Commentary

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2nd Quarter Review and Outlook

The mid-cycle slowdown in the United States appears to have ended. After two quarters of weaker gross domestic product (GDP) growth, we expect second quarter growth to show signs of recovery, on the back of inventory rebuild and a strong job market. Also, although corporate profit margins have likely peaked, liquid balance sheets should provide good support in the second half of 2007.

The consumer seems well positioned to help fuel the recovery. Despite a weak housing market, household net worth is still growing, and on the whole, household balance sheets have ample liquidity. Consumer spending should continue: Job and wage gains, above all else, drive spending, and these factors favor the consumer.

A Brief Look Back

This most recent mid-cycle slowdown wasn't much of a slowdown by historic standards, unless one considers the United States' weak first-quarter GDP growth (only a 0.7% annual rate). (See Figure 1.) The unemployment rate remained very low and bond market spreads hovered near all-time lows. Apart from housing and U.S. auto manufacturers, nearly every sector of the economy continued to expand.

To our surprise, the global economy did not slow when the U.S. economy did. This is because the U.S. mid-cycle slowdown was concentrated within housing and auto manufacturers; the slides within each were essentially domestic problems. While the U.S. consumption engine slowed a bit, it remained intact outside of the aforementioned sectors. Retail sales remained robust, as did spending on Wall Street. The stock market (as measured by the S&P 500 Index) returned 7.0% in the first half of 2007, and global stock indexes also indicate continued strength, with many at all-time highs.

Most economists seem to believe rising bond yields are a reflection of a strengthening economy rather than of inflation. Although real-estate tax inflation and energy price inflation can take a significant toll on those living on fixed incomes, the general level of inflation appears to be under control. No doubt, we have inflation in many services and products, but we also have stable—and even falling—prices in other services and products.

Rolling Recessions and the Strength of a Diversified Economy

Some worry that weakness in the real estate and auto sectors indicate the U.S. economy is headed for a recession. We do not believe this is the case. As we have discussed in previous commentaries, the strength of the U.S. economy is due in large part to its diversification. Throughout the past 25 years, the U.S. economy has experienced rolling recessions in various industry groups, while the economy as a whole has continued on a nearly uninterrupted growth track. Even during the boom in the 1980s, industry-specific recessions occurred in the energy sector, the "rust-belt" agriculture and manufacturing sectors, as well as in corporate real estate. The 1990s boom also had its share of rolling recessions: airlines, commodity companies (including steel, paper and forest, metals and mining), autos and industrial manufacturing industries all suffered steep declines. This decade is no different: Since 2000, the economy has expanded briskly, despite rolling recessions in the information technology, telecommunications and airline industries. Although we have recessions in the housing and U.S. auto industry today, the other 90% of the economy appears healthy.

So, then, what could change the recovery trajectory? The Fed certainly has the power to do so. Although very mild in relation to previous downturns, there have been two recessions in the past 25 years—both the result of aggressive Fed policy that sought to slow "excess growth" in the economy by raising interest rates. At this point, however, we do not expect the Fed to adopt such a course. The reported inflation measures do not provide the Fed with a reason to raise rates. Inflation, as measured by the Consumer Price Index (CPI), is near the long-term average of 2.5%, while the Fed's favorite inflation gauge, the Personal Consumption Expenditures Index (PCE), is near 2%. (See Figure 2.)

The Fed may be concerned about economic growth causing inflation, but such concerns would be misguided. As we have discussed in past commentaries, growth does not cause extended periods of inflation in the general economy. If growth caused inflation, the growth of the past 25 years would not have been accompanied by lower and lower inflation and bond yields. "Inflation," to quote Milton Friedman, "is a result of too much money chasing too few goods."

Excess monetary growth can lead to inflation, and the measure of money gets tricky as new forms of credit and the velocity of money change rapidly. So, do we have an excess of dollars in the global economy that will lead to inflation? It does appear the world has had excess dollars and as a result, the dollar has declined dramatically against most major trade partners.

