Lawrence Fuller, Managing Director and Portfolio Manager

PDF version of the Market Outlook

We decided to depart from our typical format this month to address the President directly in an effort to shed light on what we believe to be the greatest risk facing our country and our financial markets through the remainder of his first term in office. The Dow Jones Industrials (-3.5%), Standard & Poor’s 500 (-3.7%) and Nasdaq Composite (-5.4%) all finished lower for the month. Healthcare led sector performance with a gain of less than 1%, while the telecom sector was the worst performer, posting a loss of more than 9%.

Dear Mr. President,

It was with sound reason and centrist views as a candidate that independent voters accepted you as a viable alternative to the status quo. Yet in recent months your policy agenda has taken a sharp left hand turn off the road we believe leads to a sustainable economic recovery—a road that divides the two opposing and dysfunctional ideologies that plague Congress. Voters in Massachusetts made this abundantly clear following a special election last month in what could be interpreted as a demand that you reprioritize your agenda. Your response has been to push a more populist message that Democrats hope to be politically advantageous come November, but we view this as imprudent. The Dow Jones Industrials (-3.5%), Standard & Poor’s 500 (-3.7%) and Nasdaq Composite (-5.4%) all finished lower for the month. Healthcare led sector performance with a gain of less than 1%, while the telecom sector was the worst performer, posting a loss of more than 9%.

We endorsed your $787 billion stimulus plan last February under the auspice that it would be focused on the investments necessary to transform our economy and lead to economic growth that created jobs. What we have seen up to this point is predominately transfer payments, entitlement spending and tax benefits intended to induce consumption based growth. According to your website (recovery.gov), only $58 billion of the $275 billion in stimulus funds set aside for the grants, loans and contracts that create jobs have been paid out. Could this be one reason that the public is frustrated?

Your healthcare reform efforts, while well intentioned, did not succeed because you chose to focus on coverage before addressing cost containment. Forcing insurance companies to provide coverage for all and reducing government reimbursement rates would lead healthcare providers to negotiate higher rates with managed care companies. The higher rates would then be passed on to the insured in the form of higher premiums. The uncertainty surrounding such significant changes is more than Americans are willing to accept during difficult economic times. Our greater concern should be how we can continue to pay costs that are rising at more than double the rate of inflation. We believe that some states, facing bankruptcy, may have no choice but to no longer participate in the Medicaid program.

Your Administration’s response to the growing frustration over the economy has been to enflame the public’s outrage over the bailout on Wall Street. Meaningful financial reform that will prevent a future crisis has little to do with dictating salaries and bonuses or imposing a tax on bank liabilities to recoup losses from the bailout. Perhaps it is simply good politics, but it wreaks a hypocrisy that further undermines the public’s trust of government and thwarts the potential for progress. It is more than disingenuous to question compensation practices after approving $6 million pay packages for the CEOs of Fannie Mae and Freddie Mac this year and last, especially when the Congressional Budget Office estimates the total cost to taxpayers for the government takeover of both companies will be $389 billion. Proposing the largest banks pay a fee to cover the projected $68 billion loss likely to result from bailing out AIG and the auto industry is equally as glib when they have all repaid the loans they were forced to take with interest.

It would behoove you to recognize that we require as robust a recovery on Wall Street now as we hope to see on Main Street in the near future in order to maintain the high levels of economic growth needed to avert the looming fiscal crisis that lies ahead. Our $14+ trillion economy is saddled with more than $12 trillion in national debt. Your 2010 budget proposal totaling $3.8 trillion, which is expected to approximate 25% of GDP, has been exalted by your handlers as similar to President Reagan’s 1983 budget, which followed a recession and his first year in office. That budge totaled nearly 24% of GDP. The critical difference is that the national debt stood at less than 40% of GDP, and not the 85% we grant that you inherited today. We spent more on interest payments last year ($200 billion) than it cost to finance the wars in Iraq and Afghanistan in what was a historically low interest rate environment.

Based on Congressional Budget Office projections for the deficit over the next three years, even if we assume a 5% nominal rate of economic growth (GDP) and no increase in interest payments, the debt-to-GDP ratio will approach 100%. Economic growth has historically slowed dramatically in developed economies when this ratio exceeds 90%. Slower rates of growth result in a decline in tax revenue that further increases the deficit. Rising debt levels inevitably result in higher borrowing costs as creditors demand to be compensated for the additional risk. You can be sure that Republicans in Congress will continue to push for tax cuts, while Democrats insist on more spending initiatives, but since both are delusional, neither will materially reduce the deficit until a new crisis unfolds. Ultimately, you must use your powers of persuasion to raise taxes, reduce spending and embrace pro-growth policies that expand GDP in order to avert another financial crisis that would undermine your Presidency.

At the present time, we perceive there to be more risk to the bond market than in the stock market given the potential for a substantial increase in interest rates. We have noted our concern regarding individual investors piling into bond funds at what we believe is the bottom of the interest rate cycle, but the latest investment strategy to surface in the world of pension funds is a far better contrarian indicator. The State of Wisconsin Investment Board, which manages $78 billion, recently approved the adoption of a strategy to leverage their safest investments (government and investment grade bonds) in an effort to boost returns in lieu of investing in risky stocks following a decade of negative returns.

We believe the correction in stock prices last month (6% from recent highs) was in reaction to the more severe declines we have seen in developing markets. Australia has already raised interest rates three times in the past three months. China and India have both raised short-term rates and reserve requirement for their banking systems. They are tightening monetary policy to reign in the rise in inflation that naturally follows unprecedented economic stimulus. As the engines of global growth, it is not surprising to see investors pull risk off the table, but it is too early to tell whether these countries, led by China, will be able to contain inflation without stymieing economic growth. For the moment, the uptrend in equities markets has not been interrupted and we view this pullback as a consolidation of recent gains until we breach the previous lows on the S&P 500.