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2011-5-16 Lederer PWM Portfolio Strategy Update

2011-5-16 Lederer PWM Portfolio Strategy Update

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Portfolio Strategy Update: May 2011
For the past several weeks, I have been altering the composition of client portfolios, transitioning them to a more defensive posture. This piece discusses the reasons for the changes and details the specific investment decisions. Issues / Concerns

1) The broader economy and the stock markets may lose momentum with U.S. fiscal and monetary stimulus being scaled back.
In developed economies such as the United States, the economic recovery from the Great Recession has been mediocre at best. One would expect this weaker growth following a financial crisis. For the past year and a half, I have cited empirical data from studies performed by McKinsey Global Institute and Reinhardt/Rogoff (in their book This Time is Different, to what some have referred as “The Bible for analyzing financial crises”). The data indicate how a lengthy deleveraging (i.e., debt reduction) period nearly always follows a banking crisis, creating a significant headwind to vibrant economic growth. Since almost every financial crisis results from an excessive build-up of debt, it is common to observe declining credit growth after a crisis because: i) debtors are unable to borrow against less valuable assets (think home prices), and ii) banks are unwilling and/or unable to lend because their balance sheets contain a higher proportion of delinquent loans. In the United States, negative private sector credit growth has constrained the strength of the economic recovery. As Table 1 illustrates, this post-recession credit growth is in stark contrast to that during the typical post-World War II recovery, during which time borrowers and banks were in much better financial shape.

Table 1 The Role of Private Sector Credit Growth in Post-WW II Recoveries
GDP DECLINE DURING RECESSION PERIOD RECESSION Q4 1969 Q4 1970 -0.2% Q1 2001 Q4 2001 -0.3% Q2 1960 Q1 1961 -0.5% Q3 1990 Q1 1991 -1.4% Q4 1948 Q4 1949 -1.6% Q1 1980 Q3 1980 -2.2% Q2 1953 Q2 1954 -2.5% Q3 1981 Q4 1982 -2.6% Q3 1957 Q2 1958 -3.1% Q4 1973 Q1 1975 -3.2% Q4 2007 Q2 2009 -4.1% GDP GROWTH IN RECOVERY (FIRST 18 MONTHS) 8.8% 2.7% 9.7% 4.8% 16.7% 1.4% 9.9% 11.7% 9.8% 7.5% 4.5% PRIVATE SECTOR CREDIT GROWTH (FIRST 18 MONTHS) 15.4% 12.7% 13.6% 5.5% 23.4% 17.0% 19.5% 18.6% 16.7% 11.9% -6.2%

Data Sources: U.S. Bureau of Economic Analysis and U.S. Federal Reserve

1

To try and counteract the private sector credit decline, the federal government has increased spending by nearly 25% since early 2007. However, because of lower tax revenues due to the more-sluggish economic conditions, the higher spending has led to sizable fiscal deficits and a run-up in the national debt. At the same time, the Federal Reserve (Fed) has attempted to stimulate more credit growth by: i) cutting its short-term target interest rate to virtually zero and ii) expanding its balance sheet at an unprecedented scale via two rounds of “quantitative easing (QE),” where it has created additional reserves out of thin air (essentially printing money) and purchased U.S. Treasury and mortgage-backed debt securities in an effort to drive down longer-term interest rates.

$3,000

Figure 1 Fed Balance Sheet & Federal Government Spending: Q1 2007 – Q1 2011
An unprecedented amount of monetary and fiscal stimulus have been deployed to offset the private sector deleveraging.

$6,000

F $2,500 E D B $2,000 A L A N $1,500 C E S H E E T $1,000

$5,500

F E D G O V T S P E N D I N G

$5,000

$4,500 $500

$0

$4,000

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Q410

Federal Reserve Bank Credit (LHS)

Federal Government Spending (RHS)

Figure 2 Current Economic Recovery vs. Average of Prior Post-WW II Recoveries
110

105

Even with the huge doses of stimulus, the current recovery has lagged the average post-WW II recovery by a wide margin.

