American Capital Management, Inc. |
The “Road to Recovery” is open and clear. We are near the end of the “Great Recession” – the longest and deepest since the 1930’s. The economy is stabilizing, the financial markets are improving and investor sentiment has turned positive. The S&P 500 increased +15% in the second quarter – the best quarterly return since 1998 – and +46% since the market lows of March 6th. Importantly, the major banks “survived” the Treasury’s stress test by either receiving a passing grade or quickly raising most of the $75 billion in additional capital prescribed by the Treasury. The second quarter was the largest quarter of equity issuance on record and the banking sector represented over $60 billion of the equity capital raised. Furthermore, 10 of the largest banks were allowed to repay approximately $68 billion in TARP funds in June. These developments are the building blocks for a self-reinforcing recovery and, as a result, the environment is clearly getting healthier. The volatility index (VIX) – a measure of perceived risk in the stock market – has subsided to levels last seen prior to the Lehman Brothers collapse. The LIBOR-OIS spread, which measures banks’ willingness to lend to each other, narrowed to 40 basis points from 350 basis points in October 2008. A testament to the market’s strength and resilience is the fact that the market didn’t blink during the second quarter when GM and Chrysler declared bankruptcy. A summary of index returns through June 30, 2009 is as follows:
| Dow Jones Industrials | -2.0% | Russell 2000 | +1.8% |
| MSCI EAFE | +5.6% | S&P 500 | +3.2% |
| NASDAQ Composite | +17.0% | Wilshire 5000 | +3.7% |
The global economy is amidst an early stage of a synchronized economic recovery. The massive stimulus measures are working and the worst of the economic downturn has passed. Due to the abrupt and severe downturn, worldwide manufacturing output declined –25% for the six months ending March 31 – the sharpest decline in 40 years and world growth will be negative for 2009. Today, the world’s economies are poised for positive growth in late 2009 and 2010 led by a strong rebound in Asia and expected inventory rebuilding worldwide. In the U.S., the economic decline is ending and there is a marked improvement in the leading indicators index implying a return to growth in the quarters ahead. For example, the index increased +3.1% in April, May and June – the first three month gain since 2004. This trend will be supported by stabilization and growth in residential housing construction, a modest improvement in auto sales and manufacturing strength from inventory rebuilding – reversing the sharp declines in these sectors. For example, housing construction turned positive after a 53% decline over 3½ years. But the recovery is fragile and after-shocks may be felt. Consumer spending has improved during 2009 because of reduced payroll tax withholdings, one-time Social Security payments, lower gasoline prices, lower mortgage rates and better availability of consumer credit. However, several of these factors are one-time or temporary which may lead to a stall in the consumer spending recovery. Additionally, inventory rebuilding is beginning to create positive momentum after the largest four quarter drop on record through March 31 and a forecasted record decline for the June quarter. The key question is whether consumer spending will improve next year to sustain our recovery. If not, we may have Stimulus Plan II.
For the intermediate term, the economy will be balancing the headwind associated with de-levering the consumer and the tailwind of stimulus initiatives and the jobs created as a result. Overall, we believe that a major change in consumer behavior is underway with a return to financial responsibility that will have a positive impact on the stability of the economy in the years ahead. Housing, business investment and non-residential construction will gradually contribute to growth in the early stages of recovery, but their major impact will not materialize until 2010 and beyond. The U.S. export sector will add to GDP growth with the weak dollar and improving global trade patterns. We are encouraged by the positive trends, but recognize that there are downside risks.
Inflation is currently non-existent. In fact, the U.S. has been experiencing mild deflation in the past year for the first time in over 55 years. Most declining price pressures are coming from lower commodity and energy prices due to their epic collapse in late 2008. Without the influence of food and energy prices, core inflation is gradually increasing at less than +2% per annum. However, oil and commodity prices have increased significantly over the past four months and these increases will eventually push annual inflation into positive territory by late 2009. But the current average gasoline price is still 45% below a year ago. All in all, inflation is subdued and likely to remain low for the foreseeable future due to excess capacity and intense worldwide competitive pressures. Our manufacturing capacity utilization rate is currently at 68% - the lowest level in 42 years.
