  Oil prices peaked five months ago and have declined 20%, while natural gas remains well below its highs of last summer.  The effects of these lower prices should start to be reflected in the economy in the second half of the year.  Note that because of the importance of consumer discretionary income to the US economy, energy price trends bear watching in the coming months, as does the impact of the severe US drought on farm prices and food inflation.

China’s Evolving Economic Policy

In a year where a once-in-a-decade leadership transition is taking place, the top priority for the Chinese government is achieving sustainable growth to drive employment and rebalance the economy.  China is in the process of shifting from an export-driven economy to one that is more balanced with greater participation from domestic consumption.  During 2011, the increasing inflationary pressures in China forced the government to shift its emphasis from growing employment to fighting inflation by raising interest rates, tightening credit and redirecting or reducing fixed asset investment spending. The government had been targeting an orderly slowing of the country’s rapid growth to prevent overheating, but growth has now slowed to uncomfortable levels. The recent economic data indicates the Chinese government has overshot its target.  In hindsight, the impact from China’s policy actions on growth was greater than we expected, which has been a factor in our underperformance.  One of the critical implications of the problems of Europe is the fact that the region is one of China’s largest export markets and the slowdown there is creating multiple problems for the Chinese economy.  This will lead to four important actions by the Chinese in our view: loosening of monetary policy, implementation of domestically-focused stimulus programs, redirection of reserve investments from devaluing currencies to the purchase of strategic assets, and weakening of its currency, which is currently pegged to a rising US dollar. Each anticipated action is briefly described below:

Shift Back to Pro-Growth Monetary Policy:  Key to China’s outlook is the recent easing of inflation pressures. A year ago, China’s inflation rate was heading toward 6.5% and their government’s top policy goal was to prevent any over-heating.  Chinese policy makers raised interest rates and tightened credit requirements, which succeeded in slowing growth (admittedly—more so than we expected).  Importantly, inflation peaked last summer and has been steadily declining. Earlier this year, inflation rates fell below the key level of 4% that China’s leadership targets as a maximum, and most recently fell to 2.2%. The significant easing of inflation has given China the room to shift from a tight monetary policy to an easier one, and the PBoC has already implemented two interest rate cuts and multiple reductions in its banks’ reserve ratio requirements.  These initiatives typically begin to flow through the economy with a two-quarter lag, suggesting a positive influence on China’s GDP later this year.

Domestic Stimulus Programs:China has introduced many small but important, initiatives to stimulate its domestic economy, while working to avoid falling into debt problems similar to those of the developed nations. China will likely engage in another stimulus program to meet its own growth goals. China is in the unique position to be able to afford to stimulate its economy both from a financial perspective and from a political one, as its command and control economy allows for the type of quick decision-making process that is missing from the US and European systems.

Redirect Reserve Investments to Strategic Assets:  Without the support of effective fiscal policy, the ECB, the Federal Reserve and other central banks are attempting to devalue their currencies to preserve their competitive trading positions.  As the world’s largest holder of currency reserves, China will look to find better use of its assets than to invest solely in depreciating currencies such as the Euro. China continues to build strategic reserves in energy (oil/gas/coal) and materials (grains, iron ore and rare earths) and its state-owned enterprises continue to acquire foreign natural resource companies.  Additionally, we expect the Chinese government to continue to be a large buyer of gold with its currency reserves.

Currency Devaluation:  China’s currency is roughly linked to the US dollar, and the recent US dollar strength versus the euro has weakened China’s trading position by making its exports more expensive.  ARS believes that there is a high probability that China will resort to devaluation of its currency to protect its export industries as its domestic economy is not sufficiently developed to offset the weakening global economy. This will draw significant criticism from many in Washington, who have for years expressed concerns that China is a currency manipulator.  China’s likely response will be that it is acting in its and its trading partners’ best interests.

Investment Implications

Investors are coming to grips with the fact that the current deleveraging process will take many years to resolve. The 1930’s deleveraging process in the US, for example, took approximately 12 years. Since election cycles are significantly shorter than the deleveraging process, this makes the implementation of the necessary structural changes even more difficult.  Similarly, the industrialization of the developing nations will take years, if not decades, to complete. Secular trends do not move in a straight line and the beneficiaries of global growth will evolve over time, particularly as supply catches up with demand in selected industries, such as we have seen in the steel sector.  However, given the size of the populations of the developing economies, where hundreds of millions of people are moving into the middle class, we expect to see a strong tailwind of global demand for certain sectors for many years to come.  Investors should be focused on understanding the dynamics of the global economy and identifying the opportunities that will result. Our research has identified many companies that are the beneficiaries of important secular trends and that are selling for compelling valuations. With many corporations flush with cash that earns little to no return, the case for dividend increases, share-buybacks and accretive acquisitions is powerful and continues to grow.  ARS continues to place increased emphasis on the following areas:

Beneficiaries of the Revitalization of  Industrial America:  A sea change for US industry and corporate America is underway as wage increases from overseas competitors, low natural gas prices and for the first time in many years increasing oil and natural gas production in the United States are contributing to a resurgence in US manufacturing and its competitiveness.  Key beneficiaries include energy-intensive manufacturers, users of energy feedstock, such as chemical and manufacturing companies, pipeline companies and transportation companies, among others. The current low interest rate environment also gives companies access to historically low-cost capital to finance expansion and pursue shareholder-friendly policies such as return of cash through dividends and share buybacks.

Select Technology Companies:  Internet traffic continues to swell and is expected to grow by a factor of four in as many years. Mobility, cloud computing, machine-generated information and internet video are among the underlying drivers of internet use. Data center companies and owners of wireless spectrum will be key beneficiaries as businesses and consumers demand access to data anytime and anywhere.  We also see opportunities in the media industry, which we believe is approaching an important inflection point and content companies are set to benefit from the emergence of novel distribution outlets. Netflix, Hulu and Amazon have been purchasing content licenses at a voracious pace. Other well-capitalized companies such as Apple, Google and Intel have also expressed a strong interest in video distribution. Content owners will benefit from an expanding customer base that can be serviced at negligible incremental costs.  Further, in the face of internet-based competition, legacy distributors, such as Time Warner, Comcast and others, are likely to remain under pressure to absorb rising content costs. We believe that high-quality content owners are best positioned to benefit from the disruptive era in video distribution we see approaching.

Energy and Strategic Resource Opportunities: The energy sector appears to ARS to be particularly compelling at this time.  Equities in this sector were hurt by several concurrent factors over the past few quarters, many of which are discussed in this Outlook, including: concerns over a soft patch in US economic data, a cyclical slowdown in developing markets such as China which accounts for the greatest increase in marginal demand for oil, increasing levels of natural gas supply resulting from the US shale gas revolution and temporary excess gas inventories resulting from the warmest US winter in several decades.  Many of these factors are temporary in nature, but together they conspired to drive energy company valuations to the lowest levels in a decade when measured by valuations of cash flow and/or reserves, with several companies in ARS’ portfolios trading for less than 3x cash flow from operations.   We believe that at these low valuations, energy companies are particularly well-positioned to benefit from a cyclical recovery in the US and the developing world as stimulus from lower commodity prices and lower interest rates begins to have an impact later this year.   The attractive valuations also make these companies appealing acquisition candidates to strategic buyers.

Dividend Payers:  In our view, the Federal Reserve is likely to keep short-term interest rates low well beyond its stated target of late 2014.  With interest rates at historic lows and quite possibly set to stay there for longer than many anticipate, investors should look to benefit from the attractive dividends currently available from select US corporations with strong balance sheets and the ability to raise payouts over time.

Beneficiaries of Currency Devaluation:  Currency devaluation or debasement occurs when governments manage debt service and other obligations through monetizing or printing currency.  During such periods, as the purchasing power of fiat (paper) currency declines, tangible assets and productive businesses tend to maintain their relative values to society and appreciate in fiat currency terms.  For this reason, gold has tended to be a standout performer during times of currency debasement. We believe that gold and undervalued mining companies with growth potential, low production costs and strong cash flows should continue to comprise some portion of ARS client portfolios.