Avg Post-WW II Recovery

100

Q111
Current Recovery
Q+6

95

End

Q+1

Q+2

Q+3

Q+4

Q+5

Q+7

Q-4

Q-3

Q-2

Q-1

Data Sources: U.S. Bureau of Economic Analysis and U.S. Federal Reserve

2

Despite the flood of fiscal and monetary stimulus, the economic recovery has been mediocre at best (see Figure 2 on previous page), with unemployment remaining stubbornly high and the housing market still well off 2007 levels.

220 C A S E

Figure 3 Housing Prices & Unemployment: 2007 - Present
The flood of monetary and fiscal stimulus has done little to improve U.S. housing prices and unemployment.

12 U N E M 10 P L O 9 Y M 8 E N T 7 R A 6 T E

11

200

P S R 180 H I I C L E L 160 E I R N D H E 140 O X U S I 120 N G 100

5

(
%

)
4

May-07

May-08

May-09

May-10

Mar-07

Mar-09

Mar-08

Mar-10

Case-Shiller Housing Price Index (LHS)

U.S. Unemployment Rate (RHS)

Data Sources: U.S. Bureau of Labor Statistics and Standard & Poor’s

While the Fed’s highly accommodative monetary policy has been unsuccessful driving down unemployment and increasing housing prices, it has helped spur a dramatic rise in commodity prices, particularly food and energy prices. As a result, inflationary expectations have risen since the implementation of QE2 last November (see Figure 4 on next page). Although the Fed does not appear eager to raise interest rates to address the risk of rising inflation, Chairman Bernanke has signaled an end to QE2 in June, with the program expected to completely wind down toward the end of the year. In addition, Bernanke has explicitly said the risks of implementing QE3 outweigh the potential benefits at this time. The bottom line is that a major source of monetary stimulus is ending within the next few months. Meanwhile, federal, state, and local government spending will either have to be cut and/or taxes will have to be raised if lawmakers want to avoid a looming fiscal debt crisis. When Standard & Poor’s placed U.S. sovereign debt on negative watch last month, it was a painful reminder that fiscal austerity measures may have to be enacted in short order. Since U.S. government expenditures (including transfer payments) currently comprise roughly one-third of U.S. GDP, cutbacks and/or higher taxes will likely create a near-term drag on economic growth. 3

Mar-11

Jan-07

Jan-08

Jan-09

Jan-10

Nov-07

Nov-08

Nov-09

Nov-10

Sep-07

Sep-08

Sep-09

Sep-10

Jan-11

Jul-07

Jul-08

Jul-09

Jul-10

5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0%

Figure 4 Inflation Expectations Since Announcement of QE2
4.4%

Inflationary expectations have risen across the board since the announcement of QE2.

2.8% 2.2%

3.0%

2.2%

1.2%
May-11 Dec-10 Aug-10 Mar-11 Nov-10 Sep-10 Feb-11 Apr-11 Oct-10 Jan-11

5-Year TIPS Spread UMich 5-Year UMich 1-Year Data Sources: U.S. Treasury Department and University of Michigan Consumer Sentiment Survey

A big debate right now is whether the fragile U.S. economy is healthy enough to stand on its own once the Fed and federal/state/local governments scale back their huge doses of stimulus. I do not believe that it is, and some signs in the bond market would appear to support this view.

2) Ominous signs in the bond market raise doubts about the sustainability of the economic recovery.
At the outset of QE2, the Fed indicated that it would purchase $600 billion of U.S. Treasury bonds in monthly installments between November 2010 and June 2011. Since the beginning of QE2, the Fed has gobbled up 96% of net new Treasury issuance. With the Fed now about to exit the picture, many predict that interest rates will have to increase in order to attract new Treasury buyers to fill the gap left by the Fed. Indeed, PIMCO, a behemoth, globally renowned, bond fund manager, has publicly declared that it has sold all U.S. Treasuries in its flagship bond funds due to concerns about rising Treasury yields (and falling bond prices since prices and yields move inversely) once QE2 is over. The end of QE2, coupled with the rising inflation expectations mentioned previously, has drastically reduced sentiment for Treasury bonds. After huge demand for bonds throughout 2009 and late into 2010 (even as stocks were outperforming bonds by a large margin), bond fund flows have slowed substantially during the past six months. One would think that these developments (not to mention the long-term fiscal deficit situation) would have started to drive Treasury rates higher in anticipation of QE2 ending. However, it has been quite the contrary. Intermediate- and long-term Treasury rates have actually been declining for the past several months. I view these rate moves as a potentially ominous sign for the economy (and hence riskier asset classes) because the bond market has traditionally been a fairly accurate predictor of economic weakness.

