Category: The Outlook

On October 29th, the US Department of Commerce announced its estimate of annualized 3.5% gross domestic product (GDP) growth for the third quarter of 2009, which represented the first quarter of growth since the second quarter of 2008. Consumption increased as a result of the cash-for-clunkers and first-time home buyer initiatives, yet real disposable personal income decreased. A quarter of positive GDP growth would normally be viewed as positive for the US economy as it signals the likely end of recession. However, the GDP figure masks structural challenges facing the US. Rising consumption on lower incomes is not sustainable. For 30 years, the US has financed above-trend growth through ever-increasing levels of debt. Now this cycle of debt serving as a driver of US GDP growth has come to an end. Consumer savings rates are increasing, consumer credit outstanding is declining, and the result is muted spending and a weaker economy. US unemployment has surpassed 10%, state and local governments are facing crippling budget deficits, taxes are increasing and services are being cut.

Unlike in prior recessions, the US today is not financially capable of playing the leading role in restoring global economic growth. This Outlook focuses on the causes and implications of this important economic transformation. It will be difficult for the US to sustain its recent growth after stimulus spending begins to phase out, and many companies leveraged primarily to the US economy will struggle under these conditions. The Federal Government is now effectively the borrower and spender of last resort, as consumers and businesses are less willing or able to spend, banks are less inclined to lend, and local government budgets are strained. The stage is being set for additional stimulus. However, this comes at a time when the Federal Government is running record deficits, which, when combined with rising debt and the printing of money by the Federal Reserve, is already contributing to the decline of the dollar. The precise timing of further weakening in the US dollar is difficult to predict and there are a number of factors that could cause the dollar to rally for a period of time, as we saw late in 2008. Over the longer-term however, investors should be positioned for the preservation and growth of purchasing power in a weakening dollar environment.

In spite of the challenges confronting the US and other developed economies, developing nations are experiencing strong secular growth resulting in rising living standards for millions of people. We continue to be encouraged by the opportunities for companies with a high percentage of revenues tied to the rapid industrialization of developing markets. Companies that own tangible assets such as precious metals, oil, copper and iron ore should also outperform in this environment, as well as select agriculture and technology companies. Quality businesses with strong balance sheets that pay dividends and are not overly reliant upon the capital markets should also be included in investment portfolios, as well as high-quality, short-term (one to four year) corporate and government bonds.

As a percentage of GDP, debt swelled from 178% to 395%-the highest in modern US history, with most of this rise coming from private debt (financial, mortgage and credit card).

Assuming an average rate of 5%, the interest alone on $56 trillion of debt would cost $2.8 trillion per year, or 20% of GDP.

For a while, consistently higher borrowing allowed consumption and capital expenditures to continue rising despite a growing debt-service burden. But the US was effectively required to borrow more each year in order to maintain its growth. An example of this phenomenon was the stimulus provided by mortgage equity withdrawal earlier in this decade. From 2001 to 2006, US consumers withdrew over $2.5 trillion of home mortgage equity for one-time expenditures, providing a nearly 3% annual lift to GDP. Credit card debt also expanded rapidly during this period. However, once home prices began to decline and excess credit availability was no longer available-the fuel driving consumption was gone and all that remained was a higher debt service burden.

• First, the Federal stimulus program is expected to peak in the first half of 2010. Outlays in 2011 will shrink to approximately $125 billion from $425 billion in 2010, which equates to a greater than 2% headwind to real GDP.

• Second, the banking system remains impaired and the FDIC continues to close banks resulting in heavy assessments for surviving institutions ($45 billion at last estimate), which is further restricting lending.

• Third, GDP is currently benefitting from an inventory rebuilding cycle that may be largely completed by the middle of 2010.

• Fourth, state and local governments are budget-constrained, preventing them from serving as a source of stimulus. In fact, they are laying off workers, cutting services and raising taxes to balance their budgets.

• Fifth, the potential for higher exports helps, but exports account only for approximately 15% of US GDP and are dependent in part on the fiscal policies of trading partners. Exporting nations are helping to restore balance to US trade relations by taking steps to stimulate internal consumption, but such efforts take time.

• Sixth, consumption will remain constrained by continued deleveraging and high unemployment, as well as higher state, local and possibly federal taxes.

• Seventh, there is a potential risk of rising interest rates now that the Federal Reserve has completed its purchase of Treasury and Agency debt.

• Finally, demographic trends are becoming an economic headwind. The “baby boom” generation has passed its peak spending years and is approaching retirement age. The greatest generation of consumers is becoming a generation of asset sellers, including second homes, cars and securities. Also the number of US workers per retiree is expected to decline from five-to-one to four-to-one over the next decade.