Financials:  Several forces are combining to lead us to gradually and selectively add financials to portfolios.  While US and European banks continue to make headlines with trading losses, fines and regulatory issues, the news flow and negative sentiment towards the industry is offering potential opportunities to buy quality businesses at unusually attractive valuations.  Research is identifying interesting opportunities to purchase banks that are selling for significantly less than tangible book value, which has historically suggested material undervaluation.

Opportunistic use of Cash:  Because the business cycles have tended to be shorter in duration in the current environment of near-zero interest rates, it can be prudent to periodically hold higher cash balances in accounts, particularly during times of greater market complacency and lower margins-of-safety in company valuations. As importantly, it provides the buying power to be opportunistic and purchase shares of attractive companies at compelling valuations such as we have recently witnessed.

From time to time, the prices of the companies in portfolios will temporarily diverge from the true inherent values of the underlying businesses, and we have experienced such a period in recent quarters. During such times, a sound investment approach requires a combination of patience and judgment to identify those businesses whose values are not being properly reflected in the marketplace.  ARS made adjustments this past quarter to shift portfolios to better align with the themes outlined in our April 24, 2012 Outlook. In particular, we reduced our exposure to some companies (primarily steel related) and at the same time, increased exposure to the beneficiaries of the areas listed above, particularly in data and content businesses as well as high dividend-paying companies.  These incremental shifts, combined with significant undervaluations in many of our core holdings, should have portfolios well-positioned for the coming year.

The recent strength of the US stock and bond markets has left many market participants as well as those watching on the sidelines questioning where we go from here.  Against the backdrop of concerns about the European economies, the uncertainty surrounding US fiscal policy and a slowdown in China, the outlook for US corporations is positive.  Many companies are increasing profits and cash flows and announcing record dividend payouts.  The US industrial base is experiencing a renaissance supported by employment growth, technological advances, the decline in US natural gas prices and an improved competitive environment caused by rising overseas input costs for transportation, energy, taxes, labor and materials.  This is encouraging US corporations to bring manufacturing back home and represents a sea change for US industry and corporate America.

For the past two decades, the world has undergone a transformation with the massive transfer of wealth from developed to developing nations.  This is best illustrated in the chart below by the changes in ranking and GDP of China.

Further highlighting this shift is the fact that in 1990 six of the world’s 10 largest corporations were Japanese and none were Chinese.   Today, five of the worlds largest companies are US and three are Chinese, while none are Japanese.  With potential leadership changes in major countries including the US, China, Russia, and France following last year’s changes in many South American, European, Middle Eastern and Asian nations, we can expect further shifts in the global economy.

As this is being written, the markets have retraced some of their recent gains giving buyers an opportunity to invest at more advantageous prices. The recent announcements by Brazil and India to lower interest rates to stimulate growth are in sharp contrast to last year when many developing countries were raising rates to fight inflationary pressures.  With price pressures in China easing, it is anticipated that China will follow suit. These policy initiatives should begin to stimulate the respective economies within 6 months which should begin to be reflected in the equity markets.  We expect the major forces which we have identified in this piece to lead to significant capital creation over the next two to three years through thoughtful security selection.  Powerful forces continue to be at work favoring those equities benefitting from the current and future needs of the world’s population which is estimated to grow to 7.6 billion people by 2020.  The nascent US manufacturing resurgence combined with the rapid advancements in technology highlights an important opportunity for the United States and corporate America.

Corporate Earnings, Profits and Prices

Coming out of the financial crisis, the deleveraging (debt reduction) process for corporations targeted the key cost driver—employment.  While consumers and governments have been slower to reduce their debt levels, US corporations have been able to build their cash balances to a record $1.7 trillion.  They quickly changed their cost structures by lowering costs through layoffs, retiring high-cost debt, reorganizing business lines and through technological improvements.  The trend in the retirement of high-cost corporate debt continues, adding to profit margins, earnings and cash flows.

The consequence of record amounts of corporate cash and the Federal Reserve’s Zero Interest Rate Policy (ZIRP) in combination with shareholder pressure on corporations’ dividend policies have resulted in S&P 500 companies collectively paying dividends of $241 billion in 2011 and an expected $280 billion in 2012.  Nowhere was this trend more evident than when Apple declared an annual dividend policy of $10 billion plus a $10 billion share repurchase program over three years, making Apple the second largest dollar dividend payer in the S&P 500 after AT&T.  Apple’s low payout ratio leaves room for additional dividend increases although none are likely for some time. Recently Cliffs Natural Resources, the leading North American producer of iron ore, increased its dividend to $2.50 from $1.12 putting a yield under the stock of approximately 4% while also maintaining a low payout ratio.  These moves offer some insight into managements’ confidence in the future prospects for their respective businesses.  Although we wrote about this trend early on, we believe this is far from over.

Another aspect aiding US corporations is the gradual return of the US consumer to a purchasing mode aided by lower levels of inflation, improvement in employment and a bottoming out of the housing market in select areas of the country. While these improvements are only on the margin, the halo effect has led to an improvement in consumer spending, including autos, in recent months.  The US has also experienced a record warm winter reducing energy bills and driving consumers outdoors.  As a consumer-driven economy, positive changes in consumer behavior can add materially to GDP and corporate earnings growth.

China – In Transition But Still Growing

During the past year, Chinese officials have attempted to slow its too-rapid growth rate while effectively transitioning its economy from one driven by export-led growth to consumption-led growth to rebalance their economy and to foster a burgeoning middle class.  This is not an easy task for any nation, but one made more challenging when China’s best customers for exports are developed nations that are on fiscal austerity programs and have historically high unemployment.  The Chinese government recently announced its new GDP growth target of 7.5%.  A closer look at China’s growth targets from its 5-year plan reveals that China had targeted an 8% average annual growth rate but achieved an 11% average from 2005-2011.  China was able to achieve these tremendous growth rates in part due to unusually high levels of Fixed Asset Investment (FAI) which should be moderating and shifting in the coming years.  With a planned leadership change scheduled for later this year and the ability to lower interest rates, China has room to reverse its formerly tight monetary policy to better control its growth.  It is important to bear in mind that the government is determined to avoid social instability, and social instability is inextricably linked to employment and economic prosperity.  This has been reflected in its recent policy of significantly raising wages and committing to annual wage increases.

Today, China presents a dilemma for many who are focused on the question of how much slowing will actually occur.  However, the central theme for longer-term investors must be how and where China will invest its vast reserves to position itself as a greater economic and political force in the world and secure its long-term strategic needs.  Recently, the government has made significant investments in Latin America, Europe, the Caribbean and Africa as well as in projects partnering with companies such as Devon Energy and Chesapeake Energy.  It is worth noting that in absolute dollars a $7 trillion Chinese economy slowing to 7.5% growth would produce over $500 billion of incremental GDP in 2012.  This compares to only $200 billion generated when China grew by 10% in 2000.  It is important to focus on the absolute level of growth rather than on the percentage change.

Thoughts on Central Bank Policies

The economies of the developed world are too small for their debts especially in the face of austerity programs designed to address their deficits.  With debt costs rising faster than GDP, deficit countries are losing more money each day and austerity is having the affect of worsening the relationship of rising debt to a contracting economy (Debt/GDP ratio). These countries need three policy conditions to be met to reverse this trend – accommodative monetary policy, policies to reduce the value of the debt and productive/growth-oriented fiscal policies.  It is essential for developed nations to stop the bleeding, but it should be apparent that austerity alone will not solve their debt problems.  After the most recent Greek bailout, attention has shifted to Spain which represents an economy approximately five times larger than Greece.  Spain has reported unemployment of around 24%, youth unemployment at a staggering 50%, rising sovereign bond yields and private debt at 227% of GDP.  The current forecasts for the 2012 budget show a 1.7% contraction in the economy.  Spain will not be able to meet its deficit target of 4.4% of GDP.  With high unemployment throughout most of the developed world, these countries need to address the structural challenges while increasing the investment component of GDP to reverse this trend.  With leadership changes in so many nations in 2011 and 2012, it has become very difficult to put in place effective programs to address their economic challenges.

