Quarterly Market Commentary – Q4 2009

2009 has certainly been a tumultuous year. In March, the banking world was at the precipice of total collapse and investors’ fears were evidenced by cyclical lows in almost all major market indexes. Renowned financial institutions were facing insolvency and bankruptcy. Financial institutions, from commercial and investment banks to insurance companies and the shadow banking system, were forced to merge in order to hang on for another day. Many became federally chartered banks in order to participate in the TARP program and to take shelter under the Federal Reserve system. After the massive and unprecedented monetary and fiscal policies implemented by the US and other countries, investors regained confidence in the markets and began embracing risky assets once more. The world stock market ascended and ultimately made up most of the losses and delivered double digit returns for the year. Although the end of the Great Recession has not been formally announced, it is likely that when the official word does come from the National Bureau of Economic Research, it will be shown that the US was statistically out of the worst recession since the Great Depression in the third or fourth quarter in 2009. This was a year of exaggeration, despair and hope. The question now is what’s next. Diverse opinions span the entire spectrum from a double dip recession to economic expansion and the beginning of a cyclical bull market.

Looking Forward

After the Great Recession, 2010 is the beginning of the “Great Exit” for the unprecedented, expansionary government policy globally. Central bankers from around the globe moved swiftly and in a synchronized manner to save the financial world, and now their exit will be gradual, uneven and uncoordinated. IMF Managing Director Dominique Strauss-Kahn identified a few key concerns for this year, among which is the timing of the unwinding of government stimulus measures. Although governments are now saddled with high debts from the anti-crisis measures, trying to remove the stimulus measures too quickly could result in a “double dip” recession with advanced economies in particular falling back into negative growth. The IMF is predicting a 3.1% growth rate for the world GDP. This is a marked improvement from a year ago. However, it expects the Advanced Economies to be growing at an anemic rate of 1.3% and the Emerging and Developing Economies to be at a 5.1% rate with China leading the pack at 9%. Even within the Advanced Economies there is a significant differentiation. These differences will impact interest rate, currency value and investment return. We expect the US to recover faster and stronger than Euroland, with Japan to remain in recession during the first part of 2010.

The speed of economic recovery and market performance will be predicated on the scale and rate of withdrawal of fiscal and monetary stimulus and the support facilities in place. Some form of withdrawal is already underway, and raising rates will be the final action. China and other Emerging Economies will likely begin raising rates during the first half of 2010 with the Federal Reserve tightening towards the end of the year along with the European Central Bank. Japan will most likely leave rates unchanged this year. Rate increases are expected to be small, gradual and numerous. This will slowly reverse the monetary expansion upon which the world economy has grown to be dependent. The balancing act for central bankers is predicated on the ability of timing the withdrawal without increasing the chance of falling back into an economic contraction and at the same time not inadvertently igniting inflation by withdrawing too late or too slowly. The Chinese economy is already showing signs of inflation returning. Longer-term rates are controlled by market forces, and we expect the rate curve to steepen further which is bad news for long term fixed income. Investors are also worried about governments monetizing their debts (printing money to service debt rather than through tight monetary policy) of which the consequence is inflation.

We believe that the next few years will continue to be challenging for the US and developed economies (primarily the G7 industrialized countries). The ever-increasing public debt, the deleveraging of private industry and consumers, the re-regulation of industries, the inevitable reflation and increasing federal, state and local taxation are all impediments in an already tepid economic recovery environment. Consumers represent two-thirds of the GDP. With a double digit unemployment rate and tight lending standards, consumers would rather save than spend. At the same time, mortgage delinquencies and foreclosures continue.

Employment

The nation’s unemployment rate surged past 10% (the “U-3″ unemployment measure) in 2009. The 10% unemployment rate is calculated based on people who are without jobs and have “actively sought work” in the prior four weeks. Employers cut another 85,000 jobs in December as the U.S. economy began to recover. There are now 7.2 million fewer jobs than in December 2007 when the recession began. Many of the jobs lost during this period are unlikely to return, and it is unclear from where new jobs will come.

The number of workers drawing regular benefits has fallen, from a record 6.9 million in June to just over 5 million. Many unemployed have exhausted regular benefits and began drawing extended and emergency benefits. That number has risen from 2.8 million in late June to 4.7 million in early December. Another 5.6 million people have given up searching for jobs and are no longer drawing benefits. As such, they are not accounted for in the unemployment statistics. A broader measure of unemployment, known as the “U-6″, includes those who have stopped looking for jobs as well as those working part-time because they cannot find full-time work. This rate remained about the same at 17.3% in December from 17.2% in November.

The problem is further compounded by the structural change in employment. Even though the rate of firing, as measured by the first time jobless claims, has been improving; the rate of hiring, as measured by continuing claims, remains poor. According to the Bureau of Labor Statistics, more than two-thirds of those laid off have had their jobs permanently eliminated. This means that when hiring begins, these unemployed will not be rehired. This structural employment shift means a prolonged high level of unemployment. With federal and state subsidies for training disappearing, many of the unemployed will not acquire the new skill set to gain employment in new and different industries.

Housing

According to the S&P Case-Shiller home-price indexes, US home prices fell in November where prices in 10 major metropolitan areas fell by 4.5% and 5.3% for 20 major metropolitan areas from a year ago. Overall, the 10-city index is down 30% from its mid-2006 peak, and the 20-city index is down 29%. We are now back to the home price levels of late 2003. The Commerce Department reported that existing home sales dropped in December after three straight months of increases resulting from government tax credits. The Worker, Homeownership, and Business Assistance Act of 2009 has extended the tax credit of up to $8,000 for qualified first-time home buyers purchasing a principal residence. It also authorized a tax credit of up to $6,500 for qualified repeat home buyers. This program has been extended through April this year. This credit has boosted housing demands in certain markets, but the positive effect is expected to go away when the program expires.