Current US Federal Debt as a percent of GDP has reached 84% and is expected to grow to 96% by the end of 2010-a level not seen since World War II. After the war, the US debt burden fell rapidly as the economy grew and spending declined. Today in contrast, the Congressional Budget Office (CBO) projects that US debt-to-GDP will grow for the foreseeable future fueled by ongoing deficit spending.

The CBO’s projections call for total new debt issuance of $7 trillion over the next 10 years. The White House Office of Management and Budget, using more conservative assumptions (including that some of the Bush Tax Cuts are extended) projects total deficit spending of $9 trillion over the next 10 years, or $900 billion per year. Rising deficits increase the likelihood that Treasury rates will need to rise in order to continue attracting demand, which could derail the nascent economic recovery by increasing private sector borrowing costs. An additional concern is the cycle that could be ignited by higher government borrowing rates-the average maturity of government debt is at a 26-year low of just 49 months at an average interest rate of 3.4%, well below the average borrowing costs that prevailed over the last 40 years. If debt continues growing as projected and average interest rates were to rise to just 5%, by 2014 annual gross interest expense would approach $1 trillion, or 22% of the annual Federal budget, up from approximately 10% today.

Currency demand is impacted by many factors, including the financial health of the nation issuing the currency. Much of the dollars held by US trading partners are invested in the form of Treasury purchases. If US credit quality or the value of the dollar is perceived to be at risk of further decline, demand for the dollar could continue to fall. The US government depends on foreign buyers for at least one-third of its debt issuance and unfortunately, the US relationship with its foreign lenders is showing signs of strain. This is clear from recent calls by China to move away from the dollar as the world’s reserve currency. These calls are largely just “shots across the bow”, as there is no near-term viable alternative to the dollar as the global reserve currency. However, with the amount of deficit spending needing to be funded through year-end 2010, it is not too early for the US to begin taking the concerns of its lenders seriously.

Although there are pro-growth alternatives for stimulating the economy that might be more supportive of the dollar (such as targeted tax cuts and more liberalized regulatory policies), these proposals are not in sync with the administration’s approach. With unemployment nearing a 30-year high and an election year in 2010, Congress and the administration are understandably reluctant to pursue any policy that would be contractionary and appear willing to risk the ire of foreign lenders in order to continue deficit-funded stimulus spending.

It is important to note that devaluation does not occur in isolation and also leads to a reduction in purchasing power. There is the risk that any benefits will be offset by other countries engaging in competitive devaluations for similar economic purposes. On the other hand, China is facing pressure to appreciate the yuan against the dollar due to its stronger economy, which would be inflationary for imports and result in an effective purchasing power tax on the US populace.

Investors also need to be prepared for the possibility of a double-dip recession in the developed economies, which could be discounted by the stock markets several months before tangible signs of a slowdown emerge. Blue chip, dividend-paying companies with strong balance sheets that are not reliant on capital markets for growth can benefit in a weak economy from opportunistic acquisitions or market share gains, while dividends are increasingly attractive in a low interest rate environment. Balanced accounts should also include high-quality debt with an emphasis on shorter-term maturities (primarily one to four years), allowing for principal to be re-invested at higher rates should interest rates increase in the years ahead.

Nevertheless, global imbalances remain. The US is reaching a tipping point in its ability to continue financing its deficit spending. At its current trajectory, the US will be challenged to meet its longer-term obligations and the sheer volume of treasury bond issuance threatens to overwhelm investor demand and further weaken the dollar. The US consumer is also in need of significant balance sheet repair. The US, and to some extent much of the developed world, will need to undergo substantial deleveraging that is likely to suppress economic growth for several years.

At the same time developing economies in Asia and Latin America are undergoing rapid industrialization, which in absolute scale is the greatest the world has ever seen. This industrialization has been led by the “BRIIC” countries (Brazil, Russia, India, Indonesia and China), which have a combined Gross Domestic Product (GDP) of $9.4 trillion (15% of the world’s total) and a combined population of 3.1 billion people (46% of the world’s total). The BRIIC countries have grown to become significant economic powers, yet still have considerable growth prospects as reflected in their low GDP per capita, highlighted on the table below. To put this in perspective, if over the next decade the BRIIC countries were to grow at 7% annually, they would double their GDPs per capita (to roughly $6,000, or just over half the level of Mexico) and add approximately $10 trillion to global GDP.

Therefore we see two forces competing for investor attention: the concern over the structural health of developed economies versus the opportunities emanating from the industrialization of emerging countries. This second force is presenting significant opportunities in the form of profitable, undervalued companies who are benefiting from emerging market demand for their products. Moreover, the weakening US dollar is presenting opportunities for producers of tangible assets such as oil, gold, agricultural commodities and industrial materials, which continue to rise in dollar terms. Our investments are positioned to benefit from these forces, as well as other important investment areas where we expect capital to flow, as described further below.

