November 10, 2006When I was young, I wanted to understand the world around me. I could read history and geography, get the facts, study them, repeat them and get a good grade. I received lots of good grades. I now wonder if that was relevant. My colleagues and I have been on our annual journey to define the future and I am humbled by what an arrogant thought that is. We can only hope to test the envelope of possibilities - true foreknowledge is left to a power higher than our own. In this process, however, we have come to some possibilities and conclusions. The following are our best thoughts.
Susan Byrne, Founder and CIO
In prior letters, we have described the U.S. economy as a ship sailing safely past the perils of interest rate changes, inflation, escalating commodity prices, record deficits and swings in investor sentiment. For 2006, we termed our operative scenario “Flat-World Curve”, after Thomas Friedman’s bestseller on the subject of increasing globalization. One of the reasons we have believed in a flat yield curve, with no recession, was a theme we have sounded for many years…We are part of the world economy, not THE world economy.
Before expanding on our thoughts for 2007, however, it may be useful to review how we derive our outlook. On a regular basis, our research team analyzes the current and expected economic conditions in an effort to quantify risks and potential return for the coming period. Numerous important macro-economic variables are scrutinized independently to provide an overall perspective on the entire economy. Individual estimates are also derived for economic output (Real GDP), inflation (CPI), corporate profits of the individual S&P 500 companies (on both a capitalization-weighted and equal-weighted basis), and equity market valuation (Price/Earnings ratio). This exercise is not conducted with the objective of precisely predicting what will happen in the economy and markets but rather to provide a rational framework to assist the portfolio team in making investment and asset allocation decisions.
From our analysis, we develop an “Operative Scenario,” which we believe is the most likely outlook for 2007. To assess potential threats to our Operative Scenario and provide a risk matrix within which to invest, we consider alternative scenarios, allowing us to test the extremes. Giving prior thought to these alternative scenarios assures that there is no undue pressure to “follow the crowd” should the perception of economic and market conditions change.
With that background, our views on the coming year should be seen as an extension of the trends we have been experiencing for some time. While we are optimistic, we remain cognizant of the risks that the economy must face as it moves forward.
Our “Operative Scenario” suggests domestic real GDP and inflation will each rise 2.5% in 2007- slower than this year. Housing, the concern of many, will remain a drag on the economy through the first half of the year, but the overall lower pace of economic growth should alleviate some pressure on resource utilization rates and allow inflation to recede. A weaker dollar should help our trade deficit, and global industrialization will continue to provide demand for exports and, ultimately, the domestic economy.
Global growth continues to exceed U.S. domestic growth and fuel corporate profits, especially for those companies focused on the industrial sectors of the economy. However, an overall slower pace of economic expansion worldwide should keep growth below 2006 levels. Our expectations for the combined operating profits of the 500 companies that comprise the S&P 500 Index is $93.00 per share on a market capitalization-weighted basis, a gain of 8% over 2006, or $3.30 per share on an equal-weighted basis. We believe that crude oil will average less than $60 per barrel over the course of the year, keeping consumer expenditure growth contained.
When combined with the expected increase in earnings, we believe that equities are moderately attractive, particularly relative to bonds. However, a slower pace of economic growth may disappoint some investors, leading to increased market volatility. As we have been saying, when factoring in this slower growth, we believe investors are likely to prefer high quality securities with solid fundamentals. Under the outlook presented, our current strategy remains focused on high quality companies that have healthy balance sheets, generate strong levels of free cash flow and efficiently utilize their cash to reduce debt, repurchase stock or initiate or increase dividends.
Our interest rate forecast is superimposed on the current Treasury yield curve on the previous page. You may recall that in late 2005, when we first talked about the yield curve flattening, it was still quite steep. Now, the curve has moved into an inverted state. Looking ahead, we expect the Federal Reserve to “fine-tune” short term interest rates in the second half of 2007 with a 25 basis point cut in the Fed Funds rate and for foreign central banks to continue to reinvest trade dollars back into longer term U.S. securities, thereby causing the yield curve to remain flat to slighlty inverted.
Because past negative or inverted yield curves have been associated with economic recessions, the markets continue to grow increasingly fearful of a recession and ultimately, a housing market collapse. We continue to believe that this will not be the case. As opposed to an impending recession, we believe that the inverted yield curve, which is a function of low longer-term interest rates, has been caused by strong demand for longer-term U.S. Treasuries resulting from an excess of worldwide liquidity. This liquidity is being created by a number of factors, including the U.S. twin deficits, high levels of Japanese savings, unusually profitable fixed investments in China, the impact of foreign investment by rapidly growing Eastern European nations, and crude oil prices above the $50 per barrel mark.
Excess liquidity has been flowing primarily from the BRIC countries (Brazil, Russia, India and China). The overall population of the BRIC countries relative to the rest of the world (just over 40%) has changed little from the 1950 ’s. What has changed in the past fifty years is that these countries have developed large amounts of wealth and cash flow. Because of the sources listed above, gold and currency reserve growth in the BRIC countries has been accumulating at a double digit pace, and as pictured on page 3, the BRIC countries now represent nearly 1/3 of all reserves worldwide. Overall worldwide levels of foreign exchange and gold reserves can also be seen on the map at the beginning of this document.
The ascent of the BRIC countries has had far reaching impact for the world. As stated previously, this excess liquidity flowing from the newly rich BRIC countries has been beneficial in keeping US interest rates lower than they might have otherwise been. It has also been a key driver of commodity and real estate price strength because BRIC countries possess low levels of reserves in commodities such as crude oil, steel and copper and have worked to diversify their holdings into these and other hard assets, such as real estate, in countries with strong property rights such as the United States and Great Britain.
As a key risk to our outlook (reflected in alternate scenario 2), we will watch issues such a significant break in oil prices, a downturn in economic activity in the BRIC countries, changes to the US trade and fiscal deficits and the Japanese monetary base that could affect the creation of excess liquidity and cause changes in risk premiums among the riskiest asset classes. Such a change in risk premia would be a signal that liquidity levels may be drying up. These changes, in turn, could cause our medium to long-term rates to rise by 100-200 basis points as buyers of US Treasuries slow purchases, ultimately leading to economic recession. Other scenarios considered in our outlook include alternate scenario 1, which reflects the impact of a housing led recession and alternate scenario 3, which is indicative of an upsurge in global growth.
Details on our Operative and Alternative scenarios appear in the table on the following page. Under the risk matrix presented, our current investment strategy remains focused on high quality companies showing positive and improving fundamentals, strong free cash flow generation and unrecognized value. We will continue to invest in companies that have healthy balance sheets, generating strong levels of free cash flow and efficiently utilizing that cash to reduce debt, repurchase stock or initiate or increase dividends. We expect to find more of these companies in the manufacturing sector than in consumer-related areas as worldwide demand for industrial products & services boosts profits in this part of the market. We are confident our strategy remains appropriate for the foreseeable future, and we look forward to discussing our outlook with you in greater detail.
Click here if you would like a printable version of this article.
This information is provided for clients and prospective clients of Westwood Management and Westwood Trust, hereinafter "Westwood" and their employees. It is not an offer or solicitation to sell securities. The information provided here is copyrighted by Westwood and may not be used without its permission.