Against this backdrop, ARS expects central bank monetary policy of the developed nations to remain accommodative, and we also expect a return to accommodative policies in the developing nations this year after a period of tightening in 2011.  This combination will continue to be supportive of corporate earnings, profits and equity returns in general as it will be very difficult for the Central Banks to withdraw funds that have been injected into the banking system during the past three years. For all the money injected, most of it is still sitting on bank balance sheets or used to purchase sovereign debt and not being lent to the private sectors to more efficiently stimulate the economies.  As a consequence, the equity markets received a critical boost to investor confidence with the decisive actions of the European Central Bank’s (ECB) Chairman Mario Draghi to support the banking system through its Long Term Refinancing Operation (LTRO) of about $1.3 trillion.  Mr. Draghi replaced Mr. Trichet as head of the ECB and dramatically shifted the European policy emphasis from price stability to recovery and growth starting in the fourth quarter of 2011.

Since 2008, the ECB balance sheet has expanded by over $1.4 trillion, the US has added approximately $2 trillion, the Bank of England $200 billion, the Bank of Japan $800 billion, the Bank of China $2.5 trillion, the Swiss National Bank $300 billion, French Central Bank $430 billion and German Bundesbank $700 billion. It is worth noting the role of Massachusetts Institute of Technology (MIT), which favors the use of aggressive and active

monetary policy to solve problems. Among those influenced by their time at MIT are Federal Reserve Chairman Bernanke and President of the NY Federal Reserve Dudley, Mr. Draghi (ECB), Mr. King (UK), Mr. Monti (Italy) and Mr. Fischer (Israel) as well as the Greek Prime Minister Papademos and Mr. Blanchard, a chief economist of the IMF.   It would not take a leap of faith to conclude that it will be a significant period before central banks begin to pull liquidity from the system, nor should one expect a dramatic increase in interest rates in the foreseeable future.

Chairman Bernanke supported by two of the most important policy makers, Vice Chair of the Board of Governors Janet Yellen and William Dudley, remains concerned about repeating the key policy mistakes of the 1930’s. Supporting continued accommodative policy in the US are the fears about sustainability of the recovery in jobs and housing which officials believe may remain challenged through 2014.   The FOMC is also painfully aware of the impact of rising interest rates on the deficit and interest costs on the national debt.  With interest costs now approximately $211 billion, a significant rise in rates would have a material impact on deficit savings and future fiscal policy decisions.  The Fed is mindful of the inflationary pressures brought about by rising gasoline prices for consumers as well as other inflationary issues but believes that the greater challenges to economic growth remain jobs and housing.  Federal Reserve policies may assist in addressing the cyclical challenges to employment, but the structural employment issues of the mismatch between the required skills for available and future jobs and the skills of the existing unemployed labor pool will require time, investment and significant fiscal policy change. Recognizing that risks and headwinds will continue to be present in the global economy, we continue to anticipate that the Central Banks of the developed world will maintain aggressive monetary policies to support growth in the face of austerity budgets. This has profound implications for investment security selection.

Investment Implications

The diverse needs of the global nations and economies will favor those companies that (i) can lower costs and increase productivity, (ii) have strong global franchises with meaningful barriers to entry, (iii) benefit from resource scarcity, rising demand and have low-cost producer status.  Looking ahead for 2012 and 2013 and absent a global recession, which we do not foresee at this time, ARS is placing increased emphasis on the following areas:

I.Beneficiaries of the Revitalization of Industrial America

A sea change for US industry and corporate America is underway as wage increases from overseas competitors and low natural gas prices in the United States are contributing to a resurgence in US manufacturing

competitiveness.  Moreover state-of-the-art US technology gives our manufacturers a distinct global advantage which can be a real benefit to our balance of trade, trade deficits and helps those states narrow their budget deficits.  This highlights the structural employment mismatch between companies’ needs for highly skilled labor and the availability of those with the technical skills to fill these positions.  Many companies in our portfolio are generally selling for single digit multiples of cash flow.  Projecting out a few years, these companies are selling for single digit multiples of earnings.  The current ZIRP policy described earlier gives those companies access to historically low-cost capital to finance expansion and reduces the cost of bringing business back to the US.  Business leaders who have proposed a tax holiday to bring back overseas cash have a choice of bringing cash back and paying taxes on the cash or not repatriating the cash and instead borrowing the funds whose interest costs are tax-deductable thereby reducing the revenues to the treasury.  Also, keeping the cash abroad favors foreign investment, acquisitions, and job growth over domestic alternatives.

II. Select Technology Companies

ARS is focusing on the leading companies that are poised to benefit from the mega-trends in technology that will help shape the world over the next decade.  One of these secular trends is the growth in mobility and the proliferation of smart devices. This opportunity has led to 2015 forecasts for smart phone sales to be 1 billion units with laptop and tablet sales of 600 million units. The mobility trend is being supported by two complementary forces – rising global incomes and falling technology costs – which are making these devices more accessible and affordable.  One important measure of affordability is the average weeks worked to purchase a computer.  In India for example, the average weeks worked to purchase a device in 2000 was 279 and is forecast to decline to less than 9 weeks in 2015.  Nowhere was the power of mobility more evident than during the Arab Spring as protestors relied on mobile technology and social networking to communicate, organize and mobilize. The mobility trend will also augment demand for managing, storing and analyzing data.  Separately, we believe that technological changes are raising the value of businesses that provide various forms of content including entertainment media and information services.  The internet is providing content companies with an additional distribution platform for existing assets.  Valuations for many technology companies are at historically low levels when looking at cash flow, earnings, return on capital, gross margins and cash on the balance sheet given their growth profiles.  Moreover many have committed to dividend payouts which they had not done previously.

III. Energy  and Strategic Resource Opportunities  

The international price of energy will continue to reflect rising global demand.  Because the United States has been so successful at increasing oil and gas production, the country has put itself in the position of being less dependent on imported oil if it so chooses. At the present time, there is an increase in pipeline construction and infrastructure spending in general as the major producers have announced significant discoveries both on-shore and off-shore.  This has resulted in capital flows into the oil and natural gas sector by foreign entities including state-owned-enterprises which is also leading to additional capital to develop newly discovered reserves and to process and transport these reserves throughout the United States.  To put the US energy cost advantage to a US manufacturer of $2 per mcf (one thousand cubic feet) natural gas in proper perspective, this price equates to $12 per barrel of oil on an energy content basis, versus in excess of $100 per barrel of oil or $13-16 per mcf of liquefied natural gas outside the US.  The gives the US a large economic advantage to export its surplus natural gas.

Governments have been building strategic reserves of scarce resources including oil, coal, grains and rare earth metals to satisfy their long-term growth requirements and not be dependent on the vagaries of global supply. This is an ongoing discussion in many governments around the world.  Our research shows that many resource producers are selling for 4-6x cash flow from operations and significant discounts from asset values. Under these circumstances, any companies that would be acquired would have to attract a significantly higher price in the market, since the real-world value of their reserves and assets are significantly greater than their current stock market valuations.

IV. Dividend Payers

Last October, the FOMC committee released its 2014 year-end forecast for an unemployment rate of 6.8% to 7.7% with inflation at or below its target rate of 2.0%. As we wrote in our November 2011 Outlook, this suggested to us that the committee may not believe it appropriate to raise interest rates until at least the end of 2014 instead of the middle of 2013.  Our view was confirmed in a statement by the Federal Reserve made in mid-January of this year. Last week, Janet Yellen suggested that unemployment and housing market conditions might warrant the low rate policy extending through 2015. With interest rates at historic lows and likely to stay there for some years, investors should look to benefit from the attractive dividends currently available from select US corporations with strong balance sheets and the ability to raise dividends over time.