We have seen a large divergence in the growth of dollar liquidity as compared to nominal GDP growth since the technology bubble burst in 2000. This has occurred before, ushering in inflation during the 1970s. We have also experienced periods when the reverse was true; for example, a lack of liquidity ushered in disinflation in the 1990s and the 1920s and deflation in the 1930s. Inflation today may not manifest itself in the same manner, however. We can have "too much money chasing too few goods," but because there is an excess supply of labor in today's global marketplace, a shortage of products is not an issue, except perhaps in the case of certain commodities. However, we do possibly have too much money chasing too few assets and as a result, global asset inflation has occurred. We also may be understating GDP growth, as economic measures sometimes lag the changing world or we may be underestimating the size of the dollar-based economy outside of the United States.

In the major economies around the globe, almost every investable asset has dramatically appreciated in value. Land, commodities, bonds, stocks, commercial real estate, timber, art, collectable automobiles and oil and gas are all on a large upward trajectory. Asset values look high and inflated, but it's another question whether the inflation moves into the liability side of the balance sheet and general price levels go up. The key factor will be if the excess global liquidity has been used for productive purposes; if so, we believe the risk of inflation is reduced.

We must also realize the marketplace is an excellent measure and reflection of future prospects, on average and over the long term. At times, price levels look extraordinary but subsequently, the economy or business executes well and realizes the potential reflected in the seemingly high prices. Remember Alan Greenspan's comments in 1996, when he stated that stock levels had reached a level of "irrational exuberance"? This was at a market level of 700 for the S&P 500 Index; today the index is above 1500. Greenspan did not recognize the wisdom of the market and the millions of minds contributing to it—a market that collectively understood that a tremendous period of growth in global and domestic economies lay ahead.

As we noted, asset values today look high and may imply inflation, but the global growth story is compelling and appears to be real. Millions of new people each year are entering the global economy. China, India, Mexico, Russia, Brazil, Vietnam and other emerging markets are participating quickly and we hope for the long run. The excess liquidity has manifested itself in cheap debt capital and a weak dollar, along with financial and hard asset appreciation, but global GDP growth has been remarkable and stable like no other period in history.

The excess labor and shortage of assets has caused an interesting inflation/deflation global balance. Continued growth in the world economy can easily absorb the excess liquidity; and as the excess laborers become consumers, the balance can be shifted to build additional capacity in products to meet the new demand—without an inflationary blow off. The actions and reactions of political policy makers around the globe will help write the end to this story.

In fact, we believe the world governments' ability and willingness to change the rules of the game represents the biggest risk to continued global expansion and what happens with excess liquidity. (Of course, exogenous shocks from terrorism, weather and financial mishaps would play a role as well, but these influences are highly unpredictable.) The protectionist movement in the U.S. Congress has the power to dramatically change the global trade picture, by raising borrowing costs and import prices while at the same time slowing exports. (This could all be accomplished with the good intentions of getting China to play fairly.) Also, many countries are starting to strike up nationalist tendencies and are grabbing private property, as we see in Venezuela and Russia. And, unfortunately, some in the U.S. Congress believe energy profits are owed to the nation, and not to the owners and risk takers of capital.

We have already seen an assault on private equity and hedge funds, through the taxation of carried interest at capital-gains tax rates. (While we're also aghast at the huge paydays some of the top private equity and hedge fund managers receive, we believe that's between them and their clients.) Much of the carried interest gains are reinvested back into the funds; and in many cases, these funds do an exceptional job of allocating capital and penalizing capital abusers. The change in tax is nothing more than a confiscation of wealth by government.

Moreover, as Congress looks to roll back tax reductions on capital gains and dividends, further taxes on capital are under consideration. In a capitalist society, it is important not to penalize capital as the double taxation on dividends does. (That is, dividends are taxed once at the corporate level, and then distributed to owners and taxed again at the individual level.) Most importantly, taxing capital gains at higher rates freezes capital in unproductive places, as owners of capital choose to avoid the tax by not taking the risk of redeploying capital into another venture. Congress would be well served to note that most of the world has no tax on capital gains, or rates that are very low.

