March 2009

March 18, 2009

Economic Outlook
I would expect any economic improvement to be gradual as consumers and companies deal with the credit market realities that are likely to improve slowly. Individuals must have credit available in order to buy houses, cars, and other big ticker items. The level of access for the average consumer to bank loans impacts the extent to which the economy can recover.

Corporations also need access to credit and this availability is currently a mixed picture. Highly rated companies have found access to credit fairly easily. This portion of the business sector would be largely comprised of large, well-known companies, but can encompass smaller companies with good balance sheets. For example, we’ve seen both Proctor & Gamble and Cisco recently issued bonds that have quickly sold out. Medium and smaller corporations with more challenged credit ratings that have debt maturing this year are having a tougher time obtaining refinancing and loans for operating capital or expansion. Banks are lending to businesses. However, banks are lending much more conservatively right now and are not willing to take on loans to businesses that do not have a high probability of being able to pay back the loans. Lending standards have simply tightened significantly in reaction to the high losses banks have recently seen from loans based on lower standards. It is unlikely that recently “burned” bankers will greatly relax their new, higher standards in the short-term.

Factors to Recovery
There are 4 factors that have the potential to contribute to an improved economic outlook by the 2^nd half of this year.

- Highly stimulative Federal Reserve monetary policy aimed at restoring the economy to its long-term growth track and Treasury policies aimed at removing troubled assets from the balance sheets of financial institutions. Both of these governmental moves are designed to help ease bank lending.

- Infrastructure spending on projects that create jobs and associated economic activity. I would note that although some of the infrastructure projects slated for funding under the stimulus bill will not begin until 2010, there are projects already underway that have begun and created jobs due to this provision of the stimulus plan.

- Very low interest rates which should have a positive effect on consumer borrowing after confidence in the banking system is restored and consumers begin to borrow rather than just save.

Individuals who do have good credit scores are finding historically low interest rates for home and car loans. As credit restrictions ease we should see more loans for those with more average credit scores. This will be a key factor in finding a bottom for many housing markets. Home mortgage rates have recently been below 5%, but many Americans can’t qualify due to lower home values. As we see lending institutions adjust to the new lower values we will see more people qualify for loans, but this adjustment period is going to take some time.

- Reductions in individual tax rates for most households (individuals earning less than $75,000 and couples making less than $150,000 annually) will provide an about an additional $35-65 per working family in monthly cash flow starting in April. (1) While this is not a large amount of money per person it is multiplied across the millions of wage earners in this country and will begin to hit workers’ wallets in April. Some of these funds are likely to be spent immediately.

Frozen Credit
One of the most important challenges facing the government this year is the restoration of confidence in the banking system. The largest banks are considered “too big to fail.” The reality is that their balance sheet problems caused by bad loans must be resolved in order to restore the health of the credit markets. The difficulty in resolving the banking crisis revolves around the valuation and pricing of bad loans. This issue was first brought up last September, before the passage of October’s TARP program, and has still not been resolved 6 months later! The new Treasury Secretary (Tim Geithner) is currently working on this issue and is expected to announce a plan for resolving it late this month.

Many professionals continue to favor some variation of the Resolution Trust Corporation (RTC) model which was used to resolve the S&L crisis twenty years ago as a means to remove toxic assets from bank balance sheets. I would remind clients that between 1988 and 1995 over 1,000 financial institutions were closed and the RTC took over $347 billion in assets from these institutions. (2) Goldman Sachs has estimated the value of troubled assets to be over $5 trillion. (3) While it is still possible to manage a RTC style takeover of these assets and still turn a profit for the American taxpayer as the RTC did, we will need a well-crafted plan from the Treasury in order to deal with this large a pool of assets.

The negative rate of growth for the 2008 4^th quarter GDP was revised at the end of February to -6.2% (on an annualized basis). This was a drop from the preliminary estimate of -3.8%. (4) This figure reflects the heavy job losses and dysfunctional credit markets conditions that prevailed in the 4^th quarter. The entire quarter showed a credit marketplace that was essentially frozen, making it very difficult for consumers and businesses to take out new loans and make financing arrangements for new purchases. We have seen credit conditions improve some since the 4^th quarter, but 2009 1^st quarter GDP is expected to be negative by many analysts and I would agree with this assessment. (5) I think we could see 2^nd quarter economic activity showing some improvement when compared to the 1^st quarter. We likely will have to wait until the latter half of 2009 before we start to see more positive general economic news.

Federal Reserve Update
The 3-month London Interbank Offered Rate (LIBOR) currently stands at 1.33% (6), while the 3-month Treasury Bill (T-bill) rate stands at 0.24%. (7) The over 100 basis point* difference between the two rates is known as the “TED spread” and is a measure of the risk inherent in loans between banks. In more normal credit markets the TED would stand at 50 basis points or less. During the October/November 2008 time period when credit market conditions were at their worst, the TED spread grew to just over 460 basis points—a huge jump! (8) Although the credit markets are still tight, we are not seeing the same level of fear keeping banks from transacting with each other that we saw just a few months ago.