At the same time, developing and emerging economies continue to experience strong GDP growth. These nations are working to raise living standards for vast numbers of people by investing heavily in their productive capacity and infrastructure. China in particular, as the world’s largest creditor and surplus nation, is able to fund these growth initiatives on the back of historic global financial imbalances and a treasury flush with accumulated and still-growing foreign reserves. With over $2.1 trillion in reserves at latest count and a continuing trade surplus, China can maintain this investment and stimulus for a long time if they choose to. However, China and other developing economies will ultimately need to stimulate domestic consumer spending to build more balanced and self-reliant economies.

In contrast, China’s stimulus package represents nearly 13% of their GDP and is heavily concentrated on productive investment. Of the $586 billion committed, approximately $220 billion is for public infrastructure development (railway, road, irrigation and airport construction), $145 billion is for post-earthquake reconstruction in Sichuan and another $135 billion is for rural and sustainable development and technology advancement, for a total fixed asset investment of over $500 billion, or nearly 12% of GDP. By comparison, the US fixed asset investment of $150 billion represents approximately 1% of GDP. China’s stimulus plan has already been credited with lifting anticipated GDP growth prospects, which were recently revised upward for 2009 by the IMF to 7.5% up from its 6.5% estimate in April. China’s infrastructure plan has also helped to “prime the pump” for other markets as high demand for steel, copper, iron ore and other raw materials have boosted the growth outlook for resource-rich exporting countries such as Australia, Canada and Brazil.

Complementing the two approaches highlighted above, over 700 policy initiatives have been announced around the world since the start of the economic downturn. These have included stimulus programs, tax incentives, industry bailouts, interest rate cuts, lending programs, loan guarantees and quantitative easing (printing money), among others. The majority of this spending is targeted for the second half of 2009, 2010 and 2011. The size and scope of these coordinated actions are without precedent. It is important to note that over 40% of the combined revenues of S&P 500 companies are generated outside the US. As such, many companies stand to benefit from global policy initiatives regardless of the ultimate success of US efforts.

While significant concerns remain, there are key differences, as summarized in the chart below:

These improvements in the financial and economic underpinnings of the US have not corrected the long-term imbalances we face. However, they do reflect and have resulted in greater stability (at least for the time being), which we believe creates an environment where asset classes will not be as closely correlated and the inherent undervaluations of select businesses become more fully recognized.

Our focus continues to be investing in the beneficiaries of where global capital will flow over the next 24-36 months. The portfolios are built primarily with North American-based companies and select American Depository Receipts (ADRs) that will benefit from emerging economy growth without the political and capital market risk of investing directly in foreign markets. Due to their strategic importance and attractive valuations, many of these companies offer the additional benefit of being well-positioned to participate in future industry consolidations.

The equity and balanced portfolios are positioned for the appreciation of real assets against most currencies, a weaker dollar and continued growth in the emerging economies. In response to emerging market infrastructure investment, we see opportunities in companies with significant international sales in the areas of energy (oil), food (fertilizer and seeds) and infrastructure (steel, iron ore, and copper). To protect against further weakness in the US dollar, we continue to invest in gold and silver companies whose operating profits and cash flows would expand appreciably in response to any price rise in the underlying metals. In a rapidly changing world, the need for countries to focus on national security provides targeted opportunities among defense companies.

Our introduction of technology companies in recent months reflects our view of the needs of companies and governments to increase their productivity in both the developed and emerging economies. Finally healthcare companies, many of which were abandoned by the stock market due to concerns over the outcome of healthcare reform, are now trading at historically low valuations with strong balance sheets, high dividend yields, and in many cases, improving fundamentals. With respect to fixed income securities, we continue to focus on shorter-term maturities among investment grade issuers, although we will selectively target longer-term maturities of good credits offering attractive total returns.

As we stated in our last Outlook, we believe that a two-tiered market can develop whereby the beneficiaries become standout opportunities for returns irrespective of broader market performance. This continues to be a time for thoughtful investment security selection in a more complex global environment.

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

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

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

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

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

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

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

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

Governments have chosen the latter. Since the crisis began, governments and central banks have announced no fewer than 550 policy initiatives to stimulate the global economic system with the majority of these policies coming in recent months. It may take several months or quarters for these initiatives, which are financed by increasing deficits and central bank monetary creation, to have maximum impact. The Federal Reserve and other central banks have unlimited power to create money, and logic and prior experience would suggest that excessive monetary expansion will likely lead to higher prices over time. Indeed central banks seem to have concluded that the extent of economic weakness combined with the frozen credit system will require monetary expansion in order to prevent deflation.

On March 18th, Federal Reserve Chairman Bernanke took a most significant step to restore confidence and stimulate the U.S. and global economies by implementing an aggressive monetary stimulus policy called quantitative easing. Quantitative easing essentially involves printing money. One of the consequences of monetization is that we are continuing to stimulate the existing imbalances (trade and fiscal deficits) in the global system that have been built up over years, which we are now trying to address. The imbalances stem from a global economy that had become U.S. consumer-centric.

