Category: The Outlook

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.

Congress’s recent passage of tax legislation should temporarily improve business and consumer confidence, while lifting some of the burden from the Federal Reserve which now does not have to go it alone in boosting economic activity. The extension of the Bush tax rates has provided some temporary relief to many small business owners, who had otherwise faced significant tax increases in the coming year. The payroll tax deduction component is expected to save workers $120 billion in taxes. A portion of this deduction will go into savings or debt pay-down, and some portion will be spent on imported goods which will tend to increase the U.S. trade deficit. However, at least some portion of the $120 billion tax reduction should provide economic stimulus. The Federal Reserve’s second program of quantitative easing, dubbed QE2 which is targeted at $600 billion and extends to June 2011, is also supporting the near-term outlook for U.S. equities. Many U.S. companies are prospering and enjoying significantly higher growth and strong earnings resulting from cost cuts made during the financial crisis. This continues to encourage corporations to enact dividend increases, share buybacks, and to engage in further merger and acquisition activity. We expect these trends to continue in 2011.

Much has been written about the developing economies’ increased role in global GDP growth. The chart below lists the annual projected GDP and debt for several leading countries as well as their currency reserves. This chart clearly highlights those countries that are projected to benefit from their current growth initiatives for many years. One of the noteworthy points from the chart is that the developing countries continue to generate currency reserve growth while the developed economies, with some exceptions, continue to compound their debt burdens. The numbers below also demonstrate the muted expected growth in the developed world.

Global GDP, Debt and Currency Reserves Overview Statistics

Because the United States is the leading power, largest economy and source of leading-edge innovation, it must foster global solutions, not just national ones. It must embark on pro-growth policies at the same time that deficit reduction is addressed. The U.S. needs to immediately address its shortfall in essential infrastructure and education investment, which unfortunately is not happening. While Asian demand can and will generate some U.S. job growth bringing global trade into somewhat better balance, international cooperation is vital. Without international cooperation on addressing the imbalances, currency wars and potential trade friction are likely to persist or increase.

At the same time the European economies must reform themselves rather than rely on austerity to address debt issues. Austerity programs without growth initiatives will just promote stagnation and social stress and cannot contribute to global solutions. Higher growth leads to higher employment and low or no growth leads to further weakening of the financial system with increasing bank liabilities and further economic contraction. Moreover, global financial markets require global financial regulations, otherwise there will always be a race to the bottom with those countries with the weakest regulations attracting the largest capital flows resulting in future financial instability.

The world’s population has nearly doubled over the last 40 years. However, most of that growth has occurred in the developing world. Following World War II, the western world and Japan rapidly built or re-built their industrial infrastructures, while South America, Africa, the communist blocs and Asia ex Japan remained relatively impoverished and agrarian-based. Thus the developing markets had relatively limited demand for the necessities of industrialization despite their growing populations. As the developed world matured, demand for many key commodities began to slow, leading to lower prices, and in turn, reduced investment in new production. Throughout the 1980’s and 1990’s, prices for key commodities remained depressed, and producers mined their highest-grade and most profitable ore bodies just to stay in business. All the while, the world’s population continued to increase by nearly 75 million each year.

Beginning in the late 1970’s and accelerating after the fall of the Soviet Union, key political changes began to unfold in the developing world as several of the largest countries by population began implementing market-based reforms for their economies leading ultimately to China’s admission to the World Trade Organization (WTO) in 2001. Developing countries with large populations and lower labor costs had a key cost advantage allowing them to gain market share and increase their per-capita wealth as global free trade expanded. As the following chart illustrates, China and India, the world’s two largest countries by population, have rapidly been expanding their GDP per capita, allowing several hundred million people to transition from subsistence living to having discretionary income. Even with the continued rapid growth that is forecast by the IMF for these countries between now and 2015, China and India are still expected to have GDP per capita well below the world average, and substantially below those in the developed world:

World Population and Wealth per Capita

With increasing GDP per capita, developing nations could begin to afford some of the relative luxuries long taken for granted in the developed world, beginning with improving diets (primarily larger quantities of protein and more varied fruits and vegetables), and eventually including new appliances, electronics, automobiles, larger homes or apartments and increased access to modern healthcare. These changes in consumer behavior gradually led to increased demand for key raw materials. This increased demand is occurring after a 30-year period in which producers made only limited investment in their businesses due to weak developed-world demand. As a result, the world is structurally under-invested in key strategic areas creating a shortage of supply and causing prices to rise.

One of the areas in which the implications of global growth are clear is in agriculture. In addition to having 75 million more mouths to feed each year, improving incomes per capita are having a dramatic impact on grain demand. The reason for this is that as people emerge from poverty, their first priority is to improve their diets. In China and India, for every incremental dollar earned, the amount spent on food (often increased protein) is 0.40 and 0.70 cents respectively, compared with under 0.10 cents in the U.S. Protein is also more grain-intensive—each kilogram of chicken, pork or beef produced requires feed grains of two, four and seven kilograms respectively; therefore rising incomes can have an exponential impact on the need for grain. Furthermore, while population has nearly doubled and incomes have risen, the amount of farmable land per capita has been cut in half since 1970. This makes it critical for farmers to be as efficient as possible with the land and resources available.

There are already several signs that food supplies are becoming tight. In 2010, China was forced to import significant quantities of corn for the first time since 1996. Also, several agricultural commodities hit all-time or multi-decade highs in 2010, including cocoa, sugar, cotton and coffee among others. Rising food prices and the need to produce ever-growing quantities of grain on a limited land base mean the world will need more fertilizer and modern farm equipment in the years ahead to maximize yields. Two of the key components of fertilizer are mined out of the ground and are owned and controlled by a handful of global companies making those companies very well-positioned to benefit from continued growth in populations and incomes.

Another critical demand driver for key resources will be automobile ownership in the developing world. This year China is on-track to produce more than 18 million cars—more than the U.S. and Canada combined. Yet history would suggest that China’s auto production has room to grow substantially from these already impressive levels. Auto ownership in China is less than 50 vehicles per one thousand families. This compares with approximately 100 for Brazil, 250 for South Korea, 450 for Japan and over 800 for the U.S. Traditionally there has been a strong correlation between auto ownership and GDP per capita, and indeed the ownership levels just described are directly proportionate with the GDP per capita levels of those respective countries. If auto ownership in China moves in proportion to its expected growth in GDP per capita as forecasted by the IMF, total auto ownership could nearly double by 2015, and various estimates have China’s annual auto production increasing to 20-30 million, up from just 13 million in 2009. We expect this substantial increase in production to result in continued strong demand for iron ore and the coking coal used in the production of steel.

This rapid increase in automobile ownership in China and the developing world also helps explain why global oil demand declined by less than 2% following the financial crisis of 2008 compared with a nearly 10% peak-to-trough decline during the recessions of the early 1980’s. As the developed world slowly recovers from recession and the developing world continues to industrialize, we expect demand for energy sources of all types to remain strong. Over the last 5 years, China and India have gone from being self-sufficient in coal resources (indeed, both were net exporters) to being significant importers of both thermal and coking coal; and state-owned or state-influenced energy companies of both countries have been making acquisitions and striking long-term supply agreements around the world to ensure future adequate supplies. It is also worth noting that over 3.6 billion people in the world do not have adequate electricity and approximately 2 billion people have no electricity at all. For these reasons, we expect the owners and producers of oil, coal and other basic materials suppliers to be significant beneficiaries of the developing world’s industrialization in the years ahead.

Portfolio Implications

In this connection, the opportunity for investors is to understand these global dynamics, identify the businesses positioned to benefit and select those securities offering the best combination of risk and reward. The industries and companies that produce the vital goods and services in support of rising living standards and increasing industrial capacity will be the drivers and the beneficiaries of global growth and should be the focus for investment security selection. In addition, with interest rates still near historic lows, high-quality companies with attractive and growing dividend yields will continue to attract capital as income-oriented investors seek alternatives to the paltry yields currently available in the fixed income market.

Given the debt levels and growing deficits in the developed world, our fixed income approach should continue to be a conservative one restricting maturities to no more than the 5-8 year range unless presented with unusual opportunities. We also think it is prudent to be sensitive to the quality of municipal issuers given the budget gaps facing state and local governments.

On behalf of the team at A.R. Schmeidler, we wish you and your families a safe, happy and fulfilling New Year.

Investment Perspectives: 2011 and Beyond
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As 2010 comes to a close with the second consecutive year of positive returns in the equity markets, market participants are focused on what 2011 may bring for investors. Several important events in the developed world have mitigated the risk of an economic setback in 2011 and improved market sentiment. However at A.R. Schmeidler the focus also extends further out, for the opportunities to create capital and protect purchasing power lie in the compounding of wealth over years, and not quarters. Global Gross Domestic Product (GDP) is forecast to grow to $73.1 trillion in 2013 from $61.9 trillion in 2010 by the International Monetary Fund (IMF). This $11.2 trillion of growth represents an opportunity for thoughtful investors. Unlike in past business cycles, the developing world will play a much greater role as the BRIC (Brazil, Russia, India and China) nations alone account for 34% of projected growth. For the next several years, portfolios should emphasize those businesses that are positioned to prosper from rising global demand for many of the essential inputs needed by the world’s population of approximately 7 billion people.
Congress’s recent passage of tax legislation should temporarily improve business and consumer confidence, while lifting some of the burden from the Federal Reserve which now does not have to go it alone in boosting economic activity. The extension of the Bush tax rates has provided some temporary relief to many small business owners, who had otherwise faced significant tax increases in the coming year. The payroll tax deduction component is expected to save workers $120 billion in taxes. A portion of this deduction will go into savings or debt pay-down, and some portion will be spent on imported goods which will tend to increase the U.S. trade deficit. However, at least some portion of the $120 billion tax reduction should provide economic stimulus. The Federal Reserve’s second program of quantitative easing, dubbed QE2 which is targeted at $600 billion and extends to June 2011, is also supporting the near-term outlook for U.S. equities. Many U.S. companies are prospering and enjoying significantly higher growth and strong earnings resulting from cost cuts made during the financial crisis. This continues to encourage corporations to enact dividend increases, share buybacks, and to engage in further merger and acquisition activity. We expect these trends to continue in 2011.

Much has been written about the developing economies’ increased role in global GDP growth. The chart below lists the annual projected GDP and debt for several leading countries as well as their currency reserves. This chart clearly highlights those countries that are projected to benefit from their current growth initiatives for many years. One of the noteworthy points from the chart is that the developing countries continue to generate currency reserve growth while the developed economies, with some exceptions, continue to compound their debt burdens. The numbers below also demonstrate the muted expected growth in the developed world.

Global GDP, Debt and Currency Reserves Overview Statistics

The Outlook for the Developed World Remains Challenged
Contrary to the developing world, the fiscal regimes of the developed world, social tensions over austerity budgets and high unemployment continue to cast a shadow over the outlook. Perhaps the greatest concern facing all nations is creating jobs. Unemployment in the developed world remains at critically elevated levels, while developing nations need to continue to meet the expectations of their populations. The structural issues of most of the developed world, particularly the U.S., U.K., Japan and Europe have not been adequately addressed. While the developing economies continue to be on a growth trajectory, most developed ones are struggling with the need to foster growth and at the same time confront growing debt.

Because the United States is the leading power, largest economy and source of leading-edge innovation, it must foster global solutions, not just national ones. It must embark on pro-growth policies at the same time that deficit reduction is addressed. The U.S. needs to immediately address its shortfall in essential infrastructure and education investment, which unfortunately is not happening. While Asian demand can and will generate some U.S. job growth bringing global trade into somewhat better balance, international cooperation is vital. Without international cooperation on addressing the imbalances, currency wars and potential trade friction are likely to persist or increase.

