This is a quarterly update of economic conditions and investment strategy.
Second quarter, 2007 GDP increased at an annual rate of 3.8%, a brisk recovery from the previous quarter of 0.7%, helped by an increase in exports, a slight decrease in imports, and continued consumer spending. Preliminary third quarter economic data have limited utility, given the extreme volatility in the quarter, but, nevertheless, suggest weakness in some important sectors.
In the third quarter, severe problems with the performance of bonds backed by home mortgages, particularly those issued to sub-prime borrowers, cascaded globally into most financial markets. A number of U.S. mortgage companies disappeared; the fifth largest bank in the UK experienced a run on deposits; and investment pools around the world
experienced sharp losses from having leveraged their investments in these risky securities.
In response, the Fed cut interest rates by one-half percent to 4.75% and took additional measures to maintain liquidity. The European Central Bank, Bank of England, and other central banks also acted to provide liquidity to nearly-frozen credit markets. Early indications are that credit markets have eased a bit, but the high-risk mortgage business is likely gone—at least until memories fade.
The big question is the degree to which the slowdown in the U.S. housing market and the illiquidity in the credit markets spread to other sectors of the domestic and international economies. Our view is that they will cause a sharp reduction in growth in 2008 resulting in perhaps 1% real growth for the year and secondary adverse effects to world economic activity.
We project, on the basis of incomplete data, a one-third probability of a recession in 2008. Our recent discussions with analysts at the Bureau of Economic Analysis indicate no study underway that would trace the effects of the housing slowdown within the framework of the U.S. national income and product accounts, or the U.S. input-output accounts. The latter, which measure the inter-industry effects of an economic event, were very useful in assessing
the likely impact of the 1970’s oil embargo. We have urged senior Bureau economists to undertake a similar study.
Our stock holdings continue to perform well ahead of the S&P 500, reflecting client concentrations in energy and other natural resources, agriculture and water, and significant long-term international exposure in a number of other sectors.
In July, 2007 the National Petroleum Council issued its report to the Secretary of Energy that assesses the future of oil and natural gas to 2030 in the context of the global energy system. It revealed a major shift in the industry’s view: the days of cheap oil are coming to an end. A report from the Paris-based International Energy Agency, covering trends in oil supply and demand to 2012, reached similar conclusions. Our emphasis on companies with
reserves in politically-safe countries continues.
Conditions in other industries that we favor, e.g. metals, agriculture, water, and health care, continue to exhibit very favorable investment characteristics and we plan to maintain and add to holdings selectively. We also are reallocating holdings in these areas (including the energy sector), a consequence of other opportunities in the sector or to rebalance holdings that have appreciated disproportionately.
We continue to look at new areas of investment including technology, environmental industries, and companies benefiting from changes in demographics. The latter is a particularly fertile ground for research, e.g., the investment implications of the projection that by 2015, two-thirds of China’s population will be over 50, while 60 percent of India’s will be under 30.
Our fixed income portfolios continue to be managed conservatively. We suspect that sustained price increases in food and energy will work their way into the inflation data; therefore, we maintain bond portfolios of relatively short durations.
Regardless of our enthusiasm for an investment sector, our first and most important principle is the individual client’s circumstances and our view of the inherent risk of a given investment. For each client, we determine an appropriate allocation to each investment class. Then, we select, individually, the mix of securities that we find most attractive on a risk-reward basis. We overweight an asset class that we believe is undervalued when we think it will correct in a reasonable time period—but only if it does not compromise the client’s objectives and our overall risk profile. This discipline kept us out of the technology bubble and the current high yield and sub-prime collapse. We adhere to it as a fundamental good business philosophy.
Phil Tucker, Bill Lauer, Tom Frank, Terry McCubbin, John Edwards, Ed Dobranetski