Fourth Quarter 2009

Happy New Year!

The stock market rally continues apace, but it remains primarily liquidity driven supported by worldwide government policies of fiscal stimulus, capital injections into the banking system, and increased liquidity in the monetary system.

Recent economic optimism may be tempered later in the year by underlying and structural problems. However, over the first months of 2010, the risk is that most economists have under-estimated the strength of the economic rebound.

Real GDP growth in the U.S. saw a run rate of nearly 2.5%-3% during the boom years of the last decade, driven largely by increasing debt taken on by consumers. However, the constraints of the “new normal” may provide us with a much lower level going forward, due to a crippled consumer and high unemployment.

Nonetheless, manufacturer surveys are still advancing, indicating optimism, although industrial output remains depressed.
Retail sales are still negative year-on-year, while the consumer is still burdened with a huge debt load.
Unemployment, while beginning to moderate, will take years to return to levels seen in the mid 2000’s, and household income may not yet have hit bottom as unemployment benefits cease for those who have been out of work for more than 72 weeks.
One in six Americans now are underemployed, meaning that they are either looking for full time work, forced to accept part time work, or have given up looking entirely.

Should economic growth re-normalize more quickly than expected, the Fed will be under increased pressure to renormalizing monetary policy. The headwinds to the stock market this year include an end to “quantitative easing” both in the U.S. and abroad, removals of fiscal stimulus measures, higher taxes, and higher commodity prices.

Government stimulus and bail-out measures have stirred concerns over sovereign risk. Dubai and Greece are only the most obvious examples, but record levels of government bond issuance, as well as a generalized deterioration in public finances have fueled fears over rising government bond yields worldwide. Rising long term interest rates jeopardize the global recovery because they represent higher borrowing costs for governments, businesses, and consumers.

Historically, rising long term interest rates don’t necessarily have a negative impact on the stock market until they bypass 6%. With ten year yields currently at 3.85%, this is not yet a concern, although these yields should be watched carefully. Given the fragile nature of the world economic recovery, yields over 5% may put the financial markets under pressure.

The continuing rally in commodities is consistent with liquidity being the prime mover in a generalized reflation of assets.

The structural economic imbalances we face today may take years to overcome. Emerging markets offer attractive growth rates and should be considered by investors. However, emerging market growth, longer term, will likely be in concert with U.S. growth, rather than at its expense. The U.S. still has fundamental strengths in its infrastructure, institutions, and individuals which will prove to be an innovative and very powerful engine of growth for decades to come once these short term imbalances are overcome.

Grant Rogers

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