Global liquidity seeks the home where it will be treated best. Continued increases in credit availability and leverage have added to potential volatility and uncertainty. Going forward, the risks increase as politicians position themselves for the next election cycle. As global expansion has reached new consumers and as businesses have attempted to meet these emerging needs, governments and politicians have sought to counter this progress and maintain the status quo.

Economic growth is the solution for many of the fiscal and social issues of our time, but with growth comes uncertainty—and winners and losers. The old power base has much of the old capital. When this base feels threatened, it directs its capital to the political and legal power base to restrict competition and in turn, growth and progress. (This story has been repeated throughout history, just with different players.) Economic growth improves the quality of life for more and more people around the world each year, and can also fend off the possible inflation impact of excess liquidity.

Housing Bubble or Financing Crisis?

Many worry the housing market bubble will implode and bring down the economy. Housing market price appreciation can be explained by many factors, and the end to the appreciation can also come about in many ways; but first and foremost, the cost of financing drives this market. Baby boom demographics have had a significant impact on markets for second homes, vacation property, and of course, for homes in Sunbelt retirement areas. But, the overall level of housing price appreciation is a function of cheap and available mortgages and the after-tax cost of carrying the debt each month.

We believe housing prices outside the vacation and resort areas should hold their values as inventory clears. In our view, the housing market seems more likely to be in a slowdown and not a collapse, as long as interest rates remain near current levels. (See Figure 3.) All bets are off if the Fed raises short-term rates significantly.(However, as we have discussed, we think the Fed is unlikely to take this course.)

While we believe real estate values should hold overall, we believe conditions in the sub-prime lending market offer more significant cause for concern. The sub-prime loan market and the packaged debt securitization products (collateralized loan obligations and collateralized debt obligations) housing many of these sub-prime loans have been under severe pressure—the result of increased homeowner delinquency rates and the high degree of leverage that hedge funds use to enhance returns. financial market contagion is possible as struggling hedge funds may be forced to sell this paper, perpetuating the decline and unwinding of the high risk debt markets. Although sub-prime loans represent a small portion of the overall debt, we believe the current collapse will at least help rationalize higher risk premiums, and of course, tighter lending standards.

Continued Opportunity Potential in the Equity Markets

While we have noted that there may be signs of global asset inflation, we believe equities still have room to move higher. A supportive economic backdrop is clearly in place. Consumer confidence remains high and consumer net worth is at an all-time high. And, as we discussed earlier, we expect U.S. economic growth to continue, helped by inventory rebuild, corporate spending increases and wage hikes for workers that drive consumption. Moreover, as Figure 4 shows, stocks have actually gotten cheaper during this bull market—to us, a significant indication that the equity market has not yet reached a top. Pressure on already high historical corporate profit margins may result in single-digit earnings growth, but with the P/Es already at reasonable levels, we could see some expansion in P/Es for the first time in this cycle.

Liquidity Pools and Champagne Bubbles

The huge pool of global liquidity has resulted in a lower cost of debt capital and an increase in credit availability. This has benefited developed and developing nations alike. But, no group has benefited more from the liquidity pools than hedge fund and private equity shops. The signs of a bubble or mania in hedge funds and private equity funds are abundant; the signs of a near top are also present. A combination of factors (listed below) have inflated the bubble in the alternative fund categories. Many of these factors have been present for a number of years, but to us, the last three indicate a top is forming.