4

Figure 5 Ominous Signs in the Bond Market?
5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0%

INFLATION EXPECTATIONS SINCE QE2

With inflation expectations on the rise…

5-Year TIPS Spread

UMich 5-Year

UMich 1-Year

Data Sources: U.S. Treasury Department and University of Michigan Consumer Sentiment Survey TOTAL NET BOND FUND FLOWS* SINCE 2009

50,000 45,000 40,000 35,000 30,000 25,000 20,000 15,000 10,000 5,000 0 -5,000 -10,000 -15,000 -20,000 -25,000

bond buyers have largely disappeared.

$s in Millions

* Bond fund inflows, net of stock fund inflows

May-09

May-10

Mar-09

Mar-10

May-11

Dec-10

Aug-10

Mar-11

Nov-10

Sep-10

Feb-11

Apr-11

Oct-10

Jan-11

Mar-11

Jan-09

Jan-10

Nov-09

Nov-10

Sep-09

Sep-10

Jan-11

Jul-09

Jul-10

Data Source: Investment Company Institute

5

Figure 5 (Cont.)
FEDERAL RESERVE U.S. TREASURY PURCHASES (IN AGGREGATE BY MONTH) SINCE QE2
Net Change in Federal Reserve U.S. Treasury Holdings Net Change in U.S. Treasuries Outstanding

Nov-10

Dec-10

Jan-11

But the Fed has stepped in to purchase 96% of the net Treasury issuance since QE2.

Feb-11

Mar-11

Apr-11 $0 $100 $200 $300 $400 $500

96%
($s in billions)

$600

Data Sources: U.S. Treasury Department and Federal Reserve

However, with the Fed about to start winding down its Treasury purchases, and with U.S. structural deficit and sovereign debt issues…

U.S. FEDERAL DEFICIT AS A % OF GDP SINCE Q1 07
0%

U.S. GOVERNMENT DEBT-TO-GDP RATIOS SINCE Q1 07
140% 120% 100% 80% 60% 40% 20% 0%

-2%

-4%

-6%

-8%

-10%

-12%

-14%

Q107

Q207

Q307

Q407

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Q210

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Q410

Q107

Q207

Q307

Q407

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Data Sources: U.S. Bureau of Economic Analysis and U.S. Federal Reserve

Federal

State & Local

GSE

6

Q410

Figure 5 (Cont.)

one would have expected longer-term interest rates to have risen more recently.
10- AND 30-YEAR U.S. TREASURY RATES SINCE ANNOUNCEMENT OF QE2
5.00

4.50

4.00

30-Year Treasury Rate

3.50

3.00

10-Year Treasury Rate

2.50

The fact they have been declining may be a precursor to slowing economic g rowth.
10/22/10 11/19/10 12/17/10 12/31/10 4/8/11 11/5/10 12/3/10 1/14/11 1/28/11 2/11/11 2/25/11 3/11/11 3/25/11 4/22/11 5/6/11

2.00
8/27/10 9/10/10 9/24/10 10/8/10

Data Source: Yahoo! Finance

CATCHING UP ON CURRENT EVENTS?

Did you happen to read this story in the March issue of Time magazine? March 1972 that is

7

3) Strong economic g rowth in emerging markets (EMs) is likely to decelerate as EM policymakers take measures to slow rising inflation in their countries.
Besides the headwinds from the incremental withdrawal of U.S. monetary and fiscal stimulus, decelerating growth in EM economies may present challenges for riskier asset classes. Since late 2009, robust economic growth across most EMs has fueled the global economic recovery, outpacing growth in developed markets by a wide margin (see Figure 6). However, most EM economies are now in danger of overheating, and measures to slow rising inflation will no doubt lead to decelerating EM economic growth.

