Portfolio Commentary: 2nd Quarter – 2010

Question: What do debt crises, Gulf oil spills, Chinese labor unrest, flash crashes, the Japanese Imperial Palace, and the Tea Party all have in common?

Answer: Nothing – or, perhaps, everything – as this post will attempt to elucidate.

Volatility returned with a vengeance in the second quarter of 2010.  US stocks suffered their first quarterly loss in more than a year, with the Dow down 10 percent – including the “flash crash” of May 6^th – while foreign markets and most other indices fared no better.

A palpable mix of fear, anxiety, skepticism, and uncertainty hung over global financial markets, setting the stage for the triple bill battle royal that will largely determine the fate of markets and economies over the next many years.  This fight card features the following match-ups:

1. Stimulists vs. Fiscalists

2. Inflation vs. Deflation

3. Recovery vs. Recession

Battle #1: Stimulists vs. Fiscalists

The emergence of the Tea Party in the US is the most tangible evidence of the growing philosophical battle between what BSW refers to as the Stimulists and the Fiscalists.  The Keynesian “Stimulists” (as personified by commentators like Paul Krugman) believe that economies would benefit from further government stimulus, via federal spending, unemployment benefit extensions, holding interest rates low, and “quantitative easing” (a polite term for printing more money).  Stimulists contend that a failure to spend risks plunging the US (and, likely, the world) back into recession or, worse, depression.  The “Fiscalists” (as personified by folks like Robert Barro and John Cochrane) believe that further government stimulus is simply “pushing on a string” and will create unsustainable public debt levels that erode investor confidence in the US financial system, leading to a debasement of the US dollar or possibly even default on our debt.

This debate is not solely confined to the US, as much of the angst related to the Eurozone debt crisis was due to arguments about whether and how to impose “austerity measures” (a polite term for budget cuts) on southern Europe’s profligate spenders: Portugal, Italy, Ireland, Greece, and Spain.  In a nutshell, considering that the global recession was fueled by the expansion of credit and debt, should policy makers impose fiscal restraint and focus on getting their financial houses in order?  Or should the focus instead be increasing spending, whereby the government essentially serves as a “buyer of last resort”?  Can the answer to a credit crisis really be more credit?

Both Stimulist and Fiscalist arguments have some merit.  BSW’s aim, though, is to avoid getting lost in the intellectual debate and instead look for the investment implications of both policy stances.  From that perspective, the most likely outcome of the battle of the Stimulists versus the Fiscalists is gridlock and vacillation. Again, because of the emergence of the Tea Party, along with high unemployment levels, much of the November 2010 election chatter will center on economic issues and policy responses.  As a result, while it took one election (November 2008) to turn the Federal money spigot “on,” the next election (November 2010) will likely turn that money spigot “off.”  Historically, split federal governments have been good for equity market returns, as they often slow the pace of legislative change.  Remember that markets, and businesses, abhor uncertainty.  So while gridlock may sound like a bad word, the consistency created when nothing happens legislatively – or at least requires bipartisan compromise – is often an ideal environment for business and economic expansion.

However, legislative vacillation on the economic policy front (again, stimulism vs. fiscalism) may further hamper the recovery.  One needs look no further than Japan, whose on-again/off-again, stimulist/fiscalist waffling has mired the country in more than 20 years of slow burn recession-style contraction.  Regardless of what flavor of economic policy prevails, the only true recession exit strategy seems to be conviction and consistency – which are often in perilously short supply.

Battle #2: Inflation vs. Deflation

At its core, the Stimulist versus Fiscalist debate can be deconstructed to a simple question: Is inflation the cure or the disease?  Before jumping into that question, a quick review of terminology is in order.  Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.  Essentially, in an inflationary environment, a dollar buys more today than it will tomorrow.  Deflation, on the other hand, is a decrease in the general price level of goods and services.  Deflation occurs when the annual inflation rate goes negative, resulting in an increase in the real value of money.  Essentially, in a deflationary environment, a dollar today buys less today than it will tomorrow.

Governments and central banks fear deflation far more than inflation because the tools and techniques used to address inflationary environments, including raising interest rates and reducing the supply of money supply, don’t work so well (or possibly at all) against deflation.  Deflationary environments, such as the Great Depression or 1990s Japan, are far more pernicious and troublesome.  During a deflationary spiral, falling prices lead to a slowing of consumption.  As consumption slows, production levels fall, which leads to lower wages and, ultimately, lower demand.  As demand falls, prices fall accordingly, creating a vicious, negative feedback loop.