Although to differing degrees, the private equity and hedge fund industries are characterized by these attributes:

1. A low barrier to entry. Only a few good years or a promise to perform is needed.
2. Low or no regulation.
3. A "lottery payoff" factor, where winners are rewarded with unbelievable pay packages.
4. Excess cheap capital, due to abundant capital availability and credit.
5. A large number of funds are expected to outperform. Despite nearly perfect competition, investors expect many competitors will add alpha. Pure competition and excess returns generally will not go hand-in-hand.
6. Retail and public pension money is flowing in. These groups are typically late—or the last—to each bubble.
7. Private capital purchases of public companies, at premiums to public-market prices.
8. IPOs and business sales for hedge and private-equity shops.

Historically, retail investors and large pension plans have been the latecomers to just about every new idea, asset class and bubble. We are seeing the interest in and the availability of these alternative product areas increase each month. Meanwhile, initial public offerings for private equity and hedge funds are starting up, indicating the smart money is selling while the getting is good. At this point, we would not want to be on the buy side of anything the successful private equity or hedge fund managers consider a sell.

We have managed money through major and minor bubbles; and overall, we avoided most, if not all, of the disasters. Bubbles in Japan, real estate, emerging markets, biotechnology, and most recently, technology/telecom have all occurred in the past 25 years. In many instances, these bubbles were concentrated in an industry or small portion of the world economy. So, it was not too big a bet to avoid the bubble. But, in other instances, we recognized that the better course was to leave the party early—even if this meant we appeared to play the fool for a time as the party went on.

The technology/telecom bubble was easy to identify, but it was difficult to time an exit. The key issue that concerned us was that the market was providing huge amounts of capital to "business ideas" with the expectation of very high returns on capital for all, as reflected in the stock values of the entire sector. But as we learned in Economics 101, if capital is cheap and available, and if a huge number of competitors are entering a market or industry group, then we have nearly perfect competition setting up and no business in the group earns excess returns. Even if the perfect competition scenario is not developed fully, it is not logical to expect the return on capital for these companies to exceed normal levels, given such a large number of competitors who all have capital and ideas. The competitive business world just does not work that way, and neither do the financial markets.

Today, there are huge pools of capital in many forms seeking high returns, and the area that pays the best for talent is the hedge fund and private equity space. High compensation does not necessarily repeal the laws of economics and the markets, however. Too many competitors with cheap capital, abundant access to credit, and promises for big and quick payoffs is not a prescription for success. The smart money has begun to sell. Moreover, Congress is on the prowl for more revenue and has its sights on the carried interest portion of these industries' returns. The champagne bubbles are not for investors celebrating good performance, but for investment managers celebrating the sale of their business at high prices.

It's possible the excess in private equity and hedge funds slowly shrinks as mediocre performers are eliminated and regulations and transparency cut into the industry growth and profitability. Poor performance could cause the decay of these markets while continued growth in global markets offers opportunities for other skill sets and industry groups.

However, if the bubble bursts in the alternative space, there could be critical implications across markets. "Flight-to-quality" assets would probably be the best place to be. This scenario would favor government bonds—both U.S. and developed foreign countries—as well as global large-cap growth stocks and cash.

Current Positioning

We expect the increased equity and debt market volatility to continue. These conditions have been playing well into our positioning during the last quarter, and going forward, we remain comfortable with our less-cyclical and more-stable asset selection approach.

Reflecting our bias toward less cyclical sectors, we are generally favoring consumer growth and healthcare, while marginally decreasing allocations to financials. Within cyclical areas of the market, we have found opportunities in international infrastructure and engineering-related companies. We have maintained overweighted allocations in information technology, as well.

We continue to favor growth companies over value companies; to us, the earnings slowdown and relative valuation differences favor growth stocks. When one adjusts for quality and capital access risk, large- and mid-cap companies look more attractive than smaller-cap issues. We have also continued to overweight high-grade balance sheets and higher credit quality companies relative to the market benchmarks. The very slim risk premium for accepting higher-risk, low-grade assets—in both the equity and debt markets—presents an unattractive risk-reward tradeoff, and one that we are moving away from.

We remain optimistic, though characteristically selective, about international equity markets. Some sectors and countries offer better relative valuation and a stronger economic backdrop than the U.S. alternative.