Special Edition — Mid-year Market Update

William F. (Ted) Truscott, Chief Investment Officer
July 23, 2009

As I sat down to write this mid-year update, I couldn’t help but reflect upon the extraordinary journey we have taken in the financial markets lately. Add in the instability of the international political scene and we may in retrospect consider the last six months one of the most interesting and frightening periods in modern history. Below is my humble attempt to capture this period, stare into an uncertain future and discuss reasons to be optimistic in the face of the daunting challenges that lie ahead.

The big picture

Some of the foremost policymakers and economists around the world are debating whether this stimulus is appropriate. One camp openly frets about higher inflation or even hyperinflation (very high or out of control inflation) while the other camp believes the response is entirely necessary given the real threat of deflation. The dollar sign on the distant iceberg is a reminder that the United States is a debtor nation. This fiscal year's budget deficit may exceed $1 trillion and our country will need to borrow significant amounts of money to finance that deficit.

We are not the only country that has increased its debt in the face of the financial crisis. A recent issue of The Economist focused on debt in a commentary titled "The biggest bill in history."

Not since the Second World War have so many governments borrowed so much so quickly or, collectively, been so heavily in hock. And today’s debt surge, unlike the wartime one, will not be temporary. Even after the recession ends, few rich countries will be running budgets tight enough to stop their debt from rising further. Worse, today’s borrowing binge is taking place just before a slow-motion budget-bust caused by the pension and health-care costs of a graying population.
The Economist, "The biggest bill in history," June 13, 2009, Volume 391, Number 8635, p.13

The rapid increase in debt in the developed world is the result of stimulus packages and social safety nets kicking into high gear in order to combat the severe and rapid downturn in the world's economy. Was this necessary?

Jim Grant, editor and author of Grant's Interest Rate Observer, captured the size and scope of the policy response to the credit crisis in a chart, which we simplified below. The chart depicts the cumulative monetary and fiscal stimulus used to combat the Great Depression, the subsequent 10 recessions and the current downturn. The current stimulus, as measured by Grant's, is 3.6 times larger than the one enacted to combat the Great Depression and is nearly 11 times larger than the average response to previous downturns. It includes the deficit resulting from a $787 billion stimulus package and the expansion of the Federal Reserve’s balance sheet to over $2 trillion.

	Length(months)	Decline in GDP	Monetary stimulus	Fiscal stimulus	% of GDP
Great Depression	43	27%	3.4%	4.9%	8.3%
Avg. of 10 downturns in between	10.6	2.14%	0.24%	2.59%	2.73%
Current downturn	?	?	18.0%*	11.9%*	29.9%*

Source: Grant's Interest Rate Observer: April 3, 2009. Fiscal stimulus measured as budget deficit as % of GDP. Monetary stimulus measured as cumulative change in the Federal Reserve's balance sheet.
* = estimated by Grant's.

There are really only two ways to think about this chart; either: a) the authorities have completely over-reacted to a downturn that is similar in severity to that of 1981–1982; or b) the authorities knew that the credit crisis had the potential to cause a downturn as bad as or worse than the Great Depression. I am in the latter camp. Remember that Central Bank head, Ben Bernanke, is one of the world's foremost authorities on the Great Depression. He knows that policy was not sufficient to combat a severe financial panic in those days. He is not about to risk repeating history even if the current policy response creates new risks in the future.

The good news is that we believe the plan has worked so far. Bernanke and the U.S. Treasury put a highly creative and sometimes ad hoc plan together to unfreeze the credit markets, which was a necessary prerequisite for a resumption of economic growth.

Ameriprise Financial economist Russell Price expects growth to return in the third quarter of 2009 at an annualized rate of 0.7%. Fourth-quarter annualized growth is expected to be stronger at around 2%, followed by growth of 2.4% for 2010. This would be welcome news. However, we note the upturn in growth is sub-par relative to what we have seen after past recessions, and this is why many economists are forecasting a jobless recovery in 2010.

What are the causes of a sub-par recovery? We have felt for some time that this downturn is different from previous recessions because its root cause lies in the bursting of a credit bubble, which led to a near-six-month shutdown in the credit markets. Banks loaned too much money based on heavy credit demand driven in turn by the low interest rates established in the early part of this decade. The chart below provided by The Bank Credit Analyst shows that bank lending as a percentage of GDP spiked far above its long-term trend line during this decade.

Consumers, who feasted off credit in the first seven years of this decade, boosted consumption as a percentage of GDP to a near-record 71% and simultaneously took the savings rate to zero. We will not return to this level of consumption anytime soon. Housing prices have fallen and consumers can no longer use appreciating home values to prop up their consumption. Credit is now scarce as opposed to plentiful and consumers must repair damaged balance sheets through more saving and less spending. The paradox, of course, is that the government does not want us to completely abandon our addiction to consumption. A growing economy is in part predicated on a reasonable level of consumption. Many of our clients have commented on this paradox. So think of this problem in Goldilocks terms. Consumption and the corresponding savings rate should neither be too hot nor too cold, but at a level that is just right.