Almost 3 million homeowners received at least one foreclosure filing during 2009, setting a new record for the number of people falling behind on their mortgage payments. After four months of gains, home prices flattened in October. Under the $75 billion government program introduced in March 2009, lenders are paid to lower borrowers’ mortgage payments. The program was established to help up to 4 million borrowers before expiring in 2012. This effort, however, is not set up to tackle two contributing forces driving mortgage delinquencies: rising unemployment and risky home loans. Over the next few years, loans such as the option adjustable-rate are scheduled to shift to potentially higher interest rates, setting up the likelihood of a cascade of foreclosures to come. According to the first report issued by the Treasury Department in December, only about 4% of troubled borrowers have received help under the program. As of November 30, 31,382 homeowners converted from trial adjustments to long-term assistance while almost the same number of homeowners in trial modifications has been denied permanent conversion. Under the program, delinquent borrowers are placed in trial modifications for a few months to make sure they can meet the new payments and to allow them time to submit their financial paperwork. If qualified for a permanent modification, a borrower will make the lower payments for five years, after which time the interest rate is set at the rate at the time of the adjustment, or about 5% today. However, many borrowers failed to keep up the trial payments or did not submit the required financial documentations.

The government has kept the mortgage rates low and stepped in to replace the shadow banking system to keep liquidity in the mortgage market through the takeover of Fannie Mae and Freddie Mac, among other extraordinary measures. The Federal Reserve now holds $909 billion of mortgage-backed securities. In the past year it has purchased 73% of the mortgages that Fannie Mae, Freddie Mac and Ginnie Mae churned out in securities. The buying program is expected to conclude by the end of March with a total of $1.25 trillion in mortgages purchased. With the removal of support, mortgage rates may rise and further aggravate the housing problems.

Separately, more than 6% of commercial-mortgage borrowers in the U.S. have fallen behind in their payments with almost $40 billion of commercial-mortgage-backed bonds coming due this year. That is the highest delinquency rate since the advent of commercial-mortgage-backed securities. By year end, delinquency rates on loans for hotels, shopping malls and other commercial properties could rise to 9% or more. Although this is small when compared to residential mortgage problems, it is nonetheless adding more stress to a fragile financial system.

Consumer

Personal bankruptcies soared last year, especially in Western states hit hardest by the real-estate bust. In states such as California, Arizona and Nevada, where housing prices soared and then collapsed during the past decade, consumer bankruptcy filings rose roughly twice as much as the national average increase of 32%. Homeowners fell behind on mortgages and could no longer tap into their home equity to pay down other debts. For most of the last decade, consumers represented two-thirds of the US GDP. Our insatiable desire to buy propelled this nation to become the consumer of all world goods and left behind a huge trade deficit. Partially fueled by rapid increase of home value and partially fueled by cheap money, consumers mortgaged their homes to go on a multi-year buying binge and lived beyond their means. The disappearance of the shadow banking system, the collapse of housing prices and the Great Recession have forced consumers to deleverage and become prudent consumers. As reported by the Federal Reserve, consumer credit outstanding decreased at a seasonally adjusted annual rate of 8.5% to $2.465 trillion. This $17.5 billion shrinkage is the largest on record. US consumers reduced borrowing by cutting credit card use nearly 20%. Furthermore, credit card use fell 10.5% in September and 9.9% in October. As a contrast, the “personal saving rate” has increased since the 18-month period from mid-2005 to the end of 2006 when the personal savings rate was in negative territory. In May last year the rate was at 6.2% and down to 4.7% in November. The drop in savings rate coincides with the strong gains in the stock market and is not necessarily suggesting the return to mindless consumption. Simply put, consumers are not likely to be back supporting the US GDP in the pre-Great Recession manner anytime soon.

What has been particularly alarming is the debt to GDP ratio. According to the McKinsey Global Institute study, the US has a total public and private debt equaling three times the current GDP. In the case of Japan, it is at 471% and for UK it is at 486% of their respective domestic GDP. Public debt alone in the US is almost the same as the current GDP. The only time that we have exceeded this level of debt was during WWII. This is the first time that developed or advanced economies are net borrowers while developing or emerging economies are net creditors. This flow of capital is not likely to change in the near future. The theme in the advanced economy is deleveraging, whereas the theme in developing economies is growth.

In conclusion, the Great Recession may be over, but no one can feel it. The contributing factors that got us here are still in place. As long as we have high unemployment, unsettled housing and mortgage markets and a general lack of credit, the US economy will remain sub-par. The stock market was oversold in March last year, and it is overbought at the end of 2009. A 10% to 15% pullback in the US stock market is expected before resuming its forward and upward march. Our biggest concern for 2010 is the withdrawal of government support in the economy and market perception of inflation. It is our hope that the Federal Reserve and the US Treasury will take a balanced approach in minimizing the unintended consequences of their actions and inactions.

EXHIBIT A – Mutual-Fund Yardsticks:

Fund category performance as of December 31, 2009. Total return includes capital appreciation and reinvested distributions. Returns shown for periods of one year or less are cumulative. Three-year, five-year and 10-year returns are annualized.

Source: WSJ/Lipper

Note: All bond-fund data are preliminary.
n.a. = Not available.