The Recession Is Over ! ? !

The President, The Fed Chairman, The Treasury Secretary and other influential Politicos have declared – “The Recession Is Over”.  We have to agree, academically speaking of course.  We believe that the 3rd and 4th quarters of 2009 will produce positive GDP growth – versus significantly weak year over year numbers (recall the crisis started in the 3rd quarter of last year).  Two positive growth quarters will mean, again academically speaking, that the recession ended around July of this year.  Most economists are no longer forecasting a V or W recovery, as the topic of conversation has shifted towards a square root recovery.     

You may recall that we stated, “housing (mortgages) and leverage were the primary culprits for the implosion…. and will also be the primary catalysts for a resumption of economic growth” (CCI Second Quarter 2009) Since then, we have been closely watching the housing statistics and while we are not out of the woods yet, we are pleased to report that during July the Case-Shiller home price index posted its third consecutive month over month increase while the inventory to sales ratio for both existing and new homes has declined meaningfully as well.   Additionally, the consumer has been deleveraging and confidence has trended higher over the past six months.  As measured by the University of Michigan Consumer Confidence Index, consumers are feeling more confident.  We attribute this confidence boost to 1) the increasing rate of unemployment has slowed 2) residential real estate values have stabilized in 17 of the top 20 metro areas 3) household net worth increased 3.9% during the 2nd quarter and will post another quarterly increase when the 3rdquarter numbers are released and 4) Americans are optimistic people and pent-up demand to consume can only be contained for so long (even though we believe the savings rate will adjust to a new higher normal level for an extended period of time).

 Existing Home Sales and Inventory - Annual Sales Rate

    Source: Bloomberg

By using the phrase, “academically speaking” when referencing the end of the recession, we are putting a caveat on this declaration as we find it hard to sincerely declare that the recession is over when unemployment is approaching 10%, the commercial real estate market is deteriorating, wage growth is weak, household net worth is still meaningfully below year ago levels and Main Street is still feeling the pain.  While we do expect positive GDP growth in the 3rd quarter and 4th quarters, we find ourselves asking – what then?  It is clearly a reasonable question to ask – is this real growth or stimulus induced growth and confidence?  We expect growth in 2010 to be modest as unemployment trends lower (but still at elevated levels), capacity utilization troughs and starts to improve – this will be the key metric to track when looking for inflation - and consumers reevaluate an environment with less government stimulus, greater government regulation and higher local, state and federal taxes.  As we always point out, the consumer is still the key to a sustained recovery and we do not see a return to pre-crisis confidence and employment on the horizon. 

Understanding Interest Rate Risk – The Case for Shorter Maturities

We are constantly asked how interest rate risk can impact a portfolio in a rising rate environment.  We hope the following simple explanation is of value…. If interest rates rise by 1% in a given 12 month period, a bond with a

maturity of 10 years and duration of 9.5 would experience a principal decline of 9.5%.  For a bond with a maturity of 4 years and duration of 3.5, the principal value off that bond would experience a decline of 3.5%.  Concurrently, both bonds are paying interest payments during the year (let’s assume a 4.5% coupon) which means that at the end of the 12 month period, the total rate of return on the 10 year bond is negative 5.0% while the total rate of return on the 4 year bond is positive 1.0%.  If we increase the interest rate rise to 2% in a given 12 month period, the magnitude of the volatility is amplified - the total rate of return on the 10 year bond is negative 10.0% while the total rate of return on the 4 year bond is negative 2.5%. 

This example is designed to illustrate interest rate risk and doesn’t factor credit risk, reinvestment risk or yield curve shifts into the total return calculation. 

We believe that as unemployment peaks, capacity utilization trends upward and wage growth resumes, the Fed will start to tighten rates and market interest rates will trend higher during 2010 – 2012.  At Carret, during rising rate environments, DURATION is the key metric we focus on to reduce client’s portfolio volatility and enhance total return.    

The Fed & Central Banks

Globally, Central Banks continue to remain accommodative in an effort to stimulate global economic growth.  The Bank of England is at 0.5%, The Bank of Canada is at 0.25%, The European Central Bank is at 1.0% and the Federal Reserve Bank maintains its 0.0% - 0.25% range.  The Fed has now been using the phrase “exceptionally low levels of federal funds rate for an extended period” since March and we anticipate the Fed will keep the spigot open into 2010. 

The Fed did extend the time period (from a deadline of December 31, 2009 until the end of the 1st quarter of 2010) over which it will continue to purchase agency debt and mortgage securities; however, they did not alter the $1.45 trillion amount of those purchases as many expected.  To date, the Fed has repurchased about 70% of their mortgage allocation and about 65% of their agency allocation.  The repurchase of U.S. Treasuries has basically concluded at quarter end.    

Just a thought and something to watch…..  The risk of a weak dollar and a continuing decline in American’s global purchasing power remains a serious long term concern.  The IMF and G-20 have been considering / slowly implementing a plan to craft a potential currency to rival the dollar as the world’s reserve currency. Many world leaders are taking advantage of our crisis and mounting debt problems and are being more assertive in global financial and political circles.  China, one of the largest investors of our government debt has pledged to invest $50 billion in the new IMF notes (bonds), a clear move away from the US markets.

For those of you who do not travel outside of the US, this will not have a material impact on your standard of living any time soon, but for those of you that travel abroad…. The Euro / Dollar conversion is already painful.

The Economy, Interest Rates & Inflation

The 3rd quarter started with clear signs that the economy was improving.  Survey data became less mixed and reached levels consistent with a growing economy.   The housing market started to show signs of life in the early stages of the 3rd quarter.  It is apparent that the consumer (housing and deleveraging) will be the key to the strength of the recovery. 