The typical policy response to deflationary environments is to lower interest rates and increase the money supply, which is exactly what the US Federal Reserve has done.  But with the Federal Funds rate already at 0 percent, the “interest rate gun” is seemingly out of bullets.  Yet while prices have continued to fall for a variety of assets (houses, cars, equities, iPhones, etc.), it remains unclear whether we are truly suffering from deflation or simply dis-inflation?  The situation is raising alarms, including the head of the St. Louis Federal Reserve, James Bullard, as he discusses in this very recent paper.

To answer this question, many economists again look to Japan, the most recent example of deflation, for clues, signs, and analogs.  Consider that at the height of the Japanese real estate bubble, according to the Financial Times, the three square kilometers of land underneath the Japanese Imperial Palace in Tokyo was equal to the value of all land in the state of California.  When the bubble burst however, real estate prices declined in some areas by more than 80 percent.  What followed was a long (and ongoing) period of economic stagnation, despite Japan holding interest rates at the lowest level of any developed nation.

As discussed in our June 3^rd Economic Update, BSW believes that the US is likely to avert a full scale deflationary environment and, instead, is suffering from an acute period of dis-inflation.  The US economy is exceptionally diversified and businesses have been quick to shed workers and rebuild their balance sheets, while US domestic demand strongly benefits from immigration and positive demographics.  We are less convinced that the Federal Reserve can successfully “thread the needle” of both halting dis-inflation and avoiding significant inflation in the future.  Consequently, our investment portfolios include allocations to assets that benefit from dis-inflation (bonds, consumer staples), as well as assets that protect against inflation (TIPS, gold, commodities, growth equities).

Battle #3: Recovery vs. Recession

For investors, the Stimulists vs. Fiscalists and Inflation vs. Deflation debates are merely a prelude to the main event: Will the recovery survive or is a double-dip recession at hand?  The recovery argument is supported by many “micro” positives, including corporate earnings, falling consumer loan default rates, inventory levels, home sales, and business activity measures.  Unfortunately, these positives have been overshadowed by “macro” negatives such as the Eurozone debt fiasco, anemic job growth, legislative and regulatory uncertainties, and the ongoing negative psychological impacts of the Gulf oil spill, Iraq and Afghanistan wars, and the Flash Crash.

Despite these very real “macro” challenges, BSW believes that a double dip recession is possible, but not probable.  Quite simply, the US economy failed to rebound strongly enough to set the stage for another, deeper crash.  The most likely scenario is that the current, sluggish and tepid pace of domestic economic growth will continue through the remainder of 2010.  In terms of the global recovery, however, it is far more useful to look beyond the United States, and Europe, for that matter.

As discussed in our Fourth Quarter 2009 Portfolio Commentary, one of BSW’s key investment themes is the general transfer of wealth and power from the West to the East and, specifically, the rise of the Asian middle class.  And while the US news media was busy navel gazing about American Idol judges, the Twilight saga, and Chelsea's wedding this summer, three news stories of immense economic and historical proportions quietly emerged from Asia to further bolster our conviction about this investment theme.  First, China has now supplanted Japan as the world’s largest economy, a three decade “economic miracle” that has lifted hundreds of millions of people out of poverty while creating one of the world’s largest and fastest growing markets.

Second, China has now supplanted the United States as the world’s largest consumer of energy – a dubious title that the US has held since the early 1900s.  Third, as discussed in our June 15^th Portfolio Update, widespread labor unrest and, remarkably, strikes have resulted in steadily increasing Chinese wage levels (Apparently The Economist is also reading BSW's blog!  See their July 31st cover below).

In terms of the Recovery vs. Recession battle, the impact of these developments cannot be overstated.  Perhaps the biggest challenge to the global recovery has been that the historically voracious spending of US consumers is likely to be absent for quite some time, as US consumer struggle with elevated unemployment levels, underwater home values, and upside down personal balance sheets.  What could possibly take their place?  The emerging market’s burgeoning middle class, composed of 1.15 billion people throughout Asia and Latin America – the largest such cohort in history.