The markets

We care a great deal about the economic outlook because it drives corporate cash flow and earnings. Cash flow pays interest and principal on bonds, and rising earnings fuel increases in stock prices.

The last six months have been among the most volatile that we have witnessed in close to 80 years. The bond market was deeply concerned about a depression in late 2008 and early 2009, and prices reflected this concern. Record-wide spreads (the compensation investors receive for taking on extra risk) in the corporate, high-yield, mortgage, loan and municipal bond sectors were testimony to this dire forecast. Spreads have narrowed considerably as Bernanke’s rescue plan took hold and investors gained confidence. Corporate, high-yield and other spread products now provide, at best, an adequate return to compensate for the risk of default in a tough recession. They no longer provide the huge opportunity we have discussed in previous market updates — and for those who followed our guidance in the late fall and early winter, some profit-taking may be warranted. But even though bonds may not offer as much opportunity as they used to, they are still likely to provide a competitive return, versus stocks.

The chart below, again provided by The Bank Credit Analyst, shows that high-yield bond spreads are below fair value while corporate bond spreads remain slightly above fair value. In short, corporate bond spreads still offer some opportunity while high-yield bond spreads may not. This chart also provides graphic evidence of why we were so bullish on bonds starting in the fall of 2008. The spikes in the chart show a deeply distressed credit market paralyzed by fear and risk aversion. Our thinking was simple — the government’s plan was designed to restart the credit market because credit is the grease of a functioning economy. If the plan worked, bond prices would rise and spreads would fall. If the plan didn’t work, the spreads reflected enormous compensation for the risks assumed. With perfect hindsight, our views appear to have been correct. We caution that similar opportunities are now much tougher to discern.

The S&P 500, a broad index that measures the stock market, collapsed during the first part of this year and reached a low of 666.79 on March 6. The market has since rebounded and closed at 940.38 on July17, an increase of some 36.5%. The improved sentiment reflects investor willingness to assume risk, optimism that the economy will grow in the second half of the year and hope for improved earnings in the second quarter and beyond. Much of this rally occurred in the 45 days after March 6. To the buy-and-hold investor, the relief was welcome. To those who had abandoned the stock market, the rally was a cruel reminder that predicting market behavior is next to impossible. As the saying goes, everyone is wrong at the turn.

It is my view that stocks are going to spend much of the next year trading sideways with a modest upward trend, reflecting capital appreciation in the mid-single digits. Add in a reasonable dividend and stocks are likely to provide a return in the mid- to high-single digits over the next year. Single-digit returns reflect two factors. First, the market is fairly valued (see the chart below from The Bank Credit Analyst) — it is neither cheap nor dear. Therefore, stock market advances will depend heavily on the growth in corporate earnings. Second, deep cost-cutting resulting in an unemployment rate likely to surpass 10% in 2010 will help most corporations adjust to a deep downturn in revenues and produce modest earnings growth.

Our asset allocation portfolios have a very modest preference for stocks over bonds. This reflects the fact that our Capital Markets Committee and quantitative models see stocks as offering only a small pickup over the returns of spread bond product.

In addition to our neutral stance on stocks versus corporate, high-yield and municipal bonds, what else can be done to configure a portfolio for the risks we have outlined above? For those who worry about deflation winning the day, the technology sector offers interesting benefits. This sector is used to falling prices. Also, most technology companies have little debt (a real plus in a deflationary environment) and healthy levels of cash. For those worried about inflation, TIPS can be a good hedge. Stocks can also be a hedge against inflation. My investment experience in Latin America suggests that stocks can maintain value even if they do not provide high, real returns. Some companies thrive in high-inflation environments. In other cases, the market understands the real value of the company’s plant and equipment, and will push up the nominal price of the stock to compensate for distortions created by inflation. Finally, emerging markets offer potentially higher growth rates and many are in much better financial shape than developed countries.

The future

In these tough times, the media has helped feed pessimism through negative articles about the future. We wonder how we will emerge from this crisis and what will provide the new sources of economic growth. Here are a few thoughts about potential future growth engines. Not all of these ideas represent great investments, and there may not even be a way to invest in some of them today. However, keep in mind that only a few understood the widespread potential of the railroads, the internet and other radical innovations that brought prosperity to our economy. Some of these ideas may be just as transformative tomorrow.