At the same time the European economies must reform themselves rather than rely on austerity to address debt issues. Austerity programs without growth initiatives will just promote stagnation and social stress and cannot contribute to global solutions. Higher growth leads to higher employment and low or no growth leads to further weakening of the financial system with increasing bank liabilities and further economic contraction. Moreover, global financial markets require global financial regulations, otherwise there will always be a race to the bottom with those countries with the weakest regulations attracting the largest capital flows resulting in future financial instability.

Longer-Term Drivers of Developing World Growth and Investment Implications
Structural challenges in the developed world can make it easy to overlook the compelling growth drivers we see in the developing world. Moreover, as we have often discussed, the 24-hour business news cycle has made for a preoccupation with the short-term making it easy to lose sight of longer-term opportunities. With this in mind, we thought it would be helpful to summarize some of the compelling statistics that we uncover in our research each day that strengthen our conviction in the companies and sectors in which we invest.
The world’s population has nearly doubled over the last 40 years. However, most of that growth has occurred in the developing world. Following World War II, the western world and Japan rapidly built or re-built their industrial infrastructures, while South America, Africa, the communist blocs and Asia ex Japan remained relatively impoverished and agrarian-based. Thus the developing markets had relatively limited demand for the necessities of industrialization despite their growing populations. As the developed world matured, demand for many key commodities began to slow, leading to lower prices, and in turn, reduced investment in new production. Throughout the 1980’s and 1990’s, prices for key commodities remained depressed, and producers mined their highest-grade and most profitable ore bodies just to stay in business. All the while, the world’s population continued to increase by nearly 75 million each year.

Beginning in the late 1970’s and accelerating after the fall of the Soviet Union, key political changes began to unfold in the developing world as several of the largest countries by population began implementing market-based reforms for their economies leading ultimately to China’s admission to the World Trade Organization (WTO) in 2001. Developing countries with large populations and lower labor costs had a key cost advantage allowing them to gain market share and increase their per-capita wealth as global free trade expanded. As the following chart illustrates, China and India, the world’s two largest countries by population, have rapidly been expanding their GDP per capita, allowing several hundred million people to transition from subsistence living to having discretionary income. Even with the continued rapid growth that is forecast by the IMF for these countries between now and 2015, China and India are still expected to have GDP per capita well below the world average, and substantially below those in the developed world:

With increasing GDP per capita, developing nations could begin to afford some of the relative luxuries long taken for granted in the developed world, beginning with improving diets (primarily larger quantities of protein and more varied fruits and vegetables), and eventually including new appliances, electronics, automobiles, larger homes or apartments and increased access to modern healthcare. These changes in consumer behavior gradually led to increased demand for key raw materials. This increased demand is occurring after a 30-year period in which producers made only limited investment in their businesses due to weak developed-world demand. As a result, the world is structurally under-invested in key strategic areas creating a shortage of supply and causing prices to rise.

One of the areas in which the implications of global growth are clear is in agriculture. In addition to having 75 million more mouths to feed each year, improving incomes per capita are having a dramatic impact on grain demand. The reason for this is that as people emerge from poverty, their first priority is to improve their diets. In China and India, for every incremental dollar earned, the amount spent on food (often increased protein) is 0.40 and 0.70 cents respectively, compared with under 0.10 cents in the U.S. Protein is also more grain-intensive—each kilogram of chicken, pork or beef produced requires feed grains of two, four and seven kilograms respectively; therefore rising incomes can have an exponential impact on the need for grain. Furthermore, while population has nearly doubled and incomes have risen, the amount of farmable land per capita has been cut in half since 1970. This makes it critical for farmers to be as efficient as possible with the land and resources available.

There are already several signs that food supplies are becoming tight. In 2010, China was forced to import significant quantities of corn for the first time since 1996. Also, several agricultural commodities hit all-time or multi-decade highs in 2010, including cocoa, sugar, cotton and coffee among others. Rising food prices and the need to produce ever-growing quantities of grain on a limited land base mean the world will need more fertilizer and modern farm equipment in the years ahead to maximize yields. Two of the key components of fertilizer are mined out of the ground and are owned and controlled by a handful of global companies making those companies very well-positioned to benefit from continued growth in populations and incomes.

Another critical demand driver for key resources will be automobile ownership in the developing world. This year China is on-track to produce more than 18 million cars—more than the U.S. and Canada combined. Yet history would suggest that China’s auto production has room to grow substantially from these already impressive levels. Auto ownership in China is less than 50 vehicles per one thousand families. This compares with approximately 100 for Brazil, 250 for South Korea, 450 for Japan and over 800 for the U.S. Traditionally there has been a strong correlation between auto ownership and GDP per capita, and indeed the ownership levels just described are directly proportionate with the GDP per capita levels of those respective countries. If auto ownership in China moves in proportion to its expected growth in GDP per capita as forecasted by the IMF, total auto ownership could nearly double by 2015, and various estimates have China’s annual auto production increasing to 20-30 million, up from just 13 million in 2009. We expect this substantial increase in production to result in continued strong demand for iron ore and the coking coal used in the production of steel.

This rapid increase in automobile ownership in China and the developing world also helps explain why global oil demand declined by less than 2% following the financial crisis of 2008 compared with a nearly 10% peak-to-trough decline during the recessions of the early 1980’s. As the developed world slowly recovers from recession and the developing world continues to industrialize, we expect demand for energy sources of all types to remain strong. Over the last 5 years, China and India have gone from being self-sufficient in coal resources (indeed, both were net exporters) to being significant importers of both thermal and coking coal; and state-owned or state-influenced energy companies of both countries have been making acquisitions and striking long-term supply agreements around the world to ensure future adequate supplies. It is also worth noting that over 3.6 billion people in the world do not have adequate electricity and approximately 2 billion people have no electricity at all. For these reasons, we expect the owners and producers of oil, coal and other basic materials suppliers to be significant beneficiaries of the developing world’s industrialization in the years ahead.

Portfolio Implications
Our portfolios and results have benefited from our longer-term focus on the global divergences and opportunities. The deleveraging in the developed world and industrialization in the developing economies will continue and remain the defining features for investment security selection and portfolio management. Short-term cyclical improvements in the U.S. will increase corporate profits and equity returns over the coming period. At the same time low interest rates are continuing to enable companies to improve their balance sheets, in many cases already strong, and increase their earnings as higher-cost debt is replaced by lower-cost debt. Coming on top of already strong corporate balance sheets, select companies and industries are well-positioned to benefit from the forces at work in the global economy. The headwinds we have discussed will not vanish without fundamental change – the type of change which most governments have proven unwilling or unable to effect – which should mean that the volatility experienced in 2010 should continue.
In this connection, the opportunity for investors is to understand these global dynamics, identify the businesses positioned to benefit and select those securities offering the best combination of risk and reward. The industries and companies that produce the vital goods and services in support of rising living standards and increasing industrial capacity will be the drivers and the beneficiaries of global growth and should be the focus for investment security selection. In addition, with interest rates still near historic lows, high-quality companies with attractive and growing dividend yields will continue to attract capital as income-oriented investors seek alternatives to the paltry yields currently available in the fixed income market.

Given the debt levels and growing deficits in the developed world, our fixed income approach should continue to be a conservative one restricting maturities to no more than the 5-8 year range unless presented with unusual opportunities. We also think it is prudent to be sensitive to the quality of municipal issuers given the budget gaps facing state and local governments.

On behalf of the team at A.R. Schmeidler, we wish you and your families a safe, happy and fulfilling New Year.

Copyright © 2010 by A.R. Schmeidler & Co., Inc. All rights reserved.

The information and opinions in this report were prepared by A.R. Schmeidler & Co., Inc. (“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. ARS and its employees shall have no obligation to update or amend any information contained herein. The contents of this report do not constitute an offer or solicitation of any transaction in any securities referred to herein or investment advice to any person and ARS will not treat recipients as its customers by virtue of their receiving this report. ARS or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments mentioned herein.

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For perspective, the global economy is experiencing two powerful secular forces that will continue for years if not decades. The first is the deleveraging of most developed economies after more than 20 years of easy money and excessive indebtedness. The second is the rapid industrialization of the emerging economies that is creating dynamic shifts in the demand for the necessities required to support their rapid growth. The result of these forces has been the massive transfer of wealth from West to East, as we have written about previously. The efforts to stimulate the global economy after the financial crisis have accelerated these divergences. We believe that consistent focus on these enduring trends will enable serious investors to position their portfolios in the attractive companies that are beneficiaries of these dynamic periods while avoiding those companies that will be negatively impacted. This Outlook will focus on the impact of continuing currency creation by central banks against a backdrop of an unprecedented global financial environment.

GDP Growth, Fiat Currency and Reserve Currency Defined

A reserve currency, or anchor currency, is a currency which is held in significant quantities by governments and institutions as part of their foreign exchange holdings because of its perceived importance, stability and liquidity. It also is the international pricing currency for products traded on global markets such as oil, gold, non-ferrous metals, grains and other commodities. The U.S. dollar has enjoyed the status of being the world’s reserve currency since the Bretton Woods agreements of July 1944. From that time and continuing up to the mid-1980’s, the U.S. was the largest creditor nation and the fastest-growing economy in the world. This contrasts sharply with its current position as the largest debtor nation with the largest deficits and sub-par growth.

The Challenge for the Developed Economies

Central banks and governments continue to face difficult choices in dealing with increased social, economic and political challenges. The recent efforts to implement austerity programs by European governments are undermining the social order. High unemployment rates, worker strikes and political backlash against incumbent leaders continue to dominate the headlines, particularly with respect to France, Greece, Poland, Spain and Portugal. Consequently, opposition to further fiscal stimulus initiatives leaves countries more dependent on export growth. To achieve this, these developed countries’ currencies must be devalued. Japan, which is export-driven, recently took steps to weaken the yen to protect the competitiveness of its exports. However, Japan’s efforts to weaken the yen are being hindered by the specter of further QE by the U.S. Federal Reserve (Fed), which is widely expected to be implemented at the next FOMC meeting in November (dubbed “QE2” by the financial press). This prospect is weakening the U.S. dollar versus the yen. Japan’s experience highlights the interconnectivity of the global economy and foreshadows the risks of a currency war as other countries continue to take steps to devalue their currencies or implement capital controls. Brazil and Thailand recently introduced tax increases to slow the flow of capital into their economies for fear of overheating and making their exports more expensive. Capital inflows have the effect of pushing up the value of a currency making exports more expensive and less competitive.

In the U.S., the headwinds from high unemployment levels, low interest rates and the need to bring state and local budgets into balance leave this economy in a state of disequilibrium. The U.S. can no longer count on an over-leveraged consumer to drive GDP growth, and in light of this the current administration has made doubling exports over the next five years a priority. This makes a cheaper U.S. dollar a necessity. Unfortunately for the world’s central bankers, currency moves do not occur in isolation. Further complicating the global currency picture is China’s currency policy. China is a leading exporter, the largest creditor to the U.S., the owner of the largest currency reserve and one of the fastest growing economies that has pegged its currency to the dollar. So a weakening U.S. dollar pulls down the Chinese yuan (or renminbi) putting further pressure on other nations’ exports as their currencies effectively appreciate against the yuan. Consequently those countries risk losing market share to the Chinese until they devalue their own currencies.

We are in a period of competitive currency devaluations as nations are forced to act and react to one another’s policies. Attempts to manage currencies in this fashion are short-term oriented and merely postpone the hard decisions ultimately required for structural change. At some point, coordinated action by governments will be required.

The Fed Dilemma

The Fed is faced with a difficult choice. The Fed may continue and accelerate its efforts to stimulate the economy or let the economy deflate which would certainly lead to a deep recession. Both choices have a cost. The Fed has come out in favor of further quantitative easing to attempt to stimulate the economy. This could devalue the dollar and benefit exports but at the expense of potentially generating high inflation in the future and lowering the U.S. standard of living. If the Fed does not act it would be out of compliance with its mandate, and the economy would likely decline further unless the government embarked on well-targeted stimulus programs. After recent comments by several Fed officials, the Fed appears likely to move ahead with QE after the November 2nd mid-term elections, although the amount and timing of implementation are less certain. The scale of central bank monetary creation and intervention that is reportedly being considered is without precedent. We would not be surprised if the total amount of QE ultimately viewed to be required over the next few years is in excess of $2 trillion or approximately twice the size of the Federal Reserve’s balance sheet.