Inflation and deflation are hot topics in the financial markets today. On the one hand, the severe decline in demand and considerable slack in the economy have created deflation in the U.S. while an accommodative monetary policy and large budget deficits have created fear of significant inflation on the horizon. This concern is heightened by the suggestion that the Federal Reserve has lost some independence and will be politically encouraged to remain accommodative for longer than may be wise. In response, some investors have bid up gold to over $900 per ounce, sold Treasury bonds and U.S. dollars on the premise that inflation will lead to higher interest rates and a devaluation of the dollar. We believe high inflation is unlikely over the intermediate term, but acknowledge the fear is credible given the current economic circumstances. More specifically, the government debt load has grown significantly from $5.8 trillion last September to $7 trillion on May 31, and another $2 trillion is needed in the next 12 months. As a result, the deficit and debt as a percent of GDP will hit the highest levels experienced since WWII. Adding to this dynamic is the fact that foreign ownership of U.S. Treasury debt outstanding has increased to over 50% from considerably lower levels 10 years ago. As a result, the U.S. is dependent on the willingness of foreigners to finance our deficit spending, a factor that complicates geo-political considerations for the financial markets. Deflation remains a risk, but this risk is rapidly diminishing as the world reflates in response to massive monetary and fiscal initiatives.
As a result of the Fed’s actions, short-term interest rates are historically low and are likely to remain near zero for the balance of 2009. Yields on 10 year Treasury notes have increased from 2.25% to 3.71% since December as investors have sold “safe haven” investments in favor of riskier assets. As an example, high yield bond indices are up more than +15% year-to-date. From the perspective of borrowers, interest rates on corporate bonds, municipal bonds and mortgages have declined during 2009. To help push rates lower, the Fed initiated a seldom used technique of open market purchases of mortgage backed securities and Treasuries in an effort to drive down interest rates for mortgages. It is expected the Fed will purchase $1.25 trillion in mortgage backed securities and $300 billion in Treasuries during the year and the Fed is almost 50% complete with these purchases. These efforts are helping keep mortgage rates lower than last year’s levels to aid the housing industry.
Once the recovery gains greater strength, the Fed will gradually begin reversing the easy money policy initiatives. Traditionally, the Fed begins with increasing the fed funds rate, but this next period of tightening will likely begin with the Fed removing some of the emergency liquidity facilities established in the downturn and terminating their securities purchase programs. Scaling back these extra measures will serve as a signal to investors that restrictive policy is on the way. Once this process begins, interest rates may increase somewhat in anticipation of a future hike in the fed funds rate. For now, the Fed is on record saying “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” We expect yields on corporate bonds and high yield bonds to decline as the recovering economy helps diminish the refinancing and default risk currently implied in these bonds. Positively, the capital markets have been more receptive than expected to new issuance of debt and equity securities, which helps bring down the cost of capital and augments the recovery process.
The stock market has fluctuated wildly while increasing slightly this year. For example, after a decline of –30% through March 6, we experienced a rebound of +44% through June 11 – the best three month gain in 70 years. But the S&P 500 is still off –38% from its peak of 1565 on October 9, 2007. Today, the markets are transitioning from a period of rallying on “bad news” to a period of rallying on “good news.” Investors have moved from extreme pessimism to a more balanced outlook. This moderation is becoming evident in the lower volatility of the stock market and the declining short interest in stocks. The market will be fragile as this transition is underway. Essentially, sentiment has improved in advance of the fundamentals and it will be important to see evidence of improving economic fundamentals and earnings growth to sustain the market’s strength. It is “show me” time.
The stock market is valued at 15.9x estimated operating earnings of $60 for the S&P 500 this year which is neither expensive nor cheap. Quarterly earnings for the S&P 500 continue to decline year over year, but this is expected to change in the fourth quarter of 2009 when earnings are expected to gradually increase with favorable comparisons. It is possible that earnings could rebound more strongly in 2010 than expected due to intense corporate cost cutting and the reversal of write-downs associated with mark-to-market accounting in 2008. Operating earnings could be $70-80 in 2010. In addition, GM, AIG and others have been removed from the S&P 500 and replaced with healthier companies. Earnings typically advance more strongly than expected coming out of a recession, so it is plausible the market is actually cheaper than consensus figures suggest. Technically, the market’s indicators remain constructive with breadth, momentum and volume experiencing favorable trends. In addition, investors have significant buying power with cash in money market funds equal to 37% of the market value of all stocks. The trend is positive, but we are likely to experience a pause or correction at some point.
In summary, the recent developments within the financial markets are encouraging. The crisis of confidence has passed and there is evidence that the economy is on the “Road to Recovery.” Within our universe of quality small and medium sized growth companies, we see excellent investment opportunities ready to prosper as economic headwinds turn to tailwinds. The markets may develop another “bout with doubt” as a series of adverse events challenge the recovery, but it is unlikely that the markets will re-enter the fearful and panicked state that existed from September 2008 through March 2009. If a correction develops, we favor making selective investments to benefit from a further recovery in stock prices over the intermediate-term horizon.