In defining the environment for this outlook, it continues to be clear that a select group of equity securities and corporate bonds will be beneficiaries. The areas of focus for equity portfolios continue to be energy, industrial, materials, precious metals (including gold), defense and agriculture companies. In the corporate bond area, we remain focused on strong balance sheet issuers with an emphasis on maturities in the 1 – 4 year range.

At the same time, we are witnessing the coming-out party for China on the international stage and its continued development as an economic power. With approximately $2 trillion in currency reserves and the status of largest creditor nation and foreign holder of U.S. Treasury debt, China has become one of the most influential countries. While it is early in its development (including its military strength) and not without its own domestic challenges, China’s recent call for the consideration of a global reserve currency signaled its intention to play a leadership role as an economic power. However it also served a cautionary warning that in any further policy response requiring borrowing, the U.S. would need to be sensitive to the interests and concerns of its largest lender. The U.S. challenge is that China’s concerns are voiced at a time when the U.S., the leading debtor nation, needs to increase its debt still further to stimulate its economy and put its fiscal house in order.

China’s economy has been unbalanced by being too dependent on its export markets. The Chinese government has now embarked on an aggressive program to develop its domestic economy so as to lessen its dependence on exports. China has committed $300 billion to building a 100,000 mile state-of-the-art railroad system which involves some 400 million tons of steel, or approximately 25% of the world’s annual steel capacity. The Chinese government has implemented a strategic program to meet its long-term needs through acquisition of interests in foreign companies to secure critical resources. Moreover for it to be less dependent on the U.S. Dollar, it has, for the first time, agreed to provide $95 billion of its currency to Argentina, Indonesia, Malaysia, South Korea and others through currency swaps so importers can avoid paying for Chinese goods with U.S. Dollars. This will have the effect of elevating the status of its currency (Renminbi) versus the U.S. Dollar.

The chart below illustrates the extent of the shift in economic fortunes by showing the amount of China’s reserves versus that of the United States and the continuing trade deficit of the U.S. as expressed in the current account balance column. As can be seen from the current account balance, the United States continues to pour significant amounts of dollars into the world economy. Rebalancing the global economy will require China to build its own consumer-driven economy which it has committed to do. However, this will occur only over a period of years.

On March 18th, the Federal Reserve shocked the markets with its own aggressive program of quantitative easing totaling approximately $1.5 trillion, including large additional purchases of mortgage-backed securities to reduce mortgage rates. Since none of these moves occurs in isolation, we expected other export-dependent countries to do the same, with the most likely next candidate being Japan whose interest rates have been virtually zero for an extended period of time. In spite of those low rates, the Japanese economy has suffered a contraction and sure enough, the Bank of Japan (BOJ) has begun a similar program. The BOJ is increasing its purchases of Japanese government bonds by nearly a third to offset the pressures created by the global financial crisis.

These moves may not end here as the ECB now stands out as having the highest interest rates among the G7 countries and accordingly is perceived as being behind the curve. The largest economy in the Eurozone is Germany, and Germany is slowing rapidly as they are quite export-dependent. After the Fed’s announcement, the dollar weakened against the Euro by more than 7 cents, putting further pressure on the ECB to do something similar. In fact, as a result of the Fed’s move, the sharply higher Euro ended at its highest point this year. We believe this will force the ECB to act more aggressively beyond the recent 25 basis point rate cut. A decision made by the G20 to avoid competitive currency devaluations suggests the likelihood of coordinated Central Bank intervention (increasing money supply simultaneously) in future policy actions.

An important responsibility of the U.S. Government is preserving the dollar’s role in international finance. Failure to preserve the dollar’s role as the international reserve currency will introduce an economic and political outcome which can weaken the U.S. global role. In transferring the debt burden to the government, the total balance sheet expansion of the Federal Reserve ultimately could be in the range of $4-6 trillion up from $950 billion a year ago. According to U.S. Budget Watch, the U.S. has committed to finance and backstop nearly $12 trillion of financial assistance which represents 85% of the Gross Domestic Product.

Ben Bernanke, the Chairman of the Federal Reserve, has emphasized the Fed’s ability to remove excess liquidity from the system before inflation becomes a problem. However, we should be aware that a muted economic recovery is likely to be the outlook, and under those conditions the Fed’s removal of excess liquidity could have the effect of raising interest rates thereby slowing the economy from an already sub-par level of growth. Therefore, the Fed could be forced to maintain higher than normal levels of liquidity for an extended period of time. Based on the scale of monetary creation it is reasonable to expect a higher cost of living to emerge from this environment.

