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First Quarter 2010

The economy is normalizing according to a number of measures. The past two years represented a severe adjustment process due to the high debt accumulated during the economic bubble and the high levels of spending relative to income. The recession was in fact an adjustment of consumer behavior, and because consumption is two thirds of GDP, the downward adjustment in personal spending translated into a substantial recession. There is now evidence that a good deal of the adjustment process has occurred, demonstrated by a sharp rise in personal savings rates and a generalized, ongoing reduction in debt.

From this, all economic indicators are following. There has been a marked improvement in manufacturing, sentiment, leading indicators and employment, although we should expect the rebuilding of employment to be slow as companies have excess inventories and capacity which needs to be worked through first. With a rising economy, commodity prices are edging up, with oil nearing $87 per barrel. GDP growth in the fourth quarter of 2009 grew at 5.6%, which was due to an unusually large amount of inventory rebuilding in anticipation of future growth. It will not be so large over the next few quarters, but nonetheless the recovery’s momentum is building.

While inflation remains subdued in the U.S., it is picking up in China. Food represents one third of the Chinese consumption basket, and drought has increased grain and rice prices, while meat prices are up over 70% in recent years. There is also evidence of wage inflation in the coastal regions of China, while real estate prices are spiking. A revaluation of the Chinese Yuan would cool down import prices, because China imports a great deal of oil, food, and commodities, which, because they are priced in dollars, would suddenly become cheaper to the Chinese. It is possible, even likely, that this will occur at some point this year. Given the amount of imports from China, both in the U.S. and the Euro zone, this may result in some price inflation of the goods we import. This may also lead to a lower level of imports, as U.S. goods become more price competitive, which will have a positive impact on the trade deficit.

Investors should note that there are still trillions of dollars sitting in cash, checking accounts and money funds seeking a home in a near zero interest rate environment. With any further signs of recovery, it is quite possible that the liquidity driven rally seen over the past year continues.

The threat to the recovery lies in fiscal rebalancing, as governments cut spending and raise taxes. We are likely to see spending cuts as well as tax increases in the coming years. In some countries, (as in some U.S. states) this will be severe. Favoring tax efficient investments going forward thus makes sense, but only if risks are well taken into account.

Grant Rogers
Partner

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