9

Figure 6 GDP Growth (Annualized by Quarter): Q4 2009 – Q4 2010

7

5

3

1

Data Source: Trading Economics
-1

-3 Q4 2009 Q1 2010 U.S. Q2 2010 Euro Area Japan Q3 2010 Q4 2010 EMs {EM figures are a weighted average for countries in the MSCI EM Index}.

QE and Its Impact on Emerging Markets To keep their exports more competitive on the global stage, mercantilist EM countries (particularly China) depend a great deal on lower currency exchange rates. During the past several years, though, the Fed’s QE programs (and lesser-discussed QE programs in Europe and Japan) have created some significant challenges for EM policymakers trying to stave off currency appreciation. Since the Fed’s extremely loose monetary policy has created a huge tailwind for U.S. dollar depreciation, EM countries have had to either increase their own money supplies and/or “recycle” reserves back into the United States via U.S. Treasury purchases to prevent their currencies from rising too much. 8

Because most EM economies exited the Great Recession in much better financial shape (e.g., lower unemployment, modest debt levels, and healthy banking systems) relative to the overly indebted developed-market economies, the increased money supply/higher excess reserves in reaction to the Fed’s QE programs have functioned like an inflationary tinder box. Figure 7 illustrates how inflation in EM countries has been much higher relative to that in the United States, Euro Area, and Japan since QE2 was implemented.

Figure 7 Year / Year Inflation Rate (by Month) Since Announcement of QE2
6

Extremely accommodative monetary policies in developed markets have led to higher inflation levels across most EM economies.

5

5.1% 4.1%

4

3

3.2% 2.8% 1.8% 1.1%

2

1

0

0.0% -0.6%
Dec-10 Oct-10 Nov-10 Jan-11 Sep-10 Feb-11

Data Source: Trading Economics
Mar-11 Apr-11

-1

U.S.

Euro Area

Japan

EMs {EM figures are a weighted average for

countries in the MSCI EM Index}.

Thus far, most EM policymakers have taken their time addressing the rising inflation because efforts to combat rapidly escalating prices would ultimately lead to exchange-rate appreciation, which would adversely impact export growth. Figure 8 (top of the next page) illustrates how “real” interest rates across most EMs are either negative or barely positive – arguably not high enough to curtail the inflationary pressures. However, because policymakers understand that rising inflation can spur social unrest (it is not a coincidence that the Middle East uprisings started after food prices jumped considerably), they are starting to confront the issue by raising interest rates and/or allowing their exchange rates to rise. These tightening measures are almost certain to slow the rate of growth in EM economies. As one can observe from Figure 9 (bottom of next page), EM stocks have lagged those in developed markets since late November, plausibly in anticipation of slower economic growth. These slowing EM economies may lead to a deceleration in global growth later this year.

9

Figure 8 “Real” Interest Rates* Across Emerging Markets
BRAZIL TURKEY SOUTH AFRICA HUNGARY PERU MEXICO CHINA CHILE INDONESIA TAIWAN MALAYSIA COLOMBIA PHILIPPINES POLAND THAILAND CZECH REPUBLIC KOREA RUSSIA INDIA EGYPT -4.0% -2.6% -0.3% -0.5% -0.9% -1.2% -1.4% 1.4% 1.3% 1.2% 1.1% 1.0% 0.8% 0.6% 0.4% 0.2% 0.1% 0.0% 2.0% 5.3%

Most EM countries will almost certainly need to tighten monetary policies during the next few months to address inflationary pressures.

* Real interest rate defined as the benchmark interest rate, less the 12-month change in inflation.

Data Source: Trading Economics

120

Figure 9 MSCI EM Index vs Russell 3000 Index (Nov. 2010 – Present)
EM stock market underperformance since November may be a precursor to slower EM economic growth later this year.