Importantly, gold as a percentage of many countries’ reserves had been declining over the past decade and, as a result of continued monetary creation, can be expected to become significantly smaller unless this trend is reversed. One indication of this reversal is Russia’s recently announced intention to increase its gold stock from 500 tons to 1,200 tons which would cost $20 billion. This was followed by news that another exchange traded fund (ETF) backed by gold was introduced for investors in the Middle East. With the significant increase of global money supplies to stimulate growth, it is reasonable to expect that prices of gold and other assets traded in world markets will rise over time at a rate different from the past decade.

The American Society of Civil Engineer’s recent report indicates that U.S. infrastructure spending needs have now grown to $2.2 trillion over the next 5 years much of which can no longer be postponed. To put this in further perspective, these needs are for a population of only 320 million people, while China’s and India’s industrial needs are for an estimated 2.2 billion people.

With the worldwide population estimated to grow by 74 million people annually, another area of concern is the prospect of growing food shortages for the world’s population. According to a recent policy document of the G8 agricultural ministerial meeting, global food production needs are expected to double by 2050. In the more immediate term, excess crop inventory relative to consumption is near a 30-year low. Despite global back-to-back record crops, crop prices remain well above 10-year averages, and the world could be one major drought away from facing serious food shortages. As a result of the financial crisis, farmers in many countries are reducing their plantings setting the stage for price increases for agricultural products.

One of the world’s most critical resources is energy and it is also one where capital spending has been significantly reduced. Since last year, the number of North American drilling rigs in operation has declined by an estimated 50%. A recent International Energy Agency (IEA) report highlighted the challenge of maintaining global production because capital expenditures had been running at approximately $350 billion annually and now those expenditures have been reduced by 50%. At this reduced rate of investment it is estimated that global production capacity will fall by 3 million barrels per day over a 1 year period from 86 million barrels. When global demand for energy increases, it could be difficult to meet world needs without prices rising from current levels.

As a result of the many months of market declines, there are now many trillions of dollars, historically record levels, on the sidelines waiting for the opportunity to achieve better returns than those offered by cash. The March equity market surge was a reflection of some capital seeking higher returns in the form of select equity and corporate bond securities. At ARS we remain focused on 3 key drivers for portfolio strategy: preservation of principal, capital appreciation, and protection of purchasing power. The emphasis for equity portfolios remains on energy, industrial, material, precious metals (including gold), defense and agriculture companies. In the corporate bond area, we remain focused on strong balance sheet issuers targeting maturities in the 1 – 4 year range.

As we look out over the coming months, there is no doubt that governments around the world will spend whatever it takes to repair the global financial system, the global economy and to restore confidence in countries and the markets. The actions of the G20 leaders, central banks and local governments in the past month alone highlight the global commitment. While there may be some unintended consequences of these actions, it is important to bear in mind that, as a result of the economic downturn, distinct undervaluations have been created in many of the beneficiaries of these policy initiatives. Investors with judgment, understanding and patience should benefit from these opportunities. As we emerge from this period, the great values that are being created could result in investment returns that are the most attractive that have been seen in years.

In most democratic political systems, governments’ primary responsibilities are to fight recession and deflation by re-inflating their economies. No government can stay in power for long if it allows deflation and the accompanying rise in unemployment to overwhelm its economy. In emerging democratic societies, it is even more important to avoid deflation as the potential for social instability can lead to a return to autocratic government. Since the problems emanated from the United States, much of the solution will rest with the United States, but coordinated global responses will be one of the several factors needed to repair the global financial system and restore the world economy to more normalized and sustainable growth.

While the financial system is severely damaged, there is reason for optimism based on the commitment of world leaders to work together to implement the necessary fiscal and monetary policies. An example is the recently announced stimulus program by the Chinese government of $586 billion, which would be the equivalent of a United States stimulus program on the order of $2 trillion. This program, which is for infrastructure and urbanization, underscores the commitment of the Chinese Government to promote growth to absorb their large labor force and prevent unemployment. We expect the emerging economies to drive world growth, and portfolios should own the companies that are the beneficiaries. Importantly, it should not be forgotten that the stock market discounts economic change many months in advance, and while our ongoing problems will continue to create headlines, opportunities will present themselves well before we emerge from this economic slump.

At this time, there is no source of economic stimulus other than the U.S. government and the Federal Reserve. The most dominant feature of past recessions was that we could always count on the consumer to spend as consumers account for 70% of Gross Domestic Product. This time, the consumer is over-debted and has less access to credit as credit is being withdrawn by the banks. While many businesses have strong balance sheets, they are limited in their ability to access credit and fund normal business activity. The financial crisis became so severe that banks were unwilling to lend even to each other.

