I’d like to say that all the activity and effort being put forth by the new Obama administration in terms of rescue packages, new regulations and tax changes will have a major positive impact in the short-term. But I don’t see it happening. Given this outlook, our assessment of economic (GDP) growth is negative for the year, flat (near zero) growth for next year (2010) and modest growth for 2011. As a result of this assessment, we are maintaining our current tactical asset allocation overlays for all our Strategic Allocation funds in the 2nd quarter.

As the tactical weighting table below illustrates, we remain underweight equities. Within equities, we are slightly overweight on growth stocks. Value stocks include financial institutions and our underweight here reflects the view that the financial sector is far from being on the road to full recovery. Internationally, we favor developed versus emerging markets as the latter have been especially hurt by the collapse of commodity prices and the steep decline in capital availability.

The Financial Sector

The situation in the financial sector is as murky and cloudy as it was three months ago. Some have proposed “pulling the plug” on Citigroup and other troubled financial institutions (i.e. nationalization or letting them fail). But this is not as easy or simple a solution as it might appear. It could have the impact on the markets that the failure of Lehman Brothers had last autumn. In my opinion, the best course of action for Citigroup, AIG and a few other very troubled financial institutions would be a systematic dismantling of them: Sell the valuable pieces and use the proceeds to cover the losses from the toxic debt they are holding. But there is clearly no political will for doing this in Washington, D.C. If nothing else, a change in the senior management at these banks is called for.

In addition, I’d like to see the Fed and the Obama administration become more aggressive in general about the financial crisis. Simply supporting badly wounded companies with capital infusions, loans and guarantees— hoping they will slowly recover and earn their way out of the financial holes they are in— is both a very slow process and one with some likelihood of failure. One of the problems we are facing in the banking sector right now is excess capacity for lending on one hand, but also a reluctance to lend (and borrow) by banks, businesses and households because of the delevering process which is underway.

The U.S. Automobile Industry

The U.S. auto industry is another area, like the banking sector, which is in need of a major overhaul. While Ford Motor Company appears to be getting by for the time being, even they are facing the

pressures of too much inventory, too much capacity and too little demand. As for General Motors, they are essentially insolvent. The best option would be either a Chapter 11 bankruptcy filing (allowing them to shed assets) or even Chapter 7 controlled liquidation. And the recent forced resignation of CEO Rick Wagoner—who opposed such a move—suggests the government may be weighing this option. But here again, as I noted with Citigroup, the political will to do something this dramatic (save perhaps a Chapter 11 filing) does not exist. Nonetheless, like the banking sector, much of the U.S. domestic automobile industry is limping along on the basis of government infusions of capital and loan guarantees.

Deleveraging and Inventories

One of the common themes in our analysis and views on the economy going forward is the need to pare back “inventories”. For the banking sector, it is an ‘inventory’ of toxic assets on their balance sheets. For the auto industry, it is the need to pare back inventories of automobiles and reduce the number of dealerships and manufacturing capacity. For the housing industry, the need is to reduce the backlog and inventory of unsold or foreclosed homes. For households, it is the need to reduce their inventory of debt as part of a broad deleveraging process. And this will take time, especially given the current environment for jobs and unemployment rates.

As for efforts by the Obama administration to put a floor under home prices with financial assistance and providing judges with the power to rewrite mortgages, I don’t think this will have a dramatic effect. Rewriting mortgages is a slow process. So long as the unemployment rate continues to rise, rewriting mortgages will be offset to some degree by rising default rates. In this respect, a better approach to solving the long-term housing and

mortgage crisis would be to keep people working. Keeping people employed will also help spur demand for housing among non-owners who begin to see housing prices fall to levels they can afford.

Federal Government Budget

As for the new federal budget, I believe it is simply delaying the pain we need to face for years of overspending while possibly laying the price for this on the next generation in the forms of debt and inflation. My biggest concern is the massive federal budget deficit projected out for the next few years. Our budget deficits were already unsustainable long-term before this plan was introduced. One impact will likely be a continuation of the long-term trend of the dollar devaluing versus other currencies.

Looking outside the U.S., one potential risk which has to be considered is the possibility of a sovereign debt default by a country, most likely in Europe. The issue here is that other countries—with much smaller economies than the U.S., and lacking the special global reserve currency position we occupy—have a much more limited set of options to deal the their financial sector debt crisis. Hungary is one example. Iceland is already in default. The broader potential impact of the global financial crisis in Europe is the possibility that the monetary union of Europe might weaken. In fact, drastic fiscal and monetary actions in a number of countries are required but will likely not occur as the domestic political agendas in each country will supersede these required changes.

Conclusion

Massive government spending in the short-term might have a positive impact on economic growth (GDP) during the next twelve months, but the crux of the issue is how consumers and households (and businesses) ultimately respond. And since consumers are in the process of both deleveraging and increasing their savings rates (keep in mind the median age of the Baby Boom generation is now 53—twelve years from retirement age—and looking at badly depleted retirement accounts), the outlook for a strong jump in consumer spending as we’ve seen coming off past recessions is unlikely.

The economists at the National Bureau of Economic Research (NBER) may technically declare this recession has ended later this year, but for most people it will continue to feel like one long after the official end. While we are in a recession, the challenges we are facing are nothing like what causes and occurs in a ‘typical’ recession. Most recessions begin when an economy overheats and central banks are forced to restrict credit availability to tame inflation and overexpansion. In this recession, central banks are tripping over each other to flood the global economy with credit and liquidity. In other words, the fundamental challenge we are facing is not a global recession but a global deleveraging by banks, households, businesses and investors.

Given the lack of political will to take some difficult and painful decisions in the short-term, the outlook for the path out of this current recession and bear market is likely to be a long and protracted period of low growth, higher inflation and stubborn unemployment. There won’t be huge numbers of unemployed as we had in the 1930’s but it will certainly be a far different environment that most people have become accustomed to during the 1980’s, 1990’s and the first half of this decade. As some have described our current situation, it is not the Great Depression of the 1930’s, but could very well be the Great Recession of our era.

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