R E 115 L A T I 110 V E R 105 E T U R 100 N

Russell 3000

15.2%

MSCI EM Index 2.5%

95
10/29/10 11/12/10 11/19/10 11/26/10 12/10/10 12/17/10 12/24/10 12/31/10 1/7/11 2/4/11 3/4/11 4/1/11 4/8/11 11/5/10 12/3/10 1/14/11 1/21/11 1/28/11 2/11/11 2/18/11 2/25/11 3/11/11 3/18/11 3/25/11 4/15/11 4/22/11 4/29/11 5/6/11 5/13/11

10

4) Historical trends do not bode well for the second half of 2011.
In addition to the economic headwinds noted thus far, historical trends are not supportive for riskier asset prices later this year. As I noted in the Lederer PWM 2011 Outlook, almost every short-term (cyclical) bull market within a longer-term (secular) bear market has fizzled out before reaching 9 quarters. Since the most-recent cyclical bull started in early March 2009, early June would mark the 9-quarter mark. Moreover, the Ned Davis Research S&P 500 Cycle Composite for 2011, which the stock market has generally followed this year (other than the short-term pullback caused by the Japan earthquake), exhibits weakness during the second half of the year (see Figure 10).

Figure 10 The Ned Davis Research (NDR) S&P 500 Cycle Composite for 2011
112

110

Should the stock market continue to follow the NDR Cycle Composite for 2011, a second-half correction would occur.

108

106

Cycle Composite Equal-weighted Average of One-, Four-, and 10-year Cycles
104

2011 YTD

102

Japan Earthquake

100
31-Jan 2-Mar 1-May 1-Jan 30-Aug 31-May 28-Nov 30-Jun 31-Jul 29-Oct 1-Apr 29-Dec 29-Sep

Data Source: Ned Davis Research

11

Investment Actions This section details the specific investment decisions made to reduce portfolio risk.

1) Sold U.S. small- and mid-cap stocks
These traditionally riskier asset classes have benefitted disproportionately from the Fed’s exceptionally loose monetary policy, which has not only increased liquidity in the financial system, but also provided greater incentive to take risk (since holding cash earning less than inflation is not an attractive long-term option – investors are thus forced to go out on the risk spectrum). As Figure 11 shows, small-cap stocks have outperformed larger-cap names by a wide margin during the past decade, when the Fed frequently held rates below the rate of inflation.

Figure 11 Relative Return of U.S. Small-* vs. Large-Cap* Stocks: Aug. 2000 – April 2011
300% 280% 260% 240% 220% 200% 180% 160% 140% 120% 100%
Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Apr-01 Apr-02 Apr-03 Apr-04 Apr-05 Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Aug-00 Aug-01 Aug-02 Aug-03 Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Apr-11

Shaded areas represent periods of negative U.S. real interest rates

U.S. small-cap stocks have outperformed large-caps by a wide margin during the past decade, during which time the Fed kept monetary policy highly accommodative.

* S&P 600 Index used to represent small-cap stocks; S&P 100 used to represent large-cap stocks.

Data Source: Yahoo! Finance

Now, after a long period of outperformance, small- and mid-cap valuations are significantly richer than those of larger-cap stocks. And, with liquidity likely to be scaled back (due to the end of QE2) and almost every central bank (particularly EM central banks) tightening their monetary policies, I think small- and mid-cap asset classes may underperform given their already lofty valuations (relative to larger-cap names). 12

2) Cut EM equity positions
Although I am bullish on EMs longer-term, I am concerned that they could experience greater declines should the stock market sell off during the next 3-6 months. For example, during the vicious bear market from late 2007 through early 2009, the MSCI EM Index declined nearly 70%, while the S&P 500 fell by 55%. This underperformance occurred despite the fact EM economic fundamentals were more favorable to those in most developed-market economies. While a global growth slowdown would relieve some of the inflation pressures in the EMs (reducing the need to tighten monetary policies as rigorously), I believe it would still be a net negative for EMs because many rely upon larger industrialized countries to purchase their exports, a huge growth driver in many EM economies. If the larger developed-market economies are in worse shape, the ripple effects would almost certainly be felt in the EMs.