BSW’s growth portfolios are fundamentally aligned with this long-term trend, via investments in Asian companies focused on domestic Asian markets and consumers, countries engaged directly in trade with Asia (like Australia and Germany), and global companies that provide the basic staples first purchased by emerging market consumers.  As Mark Twain might say, “reports of the global economy’s death have been greatly exaggerated.”  Indeed, the global economic recovery is in better shape than news reports often suggest – but its center of gravity continues to shift away from the US and toward Asia.

Portfolio Performance Summary:

BSW’s Growth Portfolio’s performed admirably during the volatile environment of the Second Quarter of 2010, once again benefitting from our defensive positions in gold, managed futures, and dividend-producing equities.  For the second quarter of 2010, BSW’s Growth Portfolio was down 8.5 percent, handily beating our primary macro-benchmark, which was down nearly 12 percent.  (As a reminder, BSW’s macro-benchmark is composed of 60% S&P 500, 20% Russell 2000, and 20% MSCI EAFE.)  Thus far for 2010, BSW’s Growth Portfolio is down 6 percent, again strongly outperforming its macro-benchmark, which is down 7.5 percent year-to-date.

Past & Future Changes:

Gold:

As discussed in our June 15^th Portfolio Update, we took profits on our gold holdings in mid-June, trimming them back to our original allocation targets when gold reached its highs of ~$1250 an ounce.  We continue to hold gold as protection against both skittish investor sentiment and inflation risks, but will continue to look opportunities to make tactical sales.

Emerging Markets:

We have shifted a portion of our emerging market exposure from the MSCI Emerging Markets index to the stocks of dividend-paying Asian companies focused on Asian consumers.  Many of the companies underlying the MSCI Emerging Markets index are related to natural resource intensive infrastructure projects.  Infrastructure spending is a key mechanism by which emerging economies “dial-up or dial-down” their GDP.  While infrastructure will continue to be a major driver in emerging economies, we have more confidence in the spending habits of increasingly wealthy Asian consumers on small luxuries than government spending on large, capital-intensive projects.

Short Yen:

In late July, we initiated a short position on the Japanese Yen.  As the Eurozone debt crisis unfolded, investors fled “risk” assets and the Euro for the relative safety of the US dollar and the world’s third major currency, the Yen.  During this time period, the Yen is the only major currency against which the US Dollar has weakened.  The Yen/Dollar exchange rate is now at historic lows, with $1 only buying about ¥85.  Yet Japan’s debt to GDP ratio is now 120% and nearly half of that debt is scheduled to mature in less than one year.  Just as the global financial spotlight illuminated Greece’s unsustainable financial condition, we believe that Japan’s precarious financial condition will soon come under intense and uncomfortable scrutiny, putting downward pressure on the Yen.

Overweights & Underweights:

In terms of our portfolio overweights and underweights, we are now positioned as follows:

• US Large Cap: Overweight
• US Mid Cap: Overweight
• US Small Cap: Underweight

• Foreign Developed: Underweight with tactical overweights to select countries

• Emerging Markets: Neutral

• Commodities: Neutral

• REITs: Neutral

• Opportunistic: Overweight

Summary:

We hope this Portfolio Commentary provides you with better insight into the components of your growth equity portfolios and our current economic and investment outlook.  If you would like to discuss these positions or your portfolio in greater detail, please don’t hesitate to contact BSW.  As always, we are happy to help.

-David Wolf, Chief Investment Officer

Portfolio Update: Gold & Chinese Labor

Gold:

We recently took profits on our gold position, trimming them back to our original target allocation, and netting profits of roughly 27 percent. The shiny, yellow metal has been on a tear in 2010, up nearly eleven percent year-to-date and trading above $1200 an ounce.  Advertisements for gold coins and gold liquidation services seem to be appearing even faster than medical marijuana dispensaries these days.

Gold’s rise seems largely driven by fears related to the Eurozone debt crisis and the US Federal Reserve’s ongoing stimulative monetary policies.  From a longer-term perspective, gold is still far from its inflation-adjusted high of roughly $1850 an ounce.  Could gold continue to go higher?  Of course.  But when articles about gold investing begin appearing in faux-news rags like Time magazine, it is prudent to lock in some gains.  Indeed, should the Eurozone debt crisis abate, gold could quickly lose some of its luster.