July non-farm payrolls pleasantly surprised to the upside, showing a loss of 247,000 jobs after falling a revised

443,000 in June.  Monthly payroll revisions have been positive since March suggesting that an uptrend is in progress.   Treasury yields soared early in the 3rd quarter.  2-year yields leaped 32 basis points, 5-year yields jumped 40 basis points, 10-year yields jumped 36 basis points. Very short rates are essentially fixed at this point.   Inflation is becoming less of a near-term concern.  The story appears to be turning positive for the housing market.  Sales are higher, inventories are lower and year over year price declines are slowing.

The manufacturing sector continued to strengthen in August as inventories held a supply/demand balance.   Housing appears to have bottomed mid way through the 3rd quarter and is showing signs of improvement.  Even though the jobs numbers look better, the jobless rate continued its climb and may ultimately top out at 10%. 

The August non-farm payrolls report showed a loss of 216,000 jobs – better than consensus expectations. This reversed the recent trend to lower job loss revisions.  The unemployment rate jumped from an unexpectedly low 9.4% to 9.7%. Although losses in the goods-producing sector dropped dramatically in July, they picked up in August.

Treasury yields switched direction in August with yields dropping roughly 40 basis points along the curve (2 years through 10 years).  These yield declines more than offset the prior month’s increases. The rising rates reflect both the strengthening economy and the enormous amount of Treasury supply now hitting the markets to fund all of the government recovery programs.  The FOMC’s August 11-12 meeting ended with only minor changes in policy. Rates were left unchanged.  However, the Fed did announce that the duration of the Treasury purchase program will be extended with no change in size.

As the quarter closed out – The economic picture turned slightly less optimistic.  Key indicators, such as, consumer sentiment and the housing sector slumped a bit in September.  Consumer sentiment, while higher, remains depressed relative to historical norms.

Treasury yields continued their decline in September while the yield curve continued to flatten.  2-year yields dropped another 6 basis points while 10-year yields slid 22 basis points. The 2-year to 10-year spread  flattened but is still trending at over 200 basis points.  Falling Treasury yields reflect continued demand for U.S. securities and less concern surrounding inflation. 

Taxable Bonds

In hindsight, our move away from Treasuries and Agencies towards risk – corporate bonds – in the 1st quarter has rewarded our clients well.  Lower rated corporate bonds have benefited the most from the improving macro-economic outlook.  Corporate credit spreads have tightened significantly from the “end of the world” environment of the 4th and 1st quarters.  Today, corporate credit spreads are still attractive with Investment Grade A rated bonds trading on average at 2.06% above comparable Treasury bonds. With the economy improving, we continue to believe that corporate bonds will outperform Treasury and Agency debt issues.      

We think short / intermediate duration portfolios will outperform longer duration portfolios over the next several years and would encourage investors to focus on total return versus current yield (please see our conversation on Interest Rate Risk).

Municipal Bonds

The market’s appetite for risk grew during the 3rd quarter.  In the case of Municipal Bonds – this means that investors were willing to pull dollars from “the sidelines” and move out on the yield curve.  As confirmation, many of the new issues (New York and California included) that came to market were met with strong demand.  Additionally, secondary market supply has been trending lower when compared with the previous few quarters. 

The move from money market funds to the municipal marketplace continued to push yield spreads lower.  As a result, demand is starting to outpace supply.   The best performing portion of the municipal market has been on the long-end of the curve.  However, there are possible implications to extending maturity at this point.  Instead, we see great relative value in the intermediate sector with strong risk-adjusted returns expected over the long run.   The headline risks that held municipal yields at higher levels have started to quiet down thus allowing yields to drift lower. 

The “players” in the municipal marketplace have continued to evolve.  Insurance companies and hedge funds have largely been absent from the market this year.  This also has an effect on shifting supply and demand dynamics.  During the 3rd quarter - the municipal market benefited from strong demand and light supply. 

Our bias has been to be opportunistic while remaining defensive.  It is our belief that intermediate maturities may provide protection against inflation while generating positive cash flow.   If short-term rates rise faster (and higher) than long-term rates – the yield curve will flatten.  The resulting opportunities for re-investment should be positive. 

Demand for intermediate and long maturity bonds continued to grow (throughout the 3rd quarter) as fears of inflation receded and investors searched for higher yields. Money flows accelerated out of money-market funds onto the yield curve.  As a result, tax-exempt bonds posted positive returns for the quarter. 

The demand / supply imbalance for municipal bonds has resulted in varying degrees of value along the yield curve.  Municipal yield ratios at the short-end of the market dropped to 55 percent of comparable Treasury yields. Long-term Municipal / Treasury ratios were tracking at over 90%.  The historic relationship (or ratio) between municipals and Treasuries is 80%. This disconnect creates added-value in the high-quality / intermediate-maturity universe.

Carret Bond Strategies

Municipal Bond: Utilizes top-down and bottom-up fundamental research with the goal of generating high after-tax returns coupled with the preservation and growth of capital.  Focus on investment grade municipal bonds with an intermediate duration.

Taxable Bond: An investment-grade intermediate duration portfolio focused on corporate, government agency and U.S. Treasury bonds coupled with select opportunities in preferred securities. Utilizes top-down and bottom-up fundamental credit research with the goal of generating high current income with the preservation of capital.

Past performance may not be indicative of future results. Different types of investments and investment strategies involve varying degrees of risk, both short-term and long-term, including principal loss and fluctuation. No client or prospective client should assume that any material in this document serves as the receipt of or a substitute for, personalized advice from Carret Asset Managment, LLC or from any investment professional. Due to various factors, including the passage of time and changing market conditions, such content may be outdated and no longer reflective of current holdings or position(s).

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