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Third Quarter 2011

The world economy is looking increasingly binary; either a credible solution to the Greek crisis is engineered in the near future by European leaders, or there is a risk of falling into a “double-dip” recession worldwide. Whether we are in a recession or not (as defined by two quarters of negative economic growth) it certainly feels like one to many Americans. In the third quarter of 2011, exports have slowed down globally, job growth remained very anemic, consumer confidence neared its lows of early 2009, the housing market continued to deteriorate, and sentiment took a turn for the worse. The S&P 500 index lost 14% in the three months since the end of June, which was the worst quarter for stocks since March of 2009.

There are many contradictory signals at the moment. While we have experienced a stock market correction in Q3, stocks are not falling the way they would if we were entering into a real recession. Yet the month of August brought virtually no job growth to the U.S. economy, which is certainly not indicative of a recovery, and the first time this has happened in 66 years. The major drags on the economy in the first half of the year- supply shocks from the Japanese earthquake, high gasoline prices, political brinksmanship with the Federal budget, the subsequent downgrade of the U.S.’s AAA credit rating and European debt woes, either have dissipated or will be dissipating (given a more favorable outlook in Europe). This is leading some economists to revise GDP growth forecasts for the second half upward. On the other hand, the OECD cut its forecasts for the US recently, saying that the economy grew only 1.1% in the third quarter and is likely to grow by only 0.4% in the fourth. Some believe that the dysfunctional manner in which the U.S. Congress acted over the budget deficit in July was in itself the reason for economic weakness in recent months.

German and French leaders pledged today to deliver a plan to stem the European debt crisis by November 3rd.
The $600 bln. European Financial Stability Fund (EFSF), created in May 2010, exists to stabilize European banks from the fallout of a Greek default, and to help support the Spanish and Italian bond market, which is the real source of investor concern now that a controlled Greek default is a foregone conclusion. While recapitalization of banks is their top order of priority, European leaders need to take far reaching measures which will be both painful and politically difficult. Many feel the EFSF is not big enough, to begin with. More importantly, Pressured European economies need a budget surplus, particularly Italy and Spain, or Europe needs to move toward a tighter fiscal union. Budget surpluses can only be achieved through new taxes to bring down debt/GDP ratios or through fiscal transfers from Northern European states. Even more difficult to realize, though equally important for a “lasting” solution in Europe, will be structural labor and pension reforms. Without these measures, it is likely that the Euro, and the European Union, will not survive in its current format. As in the U.S., the source of concern in Europe is whether governments are indeed up to the job of creating meaningful reforms.

In mid September, the Federal Reserve Bank launched “Operation Twist”, a stimulus operation consisting of selling $400 billion of short term treasuries and buying long term treasuries with the proceeds over the next nine months.
Their ambition is to drive down interest rates on mortgages and business loans in order to stimulate consumers and business to resume spending.

The events of the past three months have produced extreme volatility which was, at times, reminiscent of 2008.
Investors sought the safety of U.S. treasury bonds, whose ten year yields dipped below 2% for the first time in 50 years. The financial markets may remain volatile until the European debt crisis heads towards resolution. Meanwhile, defensive postures remain warranted until we see more positive economic signs on the political and economic front.

The current environment continues to favor blue chip companies with high and growing dividends, non cyclical sectors such as consumer staples and utilities, Master Limited Partnerships, and REIT’s. The stock market is extremely cheap, with a P/E based on the expectations for next year’s earnings at only 10.16 times. Compare this with the historical level of 15.9 times earnings. Investors may remember this year as a succession of crises, but also as an excellent buying opportunity.

Grant Rogers

Partner

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