Labor Unrest in China:

Although largely overshadowed by the ongoing saga of the Gulf oil disaster, China’s labor markets are in the midst of immensely historic and critically important changes.  Two ongoing strikes at a Honda Motor factory are the latest instances of Chinese labor unrest, which began with the suicides of ten workers at Hon Hai Precision Industry Co., the world’s largest contract manufacturer of electronics, including Apple’s iPhone and iPad.  The situation is simply astounding – coordinated strikes in a country long regarded as one of the world’s worst human rights offenders. As evidence of how rapid the pace of change is in China, consider that Tiananmen Square was little more than 20 years ago, in 1989.

As discussed in BSW’s June 3^rd blog post, by linking its currency, the Yuan, to the US Dollar, China is effectively importing US interest rate policy.  This has caused rampant inflation in China and growing discontent among China’s workers that they are working too hard for too little pay.  Pressure on companies to raise wages and improve labor conditions is coming from both workers and (amazingly) the Chinese government, which is looking for alternative means to dampen the impacts of domestic inflation without resorting to a currency adjustment.  Although the labor drama is still unfolding, it is clear that the costs of doing business in China are going up and that is causing companies to evaluate shifting production elsewhere – maybe even back to the United States.

Anecdotally, consider Boulder-based EcoProducts, the world’s leading producer of environmentally friendly foodservice products, like compostable cups, plates, and cutlery.  EcoProducts is the first portfolio company in Greenmont Capital Partners II, a venture capital fund in which BSW invests and participates.  Speaking at Greenmont’s annual meeting in Boulder on June 14^th, EcoProduct’s CEO, Bob King, discussed how the company currently manufactures many of its products in Asia, but that situation may change. EcoProducts, which is on target to grow 2010 revenues to more than $60 million, is now large enough to have significant negotiating leverage with its raw materials (primarily corn and sugar cane) suppliers.  This negotiating leverage, combined with increasing production costs (via labor) in Asia and the marketing benefits of being “Made in the USA,” may now make domestic manufacturing a viable strategy.  While EcoProducts has yet to make a final decision, the situation is representative of the benefits that BSW accrues from conversations with our manager colleagues (like Greenmont), the executive teams leading our portfolio companies (like EcoProducts), as well as our clients (who are also tremendously successful entrepreneurs, executives, connectors, etc.).  Real life, on-the-ground insights help us immediately see the influence of global economic dynamics, better anticipate their impact on the investment markets and, ultimately, position client portfolios to benefit.

-David Wolf, Chief Investment Officer

Economic Update – “May you live in interesting times.”

Reviewing our library of investing and business publications this morning, it’s striking how rapidly global economic sentiment can change.  As case in point, the April 12^th issue of Businessweek magazine carried side-by-side articles titled, “Drill, Baby Drill,” about the planned expansion of offshore oil drilling off both the Atlantic and Gulf coasts; and “Things Are Looking Up,” which discussed growing confidence levels from the stock market expansion.  Six weeks later, on the heels of the largest oil spill in US history, the Eurozone debt crisis, and some mixed economic data, Businessweek is singing quite a different tune.  Was Businessweek too optimistic in April?  Is it too pessimistic now?  Why the perpetually manic vacillation between the glass being half full versus half empty?

In light of recent equity market and currency market volatility, domestic flashpoints surrounding immigration and environmental disasters, and international tensions on the Korean peninsula and in Thailand, the expression, “May you live in interesting times,” certainly comes to mind.  Is the expression a blessing…or a curse?  It depends upon your point of view.  Does “interesting” mean dangerous or turbulent?  Or exciting and ripe with possibility?  At BSW, we aim to cut through the hyperbole and white noise of general media blather and distill out the most probable investment outcomes, their impact on your portfolio, and how to be best positioned for long-term success. As such, we would like to share with you our current thinking on a few recent issues.

What Happened to the Recovery?

Since its April high, the S&P 500 has fallen about 12 percent, the end result of a domino effect triggered by the Eurozone debt crisis.  As concern about Greece’s solvency grew, the faltering, impotent response of the European Union and the European Central Bank failed to reassure markets of the monetary union’s solidarity.  Further, many economists worry that the harsh austerity measures meted out to Greece and its spendthrift peers (Portugal, Ireland, Italy, and Spain) would be an immense drag on European economic growth and, hence, global economic growth (the European Union is the world’s largest economic zone by GDP).