With people living in retirement for longer and with traditional income investments producing far lower returns than often needed, the demographics of the US are leading income-oriented investors to consider increasing exposure to equity investments for income replacement.  In addition, the return assumptions of institutional investors are making asset allocation decisions more difficult given the anticipated future returns of fixed income investments.  After posting strong returns in 2011, many of these companies have lagged the benchmarks in the first part of 2012.  However, ARS has identified high-quality equities with dividend yields of between 2.5% and 4.5% (compared with market average yields of closer to 2%) and Price/Earnings ratios, in many cases, ranging between 8-14 times.  These companies appear undervalued in the absolute and look particularly compelling relative to fixed income offerings currently available in the market.  A further benefit is that many of these companies are in defensive sectors such as healthcare, consumer staples, telecom and utilities, with strong, defensible franchises that tend to outperform at times when market fears over deleveraging risks are at their greatest.

V. Beneficiaries of Currency Devaluation

Currency devaluation or debasement occurs when governments manage their nations’ debt service and other obligations through monetizing or printing currency, which eventually can lead to rapid inflation.  During such periods, as the purchasing power of fiat (paper) currency declines, tangible assets and productive businesses tend to maintain their relative values to society and appreciate in fiat currency terms.  For this reason, gold has tended to be a standout performer during times of currency debasement.  As governments continue to run deficits and increase their national debts, the choices for governments become limited. They can go into the open market to borrow which often forces rates higher or they can rely on the central banks to become the lenders of last resort.  This process must occur absent sensible fiscal policies which must involve a combination of pro-growth investments, tax increases/reforms and spending reductions or efficiencies.  Despite this risk, we are continually surprised by how little exposure the average investor has to precious metal investments. For these reasons, we believe that gold and/or undervalued mining companies should continue to comprise some portion of ARS client portfolios.

VI. Financials

In late 2006, our research identified growing stresses in the housing market which led to concerns about US financial institutions.  For several years, ARS has avoided investing in financial companies.  The concern since the financial crisis was in part a reflection of our concerns about the deleveraging process for consumers and the recovery in employment and housing. In addition, the uncertainty regarding the regulatory environment

including the impact of Dodd-Frank on the business models of financial institutions and their future profits, as well as the uncertainty of the value of their assets and extent of their liabilities worked against one’s ability to effectively value the businesses and disqualified these investments from our selection process.

We believe that several forces are combining to lead us to gradually and selectively add banks into portfolios.  The recent stress tests conducted by the Federal Reserve, who as the banks’ regulator has unique access and insight into the assets and liabilities of banks, identified the institutions that were in the strongest financial position and provided a basis for security selection that had not been present before. Research is identifying interesting opportunities to purchase banks that are selling for significantly less than 1x tangible book value, which has historically represented undervaluation.  Another positive factor is the improving economy which has strengthened the jobs and housing markets.  While we believe that there remain many challenges in the recovery, the improvement in housing and consumer balance sheets has provided relief to the banks which will tend to lead to improvement in their loan portfolios.

The challenges of Europe and its banks stemming from the sovereign debt crisis are offering the stronger US banks an opportunity to gain a competitive advantage at a critical time to acquire loans and assets at deep discounts and to serve as an important source of capital market expertise at a time of need for the emerging economies.  Although financials have been one of the best performing sectors in the market this year, we believe that investors should continue to be selective, and we urge caution as the problems of the past are not fully behind us.

VII. Opportunistic use of Cash

As discussed in recent Outlooks, it can be prudent to periodically hold higher cash balances in accounts, particularly during times of greater market complacency and lower margins-of-safety in company valuations.  Having higher cash balances can make it easier to ride out periods of heightened volatility. More importantly, it also provides the buying power to be opportunistic and purchase shares of well-positioned companies at very attractive valuations, such as we saw in September and are currently seeing now for selected companies.

The Focus on Long-Term Capital Appreciation

In order to compound rates of return to build capital over time, the minimization of business risk is at the forefront of our security selection.  Therefore, security selection should emphasize clarity, qualitative and quantitative appeal. There will be periods such as the internet boom where the speculative nature of the markets drove the averages pushing prices up without regard to value, but over the intermediate to long term, investors should expect value will be awarded.

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As we end 2011, we are sharing our thoughts on building capital and protecting purchasing power in a complex and dynamic $65 trillion global economy filled with investment opportunity but also risks with over $200 trillion in global credit and an estimated $700 trillion in derivatives. This has been a particularly volatile year for the US stock market and we are disappointed that 2011 has not met our desires for investment returns.  In recent Outlooks we discussed the debt problems of Europe and most of the developed world and its impact on global economic growth.  Investors are coming to grips with the fact that sovereign debt is no longer an AAA-rated, risk-free asset class, which has wide-ranging implications for the structure of the capital markets, and therefore investment policy, security valuation and risk assessment.  Further complicating matters is that the U.S. Congress has been dysfunctional at a time in which thoughtful governance is needed, and this is unlikely to change before next year’s election.Since 2008 we have been of the view that governments would need to implement appropriate monetary and fiscal policies to stimulate growth while addressing longer-term debt and deficit problems.  In the developed world, economic policy decisions have fallen short of what is needed to deal with these dual problems. The inability of policymakers both here and in Europe to provide a credible response has damaged investor confidence and increased market volatility.  Although short-term interest rates are at or near zero percent, investors should not conclude that monetary policy is sufficiently accommodative.  Recent swings in the US dollar are reflective of the lack of liquidity in the global system and the high regard for the US dollar and US treasury securities as safe havens during times of uncertainty.  The newly-established currency-swap lines between the Fed and five other central banks and the strong demand by European banks for the European Central Bank’s (ECB) recently created, unlimited three-year loan facility have resulted in the ECB lending $640 billion to more than 500 banks. This highlights the pressing need for more global liquidity and the inevitability of additional currency creation.  This process has begun despite resistance from some European leaders as roughly $250 billion of the new facility represented quantitative easing (the creation of new currency).

These concerns have left many investors confused and struggling to make sense of it all.  We believe that one of the important implications is that market participants have been increasingly using the equity markets to wager on transient perceptions of macro opportunities (“risk-on”) or concerns (“risk-off”) rather than on business valuations and fundamentals.  This short-term perspective reminds us of Warren Buffet’s expression from his mentor Benjamin Graham—in the long term the market is a weighing machine, reflecting business fundamentals and cash flows; in the short-term the market is a voting machine, reflecting popular perceptions.  We view the market as a medium of exchange that allows investors to trade dollars for the ownership of shares of world-class businesses and not as a short-term trading vehicle.  While we expect to see continued market volatility next year, our research has identified many businesses that are selling at particularly attractive valuations as the short-term perceptions of global problems have created a mismatch between current market prices and the real world values of these businesses.Heading into 2012, there remain many challenges for world leaders to address including but not limited to: the European sovereign debt and deficit problems, the well-publicized US deficit, housing and employment problems and growing concerns about China’s continued GDP growth and a possible real estate-related credit bubble. To be clear—there is also some good news.  Developing market governments are seeing inflation pressures ease, giving them the cover needed to begin easing monetary policy and shifting focus from fighting inflation to stimulating growth as evidenced by the approximately 50 policy initiatives announced by governments and global central banks since August.  These easing initiatives are the fuel for cyclical growth over the next two-to-three quarters which would help build on the recent improvement in US economic indicators.  Next year we will again be striking the delicate balance of managing between the forces of deleveraging on the one hand, and industrialization and growth on the other hand, to build capital and protect purchasing power.  Given this background of significant opportunity but also meaningful risk, ARS has been constructing portfolios with allocations to four key areas described in our November Outlook: “crown jewels” of the global economy, high dividend payers, gold/gold miners and cash.  We describe each in detail below.