3) Purchased long-term bonds (anticipated 3-6 month holding period)
Given my concerns about slowing economic growth, I purchased positions in two exchangetraded funds that hold long-term bonds (the PIMCO 25-year Zero Coupon U.S. Treasury Index ETF and the Vanguard Long-Term Corporate Bond ETF). I think that these positions would likely perform well should riskier asset class prices decline. Obviously, there are risks to holding long-term bonds in the current environment. The biggest, in my opinion, would be if U.S. inflation started to really accelerate. Though I believe higher inflation will ultimately result from this country’s profligate policies, I do not think it will become a problem during the next 3-6 months. Despite the Fed expanding its balance sheet (a potentially harmful inflationary risk because banks have significantly more reserves against which to lend), inflation has yet to pick up because credit growth has been virtually nonexistent. Again, the lack of loan demand is not surprising on the heels of a financial crisis, when cutting debt is a top priority for an overleveraged consumer facing an environment consisting of high unemployment and lackluster wage growth. Thus, the reserves created by the Fed have remained trapped in the banking system and are not flowing out into the economy. To quote BCA Research, the Fed is pushing on a string trying to stimulate the economy via strong private sector credit growth (see Figure 12 on next page). Of course, if loan demand was to pick up and if banks were to start deploying their reserves by lending en masse, then the tinder box created by the Fed when it expanded banking reserves at an exponential rate would be ignited, and inflation would certainly follow. However, given the historical post-crisis precedents, coupled with still-weak real estate markets (both residential and commercial) and an over-indebted consumer worried about the employment situation, I view this risk as remote through the end of this year. In light of current Fed policy, rising commodity prices, particularly food and energy prices, could also drive underlying inflation higher, negatively impacting long-term bond prices. When one looks at recent inflationary expectations (refer back to Figure 5), the risk would appear to be legitimate. Yet, I think rising near-term inflation is unlikely to become a problem because of the current employment climate, where workers have little bargaining power to ask for higher wages. As Gluskin Sheff ’s David Rosenberg has shown, wages are a key determinant of consumer price inflation (see Figure 13 on page 15). 13

Figure 12 The Fed Pushing on a String?
$1,600

U.S. EXCESS BANK RESERVES: 2008 - PRESENT

$1,400

$1,200

Though banks are sitting on a boatload of excess reserves (against which they can lend)…

$1,000

$s in Billions

$800

$600

$400

$200

$0

May-08

May-09

May-10

Dec-08

Dec-09

Dec-10

Apr-08

Apr-09

Apr-10

Aug-09

Mar-08

Mar-10

Aug-10

Data Source: U.S. Federal Reserve

10% 8% 6% 4% 2% 0% -2% -4% -6% -8%

YEAR / YEAR BANK LOAN GROWTH: 2008-2010

…loan g rowth has remained sluggish...

Q108

Q208

Q308

Q408

Q109

Q209

Q309

Q409

Q110

Q210

Q310

Mar-11

Nov-08

Nov-10

Feb-08

Sep-08

Feb-09

Sep-09

Feb-10

Sep-10

Apr-11
Q410

Jun-08

Jun-09

Oct-08

Oct-09

Jun-10

Oct-10

Jan-08

Jan-09

Jan-10

Data Source: FDIC

Jan-11

Jul-08

Jul-09

14

Figure 12 (Cont.)
2.1x

VELOCITY OF MONEY IN THE UNITED STATES: 2001-2010

2.0x

1.9x

1.8x

1.7x

…while the velocity of money* remains well below pre-crisis levels.