Under president-elect Obama, we expect a major infrastructure spending program and large grants to the States to be passed by congress early in the New Year. Foreign central banks are now coordinating monetary policy which must be hard-hitting if it is to be effective. That means interest rates must be lowered further (Japan’s is still near zero) and injections of liquidity must continue to offset the trillions of dollars of asset-backed securities, which now are of questionable value and are largely illiquid. It should be noted that Germany, the most powerful member of the European Union, is not entirely supportive of a major stimulus program for their economy because the government has a greater fear of inflation than unemployment. This exemplifies the challenges and complexities of coordination facing leaders in solving this problem.

The United States enjoys the unique characteristic of being the largest reserve currency country in the world. Therefore, since all its debts are in dollars, it is able to discharge its obligations by printing U.S. dollars. Because there has been a need for dollars overseas causing our currency to appreciate, the Federal Reserve in one day arranged a currency swap program of $620 billion with 14 countries. This program gives countries access to U.S. dollars in exchange for their currencies. This was necessary to satisfy the overseas demand for dollars, which had contributed to the strengthening of the dollar exchange rate causing our export sector – the last remaining pillar of economic strength for the U.S. – to weaken. Because of all the liquidity being created to stimulate the economy, there is a substantial probability the dollar will begin to decline in 2009.

Retail investment demand rose 121% to 232 tons in Q3 as strong buying was reported in European and U.S. markets. We are also aware that gold shortages exist among bullion dealers around the world. In Europe, third quarter demand reached an all-time high of 51 tons and France became a net investor for the first time since the early 1980s. India was a major contributor to increasing demand, as were China, Indonesia and the Middle East. All this comes at a time when many Central Banks, which had been reducing their gold reserves, have stopped selling. Furthermore, worldwide production costs have been rising. The result of the combined forces of increasing demand, limited supply and concerns about the value of currencies worldwide could give rise to significant increases in gold prices in the coming months.

With this in mind, equity portfolios should be positioned to take advantage of owning the beneficiaries of massive infrastructure spending from the domestic and global stimulus programs. We also plan to target securities that benefit from a weaker dollar including gold investments and export-driven companies. Moreover, leading health care companies, especially those with strong positions in the generic drug space, should be represented as well as defense companies whose services are needed to maintain the U.S. position as a world leader. We continue to emphasize dividend income as an important element of total return. We intend to take advantage of opportunistic investments, including merger arbitrage situations, which exist due to the unusual valuations in the market. Finally, in the coming weeks, an allocation should be made to select financials, energy, industrial and materials companies whose shares have been oversold as a result of deleveraging and forced liquidation as selling pressures abate.

For fixed income investments, there are significant opportunities in investment grade corporate securities of high quality companies in the 3-4 year maturity range. At the present time a bubble has been created in the short-term treasury market as investors have been interested only in absolute safety without regard to yield. This has caused short-term treasuries to sell at prices that produce virtually no income. When this short-term phenomenon reverses itself, as it inevitably will, interest rates on treasury securities will begin to rise.

We wish our readers a happy, healthy, peaceful and prosperous new year!

The continued de-leveraging of institutions including hedge funds, commercial banks and investment banks, and the government bail-out of Freddie Mac and Fannie Mae reflect the deteriorating condition of the U.S. financial system. The impact this is having on equity markets is clearly negative. In the process, investments unrelated to the financial sector and which benefit from continued global growth have become even more attractively valued than they were before the market’s recent decline.

As the federal government, the U.S. Treasury, and the Federal Reserve have taken on the responsibility and burden of protecting the economy, the cost can have a negative impact on the federal budget deficit and on the foreign exchange value of the U.S. dollar. As a result of the AIG crisis, the Federal Reserve has made an historic and unprecedented decision by taking a 79.9% equity stake and providing $85 billion short-term funding.

In light of these financial stresses, we expect to see the prices of precious metals and other commodities traded in world markets to rise in dollar terms over time. We also expect to see a general recognition that the greatest investment beneficiaries of these events will be those companies that produce real goods and products and not financial paper. We anticipate continued global growth, although perhaps at a slower pace. The demand for the products and output of corporations which serve the industrialization and urbanization of overseas economies will continue to increase. Many companies benefiting from global growth have experienced stock market declines to the point where they are now selling at a discount of 40-60% of their real-world values, or 4 to 8 times earnings and 3 to 6 times cash flow from operations. These companies have solid balance sheets, strong managements, and important global market positions. Of equal importance, the strong cash flow and balance sheets reduce their reliance on financial institutions to support their growth. In our view, many of these companies represent what we like to call the crown jewels of the world’s industrial economy.

This year we have witnessed a partial and temporary breakdown of the global financial system. Recent events have proven how difficult it is to predict what stage we have reached in the de-leveraging process. We expect to see continued pressures in the financial system. However, we believe that this may be a time to take advantage of extraordinary opportunities and to do this in a measured way over the coming weeks and months. One critical factor we are watching closely is the amount of cash held by sovereign wealth funds, private equity funds, hedge funds and money market funds, much of which is positioned to take advantage of these increasingly attractive equity valuations. Still, we continue to expect a significant amount of market volatility. In these times, market participants’ decisions tend to be driven by emotions and perceptions while losing sight of the business fundamentals. Notwithstanding the uncomfortable environment in which we are operating, we continue to identify and invest in companies that are demonstrably undervalued in terms of assets, cash flow and earnings power. At some point in the future, investors will be able to look back and see the investment opportunities that had developed.