* A basis point is 0.01%. 100 basis points = 1.00%

The table below clearly shows the aggressive action taken by the Federal Reserve with regard to their monetary policy. This policy is mainly comprised of 1) currency in circulation and 2) member bank deposits at the central bank. The very large expansion in this monetary base illustrates just how determined the Fed is to do whatever is necessary to restore economic growth and provide liquidity to the financial markets.

** Adjusted for Consumer Price Index for the year through 1/31/2009. (9)

Are Any Businesses Doing Well?
There are a number of sectors that are actually holding up well during this current downturn. In general, value-oriented companies are holding their own. Wal-Mart reported February sales growth of 5.8% when compared to February 2008. (10) Dollar Tree (which sells every item in the store for $1.00) reported 11% higher profits in their quarter that ended in January 2009. (11) Big Lots and Family Dollar are both reporting solid profit growth. McDonald’s business is holding up well as consumers trade down to lower price restaurants. Overall retail sales for both January and February have been better than expected. This does not mean that the retail sector is seeing wonderful numbers, just that it is doing better than had been predicted.

The health-care sector is looking well from a profit standpoint. Bristol Myers is expecting 12% profit growth in 2009. (12) Merck’s decision to purchase Schering-Plough and Roche’s offer for Genentech are both moves by companies in good financial condition that are looking to expand further. These mergers are healthy and would not be occurring if any of the companies involved were not solid.

“Sin” companies like Altria (formerly Philip Morris) that sell tobacco and alcohol related products are seeing steady demand for their products and expect 2009 profits to be higher than 2008 levels.

Energy pipeline companies are also reporting earnings somewhat above 2008 levels and continue to pay out fairly high quarterly cash distributions. We have seen several of these companies paying above 10% yields due to their high distribution levels and lower overall stock market prices.

The headline layoff figures that were widely reported for several well-known large companies in January are not likely to continue at this pace in 2009. I think we are currently in the midst of the worst job reductions and additional layoffs by companies later this year will likely be at significantly lower levels.

Statistics in Context
It was widely reported in February that January job losses were the worst since 1974. When comparing a job loss figure from the current economy to a point in the economy 30+ years ago it makes for a great headline. What the headline fails to point out is the way in which the economy has changed in those years. The number of jobs in the U.S. economy in recent years is almost double that of the 1974 figure. A simple examination of just the changing population figures begins to show how the U.S. has changed in the past few decades. The U.S. Census Bureau estimated the 2007 U.S. population at just over 300 million people. Their population figure for 1970 was just over 200 million people. The loss of 60,000 jobs in a population of 200 million would be comparable to a loss of 90,000 jobs in a population of 300 million.

Examples of misleading uses of statistical reports are common. I would caution clients to be careful when reading articles based on statistics to make sure to place the numbers mentioned in context if the author of the article has not done so. We all know that apples to oranges comparisons are not meaningful, but sometimes it can be difficult to know when this is happening. While one can easily make superficial comparisons to the past, in order to obtain a more meaningful comparison the figures do need to be placed in the context of how the nation has changed during the time frame being analyzed.

Planning For the Future
I expect to see some improvement in the economy starting by June or so. I recently watched an interview of Warren Buffett in which he pointed out that the DOW is 100 times higher than it was 100 years ago. To say that this past year has been challenging on the economic front is something of an understatement! In trying to assess investment strategy it is important to place recent activity in a larger context. More than 90% of home mortgages are being paid in a timely manner. While unemployment is higher than it has been, over 90% of those who are actively seeking work are employed.

In the last year the United States went from a zero savings rate to saving over 5%. That has been a large and abrupt change. Although this has been an additional negative for the economy at this time, saving money is advisable on the individual level. Many people have begun examining their personal finances and making changes to lifestyles that will strengthen our economy in the long-term. These are interesting times and I look forward to seeing the shape of the economic landscape on the other side of this downturn.

(1) http://www.chicagotribune.com/news/la-na-stimulus-qna18-2009feb18,0,324205.story
James Oliphant February 18, 2009

(2) http://www.fdic.gov/bank/analytical/banking/2000dec/brv13n2_2.pdf

(3) http://online.wsj.com/article/SB123328162860331981.html?mod=dist_smartbrief

(4) http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

(5) http://www.economist.com/countries/USA/profile.cfm?folder=Profile-Forecast

(6) http://www.bankrate.com/brm/ratewatch/other-indices.asp

(7) http://www.federalreserve.gov/releases/h15/data/Business_day/H15_TCMNOM_M3.txt

(8) http://www.bloomberg.com/apps/quote?ticker=.TEDSP%3AIND

(9) Bob Brinker’s Marketimer, March 5,2009; Volume 24, No. 3

(10) http://www.bloomberg.com/apps/news?pid=20601087&sid=azXGHR.nY.As&refer=home

(11) http://www.dollartreeinfo.com/investors/global/releasedetail.cfm?ReleaseID=367449

(12) http://www.zacks.com/commentary/10070/Bristol+Myers+Squibb+Co

The information contained in this newsletter is for general use, and while we believe all information to be reliable and accurate, it is important to remember individual situations may be entirely different. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a solicitation of the purchase or sale of any securities.