Implications of an Extended Low Rate Environment

Importantly, low rates have benefited many corporations by allowing them to strengthen their balance sheets, increase share repurchases, fund mergers and acquisitions and raise dividends. Many companies’ shares yield more than the interest they pay on their bonds. This valuation disparity cannot endure and we expect it to be reconciled through the continuing flow of capital into high-quality equities with attractive and growing dividends.

The Role of the U.S. Dollar as a Store of Value

This trend is leading to a shift in demand from fiat currencies toward hard assets, as reflected by the actions in recent years of various countries with surplus foreign reserves. Countries such as Russia, China, India, among others have been diversifying their foreign reserves into developing market currencies, as well as fixed and strategic assets and commodities, including oil and gas companies and projects, iron ore and copper mines as well as gold, among others.

Portfolio Strategy

In addition, in the environment of low interest rates that we expect to persist for some time, those companies with secure and rising dividends will continue to attract interest as investors seek higher returns. Leading pharmaceutical, consumer staples and even technology companies currently offer attractive and growing dividend yields and should be among the primary beneficiaries. These companies also enjoy strong balance sheets and significant revenue growth from the developing markets.

Fixed income security selection is focused on relative-value income opportunities with a short to intermediate duration. With regard to credit selection, we favor companies whose balance sheets are stable or strengthening. With the severe budget constraints facing states and municipalities, we are particularly cautious with regard to the municipal bond market. Given continuing economic and sovereign debt challenges, there is a high probability that demand for U.S. Treasury debt will remain strong keeping the rate structure at low levels.

Consistent with our 40 year history, ARS continues to focus on select undervalued businesses that are positioned to benefit from important secular trends. While investors continue to express concerns about investing in the broad market, ARS believes that this remains a time for opportunistic and thoughtful security selection as we continue to expect to see separation and outperformance for those companies that are well-positioned to benefit from the global divergences and imbalances described above.

The Forces of Currency Devaluation and the Impact on Investment Strategy

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The recent International Monetary Fund meeting may have marked another lost opportunity for global coordination by governments to rebalance and stimulate the world economy. Leading nations are focusing on their economic and political self interests rather than cooperating to maximize the best outcome for all. Over the past two years, the divergences between the surplus and deficit nations have grown and accelerated given the dramatically different profiles of the developing and developed economies. Since our inception, A.R. Schmeidler (ARS) has focused a significant amount of research effort around the study of global capital flows recognizing that capital always flows to the highest rate of return. At the core of global capital flows are currencies which serve as the transmission mechanism of the global economy.
For perspective, the global economy is experiencing two powerful secular forces that will continue for years if not decades. The first is the deleveraging of most developed economies after more than 20 years of easy money and excessive indebtedness. The second is the rapid industrialization of the emerging economies that is creating dynamic shifts in the demand for the necessities required to support their rapid growth. The result of these forces has been the massive transfer of wealth from West to East, as we have written about previously. The efforts to stimulate the global economy after the financial crisis have accelerated these divergences. We believe that consistent focus on these enduring trends will enable serious investors to position their portfolios in the attractive companies that are beneficiaries of these dynamic periods while avoiding those companies that will be negatively impacted. This Outlook will focus on the impact of continuing currency creation by central banks against a backdrop of an unprecedented global financial environment.

GDP Growth, Fiat Currency and Reserve Currency Defined

Fundamental to understanding the dynamics of the Outlook is an appreciation of the sources of Gross Domestic Product (GDP) growth as well as the meaning of fiat currency and reserve currency. The components of GDP growth for any country are consumption, business investment, government spending and net exports. Fiat currency, according to Deardorff’s Glossary of International Economics, is “money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins from a central bank, such as the Federal Reserve System in the U.S.) to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, public and private.” The main functions of money are as a medium of exchange and as a store of value.
A reserve currency, or anchor currency, is a currency which is held in significant quantities by governments and institutions as part of their foreign exchange holdings because of its perceived importance, stability and liquidity. It also is the international pricing currency for products traded on global markets such as oil, gold, non-ferrous metals, grains and other commodities. The U.S. dollar has enjoyed the status of being the world’s reserve currency since the Bretton Woods agreements of July 1944. From that time and continuing up to the mid-1980’s, the U.S. was the largest creditor nation and the fastest-growing economy in the world. This contrasts sharply with its current position as the largest debtor nation with the largest deficits and sub-par growth.

The Challenge for the Developed Economies

The developed world, with the exception of a select group of resource-rich and export-driven countries, has been experiencing a deficit and debt problem that has created a heightened risk of eventual sovereign-debt default. The need to deleverage is siphoning capital away from productive uses toward debt pay-down, resulting in a muted growth outlook and high levels of unemployment. Compounding the problem of weak growth in the developed economies is that longer-term debt concerns and government obligations have bolstered the case for fiscal austerity. Governments have taken the view that further borrowing is to be avoided, thus removing the support for public spending at a time when private demand remains weak. This is the wrong time for fiscal austerity because it now places the entire burden for growth on the central banks. The conventional tool of central banks to stimulate growth is through lowering interest rates. At a time when interest rates are already near zero, some central banks are expected to soon implement additional rounds of what is known as quantitative easing (“QE”), whereby they create money to purchase assets, typically treasury bonds. The stated goal of QE is to drive down longer-term interest rates in order to stimulate business activity. Two additional potential benefits of QE are to help the Treasury finance deficits and to weaken a nation’s currency through increasing money in circulation. A weaker currency serves as a stimulant for exports, until such time as other countries depreciate their currencies in response. Under this scenario of competitive devaluation, no export-dependent country can afford a strong currency, and since there is no backing for any currency, there is no limit to how much money a central bank may decide to print.
Central banks and governments continue to face difficult choices in dealing with increased social, economic and political challenges. The recent efforts to implement austerity programs by European governments are undermining the social order. High unemployment rates, worker strikes and political backlash against incumbent leaders continue to dominate the headlines, particularly with respect to France, Greece, Poland, Spain and Portugal. Consequently, opposition to further fiscal stimulus initiatives leaves countries more dependent on export growth. To achieve this, these developed countries’ currencies must be devalued. Japan, which is export-driven, recently took steps to weaken the yen to protect the competitiveness of its exports. However, Japan’s efforts to weaken the yen are being hindered by the specter of further QE by the U.S. Federal Reserve (Fed), which is widely expected to be implemented at the next FOMC meeting in November (dubbed “QE2” by the financial press). This prospect is weakening the U.S. dollar versus the yen. Japan’s experience highlights the interconnectivity of the global economy and foreshadows the risks of a currency war as other countries continue to take steps to devalue their currencies or implement capital controls. Brazil and Thailand recently introduced tax increases to slow the flow of capital into their economies for fear of overheating and making their exports more expensive. Capital inflows have the effect of pushing up the value of a currency making exports more expensive and less competitive.
In the U.S., the headwinds from high unemployment levels, low interest rates and the need to bring state and local budgets into balance leave this economy in a state of disequilibrium. The U.S. can no longer count on an over-leveraged consumer to drive GDP growth, and in light of this the current administration has made doubling exports over the next five years a priority. This makes a cheaper U.S. dollar a necessity. Unfortunately for the world’s central bankers, currency moves do not occur in isolation. Further complicating the global currency picture is China’s currency policy. China is a leading exporter, the largest creditor to the U.S., the owner of the largest currency reserve and one of the fastest growing economies that has pegged its currency to the dollar. So a weakening U.S. dollar pulls down the Chinese yuan (or renminbi) putting further pressure on other nations’ exports as their currencies effectively appreciate against the yuan. Consequently those countries risk losing market share to the Chinese until they devalue their own currencies.
We are in a period of competitive currency devaluations as nations are forced to act and react to one another’s policies. Attempts to manage currencies in this fashion are short-term oriented and merely postpone the hard decisions ultimately required for structural change. At some point, coordinated action by governments will be required.

The Fed Dilemma

The responsibility of the Board of Governors of the Fed as mandated by The Full Employment and Balanced Growth Act, more commonly known as the Humphrey-Hawkins Act, is to establish a monetary policy that fosters maximum employment and promotes price stability. Now over 21 months after the global financial crisis, the U.S. has neither stable prices nor full employment. With stubbornly high unemployment and a core Consumer Price Index (CPI) significantly below the 2% level that the Fed has defined as healthy for price stability, the pressure on the Fed to act has increased.
The Fed is faced with a difficult choice. The Fed may continue and accelerate its efforts to stimulate the economy or let the economy deflate which would certainly lead to a deep recession. Both choices have a cost. The Fed has come out in favor of further quantitative easing to attempt to stimulate the economy. This could devalue the dollar and benefit exports but at the expense of potentially generating high inflation in the future and lowering the U.S. standard of living. If the Fed does not act it would be out of compliance with its mandate, and the economy would likely decline further unless the government embarked on well-targeted stimulus programs. After recent comments by several Fed officials, the Fed appears likely to move ahead with QE after the November 2nd mid-term elections, although the amount and timing of implementation are less certain. The scale of central bank monetary creation and intervention that is reportedly being considered is without precedent. We would not be surprised if the total amount of QE ultimately viewed to be required over the next few years is in excess of $2 trillion or approximately twice the size of the Federal Reserve’s balance sheet.

Implications of an Extended Low Rate Environment

One of the first tools central bankers used coming out of the financial crisis was to lower interest rates. For the U.S., rates have been lowered to a target of 0.0-0.25% on the short end. The 2-year treasury recently hit 0.33% while the 10-year treasury reached a new low of 2.38%. Given the challenges facing the economy, interest rates are likely to stay low for a very long time. This has serious implications for important segments of the U.S. Low rates have a dramatic impact on those who rely on a fixed income and social security, which is not providing a cost-of-living adjustment for the second year in a row. At the same time, food, energy and health care costs continue to rise. In addition defined benefit pension plans require higher rates to meet their target return assumptions and have been severely impacted by the current rate environment. Furthermore, money market funds, which have played an important role in providing funding for the commercial paper market, have been impacted as low rates have placed fees under pressure leading to fee waivers that have reduced profitability. This has led some sponsoring institutions to reconsider the viability of staying in the money market fund business. At the same time investors are seeking higher-yielding investment alternatives. Those depending on fixed income will be required to seek higher returns in an attempt to maintain their living standards which may lead to shifts in asset allocation from fixed income into dividend-paying equities.
Importantly, low rates have benefited many corporations by allowing them to strengthen their balance sheets, increase share repurchases, fund mergers and acquisitions and raise dividends. Many companies’ shares yield more than the interest they pay on their bonds. This valuation disparity cannot endure and we expect it to be reconciled through the continuing flow of capital into high-quality equities with attractive and growing dividends.

The Role of the U.S. Dollar as a Store of Value

The current fiscal budget deficit exceeds $1.3 trillion, or nearly 10% of GDP. According to the Congressional Budget Office (CBO), the U.S. national debt is expected to grow from the current level of approximately $13.5 trillion to more than $18 trillion by 2015. This is likely to be significantly more than 100% of GDP. With deficits stuck at high levels and the national debt climbing dramatically, this structural imbalance will be with us for an extended period unless fundamental changes are undertaken for which there does not appear to be the political will. Further complicating the problem is the mid-term elections for Congress which is creating policy paralysis around taxes, additional stimulus programs and trade. With the burden for U.S. growth increasingly falling on the Federal Reserve, and the Fed’s resolve to bolster employment and avoid deflation at all cost, secular pressures on the buying power of the dollar continue to rise. The U.S. dollar remains a medium of exchange, but increasingly it is losing its status as a store of value.
This trend is leading to a shift in demand from fiat currencies toward hard assets, as reflected by the actions in recent years of various countries with surplus foreign reserves. Countries such as Russia, China, India, among others have been diversifying their foreign reserves into developing market currencies, as well as fixed and strategic assets and commodities, including oil and gas companies and projects, iron ore and copper mines as well as gold, among others.

Portfolio Strategy

Our Outlook remains consistent with our writings over the past two years. There are many opportunities in U.S. companies and select ADR’s that we expect to be beneficiaries of the current environment. As the emerging economies continue to grow bringing hundreds of millions of people higher living standards, there will be continued demand for the products and services of leading multinational companies. We also remain focused on the preservation of purchasing power for client portfolios given the global pursuit of competitive currency devaluation to maintain export competitiveness, combat deflation and promote growth. If central banks are successful at debasing the values of fiat currencies over the longer term, the prices of vital goods and services that are traded internationally will tend to rise in terms of the currencies being devalued. Some of the primary beneficiaries of competitive devaluation and quantitative easing, as well as the industrialization of developing economies, are the producers of gold, silver, energy, iron ore, copper, steel and agricultural commodities.
In addition, in the environment of low interest rates that we expect to persist for some time, those companies with secure and rising dividends will continue to attract interest as investors seek higher returns. Leading pharmaceutical, consumer staples and even technology companies currently offer attractive and growing dividend yields and should be among the primary beneficiaries. These companies also enjoy strong balance sheets and significant revenue growth from the developing markets.
Fixed income security selection is focused on relative-value income opportunities with a short to intermediate duration. With regard to credit selection, we favor companies whose balance sheets are stable or strengthening. With the severe budget constraints facing states and municipalities, we are particularly cautious with regard to the municipal bond market. Given continuing economic and sovereign debt challenges, there is a high probability that demand for U.S. Treasury debt will remain strong keeping the rate structure at low levels.
Consistent with our 40 year history, ARS continues to focus on select undervalued businesses that are positioned to benefit from important secular trends. While investors continue to express concerns about investing in the broad market, ARS believes that this remains a time for opportunistic and thoughtful security selection as we continue to expect to see separation and outperformance for those companies that are well-positioned to benefit from the global divergences and imbalances described above.

Thoughts on the Global Policy Debate and Investment Implications

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Since our March 31st Outlook, the environment has shifted to one best characterized by rising uncertainty and volatility. The European sovereign debt crisis and the austerity plans now being considered have created the greatest source of uncertainty, but there are several other factors unsettling the markets, such as the outlook for corporate earnings, global financial reform, ebbing government stimulus and upcoming tax increases. In the US and Europe, governments are struggling to contain record deficits while simultaneously addressing high levels of unemployment and trying to avoid a double-dip recession, which would be far more damaging, difficult and costly from which to recover.

There is significant disagreement as to which goals to prioritize and how best to accomplish them. Most recently, one camp is arguing for further fiscal stimulus and the other for fiscal austerity, with each believing their approach to be best for boosting the economy and addressing deficits. These disagreements in economic philosophy are further complicated by what are at times conflicting national interests. The burdens of debt deleveraging will be with the developed economies for the foreseeable future. At the same time, opportunities presented by secular growth resulting from industrialization and rising living standards in the developing economies remain intact. We are witnessing a tug-of-war between the forces of deleveraging and the power of industrialization that is playing out in the media and in the markets on a daily basis.

In such an environment, maintaining perspective is paramount. ARS remains focused on taking advantage of market volatility to opportunistically invest in undervalued businesses that are the beneficiaries of enduring market forces.

While it is common for market participants to become paralyzed by uncertainty, history has proven that it is in such times that standout opportunities come to the fore. At present, we believe that the practical approach to portfolio management includes holding higher-than-normal cash positions from time to time in order to take advantage of opportunities as they present themselves. In this Outlook, ARS proposes a series of policies that we believe are necessary to put the global economy on a more sustainable course of improvement. We also review key sectors that are poised to benefit, as well as portfolio implications.

Structural Solutions Needed for Structural Problems

In our view, the sustainability of global recovery is imperiled by governments and central banks using short term solutions to solve structural problems. We need pragmatic long-term solutions to replace politicized and populist quick fixes which are too often accompanied by serious unintended consequences. The recent performance of many policymakers casts doubt on their ability or willingness to come to consensus on a constructive solution. In our opinion, policy makers need to consider implementing policy to support the following ideas:

First, we believe that this is not the time for additional contractionary policies nor excessive focus on budget reduction for the US and Europe. History has shown that any savings from such policies have often been offset by declines in GDP and government receipts thereby making further cuts necessary in a reinforcing downward cycle. This is a time for initiatives favoring sustainable economic growth and job creation. While it is critical to address the intermediate and longer-term structural issues including legacy benefit programs, growth must be the top priority.

Second, global financial reform, a key topic at the G-20 Summit, must be transnational in its implementation to prevent country-to-country arbitrage. Reforms must be carefully crafted to change any inappropriate behaviors but without being excessively punitive such as to restrict the necessary lending to businesses and consumers.

Third, the European Central Bank should arrange for long-term (5-10 year) debt facilities for the most at-risk countries in the European Union at rates set significantly below such countries’ realistic growth rates. This would give them a cost of capital that would allow them to delever and the time needed to grow out of their debt burdens without the need to access the capital markets. This would have the added benefit of taking pressure off the euro.

Fourth, when a country is already heavily in debt, it is imperative that any incremental deficit spending be as productive as possible with a high return on investment. As we have discussed in previous Outlooks, the American Society of Civil Engineers has graded the aging US roads, bridges, dams, and energy grid with a “D” and estimates that more than $2.2 trillion is required to restore the US infrastructure to acceptable levels. An infrastructure-intensive stimulus program would address these pressing needs while simultaneously creating jobs and making the country more productive and competitive.

Fifth, the US urgently needs an intelligent energy policy that takes advantage of its existing resources, including oil, natural gas and coal in a safe, responsible and economic manner. This would lessen dependence on imported oil and improve the US trade imbalance. This will require the government working alongside the energy companies rather than against them, and also require the leadership to cut through narrowly-focused special interests. Decreasing US dependence on imported oil and gas is perhaps the clearest example of how the US can stimulate its economy without increasing its deficit.

Sixth, recent events in the financial and energy industries remind us that responsible regulation is critical. However, it is equally important that regulation be appropriate and balanced in order not to unduly suppress innovation, entrepreneurship and private sector growth. Government at the highest level must work side-by-side with private industry in a comprehensive review of existing regulations with an eye toward streamlining, modernizing and where appropriate, reducing excessive regulations.

Seventh, President Obama should appoint a bi-partisan committee of respected public and private sector leaders to study and make recommendations to ensure the future solvency of US entitlement programs. This is essential for restoring fiscal health and maintaining the ongoing confidence of the holders of US Treasuries.

Eighth, the US needs to develop an intelligent tax program that encourages savings, investment and productive growth. One solution is to lower corporate taxes and capital gains rates, replacing them with increasing taxes on select areas of consumption. In the absence of a new tax regime, we are facing the sunset of the Bush tax cuts in 2011, which will be contractionary for the economy at precisely the wrong time.

Growth and jobs must be the current focus. There is a time and a place for austerity, and there is certainly a need to eliminate wasteful programs. Governments cannot afford a double-dip recession, and any government that embarks on policies resulting in a double-dip recession would likely be voted out of power. The political troubles of Australia’s Kevin Rudd present a cautionary tale for the world’s political leaders as his country has been one of the stronger economies coming out of the recession, yet he was recently replaced as Prime Minister following his controversial mining industry tax proposal.

Updated Thoughts on China

In advance of the G-20 meeting this week in Toronto, the Chinese government took steps to reduce one area of concern by indicating that it would allow for a modest appreciation of its currency, thereby reducing the threat of protectionism and avoiding the “currency manipulator” designation by the United States. Treasury Secretary Timothy Geithner has been working to have China move more aggressively to revalue its currency, but understandably China is focused on its own best interests. A growing desire of factory workers for a higher standard of living has recently resulted in higher wages and increases in food and housing subsidies. The Chinese government has not entirely discouraged this movement since it knows that higher wages will spur domestic spending and reduce its dependence on exports. Over time, this will achieve the effect of having a more balanced economy. Moreover a gradual revaluation of its currency should allow for greater domestic spending while helping to contain inflation. Importantly, it should also lead to greater economic activity and job growth for other low-cost producing emerging economies that export to China. China has been and remains a major driver of global growth, and its effectiveness in transitioning its economy is key to avoiding a global downturn. China made the strategic decision to free its economic and not its political system 25 years ago, and thus far has effectively executed a command and control administration of its economy. China now stands as the second leading global economic power and the leading creditor nation in the world.

Investments Poised to Benefit

Gold
We remain enthusiastic about opportunities in precious metals investments. When we first began investing in gold in mid-2002, the price of gold was under $325/oz. At that time, we believed that gold was going to become a new asset class promoted to institutional investors worldwide by the World Gold Council. In subsequent years, our conviction in gold increased due to concerns about growing budget deficits, the ongoing printing of money and the tendency of countries toward policies of competitive currency devaluations. Today it is striking that the forces underpinning higher gold prices are even more powerful than they were during the earlier period of the decade. This is due in major part to the increase in the quantities of reserve currencies and the fact that there is nothing backing these currencies other than the paper on which they are printed. Central banks are free to create whatever amounts they require. It is also worth noting that central banks have shifted from multi-year selling to buying, state-sanctioned quantitative easing (printing of money) has been moved from theory to practice and investing in physical gold, which used to be inconvenient requiring delivery, storage and insurance, is now available on the stock exchanges around the world through physical gold-backed investment securities that can now attract a greater number of institutional and individual investors. In addition, the marginal cost of new production continues to rise (now in excess of $600 per oz) while supply growth has been flat since the mid-1990’s and has declined over the past 5 years.

While fundamentals continue to be supportive of higher gold prices in the years ahead, experience teaches us that gold can be subject to periodic pull-backs. We therefore limit our precious metal equity investments to miners whose valuations on a net asset value (or discounted cash flow) valuation could be supported even at considerably lower gold and silver prices. These opportunities offer us a margin of safety for pull-backs as well as significant appreciation potential in stronger metals markets.

Energy
The recent oil spill in the Gulf of Mexico has proven to be a game-changing event for the US energy sector. As a result, we would expect the value of onshore and shallow-water drilling properties to be enhanced as the new regulations increase the cost of exploration and development for deep-water properties. Since share prices of oil and gas companies have declined in general in recent weeks, greater undervaluation has been created. At the same time, oil prices have begun to rise in recognition of the longer term impact on global supply as deep-water projects represented some of the greatest opportunities for reserve replacement and production growth for the industry.

The inability of BP to stem the leaking oil well has had significant near-term regulatory, environmental and company-specific implications. President Obama has halted new drilling initiatives in the Gulf, and Congress has already held hearings. The role of the Gulf and offshore, deep-water drilling is under review. Norway has also suspended some deep-water projects in a sign that this is not just a US issue. We maintain a favorable long-term view of the energy sector for reasons we have discussed in previous Outlooks, including growing global demand, limited availability and high cost of exploration and production. In just a few short years, China’s oil demand has grown from 10% of US consumption to 40% of US consumption and continues to grow as China develops its industrial and consumption base. In addition, the Middle East is also experiencing significant domestic energy demand growth.

Health Care
Although health care has been one of the most out-of-favor areas in the markets in recent months, there is considerable value in many of the leading large-cap pharmaceutical and biotech franchises. Concerns over expiring patents and changing government regulations have driven pharmaceutical valuations to their lowest levels in decades, with P/E ratios under 10x, free-cash-flow yields of 10% or greater and dividend yields of 4-6%. Several companies have dividend yields that are substantially higher than the yield-to-maturity of their outstanding long-term debt (implying a negative long-term growth rate), despite the fact that many of these companies have committed to increasing their dividend payouts over the next several years. There are a number of catalysts that should cause the market to re-evaluate these businesses over the coming quarters. First, with bond yields at multi-decade lows, companies with safe, attractive and growing dividend yields are likely to attract capital for investors requiring income. Second, with the health care bill now having been passed and its consequences better understood, a major overhang has been lifted. Moreover, the costs of the bill to the pharmaceutical industry were front-loaded while the benefits are further down the road with more Americans entering the insured rolls in the years ahead. Third, expectations for the R&D pipelines are currently quite low, yet several of the companies we have added to portfolios have several more candidates for commercialization in the next few years than they have had in the recent past. Any positive news on new drug developments is likely to provide a surprise to the market and be well-received. Finally, these businesses are global, with rock-solid balance sheets and in many cases record cash balances. They are well-positioned to use their cash flows and balance sheets opportunistically, for raising dividends, making niche acquisitions, entering into marketing or distribution partnerships, executing share buybacks or some combination of the four. In short, we find the risk-reward of these investments to be very favorable.

Technology

Technology continues to play a vital role for companies seeking to maximize productivity and is also essential to the build-out and urbanization of developing nations. In the developed markets, companies have slashed cost structures since the financial crisis making them more dependent on productivity to support their operations and growth. In addition, a capital expenditure catch-up phase following a period of under-investment is still only in the earlier innings as is a meaningful product upgrade cycle. In the developing markets, technology is increasingly integral to the infrastructure needed for urbanization, such as energy distribution, traffic systems and security. In addition, portable computing, through smart phones and tablet devices, is rapidly becoming integrated into the lives of consumers. Global penetration rates remain low, particularly in developing markets, and we expect to see profitable growth in this segment for several years. The larger, multi-national technology companies are best suited to meet many of these demands. These companies offer the additional investment benefits of valuations at multi-decade lows, rising dividends and return of cash to investors and fortress balance sheets, often with tens of billions of dollars of net cash and minimal dependence on the capital markets for growth.

Portfolio Implications

Given the uncertainty and volatility we have highlighted throughout this Outlook, ARS remains focused on employing the investment process that has served our clients since 1971. Our experience over the past four decades reminds us that it is in times of great discomfort and uncertainty that standout opportunities are most often found. Companies that are best positioned to benefit from the diverging profiles between the developed and the developing nations should continue to be prime candidates for investment portfolios. This includes businesses that own, produce and distribute the materials needed for industrialization and infrastructure development as well as those whose products and services help to raise productivity and living standards globally. In addition, ARS remains focused on the preservation of purchasing power for client portfolios given the global need for competitive currency devaluation to maintain export competitiveness. We have had the view for some time now that rates need to stay low for a prolonged period. In light of the policies now in place and those being considered, we have further conviction of the need for rates to stay low into 2012.

At present, the practical approach to portfolio management includes holding higher-than-normal cash positions from time to time in order to take advantage of opportunities as they present themselves. In the context of this environment, our portfolio implementation includes actively locking in outsized gains in successful investments as well as moving decisively to trim or eliminate positions when appropriate. This was particularly evident during the past quarter as we were quick to respond to the oil spill in the Gulf of Mexico in shifting or lowering exposure to select energy holdings, while locking in gains on select health care and materials holdings.

For fixed income investments there are relative-value income opportunities in investment grade corporate securities in the 4 to 7 year range. With regard to credit selection, we favor select financials, energy, health care and industrial companies whose balance sheets are stable or strengthening. With the severe budget constraints facing states and municipalities, we are particularly cautious with regard to the municipal bond market. Given continuing economic and sovereign debt challenges, there is a high probability that demand for US Treasury debt will remain strong keeping the rate structure at low levels.

While investors continue to express concerns about investing in the broad market, this is a time for opportunistic and thoughtful security selection from our perspective, as we expect to see separation and performance for those companies that are well-positioned to benefit from the global divergences and imbalances described above.

Since our March 31st Outlook, the environment has shifted to one best characterized by rising uncertainty and volatility. The European sovereign debt crisis and the austerity plans now being considered have created the greatest source of uncertainty, but there are several other factors unsettling the markets, such as the outlook for corporate earnings, global financial reform, ebbing government stimulus and upcoming tax increases. In the US and Europe, governments are struggling to contain record deficits while simultaneously addressing high levels of unemployment and trying to avoid a double-dip recession, which would be far more damaging, difficult and costly from which to recover.
There is significant disagreement as to which goals to prioritize and how best to accomplish them. Most recently, one camp is arguing for further fiscal stimulus and the other for fiscal austerity, with each believing their approach to be best for boosting the economy and addressing deficits. These disagreements in economic philosophy are further complicated by what are at times conflicting national interests. The burdens of debt deleveraging will be with the developed economies for the foreseeable future. At the same time, opportunities presented by secular growth resulting from industrialization and rising living standards in the developing economies remain intact. We are witnessing a tug-of-war between the forces of deleveraging and the power of industrialization that is playing out in the media and in the markets on a daily basis.
In such an environment, maintaining perspective is paramount. ARS remains focused on taking advantage of market volatility to opportunistically invest in undervalued businesses that are the beneficiaries of enduring market forces.

While it is common for market participants to become paralyzed by uncertainty, history has proven that it is in such times that standout opportunities come to the fore. At present, we believe that the practical approach to portfolio management includes holding higher-than-normal cash positions from time to time in order to take advantage of opportunities as they present themselves.  In this Outlook, ARS proposes a series of policies that we believe are necessary to put the global economy on a more sustainable course of improvement. We also review key sectors that are poised to benefit, as well as portfolio implications.

Structural Solutions Needed for Structural Problems

In our view, the sustainability of global recovery is imperiled by governments and central banks using short term solutions to solve structural problems.  We need pragmatic long-term solutions to replace politicized and populist quick fixes which are too often accompanied by serious unintended consequences.  The recent performance of many policymakers casts doubt on their ability or willingness to come to consensus on a constructive solution.  In our opinion, policy makers need to consider implementing policy to support the following ideas:

First, we believe that this is not the time for additional contractionary policies nor excessive focus on budget reduction for the US and Europe.  History has shown that any savings from such policies have often been offset by declines in GDP and government receipts thereby making further cuts necessary in a reinforcing downward cycle.  This is a time for initiatives favoring sustainable economic growth and job creation.  While it is critical to address the intermediate and longer-term structural issues including legacy benefit programs, growth must be the top priority.

Second, global financial reform, a key topic at the G-20 Summit, must be transnational in its implementation to prevent country-to-country arbitrage.  Reforms must be carefully crafted to change any inappropriate behaviors but without being excessively punitive such as to restrict the necessary lending to businesses and consumers.

Third, the European Central Bank should arrange for long-term (5-10 year) debt facilities for the most at-risk countries in the European Union at rates set significantly below such countries’ realistic growth rates.  This would give them a cost of capital that would allow them to delever and the time needed to grow out of their debt burdens without the need to access the capital markets.  This would have the added benefit of taking pressure off the euro.

Fourth, when a country is already heavily in debt, it is imperative that any incremental deficit spending be as productive as possible with a high return on investment.  As we have discussed in previous Outlooks, the American Society of Civil Engineers has graded the aging US roads, bridges, dams, and energy grid with a “D” and estimates that more than $2.2 trillion is required to restore the US infrastructure to acceptable levels.  An infrastructure-intensive stimulus program would address these pressing needs while simultaneously creating jobs and making the country more productive and competitive.

Fifth, the US urgently needs an intelligent energy policy that takes advantage of its existing resources, including oil, natural gas and coal in a safe, responsible and economic manner.  This would lessen dependence on imported oil and improve the US trade imbalance.  This will require the government working alongside the energy companies rather than against them, and also require the leadership to cut through narrowly-focused special interests.  Decreasing US dependence on imported oil and gas is perhaps the clearest example of how the US can stimulate its economy without increasing its deficit.

Sixth, recent events in the financial and energy industries remind us that responsible regulation is critical.  However, it is equally important that regulation be appropriate and balanced in order not to unduly suppress innovation, entrepreneurship and private sector growth.  Government at the highest level must work side-by-side with private industry in a comprehensive review of existing regulations with an eye toward streamlining, modernizing and where appropriate, reducing excessive regulations.

Seventh, President Obama should appoint a bi-partisan committee of respected public and private sector leaders to study and make recommendations to ensure the future solvency of US entitlement programs.  This is essential for restoring fiscal health and maintaining the ongoing confidence of the holders of US Treasuries.

Eighth, the US needs to develop an intelligent tax program that encourages savings, investment and productive growth.  One solution is to lower corporate taxes and capital gains rates, replacing them with increasing taxes on select areas of consumption.  In the absence of a new tax regime, we are facing the sunset of the Bush tax cuts in 2011, which will be contractionary for the economy at precisely the wrong time.

Growth and jobs must be the current focus.  There is a time and a place for austerity, and there is certainly a need to eliminate wasteful programs.  Governments cannot afford a double-dip recession, and any government that embarks on policies resulting in a double-dip recession would likely be voted out of power. The political troubles of Australia’s Kevin Rudd present a cautionary tale for the world’s political leaders as his country has been one of the stronger economies coming out of the recession, yet he was recently replaced as Prime Minister following his controversial mining industry tax proposal.

Updated Thoughts on China

In advance of the G-20 meeting this week in Toronto, the Chinese government took steps to reduce one area of concern by indicating that it would allow for a modest appreciation of its currency, thereby reducing the threat of protectionism and avoiding the “currency manipulator” designation by the United States.  Treasury Secretary Timothy Geithner has been working to have China move more aggressively to revalue its currency, but understandably China is focused on its own best interests.  A growing desire of factory workers for a higher standard of living has recently resulted in higher wages and increases in food and housing subsidies.  The Chinese government has not entirely discouraged this movement since it knows that higher wages will spur domestic spending and reduce its dependence on exports.  Over time, this will achieve the effect of having a more balanced economy.  Moreover a gradual revaluation of its currency should allow for greater domestic spending while helping to contain inflation.  Importantly, it should also lead to greater economic activity and job growth for other low-cost producing emerging economies that export to China.  China has been and remains a major driver of global growth, and its effectiveness in transitioning its economy is key to avoiding a global downturn.  China made the strategic decision to free its economic and not its political system 25 years ago, and thus far has effectively executed a command and control administration of its economy.  China now stands as the second leading global economic power and the leading creditor nation in the world.

Investments Poised to Benefit

Gold

We remain enthusiastic about opportunities in precious metals investments.  When we first began investing in gold in mid-2002, the price of gold was under $325/oz.  At that time, we believed that gold was going to become a new asset class promoted to institutional investors worldwide by the World Gold Council.  In subsequent years, our conviction in gold increased due to concerns about growing budget deficits, the ongoing printing of money and the tendency of countries toward policies of competitive currency devaluations. Today it is striking that the forces underpinning higher gold prices are even more powerful than they were during the earlier period of the decade. This is due in major part to the increase in the quantities of reserve currencies and the fact that there is nothing backing these currencies other than the paper on which they are printed. Central banks are free to create whatever amounts they require. It is also worth noting that central banks have

shifted from multi-year selling to buying, state-sanctioned quantitative easing (printing of money) has been moved from theory to practice and investing in physical gold, which used to be inconvenient requiring delivery, storage and insurance, is now available on the stock exchanges around the world through physical gold-backed investment securities that can now attract a greater number of institutional and individual investors.  In addition, the marginal cost of new production continues to rise (now in excess of $600 per oz) while supply growth has been flat since the mid-1990’s and has declined over the past 5 years.

While fundamentals continue to be supportive of higher gold prices in the years ahead, experience teaches us that gold can be subject to periodic pull-backs.  We therefore limit our precious metal equity investments to miners whose valuations on a net asset value (or discounted cash flow) valuation could be supported even at considerably lower gold and silver prices.  These opportunities offer us a margin of safety for pull-backs as well as significant appreciation potential in stronger metals markets.

Energy

The recent oil spill in the Gulf of Mexico has proven to be a game-changing event for the US energy sector.  As a result, we would expect the value of onshore and shallow-water drilling properties to be enhanced as the new regulations increase the cost of exploration and development for deep-water properties.  Since share prices of oil and gas companies have declined in general in recent weeks, greater undervaluation has been created.  At the same time, oil prices have begun to rise in recognition of the longer term impact on global supply as deep-water projects represented some of the greatest opportunities for reserve replacement and production growth for the industry.

The inability of BP to stem the leaking oil well has had significant near-term regulatory, environmental and company-specific implications.  President Obama has halted new drilling initiatives in the Gulf, and Congress has already held hearings.  The role of the Gulf and offshore, deep-water drilling is under review.  Norway has also suspended some deep-water projects in a sign that this is not just a US issue.  We maintain a favorable long-term view of the energy sector for reasons we have discussed in previous Outlooks, including growing global demand, limited availability and high cost of exploration and production. In just a few short years, China’s oil demand has grown from 10% of US consumption to 40% of US consumption and continues to grow as China develops its industrial and consumption base. In addition, the Middle East is also experiencing significant domestic energy demand growth.

Health Care

Although health care has been one of the most out-of-favor areas in the markets in recent months, there is considerable value in many of the leading large-cap pharmaceutical and biotech franchises.  Concerns over expiring patents and changing government regulations have driven pharmaceutical valuations to their lowest levels in decades, with P/E ratios under 10x, free-cash-flow yields of 10% or greater and dividend yields of 4-6%.  Several companies have dividend yields that are substantially higher than the yield-to-maturity of their outstanding long-term debt (implying a negative long-term growth rate), despite the fact that many of these companies have committed to increasing their dividend payouts over the next several years.  There are a number of catalysts that should cause the market to re-evaluate these businesses over the coming quarters.  First, with bond yields at multi-decade lows, companies with safe, attractive and growing dividend yields are likely to attract capital for investors requiring income.  Second, with the health care bill now having been passed and its consequences better understood, a major overhang has been lifted.  Moreover, the costs of the bill to the pharmaceutical industry were front-loaded while the benefits are further down the road with more Americans entering the insured rolls in the years ahead.  Third, expectations for the R&D pipelines are currently quite low, yet several of the companies we have added to portfolios have several more candidates for commercialization in the next few years than they have had in the recent past.  Any positive news on new drug developments is likely to provide a surprise to the market and be well-received.  Finally, these businesses are global, with rock-solid balance sheets and in many cases record cash balances.  They are well-positioned to use their cash flows and balance sheets opportunistically, for raising dividends, making niche acquisitions, entering into marketing or distribution partnerships, executing share buybacks or some combination of the four.  In short, we find the risk-reward of these investments to be very favorable.

Technology

Technology continues to play a vital role for companies seeking to maximize productivity and is also essential to the build-out and urbanization of developing nations.  In the developed markets, companies have slashed cost structures since the financial crisis making them more dependent on productivity to support their operations and growth. In addition, a capital expenditure catch-up phase following a period of under-investment is still only in the earlier innings as is a meaningful product upgrade cycle.  In the developing markets, technology is increasingly integral to the infrastructure needed for urbanization, such as energy distribution, traffic systems and security. In addition, portable computing, through smart phones and tablet devices, is rapidly becoming integrated into the lives of consumers.  Global penetration rates remain low, particularly in developing markets, and we expect to see profitable growth in this segment for several years. The larger,

multi-national technology companies are best suited to meet many of these demands.  These companies offer the additional investment benefits of valuations at multi-decade lows, rising dividends and return of cash to investors and fortress balance sheets, often with tens of billions of dollars of net cash and minimal dependence on the capital markets for growth.

Portfolio Implications

Given the uncertainty and volatility we have highlighted throughout this Outlook, ARS remains focused on employing the investment process that has served our clients since 1971.  Our experience over the past four decades reminds us that it is in times of great discomfort and uncertainty that standout opportunities are most often found.  Companies that are best positioned to benefit from the diverging profiles between the developed and the developing nations should continue to be prime candidates for investment portfolios.  This includes businesses that own, produce and distribute the materials needed for industrialization and infrastructure development as well as those whose products and services help to raise productivity and living standards globally.  In addition, ARS remains focused on the preservation of purchasing power for client portfolios given the global need for competitive currency devaluation to maintain export competitiveness.  We have had the view for some time now that rates need to stay low for a prolonged period.  In light of the policies now in place and those being considered, we have further conviction of the need for rates to stay low into 2012.

At present, the practical approach to portfolio management includes holding higher-than-normal cash positions from time to time in order to take advantage of opportunities as they present themselves.  In the context of this environment, our portfolio implementation includes actively locking in outsized gains in successful investments as well as moving decisively to trim or eliminate positions when appropriate.  This was particularly evident during the past quarter as we were quick to respond to the oil spill in the Gulf of Mexico in shifting or lowering exposure to select energy holdings, while locking in gains on select health care and materials holdings.

For fixed income investments there are relative-value income opportunities in investment grade corporate securities in the 4 to 7 year range.  With regard to credit selection, we favor select financials, energy, health care and industrial companies whose balance sheets are stable or strengthening.  With the severe budget constraints facing states and municipalities, we are particularly cautious with regard to the municipal bond market.  Given continuing economic and sovereign debt challenges, there is a high probability that demand for US Treasury debt will remain strong keeping the rate structure at low levels.

While investors continue to express concerns about investing in the broad market, this is a time for opportunistic and thoughtful security selection from our perspective, as we expect to see separation and performance for those companies that are well-positioned to benefit from the global divergences and imbalances described above.

Economic and Investment Implications of Industrialization and Deleveraging

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After a period of carefully orchestrated efforts by governments and central banks to repair the global financial system, the world has seen a resumption and acceleration of the divergences between the developing and developed economies that had existed prior to the crisis. The robust foreign reserve balances and resurgent growth of the developing nations contrast sharply with the growing fiscal deficits and slower recoveries in much of the developed world. The emerging economies led by China and India continue to be the drivers of global growth; however, the imbalances between these export-driven nations and the consumption-driven economies have continued. Government budgets have been severely damaged in the developed world as reduced tax revenues, increased entitlement costs and fiscal stimulus programs have increased deficits.

At the same time we are witnessing a powerful productivity-driven resurgence of corporate profitability. Leading businesses that are positioned to succeed globally represent standout investment opportunities based on their strong balance sheets, attractive valuations and dividend yields. Portfolios should be represented in the companies that own, produce and distribute the increasingly rare materials needed for industrialization and infrastructure development, as well as companies whose products and services help to raise productivity or living standards globally, such as in technology and healthcare. Fixed income portfolios should continue to emphasize relatively shorter-term maturities in the one to four-year range.

Global Imbalances Highlighting Winners and Losers

A massive wealth transfer from developed to developing economies partly defines the global economic condition, and is a consequence of the growing imbalances in the system. Importantly, the growth of the world economy is now being driven by the developing nations rather than the US, Europe and Japan. The International Monetary Fund estimates emerging economies will grow 6% in 2010 versus 2% for advanced economies. The developing economies are undergoing a rapid multi-decade industrialization that is raising living standards and creating a large new middle class. The resulting imbalances have increased because they are primarily export-driven and favor the developing, low cost nations, and yet they are unsustainable to the extent they rely on ongoing high consumption by the developed nations.

The following table highlights two competing forces at work in today’s global economy. The first is that China’s strong current account balance allowed the country to grow its reserves by nearly $470 billion in 2009 to $2.4 trillion (a nearly 25% increase) despite the global slowdown, while the US and Eurozone continued to amass near-record current account deficits. The second is the contrast between the healthy gross government debt-to-GDP levels of many of the exporting and resource-rich nations (China, Saudi Arabia, Australia, etc.) and the bloated levels of the developed economies. Sovereign debt among the developed nations has exploded to the point where it is nearing or has exceeded 80% of GDP—a level historically viewed as unsound.

Comparison of Sovereign Financial Condition
($ in billions, except GDP)

1 Source: International Monetary Fund; World Economic Outlook, October 2009
2 Gold valued by the World Gold Council at the end of January at $1,040.00 per troy ounce
3 Source: Central Banks/International Monetary Fund data
4 Source: International Monetary Fund; World Economic Outlook, January 2009

China Looms Large Over the Global Economy

The world is approaching an inflection point in global economic leadership. The developed nations are attempting to address the imbalances discussed earlier as the Obama administration’s recent goal of doubling exports over the next five years highlights. These divergences are an important reason for the friction between the US and China with respect to China’s exchange rate policy. On March 16th, more than 100 members of Congress called on the Obama administration to identify China as a currency manipulator with the goal of pressuring China to allow its currency to appreciate, thereby making US exports more competitive and raising the prices of US imports from China.

As the largest creditor nation, China does not want to be told what to do (certainly not publicly) and will continue to put its own interests first. China’s government has argued that appreciating the Yuan would work against its own goals, which include maximizing employment, and it believes that imbalances can be better addressed through initiatives to stimulate its domestic economy and internal consumption, such as infrastructure development and wage increases and subsidies targeted at rural areas. Ultimately, China is likely to allow for a modest revaluation of the Yuan, both for political reasons and to address emerging concerns over inflation.

With its massive foreign reserves, China was able to take control of is own destiny during the financial crisis through a $586 billion domestic stimulus plan designed to offset the impact of the global recession on its exports. This program significantly contributed to global growth by increasing demand for industrial goods, household appliances, agricultural products and basic materials. China sold more than 13 million cars in 2009, surpassing the US for the first time in history, and has sold nearly 2.9 million cars in the first 2 months of 2010. More cars require more steel, iron ore, copper, rubber, rare earth materials, technology and oil. China’s daily oil imports are now 4.8 million barrels a day up from 2.2 million barrels just a few years ago and is now the world’s second largest consumer of oil after the US, yet its per capita oil consumption is only one-eighth that of the US. As part of its long-term plan, the Chinese government has identified several critical industries, such as automobiles and energy, that the government will continue to control and manage while allowing other industries to operate in a more free-market fashion. For the past few years, China has been using its growing surpluses to diversify its dollar holdings and to secure strategic resources through investments around the world. China is not alone in securing critical resources as India is now considering a $238 billion fund to acquire energy reserves for its future needs.

Excessive Sovereign Indebtedness Remains a Risk, with Implications for Currencies and Interest Rates

Sovereign debt concerns have weighed on world markets and currencies in recent months. Swelling budget deficits, credit downgrades and refinancing risks for many developed countries such as Greece have underscored three fundamental concepts.

First, Greece’s financial challenges have highlighted the fragility of the European Union (EU) and are pressuring its members to clarify previously unspoken assumptions regarding member state relationships and interdependencies never fully addressed when it was created. Stronger EU nations are understandably reluctant to allocate national resources toward weaker members whom they view to have been fiscally irresponsible and are sensitive to the moral hazard implications of bailouts.

Again however, the interconnectivity and interdependencies of countries comes to the fore. Abandoning Greece would risk jeopardizing other over-indebted EU members such as Spain, Ireland, Italy and Portugal by causing investors and lenders to flee, driving up financing costs. Furthermore, exporting EU countries, in particular Germany, were direct beneficiaries of the excessive debt assumed by the debtor countries who borrowed to finance imports and consumption. Clearly we have not seen the last of sovereign credit risks in the EU and the leading members will ultimately need to support Greece and other countries if they expect to contain additional financial stresses in the months ahead and preserve the EU structure over the longer term.

Second, recent turmoil has illustrated the US dollar’s unique role as the world’s principle reserve currency. Concerns surrounding the structure of the EU accentuated by Greece’s recent challenges have weakened the Euro and driven market participants to the dollar. Hence the dollar has been appreciating despite the fact that the fiscal profile of the US has deteriorated dramatically from when the US was the world’s leading creditor nation. Further complicating matters, a stronger dollar is making US exports less competitive in the global market and represents an obstacle to the recovery of the US economy and the goal of doubling US exports. Over the longer term, no currency can remain a store of value and purchasing power if its supply grows in excess of demand and there are no hard assets to back it. The US administration clearly has a strong incentive to see the dollar weaker over time and we believe this is likely to lead to an environment ripe for global competitive devaluations and supportive of hard asset valuations.

Third, deleveraging is likely to require the Federal Reserve and Central Banks of developed economies globally to keep interest rates low for some time. Coming out of the financial crisis, we described a period during which the US government, consumers and corporations needed to repair the damage to their balance sheets that resulted from the excessive debt taken on this past decade. Many corporations have done a standout job rebuilding their balance sheets and S&P 500 companies are now sitting on record cash balances. However, while consumers have begun reducing their debts and increasing savings, this repair will take many years due to persistently high levels of unemployment.

Recent US employment numbers indicated that 8.4 million jobs have been lost since December 2007, and the economy must create 14.7 million new jobs or just over 400,000 jobs per month for the next three years in order to bring unemployment back to more normalized levels. Although private sector employment may be stabilizing, states and local governments will be contributing to additional layoffs as they bring budgets into balance in 2010. As discussed in recent Outlooks, many states and municipalities barely navigated fiscal 2009 with heavy financial support from the Federal stimulus package.

Without further support, these states and municipalities face a genuine crisis and will likely be forced into more dramatic cost cuts, which are contractionary. In addition to rising public sector layoffs, the nascent cyclical recovery in consumer spending that we have recently witnessed is also threatened by local tax rates scheduled to increase in 2011.

At the Federal level, the government budget deficit and debt has grown considerably as it became the lender and spender of last resort in 2009. Clearly the Federal budget must eventually be put on a sustainable path. Mexico and Japan have already been downgraded by the rating agencies and Moody’s recently warned that the AAA credit rating of the US could be jeopardized if the US continues on its present fiscal path. We are also mindful of the longer-term risks to inflation that come from excessive deficits, and that these risks grow as the actions needed to address the problem are postponed.

However, for now, excess global capacity in manufacturing, housing and labor markets is keeping inflation low, and any attempts to address budget and fiscal deficits at the Federal level in the current environment will produce greater economic weakness at the wrong time of the economic cycle. According to Janet L. Yellen, President of the Federal Reserve Bank of San Francisco, the US faces the prospect of a sub-par jobs recovery until 2013. Yellen is a well-known and respected economist who was recently nominated as Vice Chairwoman of the Federal Reserve Board. In her opinion, the current rate of inflation is undesirably low, and monetary policy cannot deliver the same kick to the economy that it has in the past and she calls the underutilization of the economy the most worrisome challenge for price stability over the next few years. Under these conditions, we question how successful the removal of monetary stimulus programs would be and we expect that the US and other developed nations around the world will likely feel the need to keep interest rates low for some time.

Resurging Corporate Profits

One significant bright spot in the US economy has been the dramatic improvement in the balance sheets, profitability and cash flows of leading corporations. Unprecedented layoffs, restructurings and inventory reductions have positioned leading companies for record profitability as revenues recover. In fact, it was precisely because the financial crisis was as severe as it was that companies were emboldened to react as decisively as they did, taking actions that might have been viewed as too extreme or unpopular under less trying circumstances. Companies with strong international sales are also benefiting from the resurging growth in the emerging economies, particularly those whose products represent essential resources or technologies required for higher living standards, productive growth and industrialization.

The financial strength of leading corporations is further evidenced by the growing number of companies now raising their dividends, with over 60 increases year-to-date versus 47 for the same period last year. In addition, S&P 500 companies excluding financials are currently sitting with more than $900 billion in cash on their balance sheets, setting the stage for increases in mergers and acquisition activity. Recently, there have been two major acquisitions in the energy sector with Exxon buying XTO Energy, and BP announcing the purchase of some major offshore assets from Devon Energy, including valuable Gulf of Mexico properties. Since merger and acquisition activity has historically tracked GDP growth, we would expect this trend to continue.

Portfolio Implications

Companies that are best positioned to benefit from the divergences between the developed and the developing world should continue to be prime candidates for investment portfolios. This includes the companies that own, produce and distribute the increasingly rare materials needed for industrialization and infrastructure development, such as oil, iron ore, copper and thermal and metallurgical coal, as well as companies whose products and services help to raise productivity or living standards globally. In 2009, we built positions in select technology companies that are poised to benefit from the product upgrade cycle as well as agricultural companies whose products are essential for enhancing food production to meet the needs of a growing world population. With the passage of the healthcare bill, we also believed that many out-of-favor pharmaceutical and biotech companies are well positioned to benefit.

As we have written in many Outlooks, we also expect this uniquely low interest rate environment to encourage capital to flow to high dividend payers, all other things being equal. With many companies realizing higher cash flow generation, rising profit margins and strengthening balance sheets, we expect dividend increases to continue. American multinational corporations with attractive dividend yields represent important investments under current circumstances as cash earning virtually nothing seeks a meaningful rate of return. We are investing in select world-class franchises trading near their lowest P/E multiples of recent decades despite having solid balance sheets, strong cash flow generation and high and rising dividend yields.

With respect to the fixed income market, we have chosen to stay relatively short term due to the concern that inflation could rise over time therefore causing longer term interest rates to rise, resulting in lower bond prices. Thus far, the excess capacity in manufacturing, housing and labor has kept inflation subdued, as evidenced by ongoing strong demand at US Treasury auctions despite record issuances.

However should sovereign debt risks rise, the US would not be immune from concerns over excessive deficits. In addition, the sheer volume of Treasury issuance expected over the next few years may ultimately overwhelm demand and result in higher interest rates. Compounding the challenge is the potential competition for investor demand stemming from state and local governments’ financing needs to help close their deficits, and the desire of investors to add to their municipal holdings in anticipation of the expiration of the Bush tax cuts and additional tax increases, which will result in higher taxes on earned and unearned income.

While many investors have expressed concerns about investing in the broad market, ARS believes that this is a time for thoughtful security selection as we expect to see continued separation and performance for those companies that are well positioned to benefit from the global divergences and imbalances described above.

After a period of carefully orchestrated efforts by governments and central banks to repair the global financial system, the world has seen a resumption and acceleration of the divergences between the developing and developed economies that had existed prior to the crisis.  The robust foreign reserve balances and resurgent growth of the developing nations contrast sharply with the growing fiscal deficits and slower recoveries in much of the developed world.  The emerging economies led by China and India continue to be the drivers of global growth; however, the imbalances between these export-driven nations and the consumption-driven economies have continued.  Government budgets have been severely damaged in the developed world as reduced tax revenues, increased entitlement costs and fiscal stimulus programs have increased deficits.

At the same time we are witnessing a powerful productivity-driven resurgence of corporate profitability.  Leading businesses that are positioned to succeed globally represent standout investment opportunities based on their strong balance sheets, attractive valuations and dividend yields.  Portfolios should be represented in the companies that own, produce and distribute the increasingly rare materials needed for industrialization and infrastructure development, as well as companies whose products and services help to raise productivity or living standards globally, such as in technology and healthcare.  Fixed income portfolios should continue to emphasize relatively shorter-term maturities in the one to four-year range.

Global Imbalances Highlighting Winners and Losers

A massive wealth transfer from developed to developing economies partly defines the global economic condition, and is a consequence of the growing imbalances in the system.  Importantly, the growth of the world economy is now being driven by the developing nations rather than the US, Europe and Japan. The International Monetary Fund estimates emerging economies will grow 6% in 2010 versus 2% for advanced economies. The developing economies are undergoing a rapid multi-decade industrialization that is raising living standards and creating a large new middle class. The resulting imbalances have increased because they are primarily export-driven and favor the developing, low cost nations, and yet they are unsustainable to the extent they rely on ongoing high consumption by the developed nations.

The following table highlights two competing forces at work in today’s global economy.  The first is that China’s strong current account balance allowed the country to grow its reserves by nearly $470 billion in 2009 to $2.4 trillion (a nearly 25% increase) despite the global slowdown, while the US and Eurozone continued to amass near-record current account deficits.  The second is the contrast between the healthy gross government debt-to-GDP levels of many of the exporting and resource-rich nations (China, Saudi Arabia, Australia, etc.) and the bloated levels of the developed economies.  Sovereign debt among the developed nations has exploded to the point where it is nearing or has exceeded 80% of GDP—a level historically viewed as unsound.

Comparison of Sovereign Financial Condition

($ in billions, except GDP)

China Looms Large Over the Global Economy

The world is approaching an inflection point in global economic leadership.  The developed nations are attempting to address the imbalances discussed earlier as the Obama administration’s recent goal of doubling exports over the next five years highlights.  These divergences are an important reason for the friction between the US and China with respect to China’s exchange rate policy.  On March 16th, more than 100 members of Congress called on the Obama administration to identify China as a currency manipulator with the goal of pressuring China to allow its currency to appreciate, thereby making US exports more competitive and raising the prices of US imports from China.

As the largest creditor nation, China does not want to be told what to do (certainly not publicly) and will continue to put its own interests first.  China’s government has argued that appreciating the Yuan would work against its own goals, which include maximizing employment, and it believes that imbalances can be better addressed through initiatives to stimulate its domestic economy and internal consumption, such as infrastructure development and wage increases and subsidies targeted at rural areas.  Ultimately, China is likely to allow for a modest revaluation of the Yuan, both for political reasons and to address emerging concerns over inflation.

With its massive foreign reserves, China was able to take control of its own destiny during the financial crisis through a $586 billion domestic stimulus plan designed to offset the impact of the global recession on its exports.  This program significantly contributed to global growth by increasing demand for industrial goods, household appliances, agricultural products and basic materials.  China sold more than 13 million cars in 2009, surpassing the US for the first time in history, and has sold nearly 2.9 million cars in the first 2 months of 2010.  More cars require more steel, iron ore, copper, rubber, rare earth materials, technology and oil.  China’s daily oil imports are now 4.8 million barrels a day up from 2.2 million barrels just a few years ago and is now the world’s second largest consumer of oil after the US, yet its per capita oil consumption is only one-eighth that of the US.  As part of its long-term plan, the Chinese government has identified several critical industries, such as automobiles and energy, that the government will continue to control and manage while allowing other industries to operate in a more free-market fashion.  For the past few years, China has been using its growing surpluses to diversify its dollar holdings and to secure strategic resources through investments around the world. China is not alone in securing critical resources as India is now considering a $238 billion fund to acquire energy reserves for its future needs.

Excessive Sovereign Indebtedness Remains a Risk, with Implications for Currencies and Interest Rates

Sovereign debt concerns have weighed on world markets and currencies in recent months.  Swelling budget deficits, credit downgrades and refinancing risks for many developed countries such as Greece have underscored three fundamental concepts.

Again however, the interconnectivity and interdependencies of countries comes to the fore.  Abandoning Greece would risk jeopardizing other over-indebted EU members such as Spain, Ireland, Italy and Portugal by causing investors and lenders to flee, driving up financing costs.  Furthermore, exporting EU countries, in particular Germany, were direct beneficiaries of the excessive debt assumed by the debtor countries who borrowed to finance imports and consumption.  Clearly we have not seen the last of sovereign credit risks in the EU and the leading members will ultimately need to support Greece and other countries if they expect to contain additional financial stresses in the months ahead and preserve the EU structure over the longer term.

Second, recent turmoil has illustrated the US dollar’s unique role as the world’s principle reserve currency.  Concerns surrounding the structure of the EU accentuated by Greece’s recent challenges have weakened the Euro and driven market participants to the dollar.  Hence the dollar has been appreciating despite the fact that the fiscal profile of the US has deteriorated dramatically from when the US was the world’s leading creditor nation.  Further complicating matters, a stronger dollar is making US exports less competitive in the global market and represents an obstacle to the recovery of the US economy and the goal of doubling US exports.  Over the longer term, no currency can remain a store of value and purchasing power if its supply grows in excess of demand and there are no hard assets to back it.  The US administration clearly has a strong incentive to see the dollar weaker over time and we believe this is likely to lead to an environment ripe for global competitive devaluations and supportive of hard asset valuations.

Third, deleveraging is likely to require the Federal Reserve and Central Banks of developed economies globally to keep interest rates low for some time.  Coming out of the financial crisis, we described a period during which the US government, consumers and corporations needed to repair the damage to their balance sheets that resulted from the excessive debt taken on this past decade.  Many corporations have done a standout job rebuilding their balance sheets and S&P 500 companies are now sitting on record cash balances.  However, while consumers have begun reducing their debts and increasing savings, this repair will take many years due to persistently high levels of unemployment.

Recent US employment numbers indicated that 8.4 million jobs have been lost since December 2007, and the economy must create 14.7 million new jobs or just over 400,000 jobs per month for the next three years in order to bring unemployment back to more normalized levels.  Although private sector employment may be stabilizing, states and local governments will be contributing to additional layoffs as they bring budgets into balance in 2010.  As discussed in recent Outlooks, many states and municipalities barely navigated fiscal 2009 with heavy financial support from the Federal stimulus package.

Without further support, these states and municipalities face a genuine crisis and will likely be forced into more dramatic cost cuts, which are contractionary.  In addition to rising public sector layoffs, the nascent cyclical recovery in consumer spending that we have recently witnessed is also threatened by local tax rates scheduled to increase in 2011.

At the Federal level, the government budget deficit and debt has grown considerably as it became the lender and spender of last resort in 2009.  Clearly the Federal budget must eventually be put on a sustainable path.  Mexico and Japan have already been downgraded by the rating agencies and Moody’s recently warned that the AAA credit rating of the US could be jeopardized if the US continues on its present fiscal path.  We are also mindful of the longer-term risks to inflation that come from excessive deficits, and that these risks grow as the actions needed to address the problem are postponed.

However, for now, excess global capacity in manufacturing, housing and labor markets is keeping inflation low, and any attempts to address budget and fiscal deficits at the Federal level in the current environment will produce greater economic weakness at the wrong time of the economic cycle.  According to Janet L. Yellen, President of the Federal Reserve Bank of San Francisco, the US faces the prospect of a sub-par jobs recovery until 2013.  Yellen is a well-known and respected economist who was recently nominated as Vice Chairwoman of the Federal Reserve Board.  In her opinion, the current rate of inflation is undesirably low, and monetary policy cannot deliver the same kick to the economy that it has in the past and she calls the underutilization of the economy the most worrisome challenge for price stability over the next few years.  Under these conditions, we question how successful the removal of monetary stimulus programs would be and we expect that the US and other developed nations around the world will likely feel the need to keep interest rates low for some time.

Resurging Corporate Profits

One significant bright spot in the US economy has been the dramatic improvement in the balance sheets, profitability and cash flows of leading corporations.  Unprecedented layoffs, restructurings and inventory reductions have positioned leading companies for record profitability as revenues recover.  In fact, it was precisely because the financial crisis was as severe as it was that companies were emboldened to react as decisively as they did, taking actions that might have been viewed as too extreme or unpopular under less trying circumstances.  Companies with strong international sales are also benefiting from the resurging growth in the emerging economies, particularly those whose products represent essential resources or technologies required for higher living standards, productive growth and industrialization.

First, Greece’s financial challenges have highlighted the fragility of the European Union (EU) and are pressuring its members to clarify previously unspoken assumptions regarding member state relationships and interdependencies never fully addressed when it was created.  Stronger EU nations are understandably reluctant to allocate national resources toward weaker members whom they view to have been fiscally irresponsible and are sensitive to the moral hazard implications of bailouts.

The financial strength of leading corporations is further evidenced by the growing number of companies now raising their dividends, with over 60 increases year-to-date versus 47 for the same period last year.  In addition, S&P 500 companies excluding financials are currently sitting with more than $900 billion in cash on their balance sheets, setting the stage for increases in mergers and acquisition activity.  Recently, there have been two major acquisitions in the energy sector with Exxon buying XTO Energy, and BP announcing the purchase of some major offshore assets from Devon Energy, including valuable Gulf of Mexico properties.  Since merger and acquisition activity has historically tracked GDP growth, we would expect this trend to continue.

Portfolio Implications

Companies that are best positioned to benefit from the divergences between the developed and the developing world should continue to be prime candidates for investment portfolios.  This includes the companies that own, produce and distribute the increasingly rare materials needed for industrialization and infrastructure development, such as oil, iron ore, copper and thermal and metallurgical coal, as well as companies whose products and services help to raise productivity or living standards globally.  In 2009, we built positions in select technology companies that are poised to benefit from the product upgrade cycle as well as agricultural companies whose products are essential for enhancing food production to meet the needs of a growing world population.  With the passage of the healthcare bill, we also believed that many out-of-favor pharmaceutical and biotech companies are well positioned to benefit.

However should sovereign debt risks rise, the US would not be immune from concerns over excessive deficits.  In addition, the sheer volume of Treasury issuance expected over the next few years may ultimately overwhelm demand and result in higher interest rates.  Compounding the challenge is the potential competition for investor demand stemming from state and local governments’ financing needs to help close their deficits, and the desire of investors to add to their municipal holdings in anticipation of the expiration of the Bush tax cuts and additional tax increases, which will result in higher taxes on earned and unearned income.

While many investors have expressed concerns about investing in the broad market, ARS believes that this is a time for thoughtful security selection as we expect to see continued separation and performance for those companies that are well positioned to benefit from the global divergences and imbalances described above.

As we have written in many Outlooks, we also expect this uniquely low interest rate environment to encourage capital to flow to high dividend payers, all other things being equal.  With many companies realizing higher cash flow generation, rising profit margins and strengthening balance sheets, we expect dividend increases to continue.  American multinational corporations with attractive dividend yields represent important investments under current circumstances as cash earning virtually nothing seeks a meaningful rate of return.  We are investing in select world-class franchises trading near their lowest P/E multiples of recent decades despite having solid balance sheets, strong cash flow generation and high and rising dividend yields.

With respect to the fixed income market, we have chosen to stay relatively short term due to the concern that inflation could rise over time therefore causing longer term interest rates to rise, resulting in lower bond prices.  Thus far, the excess capacity in manufacturing, housing and labor has kept inflation subdued, as evidenced by ongoing strong demand at US Treasury auctions despite record issuances.

As 2009 comes to a close, investors should be both opportunistic and highly selective in their portfolio construction approach heading into 2010. Central to our investment outlook is the clear separation of those companies and nations benefiting from the need to rebalance the global economy. For equity investors, the focus for portfolios should be on thoughtful security selection with an emphasis on the beneficiaries of industry consolidation, a secular weakening of the U.S. dollar, the recent rally not withstanding, and continued emerging market growth as well as high quality companies with strong balance sheets and rising dividend yields. After a strong year in the markets, we urge fixed income investors to keep their maturities relatively short and to be cautious as we see an increasing risk of sovereign debt downgrades, record Treasury issuance and rising interest rates impacting bond returns.

At the present time, the global economy is being driven by the developing nations where billions of people are experiencing rapid industrialization and rising living standards. While the developed economies must reduce the leverage in the system with consumer and government debt at historically high levels, many U.S. corporations with strong balance sheets, growing earnings and cash flow are well-positioned to benefit. Corporate productivity has risen as many companies used 2009 to refocus their businesses and lay off workers at a record pace. There are many American corporations whose foreign revenues represent 40 to 50 percent of their total revenues that are important beneficiaries of global growth and whose share prices do not adequately reflect these dynamics. For these companies, there is the potential benefit of participating both in overseas growth and any further devaluation of the U.S. dollar as foreign earnings are translated into more dollars.

This year the equity and bond markets experienced a broad-based rise fueled by aggressive and globally-coordinated fiscal policies and central bank initiatives to restore capital markets after the financial collapse of 2008. While many professional investors participated in the strong market move since March, many other market participants sat idle while holding record levels of cash earning little or no return. The reasons for this included a loss of confidence in the markets and concerns about owning stocks after a decade of near-zero returns for the market indexes. As discussed in our last Outlook, the U.S. economy will continue to face significant headwinds as we move through 2010. With much of the previously announced stimulus hitting the system in the first two quarters, ARS believes that we will see continued separation of those companies that are positioned to benefit from the global forces described above from those that will continue to struggle.

Bearing in mind that China has been dependent on exports due to an underdeveloped domestic economy and the U.S. has been dependent on imports and an over-debted consumer, a rebalancing of these two conditions has been necessary for a long time. Since China has been so dependent on its exports for growth, it has been reluctant to revalue its currency for fear of damaging its export business. Moreover because its currency is pegged to the U.S. dollar, as the dollar has declined it has put competitive pressure on other Asian countries’ exports.

We have written often in this past year’s Outlooks about the need to rebalance the global economy, but it is important to remember that this is a multi-year process. Three weeks ago Vietnam devalued its currency in order to be more competitive with China. Central banks know that their respective economies require cheap currencies for their exporters to compete with China. Central banks cannot trust each other not to devalue their respective currencies to achieve these ends. Since currency reserves reside in paper money (fiat currency) which has no backing, Russia, China, India and others have sought to protect their purchasing power under these circumstances by various initiatives including gradually converting some of their currency reserves to gold.

It is noteworthy that developing nations continue to increase their industrial capacity. At the present time, global capacity exceeds global demand for many products. For example, U.S. industrial production is well below maximum capacity and there is enormous slack in the labor force. Consequently the risks of near-term inflation should be low. However in 2010, the U.S. government will require $3.5 trillion to refund the federal debt and finance the federal deficit which equates to an average of $67 billion per week. So while near-term inflation should not be an issue, longer-term inflation could be a problem. It is vitally important that the Federal Reserve not raise interest rates any time soon if it does not wish to damage the economy, risk a double dip recession and add further to the federal deficit. If rates in general were to rise prematurely, it would be damaging to the nascent economic recovery and compound the difficulties facing state and local government budgets already struggling to meet their needs including education, unemployment, pension and medical benefit obligations.

Equity portfolios should include the companies that own, produce and distribute the increasingly rare materials needed for global growth and infrastructure development, such as oil, copper and iron ore. Companies with significant global sales exposure, and those that raise productivity or living standards are important areas of emphasis for client portfolios. In 2009, we built positions in select technology companies that are poised to benefit from the product upgrade cycle as well as agricultural companies enhancing food production for the growing needs of the world’s population. American multinational corporations with high and rising dividend yields represent important investments under current circumstances as cash earning virtually nothing seeks a meaningful rate of return. We are investing in particularly attractive opportunities in the out-of-favor pharmaceutical sector, where world-class franchises are trading at their lowest P/E multiples in history despite having solid balance sheets, strong cash flow generation and dividend yields of up to 5.5%.

For fixed income investments, investors should weigh the desirability of realizing the capital gains that have accrued to date versus holding to maturity and losing the premiums over par. Municipal investors should consider the impact of the challenges of state and local governments on the potential for credit downgrades on their municipal holdings. In general investors should be sensitive to the risks of holding bonds with long-term maturities.

While 2008 was certainly a difficult year for the global economy and the markets, 2009 has marked the beginning of the recovery. Significant work remains and progress will not always be in a straight line, but we remain excited by the opportunities we see. As 2009 comes to a close, we would like to express our appreciation to our clients for the trust and confidence they have placed in us.

We at A.R. Schmeidler extend our warmest wishes to our clients and readers for a very healthy and happy New Year.