Fears about the Eurozone’s viability caused a flight from the Euro to the US Dollar (and the Japanese Yen), driving the Euro down to its lowest levels against the US Dollar in nearly five years.  In many ways, the Dollar (and certainly the Yen) is simply the winner of the “least ugly” contest of major world currencies.  But while the dollar’s strength may be good news if you are traveling to Europe this summer, it is likely bad news for the fledgling US economic recovery.  A strong dollar makes American goods and services more expensive abroad, resulting in less demand.  Unfortunately, according to US Federal Reserve data, the US is still only utilizing about 69 percent of its industrial capacity – versus its 38 year historical average of 81 percent.  Until businesses see sustained demand, they are unlikely to utilize additional capacity or expand hiring, and without job growth, consumer confidence wanes and spending stalls.  It’s a vicious cycle with the potential for deflationary conditions if prices fall for an extended period.  Investors’ rush to safety also lowered US bond yields, which enables the US, fortunately or unfortunately, to continue cheaply financing its monstrous structural debts – and to kick its very problematic debt can down the road, at least for now.

Deflation At Home & Inflation Abroad . . . .

New York recently passed Sydney, Australia and Hong Kong as home to the world’s most expensive retail rents, at $1,725 per square foot per year.  Oddly enough, though, the highest profile retail lease signed in Manhattan recently was a record-breaking 15 year, $300 million dollar lease on 5^th Avenue by the Japanese clothier Uniqlo.  Uniqlo, which is a bit like a Japanese version of The Gap, is famous for its budget-conscious styles.  Uniqlo’s success, however, has also made it infamous and emblematic of Japan’s twenty-year battle with deflation.  Japanese economist Noriko Hama caused quite a stir in 2009 when she blasted Uniqlo’s cheaper-is-better model of yasuuri kyoso (low price competition), which she argued was "destroying society" and "self-strangling."

The Uniqlo anecdote is indicative of a broader deflationary trend.  Based upon consumer price index measures, inflation fell to a 44-year low in April, yet another sign that high unemployment and excess productive capacity are stifling pricing power.  The consumer price index, however, is a wildly manipulated number, which excludes food, energy, and healthcare, not to mention the garbage-in/garbage-out methodology it utilizes for housing costs.  Although low European inflation readings mirror those in the US, developing Asia is struggling to contain high inflationary pressures.  Many Asian countries, particularly China, have budgetary surpluses rather than deficits and continue to grow at a robust clip.  By effectively tethering their currencies to the US Dollar, however, they also expose their economies to US interest rate policy, which currently hover near zero.  In April, the US Federal Reserve’s Open Market Committee voted to keep the Federal Funds rate at “zero to 0.25 percent.”  As a result, economies like China’s risk overheating due to continued growth plus stimulative monetary policy.

Moreover, due to their manufacturing base and large infrastructure projects, emerging economies are much more influenced by commodities prices, which have eased off relatively recent peaks but are still well above their February 2009 lows.  For instance, China’s consumer price index rose a blistering 2.8 percent in April while year-over-year urban property prices climbed a staggering 12.8 percent from 2009.  In an effort to cool their economy, especially the real estate market, the Chinese Central Bank has increased bank reserve requirements, raised down payment requirements, and is widely anticipated to tighten its monetary policy soon.  Meanwhile, raw materials exporter and China-centric Australia continues to hold interest rates steady at 4.5 percent in an effort to combat inflation and speculative bubbles.

Where do we go from here?

At this point, the global recovery still faces some significant risks: the sovereign debt crisis that began in Greece and spread to Europe could further spread to Japan and even the US; a property bubble in China could burst and drag down one of the world’s strongest growth engines; the US’s stimulus-driven expansion could fade and its housing market could slump; politicians everywhere will continue to exercise terrible judgment.  Again, though, BSW’s aim is to identify the probable, not just the possible.  Many indicators suggest that the still nascent recovery is sufficiently rooted enough to continue growing.  The US Labor Department recently revised down first quarter productivity gains to 2.8 percent, suggesting that companies have wrung about as much out of their lean staffs as possible.  Service sector job growth also expanded in May, its fifth consecutive monthly gain; while the Institute for Supply Management reported that their jobs measure rose for the first time in more than two years.  Pent up demand for autos, business equipment, and restocking inventories should provide a modest to robust undercurrent of spending and job creation, while the May 2008 index of consumer confidence rose to its highest level since March 2008.

So, are the risks real?  Absolutely, but so is the recovery.  We live in interesting times, to be sure, though “interesting,” from BSW’s perspective, suggests opportunities for patient and diligent investors.

-David Wolf, Chief Investment Officer