Formerly, the U.S. economy had been the engine driving global growth, but this is no longer the case, nor should we expect U.S. economic growth of the past several years to re-assert itself any time soon. As mentioned in past Outlooks, the U.S. growth was driven by questionable lending practices and the excessive use of leverage and derivatives. Consumers, representing approximately 70% of the U.S. economy, can no longer borrow and spend as in prior years. Therefore, 70% of the U.S. economy over the next several quarters will likely experience slower growth and possibly no growth at all.

To moderate a further slowdown in the economy, three sources of financial help have appeared: fiscal stimulus, monetary stimulus and record international cross-border wealth transference. A $170 billion fiscal stimulus program was passed by congress earlier this year. This certainly helped in the short term, but it has now largely run its course, and another package will probably be required. Also, the Federal Reserve has provided monetary stimulus by keeping short-term interest rates at 2% and will probably not raise rates any time soon. At the same time, the Federal Reserve is helping the banks with a further monetary stimulus by exchanging treasury securities for assets the banks cannot sell. Finally, the greatest transfer of wealth across international borders that has ever been experienced has been financing emerging economies through our budget and trade deficits. These economies have accumulated trillions of dollars of monetary reserves, and now those dollars are flowing back to the United States as investments in our financial institutions that currently require large capital infusions to survive.

For the short term, we should expect living standards to erode in the United States as companies raise prices and wages fail to keep pace. Since financial stresses in the U.S. economy will take a considerable period of time to work themselves out, the economy will face an extended period of sub-par growth. Our slowing economy will have an impact on global growth, but world growth will continue to give long-term investors an opportunity to effectively commit investment capital for income and appreciation. For investment choices to be effective, investors must continue to confine themselves to companies that are demonstrably undervalued in terms of assets, cash flow and earnings power.

To best achieve investment objectives, we believe a portfolio should represent global diversification by owning foreign companies whose shares are traded as ADR’s (American Depository Receipts) on the New York Stock Exchange, and by owning U.S. corporations directly benefiting from non-U.S. growth, as well as participating in select opportunities in our economy.

We believe the historic growth rates we have seen in the U.S. over the past ten years will be difficult to achieve for the foreseeable future because they were based on increasing use of borrowed money. Today, the banking system is attempting to repair its capital base, and its ability and desire to lend have been seriously curtailed. Consumers, municipalities and banks are all being forced to repair their finances at the same time. This should result in slower U.S. growth and will require the Federal Reserve and the federal government to maintain an expansive monetary environment (in other words create more money).

Demand for steel exceeds supply and major U.S. steel companies are the prime beneficiaries of this imbalance. The amount of steel required for a single facility was well highlighted in a recent Wall Street Journal lead article on the $7 billion expansion of the Motiva oil refinery in Port Arthur, Texas. Once expanded it will be the largest crude oil refinery in the United States. What is particularly relevant in terms of our ongoing views of infrastructure spending is that this refinery expansion alone will consume more than 27,000 tons of structural steel and require 450 miles of pipe. This will increase the capacity of the refinery from 275,000 barrels per day to 600,000 barrels per day by 2010. Most of the world’s oil is of the heavier or acidic type, which means that significant additional investment will be required over time to refine this lower quality oil. This is a reminder that the quantities of steel and other raw materials needed for global infrastructure development are necessary, vast and will be ongoing well into this century.

The competing dynamics that investors face today involve global growth versus diminished U.S. growth. It is our view that as long as global growth continues, the beneficiaries, both domestic and foreign, will continue to be among the most rewarding investments that can be made. Given the enormous amount of dollars in the global economy, large amounts of capital will continue to flow to those regions and industries where investors can feel comfortable that returns can be significant and risks well-contained. One should continue to avoid the industries that had benefited from the over-leveraging that had occurred over the past decade and which now are retrenching and repairing their balance sheets at a cost to their existing shareholders. Furthermore, investors should be mindful not to expose themselves to industries and companies which cannot pass on their rising costs. We believe investment in the beneficiaries of global growth will continue to offer the most attractive rates of return over time even as the U.S. becomes a smaller piece of the total world economy.

As reflected in the S&P 500 earnings, the corporate beneficiaries of global growth have been doing well, and we do not anticipate this will change any time soon. Our analysis of last quarter’s earnings has reinforced our view that the global emerging economies and their infrastructure needs will remain the major drivers of economic growth. We expect this global growth to be in the range of $1.5 trillion. Very specific sectors of the S&P 500 are prime beneficiaries of this growth and according to our research are demonstrably undervalued based on earnings, cash flow and asset valuations.