Crown Jewels” of the Global Economy

Companies in this category are leaders in large, growing and essential sectors, often having some combination of barriers-to-entry in the form of a unique product offering, structural cost advantages and/or dominant brands.  Companies meeting these criteria that make it into ARS portfolios will also have strong balance sheets and attractive valuations offering a distinct margin-of-safety.  Examples of companies meeting these criteria include leading low-cost producers of inputs required for industrialization in the developing world, undervalued energy providers with valuable reserves in politically-safe jurisdictions, industrial leaders with dominant market shares or a branded provider of a disruptive, game-changing consumer service or product.After the sell-off in economically-sensitive companies over the summer and fall, many of our investments in this category are selling for 5-10x earnings and high free cash flow yields of 10%-15%.  Free cash flow is what is available to shareholders after all other company obligations.  It can be used toward dividends, debt repayment, share repurchases, and acquisitions, and can be a powerful determinant of future investment returns.Some of these companies are approaching valuation levels last seen near the bottom of the financial crisis despite having substantially stronger balance sheets.  For example:•One leading global natural resource producer was recently selling for as similar a multiple of free cash flow as it sold for early in 2009 (approximately 7x).  However, at that time, the company had just completed a large acquisition and was saddled with high-cost debt.  Today, this same company has generated so much free cash flow that it has paid off virtually all of its debt and now has net cash on its balance sheet of nearly $2 billion.•A second producer is the sole global source outside of China for an important category of raw materials.  In our models, we are assuming a long-term price for the products that this company sells that is more than 40% below the current market price.  Using these conservative assumptions, this company is currently trading for approximately 2.5x 2012 estimated run-rate cash flow. Several independent energy exploration and production companies are currently trading for approximately 4-5x cash flow and are pricing in long-term oil prices of well below $80 per barrel—estimated to be the global marginal cost for new oil exploration and development.  A few of these companies are trading below $15 per barrel of proven oil reserves, which is under the average reserve acquisition cost of the leading large cap integrated oil companies, making them attractive potential acquisition candidates.

We believe that these companies are not yet getting adequate credit from the marketplace for their strikingly cheap valuations and healthy balance sheets that in most cases are significantly stronger than in 2008.  By their nature, these businesses have meaningful exposure to economic cycles, and their quoted stock prices are apt to fluctuate with the ups and downs of the broader market over any given short-term period.  However, all of these companies are also benefitting from strong secular trends underlying their longer-term growth potential.  While we cannot predict when these companies’ valuations will be better recognized, by acquiring these marquee franchises at prices below their fair value, we believe that their strong market positions and exposure to faster-growing end markets will result in superior returns over time.  These “crown jewels” will continue to form a core anchor of ARS equity portfolios while they remain at these compelling valuations.

High-Quality Dividend Payers

In our December 2008 Outlook, we wrote “the Federal Reserve will have to maintain a historically low interest rate policy for the foreseeable future.”  This outcome seemed unlikely to many at a time when much of the market was concerned about inflation, but two years later, Federal Fund rates remain at zero percent, and the Federal Reserve recently indicated it would hold rates at these levels at least through mid-2013.  As ARS has written more recently, with an average debt maturity of 54 months and a federal debt level expected to reach $16 trillion next year, a 1% increase in interest rates would swell government borrowing costs by $160 billion per year—enough to wipe out nearly all of the cost savings over the next decade currently being contemplated by congress.  In short, ARS does not believe that the Federal Reserve can afford to raise rates, and it would not surprise us to see short rates remain near current levels for several years.

In such an environment where cash and short-term debt is earning near zero, large amounts of higher-yielding bonds are maturing and the baby boomer generation is in greater need of income as its members enter retirement, we believe high-quality stocks with above-average dividend yields, ample dividend coverage and strong balance sheets are paramount for client portfolios.  ARS has identified high-quality equities with dividend yields of between 2.5% and 4.5% (compared with market average yields of closer to 2%) and P/E ratios, in many cases, of between 8-14x.  These companies appear to be undervalued in the absolute and look particularly compelling relative to fixed income offerings currently available in the market.  A further benefit is that many of these companies are in defensive sectors such as healthcare, consumer staples, telecom and utilities, with strong, defensible franchises that tend to outperform at times when market fears over deleveraging risks are at their greatest.  During times of volatility, these companies continue to pay investors attractive dividends as they wait for better times to return.  Importantly, having an anchor in these investments can make it easier to weather the ups and downs in the more cyclically-exposed areas of client portfolios.  Additionally, the income that these equities generate can increase over time as dividends are raised.  For these reasons, high-quality dividend paying stocks will take on increasing importance in investors’ portfolios in the current environment.

Gold

Although gold has increasingly been in the news in recent months, 10 years ago when ARS first began investing in gold miners, the industry was a forgotten asset class.  Although the US dollar is estimated to have lost more than 90% of its purchasing power since the establishment of the Federal Reserve System in 1913, most Americans alive today have never lived through a sudden and dramatic currency debasement.  Because of that, except for a brief period in the 1970’s, gold has never been taken seriously as an asset class in the US.

This is not the case in other countries around the world where citizens have less confidence in their policymakers or have experienced rapid currency debasement during their lifetimes.  Currency debasement typically occurs when governments attempt to satisfy their nations’ debt service and other obligations through monetization, essentially newly-printed currency, leading to rapid inflation.  During such periods, as the purchasing power of fiat currency declines, tangible assets and productive businesses tend to maintain their relative values to society and appreciate in fiat currency terms.  For this reason, gold has tended to be a standout performer during times of currency debasement.  As governments continue to pile up debts that politicians are unwilling to ask their citizens to pay, the risk of countries turning to their central banks to monetize these debts will continue to grow.  Despite this risk, we are continually surprised by how little exposure the average investor has to gold and gold miners.  The S&P 500 has only 0.8% exposure to gold mining stocks, and most gold mining companies are based outside of the US, giving traditional equity portfolio managers limited exposure to them.  For these reasons, we believe that gold and/or undervalued gold mining companies should continue to comprise some portion of ARS client portfolios.

It should be noted that we have already begun to see the ascent of gold as an alternative to many currencies.  Over the last 10 years, gold’s purchasing power relative to most currencies and to other commodities has risen significantly.  At least some portion of this gain could be attributed to the market’s anticipation of future central bank monetization.  However, we do not believe that risks of future currency debasement have been fully reflected in the gold price.

We believe that the gold miners in ARS client portfolios are currently discounting a long-term gold price of approximately $1,000-1,100 per ounce—considerably below the current spot price of roughly $1,615.  One leading mid-cap gold producer in client portfolios has a fully-funded growth plan to more than double its gold production over the next five years.  This company is currently trading for 5x 2012 estimated cash flow assuming a $1,615 gold price.  However, even using a conservative assumption of just $1,000 per ounce of gold sold, this company would still be trading for under 8x cash flow.  This valuation represents a significant margin-of-safety in the event that gold prices were to decline, while at the same time helping to preserve purchasing power in the event that gold continues to rise in dollar terms, as we expect it will.

Cash

As discussed in recent Outlooks, the excessive debt burdens of developed economies took several years to build up and will not resolve themselves quickly.  It is quite possible that the tug-of-war between genuinely positive investment factors—developing world growth, healthy corporate balance sheets and attractive valuations, among other factors—and the concerns over slower growth and policy uncertainty, along with greater accompanying volatility is likely to be with us for some time.  At times when the economy is undergoing cyclical expansion, investor complacency will rise and the market will appear to overlook underlying challenges.  Often when the economy is softening, volatility will increase and secular leverage concerns will suddenly come back to the fore. Moreover, there is evidence that under the secular influence of deleveraging, business cycles are getting shorter.  Intermediate-term economic cycles used to be heavily influenced by borrowing rates tied to changes in the Fed Funds rate by the Federal Reserve.  With the federal funds rate held steady at zero, other factors such as inflation, which in turn is increasingly tied to swings in commodity costs, may be having a more pronounced influence on the economy.  This is evidenced by 2011 being the second consecutive year to see periods of both rising and falling economic indicators.

Under these conditions, it can be prudent to periodically hold higher cash balances in accounts, particularly during times of greater market complacency and lower margins-of-safety in company valuations.  Having higher cash balances can make it easier to ride out periods of heightened volatility. More importantly, it also provides the buying power to be opportunistic and purchase shares of favorite companies at very attractive valuations, such as we saw in September and are currently seeing now for selected companies

In Conclusion

As the year comes to a close, we are mindful of investment successes and opportunities missed.  But more importantly, our focus is on what is and what shall be best for client portfolios as we begin a new year.  In periods of difficult short-term performance, we reflect on the time-tested investment principals that have served us well over the course of 40 years.  To that end, we remain very excited about the quality and valuations of the companies we own.  By owning shares of some of the world’s leading global franchises selling for single digit multiples of earnings and cash flows, and in many cases with meaningful and rising dividends, we believe that our client portfolios are well positioned to build capital, and importantly protect purchasing power over the next 24-36 months as governments work to address the challenges of stimulating growth and reducing debts and deficits.  Although the recent initiatives in Europe have not gone far enough to solve the continent’s challenges, and the US continues to experience election-cycle gridlock, we believe a portfolio allocated among industry leaders, high dividend payers, gold and, at times, cash, is well suited to building and preserving capital in portfolios over reasonable time periods.

We extend our deepest appreciation to all of our clients, and offer our warmest wishes for health and happiness for the New Year.

The debt problems of the developed world are once again becoming too big to ignore. The lack of aggregate demand to create growth and the austerity measures to address the deficits are clouding the outlook for continued global recovery and expansion. The austerity proposals are at once too little and too much—too little to meaningfully offset deficits, yet too much to allow for economies to operate at their full potential. Significant divergences continue to exist between the surplus/creditor nations and the deficit/debtor nations which complicate implementation of the structural changes needed to rebalance the global economy. European leaders are struggling to come up with a solution for members’ debt and deficit problems due to the flawed governance structure of the European Union (EU). The United States, with its own well-publicized deficit problems, is in the early stages of an election cycle where ideological approaches have thwarted sensible economic decision making. As highlighted in the table below, government debt levels in the developed economies are already approaching or exceeding 90%of GDP—levels historically associated with reduced growth prospects as taxes are raised and/or fiscal spending reduced to service debt and interest payments:

Selected Country GDP and Government Debt Levels (2011 Estimates)

Across the developed world, several mature economies are already experiencing the highest levels of unemployment in a generation while government balance sheets are straining under excessive debt burdens. This is occurring while the Middle East is dealing with the realities of regime change as it recreates its political and economic systems, and while Japan is rebuilding after its devastating earthquake following a multi-decade economic decline. China is dealing with its own challenges as it takes steps to rebalance its economy in favor of domestic consumption over export growth, including rising inflation and credit concerns in its banking sector. However, China and other developing economies enjoy lower government debt levels, as highlighted on the table above.In the three decades leading up to the financial crisis of 2008,rising debt levels helped to prolong expansions and keep recessions relatively short and shallow. The financial crisis of 2008 derailed credit-fueled growth and ushered in a period of deleveraging during which income is re-allocated from consumption and investment to debt pay-down. In this environment, investors should expect extended periods of slow growth in the developed world, along with increased market volatility. This backdrop creates obvious challenges, but also opportunities. We expect to see increasing pressure on developed economy central banks to monetize debt burdens with printed currency. Certain investments will benefit under such conditions and investors should be positioned accordingly and in advance. We also continue to find world-class companies with exposure to developing markets that are growing. These companies have strong balance sheets and are selling for attractive valuations. While we are mindful that the headwinds discussed above will be with us for several years, our portfolios are positioned to take advantage of the current investment environment by allocating to four key areas:

1)“Crown Jewels of the Global Economy”—We continue to emphasize US-based companies that are global leaders producing the goods and services essential to industrialization and rising living standards for the world’s population;

2)Quality Dividend Payers—In response to the Federal Reserve policy to keep rates low and the growing demographic needs of an aging population to generate more income;

3)Gold and Hard Assets—To protect purchasing power during a period of competitive currency devaluations;

4)Cash—Which we will periodically manage to higher levels to take advantage of the shorter cycles and volatility.

For the past three years, our view has been that deleveraging inthe developed world and industrialization and growth in the developing economies would remain the defining features for investment security selection and portfolio management. With most of the developed world in a deleveraging process and with interest rates at or near zero, printing money (the Quantitative Easing or QE we have written about in the past) becomes the primary tool to devalue a currency, reduce the value of debt and stimulate exports. Currency devaluation for one country induces a reaction by others to gain or maintain competitive position. The cumulative effect of this process is to eventually reduce the value of all fiat currencies. Importantly, while there may be periods of temporary dislocation, currency devaluation ultimately tends to raise the nominal value of equities over time, as tangible businesses preserve their respective values within the economy in the face of declining fiat currencies. The four key areas allow us to position portfolios in the beneficiaries of this dynamic environment to protect purchasing power and build capital.

Europe Still at a Crossroads

While having a currency union with 17 members with different cultures and policies was perhaps workable when debt-fueled economic growth was strong, the flaws in the Euro structure were exposed when growth was insufficient for periphery members to manage their growing debt burdens. Once part of the EU, uncompetitive economies lost the ability to devalue their respective currencies in response to economic challenges and failed to adjust to the resulting low-growth environments. Unlike the United States, there is no central institution to deal with the crisis nor are the sovereign debts supported by any one country’s credit rating. Instead, the member nations are linked by a single currency (the Euro) and a central bank with the sole mandate of price stability (the ECB). Hence a fundamental contradiction exists between the interests of the stronger nations who want top reserve the wealth they have generated by maintaining a sound currency, and its weaker members with high unemployment who require stimulative policies.Therefore the ECB is left with two choices—to support the deflation-prone nations or to be witness to the EU effectuating the exit of some members. In either case, regaining global competitiveness will require achieving a lower cost structure across much of the region. Unfortunately the EU does not have the luxury of time to address this disequilibrium as deficits continue to rise and debts increase at an accelerating rate from already unsustainable levels.
An essential mismatch between the nations in the north and south became apparent when the growth of the EU could no longer mask the underlying differences in their cost structures. The stronger northern nations, for example Germany and France, have to-date been enormous beneficiaries of the EU as 70% of Germany’s exports involve trade with member countries.

The Germans now have to decide whether to lend support to the weaker nations or abandon them, subjecting the German economy to contracting trade flows within the Eurozone. To support the weaker nations is politically unappealing, but to abandon them would be economically damaging.
In the South, governments control a larger share of the economy and have been extremely generous in providing benefits to government employees with many retiring at 50 years of age and receiving benefits for decades thereafter. These governments have resisted cutting employment and privatizing which in turn now places an excessive burden on their private sectors to absorb the impact of austerity policies. This austerity has led to protests over the perceived unfairness of policies that require lower living standards, personal sacrifice and for the private sector to beara disproportionate burden, while in effect subsidizing government waste and inefficiency. The weak European governments must take the initiative to accelerate privatization to create more dynamic and competitive enterprises while reducing burdens from government budgets. Newly created economic efficiencies, which will ultimately promote growth, result in more unemployment over the short-term and require extensive monetary policy support to smooth the path of debt and deficit management. With interest rates spiking up in the past three weeks, there is little time left for leaders to address the problem, and the ECB and Germany in concert with the IMF and other governments need to act swiftly and decisively.

The US Employment Problem

At the August meeting of the Federal Reserve Open Market Committee (FOMC), the committee announced its decision to keep interest rates near zero until the summer of 2013. In October, the committee released its 2014 year-end forecast for unemployment of 6.8% to 7.7% with inflation at or below its target of 2.0%. This suggests to us that the committee may not believe it appropriate to raise interest rates until at least the end of 2014 instead of the middle of 2013. Similar to the global economy, the United States is suffering from a lack of aggregate demand. In order to increase aggregate demand in a deleveraging process for what has been a consumer-driven economy, policy makers will need to see a significant increase in investment to the many neglected areas of the economy including infrastructure. The infrastructure investment requirement is estimated to be in excess of $2 trillion (see table in Appendix), which if undertaken, would contribute to an exciting and positive transformation of the US economy. More important than government investments are private-sector initiatives that could be unleashed by a more pro-growth government policy orientation which could stimulate employment without adding to the US deficits. Approval of the Keystone Pipeline could have been one such example, but at present remains an opportunity delayed.

We are frequently asked when we would expect to see an increase in inflation and a significant improvement in housing. We suggest that there would first need to be solid employment growth for a sustained period, at which point we would also anticipate a reversal of Federal Reserve policy to prevent a significant increase in inflation. A review of the Bureau of Labor Statistics (BLS) October Employment Report highlights the challenge ahead for the US and suggests that it could take five to ten years or even longer to achieve an acceptable unemployment rate. As of October, the US had a total of 26.4 million unemployed and underemployed members of the labor force.1The total civilian labor force is 154.2 million and is expanding by an estimated 110,000 new entrants each month. Assuming for the sake of argument that monthly job creation were to increase to 250,000 (or 140,000 net of new labor force entrants), the number of unemployed could be expected to decline by roughly 1.7 million per year. At this pace, and assuming no new recessions, after 10 years the US would be down to approximately 10 million workers still unemployed or underemployed, which would equate to roughly 6% ofthe labor force—a more palatable level. However, realizing average job creation of 250,000 per month will be no easy feat. Over the past three months, the US has averaged only 122,000 new private sector jobs. Currently there are 22.5 million people employed by government on all levels. In the years ahead, it should be expected that some number of these jobs will be eliminated due to budget cuts, which would further add to the ranks of the unemployed.Many of the unemployed will need significant skills retraining to get back into the workforce. With rapid technological advancements and shifts in labor market structure, investment in education needs to be adjusted and increased, unlike our current policy of disinvestment. This speaks to the intellectual bankruptcy of austerity programs without growth initiatives, which will only add to the problem. Clearly, job creation is the central issue for leadership to deal with now and in the future. What is needed now are policies to stimulate private-sector investment combined with near-term government stimulus focused on maximizing returns on any new debts incurred. Any additional near-term deficit increases must be done within the context of a longer-term deficit reduction plan. Examples of private-sector initiatives that would create jobs without costing1 This 26.4 million figure includes 13.9 million members who are unemployed, as well as 12.5 million members who are classified as “underemployed”—including 2.6 million of those deemed to be “marginally attached”to the labor force (defined as those not in the labor force but who wanted and were available for work and had looked for a job in the prior 12 months, but had not worked in the four weeks prior to the survey), 967,000 “discouraged workers”(people not currently looking for work because they believe there are no jobs available) and the 8.9 million who are working part-time but would prefer to be working full-time but could not find full-time employment.

the government a dime would include streamlining of regulations,applications and approval processes for new mineral exploration,production and manufacturing facilities, and a more intelligent immigration policy making it easier for immigrants educated in US universities to remain in the country, start businesses, raise families and buy homes. The US requires an overhaul of the tax code and a rethinking of the entitlement programs. Other policies that would cost the government money but which would likely have a high return on capital include rebuilding the US power grid, investment in infrastructure and job-skills retraining programs. Infrastructure investment in particular benefits from multiplier effects (where each dollar spent creates more than a dollar of GDP) while making the US more competitive.Investment in a smart grid can lower electricity costs and reduce the cost structure of US businesses. Investment in telecom infrastructure can improve productivity. As the table below illustrates, the US internet ranking as measured by download speeds has dropped to #30—below Greece—despite the fact that the internet was invented in America:Global Internet Speed Rankings

Investment Implications

As we approach the end of the third quarter earnings reporting cycle, over 70% of businesses have exceeded analysts’ expectations for revenue growth and earnings. Many corporations are raising dividends, continuing share buybacks and providing earnings guidance at healthy levels for 2012. There has been an increase in merger and acquisition announcements for strategic assets. We expect M&A activity to continue, and with each deal,companies are making positive statements about the future prospects for their specific businesses. Moreover a closer look at some of the leading economic indicators suggests that recent easing of inflation may be filtering through and leading to some positive surprises for the US economy, particularly when compared to the low expectations and poor sentiment seen towards the end of the last quarter. In addition, a growing number of global policy initiatives (including currency intervention, and interest rate/tax cuts) are being undertaken in order to stimulate growth to counteract the contraction in many of the developed economies.

In the past decade, the world economies have opened up considerably and today’s drivers of global GDP growth are increasingly the developing economies rather than just the developed ones. Over the last decade, many US investor portfolios that were benchmarked to the S&P 500 were not necessarily well positioned to participate effectively in globalization and the shift from developed to developing economies. The critical industries benefiting from global growth were among the least represented in the index as highlighted in the table below:Globalization is not appropriately reflected in the S&P 500 Weightings

Furthermore we believe that investors need to adjust to an environment of shorter-term economic cycles within the context of longer-term secular trends. With this in mind, there is a virtue to being able to embrace the opportunities that volatility presents to long-term investors. ARS portfolios will continue to adjust the portfolio weightings among the four key areas—the crown jewels of global growth, dividend payers, gold and gold miners and cash—within the context of the secular trends and cycles.We are often asked by clients how one can be invested with all the problems facing an over-leveraged system, namely high unemployment with little or no economic growth in the developed world. In any economic environment there will always be beneficiaries of the prevailing trends, as well as companies and sectors exposed to headwinds. At ARS, the focus is on identifying the important secular trends and determining which undervalued businesses will be the longer-term beneficiaries while avoiding those areas that are most vulnerable. In a period of deleveraging and currency devaluation, capital will flow to those businesses providing the inputs that are essential for the industrialization of the developing economies and the needs of the developed economies. When countries engage in currency devaluation, this process eventually tends to increase the nominal value of gold and gold miners, hard assets and many equities. A number of the businesses involved with the production of these assets are trading today at significant discounts to their net asset values and low multiples of their free cash flows. With interest rates at historic lows and likely to stay there for some years, investors should also look to benefit from the attractive dividends currently available from select US corporations with strong balance sheets and the ability to raise payouts over time. While this Outlook discusses many of the challenges facing the global economy, our investment team is identifying businesses that our research has determined are undervalued and represent attractive longer-term investments to generate capital and protect purchasing power.

Appendix: American Society of Civil Engineers 2009 Report

During the past quarter, leading economic indicators around the world began to soften as a result of fiscal tightening in the developing world in combination with disruptions from the nuclear tragedy in Japan and record flooding in Australia, uprisings in the Middle East and rising food and oil prices. While there are always shorter-term ebbs and flows within the context of important secular trends, it is important to remain focused on the companies benefitting from enduring themes. As we start the second half, some of the same factors that were weighing on growth are in the process of reversing themselves. Manufacturing activity has been increasing and China is in the later stages of its monetary tightening policy. Furthermore Japan and Australia are beginning their re-building process, creating renewed demand for materials and loosening supply-chain bottlenecks. For ARS, our research process is presenting a number of compelling investment opportunities resulting from both the cyclical and secular trends. This Outlook focuses on the structural challenges of deleveraging facing the developed world and why we believe the Central Banks of the US and europe will be compelled to keep interest rates low well into the future. Both are likely to continue policies of currency devaluation through the purchase of government debt with newly-created money (a process referred to as “monetization”) in an effort to ease debt burdens. In his press comments following the recent FOMC meeting, Federal Reserve Chairman Ben bernanke lowered his forecast for US growth, inflation, employment growth and interest rates. In this sustained low-rate environment where trillions of dollars are earning virtually no interest, we expect money market and fixed income investors to seek the higher rates of return offered by high-quality healthcare, consumer staples, utilities and defense companies with secure and growing dividend yields well in excess of money market and shorter-term bond rates. The difficult sovereign debt situation of the developed nations reinforces our view of the risks of owning paper assets, particularly of financial institutions during a prolonged period of deleveraging, and also highlights the continued importance of gold investments in portfolios. investment portfolios should also continue to prioritize companies catering to essential needs that the world’s population cannot do without, including inputs needed for food, power, infrastructure and rising living standards. given their exposure to the economic cycle, these investments should be focused on companies with the strongest franchises, management teams and balance sheets with the best prospects for profitable growth and the greatest