• Alternative energy — an acquaintance who was highly successful in the early years of the internet told me that he had recently joined an alternative energy venture. In his view, alternative energy (wind, solar, geothermal, etc.) is a nascent industry and reminds him of how he felt about the internet in 1995. We know that our country is far too dependent on imported oil and we also know that rapid technological innovation can bring down the cost of these energy sources. Oil may be at a low price today, but that will not last forever. I am optimistic about this growing area of the economy.
• Infrastructure — Warren Spitz, portfolio manager for RiverSource Investments, has formed a fund to invest in infrastructure based on his firm conviction that infrastructure development is a secular trend that will occur in both emerging and developed economies. Infrastructure is not just roads and bridges — it can also extend to broadband internet and other features of a modern economy. We are very optimistic about infrastructure as a future source of growth.
• The internet of things — Glen Salow, our Ameriprise Financial chief technology officer, has long discussed with me a world where devices as common as washing machines are connected to the internet. Because of this connection, the machine can order a repair before it breaks down. Just thinking about this, and the many other technological innovations waiting to happen, renews my optimism about the future.
• Emerging markets — this highly volatile part of the world equity market has long been seen as a key to the future. We may now finally be at the point where emerging markets develop a sustainable path to growth. More than ever, we need emerging markets to succeed. Their young populations with a high rate of savings are a mirror image to the aging populations of Japan, Europe and the U.S. If they spend a little more and save a little less, some balance can return to the world. The export dependency of many emerging economies and Japan needs to be altered to encourage more consumption. The stage may finally be set for this to happen.

Summary

As I was finishing a presentation to clients two weeks ago in New Bedford, Mass., a gentleman raised his hand and asked if he could offer his thoughts. It was Dean Richard Ward, Chancellor Dean Emeritus and former Dean of the College of Business at the University of Massachusetts — Dartmouth, and a World War II veteran. I asked for his permission to capture and share his powerful words, which reflect both a sense of history and economic knowledge.

For at least two important reasons, I have a high degree of confidence that we are attacking the current economic crisis effectively. One is the quality and competence of the economic brain trust that the President has put in charge of creating the strategies and policies needed to win the battle. Christine Romer is chairwoman of the Council of Economic Advisors; you often see her on TV sitting beside President Obama at meetings. She is a scholar on the Great Depression and knows which actions taken were effective and which were wrong. She did not believe, for example, that the New Deal stimulus policy was implemented long enough and therefore lost its effect.

For example, the New Deal stimulus was having a positive effect in that unemployment had fallen from 25% in the early 1930s to 10% in the fall of l936. It was on this fall of unemployment rate that Roosevelt won 46 out of 48 states in the 1936 election. Then during l937, getting too cautious, the Federal Reserve increased interest rates and Roosevelt raised a number of taxes, including those on corporations. These policies caused a sharp downturn in the economy in l937 and 1938. Romer has stated that, had it not been for this tightening of money by the Fed and the rash of new taxes, unemployment could have dropped considerably.

Also included on the team is Ben Bernanke, chairman of the Federal Reserve Bank (also a scholar of the Depression years and of monetary policy issues); Larry Summers, former president of Harvard University (a brilliant economist who is advisor to President Obama and is in agreement with his colleagues on the stimulus measures the President has implemented); and Tim Geithner, secretary of the Treasury (who, though dealing with a very complex and controversial financial bailout and other treasury initiatives, faces frequently with calmness and confidence the barrage of questioning from Congressional committee members). I have listened to and watched these experts in their appearances before a knowledgeable (not all of them sympathetic) Brookings Institute audience, and have been impressed with them. I take encouragement from this high-level brain trust available to the President, the Congress and the people of the United States.

I am also encouraged by our experience after World War II. During that war the whole country was being run by the government. Most of the payrolls of many thousands of factories and businesses of all sizes were operating off of government contracts. Millions of Americans were being paid through government spending for the war. The situation was reflected during that war in the fact that the total national debt was equal to or above the gross national product of the country (critics could agree privately with each other that socialism had taken over yet they would not publicly agree because this was the war of all wars that had to be won).

Yet, when the war was over, the rush back to private sector production was massive, and over the subsequent decades, despite ups and downs in the economic cycle, our economy experienced the greatest and longest upward progress in all aspects of life in our history.

These are my reasons for feeling optimistic about our collective ability, despite likely serious potholes in the road that will ultimately bring our country rolling back toward prosperity.

Dean Ward's words are a powerful reminder that we have had far darker chapters in our economic history and that optimism, resilience and confidence are key ingredients to our future. This is probably why Dean Ward is considered a member of Tom Brokaw's "Greatest Generation." His words offer much comfort and reassurance to all of us and I am indebted to him for supplying his thoughts and making them available for this market update.

Take action today

I will end this update with a call to action to each of you — one I have repeated many times before. You need to ensure that you have a long-term plan in place to help you reach your financial goals and objectives. You need to make sound decisions today that don’t compromise your future plans, so contact with your financial advisor is more critical than ever. Talk to your advisor about your own portfolio and whether it needs any adjusting based on the unprecedented volatility we have seen over the past two years. Keeping a long-term perspective on the economy and resisting the urge to react emotionally to the ongoing challenges in the markets will allow you to share the hope, optimism and confidence that Mr. Ward outlined so eloquently above.