It is for this reason that Federal Reserve Chairman Ben Bernanke has been so aggressive in reducing interest rates and injecting liquidity into the system. The 150 basis point reduction in the discount rate and the federal funds rate since September 2007 has occurred over an extraordinarily short period of time. Originally it was felt that the Federal Reserve was acting too slowly, but the rapid shift in policy has made up for lost time. The Federal Reserve, however, is in a difficult position. They are being forced to lower interest rates to moderate the economic downturn at a time when the inflation rate is still rising. Adding to Chairman Bernanke’s dilemma is the fact that finally the Chinese currency is appreciating at a more rapid rate versus the dollar, something that the U.S. government had been encouraging China to do prior to today’s problems. But as a result of this, the cost of imported goods from China is rising and will now add further to our inflation rate. The U. S. inflation rate, because of rising energy, raw materials and agricultural costs has just taken its biggest jump since 1981. Still, the Federal Reserve appears to have little choice but to reduce interest rates once again and to continue to inject needed liquidity into the system, which will tend to further weaken the U.S. dollar.

Notwithstanding the inflation pressures that are building, there is a high probability that interest rates will be reduced further by the Federal Reserve from today’s 3% to 2.5% and possibly lower over time. It would not surprise us to see a 2% interest rate structure emerge this year. Additional credit market problems continue to eat away at the banking system’s capital, which reduces their ability to lend money and puts pressure on the Federal Reserve to reduce interest rates still further. Under former Federal Reserve Chairman Greenspan, rates were dropped to 1% in reaction to the technology and dot-com implosion and stock market decline in the early 2000’s. We believe that today’s economic problems are significantly more difficult and much more extensive, requiring the Federal Reserve to repair bank capital as quickly as possible.

The European Central Bank, whose priority is fighting inflation, has also had to contend with similar financial problems and has injected vast amounts of liquidity into their banking system. Nevertheless, their currency, the Euro, has been rising versus the dollar, hurting their exports and causing their economies to slow. Notwithstanding this, the European Central Bank, unlike their U.S. counterpart, appears to be unwilling to lower interest rates for fear of stimulating inflation.

The enormous amounts of monetary creation since last August have put upward pressure on the prices of tangible assets such as raw materials, energy, agricultural products and precious metals. In addition, the secular trend of demand for all of these products continues to rise as global infrastructure needs and rising living standards for 3.5 billion people continue apace. Under these conditions, the disequilibrium caused by rising demand and supply shortages should continue for an extended period of time. It cannot be determined how much prices need to rise in order to re-establish equilibrium, or to put it another way, what prices need to exist in order to bring supply and demand into balance. However, it is our view that this condition could last for many years. We are describing a secular trend, not a cyclical one, where growing demand and supply imbalances are expected to continue as global living standards rise.

In order to avoid a recession, it is important for us to be able to effectively deal with sub-prime credit problems as well as to deal with an entire array of questionable derivative products. Losses in the banking system are creating considerable strains in the global economy and are restricting banks’ ability or desire to lend even to one another. Moreover, the use of high levels of leverage means that as default rates rise, hedge funds and others are forced to sell, transferring risk back to the banking system. As a consequence, bank capital then gets reduced, and banks need to raise additional funds at a high cost. How much ultimately gets put to the banks has much to do with how much further home prices decline. Since this is a global issue, the Federal Reserve and foreign central banks have created a new facility for bank borrowing.

Over the past five years, when compared to the U.S. Dollar, the Euro has appreciated 43%, the Australian Dollar has appreciated 59%, the British Pound has appreciated 28% and the Canadian Dollar has appreciated 54% as seen in the following graph:

During this time, Sovereign Wealth Funds have grown to $2.5 trillion and are expected to grow to a much larger amount over the coming years. Some of the direct investments recently made by leading exporters include Sony, AMD, and Citibank.

Oil exporters have an estimated $3.8 trillion in foreign-owned assets divided among Sovereign Wealth Funds, central banks and wealthy individuals. Asian foreign exchange reserves are (according to McKinsey Global Institute) estimated at around $3.7 trillion, and if oil prices remain above $70.00 per barrel, nearly $2 billion of new petro-dollars will flow into the global financial system each day. Given the outlook for further declines of the U.S. dollar, lower U.S. interest rates and the desire of exporting nations to depreciate their currencies against the dollar in order to maintain their export businesses, we expect these large and mounting U.S. dollar reserves to be used to purchase entire corporations and substantial equity interests in U.S. publicly traded companies.

Depreciation of the dollar, growing global demand for raw materials and continuing global central-bank monetary creation has had the effect over the last five years of increasing commodity prices such as copper, silver, oil and gold as seen in the following graph: