2010 First Quarterly Report

Published: April 20th, 2010

We wish you a happy and promising spring, and with the gorgeous weather we’ve had in the North East, spring has most definitely sprung!  The markets are off to a great start in 2010 with emerging markets once again leading the way. Corporate earnings came in stronger than expected, and are gradually climbing back to their peak levels of 2007, corporate balance sheets are healthy and stock valuations are reasonable as the economy continues to heal. 

The first quarter of 2010 saw the S&P 500 stock index rise 4.9%. Institutional fund managers are tapped out with their 3.6% cash ratios sitting at historic lows so it will be up to the individual investor, who has been largely focused on income-generating securities and diversifying away from the overweight position in equities, to drive the market higher.  Fortunately the market seems to be easily able to shake off any bad news recently, which is likely a good sign for the economic recovery.  However, stock investors will most probably face greater potential volatility in the foreseeable future as governments and central banks continue to work through the aftermath of the 2008 financial crisis. 

 Furthermore, economic growth appears to be on track:

• Gross Domestic Product (GDP), turned positive late last year, rising at a 5.6% annual rate from October through December, this is good news as the GDP is regarded as a barometer of overall economic activity.  
• The unemployment rate is ever so slowly decreasing, and now hovers around 9.7%.  The economy has finally begun producing jobs. Although US consumer sentiment appears to be down, this is not reflected in their actual spending and as the job outlook brightens, so should consumer sentiment. 
• The Federal Reserve is effectively on hold and suggests that short-term rates will not be raised for some time. 

 The end of March marked the end of the Fed’s $1.4 trillion program to purchase mortgage-backed securities and housing-agency debt, and the expiry of the federal home-buyer tax credit. The end of these programs will be a true test for that sector. However, a growing number of economists believe that a strengthening economy and increase in affordable homes should allow the market to not only withstand the removal of government help but also contribute to US economic growth for the first time in two years.

Healthcare was very much on everyone’s minds  in the early part of this year as President Obama made history by successfully signing national health reform bill into law, thereby expanding medical coverage to 32 million uninsured Americans.  In the eloquent words of Vice President Biden, it really was a “big……deal”.  The market did not substantially react to the bill due to the fact that many of the controversial elements will not take effect until 2013 or later.  These include an additional 0.9% Medicare tax on wages and a new 3.8% Medicare tax on investment income for individual taxpayers with $200,000 or more in income and married taxpayers filing jointly with income in excess of $250,000. The bill will impact all investment income equally, whether from stocks or bonds.  This may be one more reason to take a second look at Roth IRA conversions, which may make sense for those at or near this income threshold.  Some of the bill’s more popular provisions include barring insurance companies from firing customers after they become sick and letting children stay on their parents’ plans until age 26. With the projected cost of the healthcare reform at $940 billion over the next decade, the Congressional Budget Office (CBO) claims that reform will reduce the federal budget deficit by $138 million…..I’m asking the same question you are – is this possible? I think the answer is unlikely.  CBO’s numbers reflect this savings mainly in new taxes and curbs on Medicare spending.  The healthcare industry is complicated and the cost is unknown.  However, it can be assumed that if you expand coverage and implement no meaningful malpractice reform, no limit on services and no incentive for the insured to look after their own care, costs will rise.  On a bright note, the bill also included a $500 million annual allocation towards “comparative effectiveness research” to help curb rising healthcare costs.

 The healthcare bill brought strong opinions on both sides of the issue.  It has been an all-consuming battle for the Obama administration and the Administration should benefit from this monumental accomplishment and be able to move forward and next take on financial regulation, which could regulate derivatives trading and give the government more authority to seize firms that are “too big to fail”.

Internationally the European Union (EU) was front and center on the world stage. Their main concern currently is Greece, which is running heavy budget deficits and has a debt load that is probably unsustainable due to the rates Greece will likely have to pay to refinance this debt.  The EU and International Monetary Union (IMF) reached an accord to provide emergency aid for Greece late in the first quarter of 2010. However, this aid will only be available once Greece exhausts all methods of raising financing in the markets. The IMF’s involvement is seen by some as a sign that the EU cannot manage its own affairs. Clearly, once the dust settles, the EU must reopen treaty negotiations to impose tough new measures and sanctions to prevent such problems in the future, especially since Greece is not the only EU country struggling with its debt burden.  Portugal, Italy, Ireland and Spain are not far behind.  Portugal’s sovereign credit rating was recently downgraded, bringing the Euro to a 10-month low against the dollar.  There had been speculation on whether the Euro will replace the US Dollar as the global currency. Well, it seems that for now, at least, the Euro is not quite ready for primetime.

The EU’s problems highlight the overall problem with government debt.  In 55 BC, Cicero, one of Rome’s greatest orators, said, “The arrogance of officialdom should be tempered and controlled, and assistance to foreign hands should be curtailed, lest Rome fall.” So, what have we learned in 2,064 years?  Evidently, nothing! Government debt to GDP by country has been worsening, and closer to home, the US deficit for 2010 is at 10.6% of GDP, public debt was at $5.3 trillion in March 2008 but now stands at $8.3 trillion (pre-healthcare bill) and is projected to expand to $18.6 trillion by the end of 2020. 

The US will have a tougher time refinancing this debt in a recovering global economy and Treasury yields can be expected to rise.  However, this mountain of debt will likely not affect the dollar’s value since the US has the second lowest debt rate amongst the top seven developed nations.  A newly appointed bipartisan commission aims to lower the debt to 3% by 2015.  Although not impossible, it is ambitious given government’s propensity to spend and its unwillingness to make tough financial decisions that may alienate voters.

The greatest risk we face right now seems to be the fiscal health and fortitude of our federal government. Ultimately, the US will have to decide between raising taxes, cutting Social Security or Medicare or spending less on everything from education to defense.  Only time will tell, however, just as spring breathes new life into the world around us, a recovery is clearly unfolding this year.  Our renewed optimism must be tempered with caution because although it is clear that consumers are able to support economic expansion, corporations, who are in good overall financial shape and have money on hand, must proactively lead the expansion. We’re not home free yet, as it will be interesting to see what will happen as governments around the world begin to unwind the monetary and fiscal stimulus programs put in place during the economic crisis.  In any event, we see a number of reasons to believe that this quarter will be as rewarding to investors as the prior quarter.  

Lastly, there is a link to a great webinar titled “An Economic and Market Update” by Liz Ann Sonders, Chief Investment Strategist of Charles Schwab & Co on our website at www.aristawa.com.  The webinar can be accessed from the home page under News.  Liz Ann gives an excellent explanation for why the current recovery is more like prior recoveries than you might think.  And while she is careful to point out the potential negatives, she provides substantial evidence for why the current recovery is both robust and likely sustainable.  It is well worth an hour of your time and will be available until May.   

Sincerely,

ARISTA WEALTH ADVISORS

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