Today is September 7, 2010  

Pacifica's 1st Quarter Investment Commentary

The following investment commentary is adapted from our more comprehensive, 17-page 1st Quarter Investment Commentary research report, which you can download by clicking here.

Both domestic and foreign stocks were down sharply in the first quarter, with losses on broad indexes in the 9% to 10% range. High-quality bonds gained more than 2%, as investors fled to quality. Commodity futures and emerging-markets local-currency bonds both did very well in the first three months of 2008, gaining 9.6% and 4.7%, respectively, based on their indexes.

The overall environment is one that we suspect will continue to be one of the most challenging investment environments in decades.  It is probable that we are already in a recession or on the verge of entering one. It’s clear that the severely troubled housing and credit markets are beginning to have an impact on the health of the overall economy. The worst phase of the credit market problems could last for several more months, and the housing problems could continue into 2009. High energy costs don’t help, but are not the primary concern. The problems facing the economy are clear:

• Housing: The housing market is in the worst downturn since the 1930s and the evidence strongly suggests there is still a ways to go. With a massive backlog of unsold homes and waves of foreclosed properties continuing to hit the market, it could take a year or longer to get inventory levels back to normal. The weakness in the housing market reduces wealth and spending, increases unemployment, and continues to contribute to dysfunctional credit markets.
  
• Dysfunctional Credit Markets: The bottom line is that credit markets are not functioning properly at present. There is an adverse feedback loop in play with losses from leveraged entities forcing them to sell assets (deleverage), which triggers more losses, and so on. The ability to borrow money at a reasonable cost to support consumer spending and conduct business is essential for a healthy economy. Perhaps even more important to a stable economy is the ability to refinance maturing debt. The longer the problem lasts, the more damage there will be to the economy.
  
• Labor Market and Consumer Spending: Not surprisingly, we are now beginning to see a clear weakening in employment and consumer spending. A weak labor market could feed back to trigger more defaults as people have a harder time servicing their debts. This could delay recovery in the housing and credit markets and become a self-reinforcing cycle. Meanwhile, declining consumer spending will impact corporate profits.

It is also worth noting that while most of the rest of the world is doing better than the U.S., Japan’s economy is also struggling and Europe’s is slowing. It seems likely that most of the developed world will continue to weaken. The emerging markets are in better shape, but we don’t expect them to be fully immune from economic weakness in the developed world.

As always, there are positives as well. The biggest positive for the economy in the near term is the aggressive, and in some respects, unprecedented action of the Federal Reserve. Though the Fed’s moves have not been as effective as they would like, they have made it clear that they will do what it takes to stop a major downturn and they still have weapons in their arsenal, such as directly buying mortgage securities in the public market.

The dollar’s weakness has also significantly improved the competitiveness of U.S. businesses versus foreign competitors. Export strength is already happening with exports contributing a significant one percentage point to economic growth over the last six quarters (annual rate). This almost offsets the economic impact thus far of the housing downturn. This benefit could diminish if the global economy weakens significantly, however.

Finally, outside of the financial sector, companies are generally flush with cash, especially relative to debt-service needs. Balance-sheet strength is surprisingly healthy for this late in an economic cycle—the result of strong profit growth and below-average capital investment in recent years.

Weighing the evidence, the odds seem to favor a worse-than-average recession, though that outcome is far from inevitable. Stocks are reasonably valued now, and further declines (depending on the magnitude) could represent an attractive buying opportunity for long-term investors.  And while we believe it is important for us to discuss the more negative possibilities, we reiterate that it is possible that we are close to a bottom, or that we have already reached a bottom. We can’t know what the near-term is going to bring, but at times like this when economic uncertainty is high, our discipline and research process keep us grounded and give us confidence in our ability to make sound long-term decisions.

Click here if you want to download our full report in PDF format.