1.6x

4.0

3.5

Y / Y %

3.0

2.5

2.0 C H A 1.5 N G E 1.0

0.5

0.0

Q101 Q201 Q301 Q401 Q102 Q202 Q302 Q402 Q103 Q203 Q303 Q403 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111
Private Sector Wages & Salaries Core CPI

Q400 Q101 Q201 Q301 Q401 Q102 Q202 Q302 Q402 Q103 Q203 Q303 Q403 Q104 Q204 Q304 Q404 Q105 Q205 Q305 Q405 Q106 Q206 Q306 Q406 Q107 Q207 Q307 Q407 Q108 Q208 Q308 Q408 Q109 Q209 Q309 Q409 Q110 Q210 Q310 Q410

* Velocity of money is the rate of turnover in the money supply.

Data Source: St. Louis Fed

Figure 13 Relationship Between Private Sector Wages and Core CPI: 2001-2011

Correlation = 72%

Wage growth appears to be a key determinant of “core” consumer price inflation. In an environment of tepid wage growth, it would seem difficult for underlying inflation to rise dramatically.

1.6%

15

David Rosenberg has also made an incredibly astute observation regarding inflationary expectations in recent years. Specifically, during the past several decades, whenever consumers have anticipated inflationary spikes, the subsequent 12-month inflation rates have turned out to be substantially below the expectations. Considering the “jobless recoveries” of the past two decades (where workers have had less-and-less bargaining power to demand higher wages because of an increasing labor pool from EM countries), it is not a huge surprise that surging commodity prices, which almost always trigger higher inflationary expectations, have eaten into consumer purchasing power because the higher food and energy prices function like a tax. With the S&P GSCI Commodity Index up nearly 30% in the six months since QE2 was unveiled, I would not be surprised to see commodity prices drop from current levels, decreasing inflation pressures and helping bond prices.

Figure 14 Univ. of Michigan Consumer Survey: 12-Month Inflation Expectations vs. Actual
6

-2.0%
5 1 2 M O N T H I N F L A T I O N

2.8% Actual 12-Month Change in Inflation

1.4%

?

E 4 X P E C T 3 A T I O N 2

1

Whenever inflation expectations have spiked up during the past two decades (mostly because of rising commodity prices), actual inflation has been significantly less than expected.

0

May-92

May-99

May-06

Dec-92

Dec-99

Dec-06

Apr-95

Apr-02

Apr-09

Jun-96

Jun-03

Aug-90

Aug-97

Mar-91

Mar-98

Aug-04

Mar-05

Oct-91

Oct-98

Oct-05

Jun-10

Jan-90

Jan-97

Jan-04

Nov-95

Nov-02

Data Sources: University of Michigan and U.S. Bureau of Labor Statistics

Another big risk to holding long-term bonds during the next 3-6 months would be if the bond markets reach a riot point where investors refuse to lend to the U.S. government at such low rates because of increasing default risk. Though I think this concern is certainly a credible one, it would appear to be a longer-term risk, especially considering the fact U.S. Treasury rates have fallen since Standard & Poor’s put U.S. sovereign debt on negative watch. 16

Nov-09

Feb-94

Sep-94

Feb-01

Sep-01

Feb-08

Sep-08

Jan-11

Jul-93

Jul-00

Jul-07

Then there is the risk that Fed Chairman Bernanke comes out and signals QE3. However, given the increasing criticism the QE policies have invoked, I do not believe the Fed would announce QE3 unless the stock markets suffered a 15%+ decline from current levels. Should such a scenario play out, bond prices would likely benefit in the interim. I am including several pieces of anecdotal evidence to support the long-term bond purchases. First, when I attended a presentation by the aforementioned David Rosenberg several weeks ago, he opened his talk by asking the audience of 500 investment managers how many thought interest rates would increase during the next 12 months. Practically everyone in the room raised their hand. When asked how many thought rates would decline, only a handful responded. I found this scene quite indicative of how virtually every investment manager has followed in the footsteps of PIMCO, positioning for higher rates. I quickly recalled legendary former Merrill Lynch equity strategist Bob Farrell’s “10 Market Rules to Remember,” one of which says that “when all the experts and forecasts agree, something else is going to happen.” Moreover, this past week while at the CFA Institute’s annual conference, which is attended by investment professionals from around the world, people responded with great surprise whenever I told them I recently purchased long-term U.S. bonds.