  aRS notes that in 2001 the federal debt stood at $5.8 trillion with interest costs of $206 billion. By year-end 2011 the national debt is estimated to have nearly tripled to $15.5 trillion but with virtually the same interest costs as in 2001 ($207 billion) due to significantly lower interest rates. Just for perspective, three-month treasury bills in 2001 yielded 3.44% versus today’s rate of 0.1%. Today’s lower rates are the end result of a multi-decade disinflation trend punctuated by the Federal Reserve’s initiative coming out of the financial crisis to hold short-rates near 0%. With the average maturity of the national debt at approximately 53 months, any increase in interest rates would rapidly filter through the government’s average debt balance resulting in higher interest expense. If the current blended rate of 1.5% were to rise to approximately 4% (still well below 50-year average rate of approximately 6%), total annual interest expense would increase to more than $600 billion. this would offset much of the benefit of deficit reduction currently being contemplated in Washington. One can effectively argue that many of the assumptions that exist in the budget projections are optimistic at best, suggesting actual deficits could be greater than those estimated in the preceding chart. Moreover with national debt exceeding 100% of GDP, a 4% cost of debt would mean that GDP would need to grow at an even higher rate than 4% (assuming the deficits are eliminated) just to keep the debt-to-GDP level constant. Achieving this rate of growth on a sustained basis is quite difficult for any developed economy, especially at a time of deleveraging. the challenge of addressing the debt burden in a politically acceptable manner will keep pressure on the Federal Reserve to continue its easy money policy. the following chart highlights the 30-year debt cycle in the US in which GDP growth was augmented by an ever-increasing ratio of total debt-to-GDP:As the chart illustrates, over the past two years, debt-to-GDP (the red line) has stabilized and begun to decline as debt capacity and appetite in the private sector has subsided. This is starting the healing process but also impeding growth as capital is diverted from consumption and investment to debt reduction. To further break the 30-year debt cycle, the economy must be reoriented to grow faster than debt, and must be led by the private sector. structural areas in which the government can help include: targeted reinvestment in infrastructure, refined immigration and education policies to match labor skills with job demand, tax code revisions to reduce disincentives for investment in the US and an overlay to regulatory policy that makes new investment and private-sector job creation paramount in the cost-benefit analysis of new and existing regulations. Recognizing that many of these are “third rail” issues, to effect the necessary change will require bold leadership from political representatives and support from business and voters and will still take some years to accomplish. One additional, and very overdue, initiative is the need to implement a strategic national energy policy which could create significant increases in employment, improve the US trade deficit and potentially be a net benefit to environmental and military priorities.

It’s About Job Creation

the foremost concern of government leaders around the world is to stay in power. Given the social and economic stresses being experienced today, the biggest concern for leaders should be job creation. At the root of the Arab Spring was broad-based discontentment in society caused in large part by high levels of unemployment, food inflation and government corruption. In the US, reported unemployment remains around 9%, and a study of the demographic segments highlights the particular challenges for women who maintain families (over 12%) and various minority groups (11% to 15%). adjusting for workers who have given up looking for work or who work parttime but would prefer full-time employment, the total unemployment rate is estimated to be closer to 16%. Importantly for President Obama, no president has been re-elected in recent decades with an unemployment rate above 7.5%. In Europe, the peripheral countries also have significant unemployment problems as indicated on the following chart:Particularly troubling are the unemployment figures for the younger demographic with Greece at 33%, Spain at 32% and Ireland at 28%. Japan has a very different problem of a rapidly aging workforce with too few new entrants to the labor pool. Finally, China faces perhaps the greatest challenge which is to create well over 10 million jobs per year to meet the growing expectations of 1.3 billion people seeking a higher living standard. the critical point missing from the current discussions in Washington is that the economy cannot recover without increasing aggregate demand. For the past several weeks we have been reviewing the “Fiscal Year 2012 Budget of the US Government” published by the Office of Management and Budget (OMB) and “Economic Indicators” prepared for the Joint Economic committee by the Council of Economic Advisors. After consideration of the numbers and assumptions, it is painfully obvious that the fiscal imbalances of the US will remain for an extended period. While politicians debate the merits of cutting spending and/or raising taxes, the idea that our nation can achieve the required GDP growth through either approach alone is seriously flawed. until the US is clearly on a path of sustainable growth, Chairman Bernanke has strongly cautioned Congress to delay any policy that would be contractionary. Unlike past recessions when interest rate reductions were aggressively pursued by the Federal Reserve and successfully stimulated economic activity, this time the rate cuts only served to halt the decline and create subpar growth. With the US unemployment rate at approximately 9%, growth must be the first priority, with deficit reduction following as part of a credible, concrete and longer-term plan.

OPEC and the Recent Strategic Petroleum Reserve Release

the tension over political and religious differences between Saudi Arabia and Iran carried into the recent OPEC meeting, highlighting conflicting priorities. saudi Arabia argued for OPEC to increase production in order to promote lower prices and support global growth. A quota increase plays to Saudi arabia’s advantage because they are one of the few OPEC members with excess capacity, and the additional revenues from higher sales volumes would be useful at a time when they are spending heavily to keep their population content. Iran, in contrast, is already producing oil near full capacity and hence any decrease in price would result in a net loss of revenues. The excess capacity of OPEC being concentrated in just a few member countries, calls into question the longer-term role of OPEC in oil price stability. Following the conflicted OPEC meeting the International Energy Agency (IEA) orchestrated the release of 60 million barrels of oil from member nations’ Strategic Petroleum Reserves (SPR). The IEA also would not rule out an additional release once the drawdown is complete. These actions would appear to shift the purpose of the SPR from a national security role to a political/economic one. The political motivation could involve portraying the IEA as the responsible party for any oil price weakness dampening Iranian hostility towards the Saudis. The second political consideration relates to the desire by the Administration to reduce the price of gasoline to help American consumers during the summer driving season. The logic that this infusion will offset the loss of Libya’s oil production is questionable due the fact that it is attempting to replace a consistent flow of high-quality crude with a one-time infusion that will eventually need to be replaced. Moreover, the 60 million barrels will only replace a little over thirty-seven days of Libya’s production, and some of the oil is coming from the reserves of Japan which is a nonproducing nation struggling to offset the loss of its nuclear power. It would also not be a surprise to see China take advantage of temporarily lower prices to continue to build its own SPR.

Investment Implications

the global imbalances built up over decades will take several years to resolve. Our recent Outlooks have highlighted the secular growth prospects in the developing world, where the industrialization of a majority of the world’s population is creating demand for critical materials and services and benefiting leading companies that are well-positioned to fulfill these needs. We have also discussed the need for deleveraging in the developed economies, including the US and Europe, which will continue to restrain economic growth. These competing forces are likely to be felt for some years. Following the recent slowdown, it is easy to forget that the global economy continues to expand with GDP growth projected to be approximately 2% in the developed world and 5% in the developing world in 2011. Based on 2010 global GDP of approximately $65 trillion, those growth levels would produce approximately $2 trillion in additional global GDP in 2011 directly benefitting the earnings of well-positioned companies. As we have written about regularly since the financial crisis, it is important to keep perspective and to take advantage of market volatility where appropriate. equity investors should continue to emphasize the ownership of leading US companies with attractive valuations offering a margin-of-safety which cater to the world’s essential needs. In our research, we continue to find several compelling investment opportunities, including high-quality franchises with defensive businesses and appealing dividend yields. These dividend yields, that are well-in-excess of money market and short-term bond rates, are taking on increased importance in this low interest rate environment. We expect capital to flow to higher yielding equity securities as the United States enters its third year with negative real short-term interest rates. For fixed income, we favor high-quality investment-grade securities of intermediate duration. Lastly, given the political practice of “kicking the can down the road” rather than addressing problems of excessive leverage in the developed world, the prospects exist for further central bank monetization and currency devaluation in order to make debts easier to handle. In this environment, precious metals will continue to play an important role for preservation and growth of longer-term purchasing power in equity portfolios.