Consumers Are Not Bamboo Green Shoots;Market Risk and Rates

Globally, we see the consumer as not the economic equivalent of bamboo green shoots—one of the hardiest and fastest growing plants used in Asia from construction to food. Since March 2009, the global market has implicitly to do with expectations of rapidity of recovery, with the S&P 500 above 900 likely incorporating either acceleration or earnings beyond our 2009 estimates. Arguably beyond the pale of consensus, instructive information currently comes not from Consumer Discretionary (underweight) but from the business details within the reporting of earnings in Consumer Staples (also underweight). Positioning for customer frugality internationally, from luxury to the everyday, brand rationalization has again ensued. Even within established brands, backward integration of cheaper, albeit less advanced, offerings has taken place.

Business changes by individual staples companies globally speak volumes for other businesses in indicating the potential for a prolonged quality oriented environment. Normality is likely further out into 2011. Risk premiums need to be watched even as LIBOR rates have dropped (such as for U.S. dollars to 0.43%), with junk bond yields down and despite low rate accommodative central banks. For market normality, greater transparency is likely to be as crucial now as after the depression and as Japan failed to pursue early after 1989. Distortions (including inflation behavior) took time to unwind from the global 1970s government deficit financing with at the other extreme, the failure of massive deficit financing to deliver from deflation in 1990s Japan- giving rise to vigilance bond premiums and heightened credit analysis. We see elevated volatility fixed income, with a neutral benchmark likely closer to 5% for 10 year U.S. Treasury T-Notes (currently 3.5%).At present equity levels (S&P 500: 980; MSCIWI: 1036) versus U.S. 10 year T-Notes, equity risk premiums appear close to 5% — under half the 12% spreads of the 1930s but close to the upper end of the 1970s-2000s. Market risk and rates indicate that equities are likely to be now sensitive to earnings recovery and rate trends. We favor, a quality overlay and also near term consolidation, our earnings recovery scenario notwithstanding.

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