Figure 15 Net Inflows Into Bonds & Bond Returns Relative to Stocks: Feb. 2009 – April 2011
$60,000 100%

$50,000 90%

BOND INFLOWS, NET OF STOCK INFLOWS ($s in Millions)

$40,000

$30,000 80% $20,000

$10,000 70% $0

($10,000)

($20,000)

Investors piled into bonds from early 2009 through late 2010 as bonds underperformed stocks by a wide margin. Now, sentiment toward bonds is low.

60%

($30,000)

50%

May-09

May-10

Dec-09

Dec-10

Apr-09

Apr-10

Aug-09

Mar-09

Mar-10

Aug-10

Bond Inflows, net of Stock Inflows

Data Sources: Investment Company Institute and Yahoo! Finance

Bond Returns Relative to Stock Returns

Mar-11

Nov-09

Nov-10

Feb-09

Sep-09

Feb-10

Sep-10

Feb-11

Apr-11

Jun-09

Oct-09

Jun-10

Oct-10

Jan-10

Jan-11

Jul-09

Jul-10

BOND RETURNS RELATIVE TO STOCK RETURNS

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Analyzing fund flows since the stock market rally began in March 2009, one can observe how sentiment toward bonds has decreased significantly since late last year (see Figure 15 on the previous page). One will also notice how bonds underperformed stocks by a wide margin as the public piled into bonds. Now, with the opposite phenomenon occurring, will bonds outperform stocks during the next six months?

4) Added to Long U.S. Dollar Positions
With the Fed essentially printing money and leaving its target interest rate at zero, the tradeweighted dollar has been shellacked since the start of QE1 (see Figure 16). With other central banks raising rates, investors have been flocking away from the dollar and into higher yielding currencies and precious metals.

120

Figure 16 Trade-Weighted Dollar and Gold Prices: 2009 – Present

$16

$15 115

The U.S. dollar has been devalued substantially since the Fed began its quantitative easing programs.

$14

$13 110 $12

105

$11

$10 100 $9

$8 95 $7

90

$6

May-09

May-10

Broad U.S. Dollar Index

iShares Comex Gold ETF

Data Sources: U.S. Federal Reserve and Yahoo! Finance

May-11

Dec-09

Apr-09

Mar-09

Aug-09

Dec-10

Jun-09

Apr-10

Jan-09

Jun-10

Nov-09

Mar-10

Aug-10

Nov-10

Mar-11

Feb-09

Sep-09

Feb-10

Sep-10

Feb-11

Apr-11

Oct-09

Jan-10

Oct-10

Jan-11

Jul-09

Jul-10

iSHARES COMEX GOLD ETF PRICE

BROAD U.S. DOLLAR INDEX

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The negative dollar sentiment has been widespread following such a large decline. And although I am bearish on the greenback long-term as long as Ben Bernanke is Fed Chairman and Timothy Geitner is U.S. Treasury Secretary, I think there is a more-than-likely chance the dollar could rally shorter-term in anticipation of the Fed starting to wind down QE2. Furthermore, should the global economy begin to slow, investors may decide to seek safe haven in the dollar, which is still the world’s reserve currency. Additionally, I believe there is a fairly strong chance the European Central Bank (ECB) and Bank of Japan (BOJ) may start to increase their money supplies at a faster pace than the United States during the next 3-6 months. The ECB is probably going to have to print more euros in order to purchase the debt of the profligate PIIGS countries (Portugal, Italy, Ireland, Greece, and Spain) to prevent a European banking crisis (many undercapitalized European banks hold PIIGS debt – this is why the inevitable PIIGS sovereign debt defaults have been delayed). Meanwhile, the BOJ may continue to inject liquidity as Japan rebuilds from its devastating earthquake. Similar to owning long-term U.S. bonds, being long the greenback could backfire if foreign investors lose faith in the government’s ability to rein in deficit spending and/or the Fed’s ability to tighten monetary policy. However, I view these risks as unlikely during the next 3-6 months, especially if the global economy was to slow.

Lederer PWM cannot guarantee any of the forecasts discussed in this portfolio strategy update

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