Surviving,Reviving and Thriving in No-Man’s Land

Even as the Federal Reserve left policy unchanged on September 21, 2010 while the National Bureau of Economic Research (NBER) declared the recession starting December 2007 had ended June 2009 and President Obama held a town hall meeting hosted by CNBC on the economy on September 20, 2010, the fragility of markets in no-man’s land remains likely to result in trading ranges (1230-1030 for MSCI World and 1220-1020 for S&P 500 indices). Currency and politics have come early in this U.S. election year. With Washington, Wall Street and corporate CEOs alike more disposed to the blame game, the Federal Reserve has a delicate balancing act and wisely left policy elucidation until November 4, after the mid tem elections on November 2, 2 010 We expect capital markets to focus on discriminating between those barely surviving, those reviving and those thriving much more so than in the last cycle with its tilt to leverage to unfettered growth. Such is the implication of current cycle elevated volatility in credit spreads in fixed income amidst low government bond yields for major credits and equity risk premiums that remain high versus those of several decades. In sum, we favor keeping fixed income exposure relatively low for reasons of capital preservation but favor smaller currencies instead of the Q2/2010 market predisposition to a barbell of major currency government and low quality junk yields. We maintain gold bullion and other precious metals as hedge with developments as disparate as in Switzerland, Japan and China indicating currency tensions. In equities, we favor strong execution companies. Early reporting companies in myriad industries and across the world indicate earnings recovery but uncertainty over revenues thus still focusing on cost containment. Meanwhile and arguably rational for job preservation, consensus appears comparatively more focused on getting 2010 right despite the year being 75% over instead of tuning up 2011 prospects- which is where the investment focus is likely to be imminently.

Lately, in addition to warnings from major forecasters such as the IMF, the OECD and the major central banks like the Federal Reserve about slowing global recovery from the pace of 1H/2010, there have been other developments. Confidence within Germany, the bright star in recovery in Europe, appears diminishing. Extreme volatility in credit spreads first for Greece and then Ireland among others, discussions of the skewed nature of bond purchases by the European Central Bank so far and their extension as well as reports of less than onerous stress testing of European banks with timeout for Greek banks point to ongoing fragility in Europe, the most immediate source of uncertainty in the summer of 2010. The stretch out to 2018 of the financial equity cushion requirements under Basle III for capital standards of 4.5% for Tier 1, 2.5% buffer and a further optional 0-2.5% apparently were agreed to only after protracted European resistance. These aspects have been underscored by some of the strongest banks in Europe forthwith proceeding with equity issuance of several billion Euros to draw distance compared to their more extended competitors, a facet seen as well in the post TARP U.S structure and in the massive equity issuance being undertaken in China. The strengthening of and differentiation amongst financial institutions is remaining a work in progress.

The stretching of currency tension may have diminished for the Euro versus the dollar over 2010 but earlier in Q2/2010 Swiss and now in late Q3/2010 Japanese intervention combined with Chinese pronouncements against expectations of quick change in currency policy are not occurring in a vacuum. It is noteworthy that strong unilateral intervention of $125 billion earlier this summer by the Swiss National Bank (SNB) to hold down the Swiss franc has been followed in recent days alone by close to $25 billion in intervention by the Bank of Japan (BOJ) to pull back the yen. While currency intervention success for central banks does depend on timing and is often expanded to multilateral action to reinforce the message to markets, the intervention actions earlier by the SNB and now by the BOJ both underscore underlying tensions in world trade. Similar volumes are being spoken in the pre-election angst in the US Congress about Renminbi exchange rates including pronouncements from the administration up to President Obama that have swiftly been followed up by a global response from China. Reemphasis that any change would be gradual has included comments from authorities within Beijing, from officials now in multilateral institutions and most interesting of all from Chinese ambassadors abroad emphasizing that while at the state GDP level, China may appear wealthy, at the individual citizen level, it is still relatively poor. Currency and trade are likely to remain in political paly especially if as expected, global growth slows into mid 2011.

In the Unites States in an environment without easy answers, unemployment on Main Street as well as reluctance in official Washington, on Wall Street and among leading CEOs to discuss the realities of closing the deficit gap while engaging in a convoluted blame game has already resulted in rising risks from parochial agendas dominating an election season that started early and swiftly after Labor Day. Not surprising as voiced in its economic list of uncertainties in the FOMC statement of September 21, 2010, the Federal Reserve will also for political reasons likely to have to be more than normally circumspect until its next FOMC on November 4, just after the November 2 mid term elections. Within the Federal Reserve and clearly versus the European Central Bank which also has its own travails, the requirement remains to assume the classical role of a central bank during uncertainty by drawing attention to deficit control while also smoothing monetary flow. Inflation measures in the United States as also implicitly discussed in the September 21 2010 FOMC in the no man’s land between deflation risks (under 1%) and classically accepted neutrality ( 2%). It indicates a Federal Reserve pre-disposed to keeping rates low but also extending quantitative ease as a last resort—with the potential for myriad internal and external dissension over the need and scale of replacement of mortgage holdings already on its balance sheet by Treasury issues. Meanwhile, other mainly Asian central banks are faced with the necessity of raising interest rates to curb inflation pressures that vary by country but are generally related to food and shelter costs for the poorer segments of their societies. It is not likely to be an easy balancing act for central banks, notwithstanding the market disposition to both favor major government bonds and move junk bond yields markedly lower to close to 2007 levels.

For equities with reporting dates globally spread out, earnings reporting season has already begun well ahead of the commonly held benchmark of quarter end. Companies in numerous industries from finance to information technology to luxury discretionary to staples have all been reporting in recent weeks. Meanwhile with two quarters of earnings for 2010 having been reported and another in the process of being released and with businesses close to commencing the last quarter of the year, we find consensus arguably due to job security being more concerned with getting 2010 right as opposed to tuning down 2011, which is imminently likely to be the investment focus in the markets. In the crucial finance sector, even as massive right downs diminish and benefits ensue from low interest rates, credit quality, delinquencies and capital strength loom not to mention uncertainty over trading revenues in investment banking. From the earnings already reported across a wide industry span, we detect that while earnings show recovery, companies in their releases appear concerned about revenue growth and excess capacity even in fast growing countries like China. As a result, the business focus remains on cost cutting. In turn, we believe that consensus estimates for 2011 can be expected to diminish and that trading range equity markets are likely into mid 2011 (1230-1030 for MSCI World and 1220-1020 for S&P 500 indices). Balance sheet and operating quality differentiation is being demonstrated already in the form of enhanced M&A activity as well as dividend policy change. In contrast to the last cycle, we believe quality of execution and financial strength will be crucial for longer than generally recognized even as double dip is avoided.