Quarterly Research Conference Call October 18, 2011

Transcription

1 Quarterly Research Conference Call October 18, 2011 SEATTLE 999 Third Avenue Suite 4200 Seattle, Washington tel fax LOS ANGELES 2321 Rosecrans Avenue Suite 2250 El Segundo, California tel fax

2 CONFERENCE CALL AGENDA INTRODUCTION &CALL OVERVIEW Jeff Maclean Chief Executive Officer Jeff Scott, CFA Chief Investment Officer BRIEF DISCUSSION OF EUROPEAN DEBT CRISIS Peter Wilamoski, PhD Senior Research Analyst REVIEW OF QUARTERLY RESEARCH FINDINGS Eric Petroff, CFA, FRM, CAIA Chief Strategist 2

3 CONFERENCE CALL OVERVIEW 1. Global Macroeconomic Conditions Developed economies appear poised to enter recessionary territory Commodity costs and rising inflation aren t helping Unresolved financial issues in the Euro have only exacerbated recessionary fears A catalyst for near term economic growth doesn t seem to be there 2. Some Issues Specific to the US Economy Macro indicators imply GDP growth is heading lower The employment situation continues to look grim, especially in an historic context Monetary stimulus remains an unresolved threat to inflation; however, fiscal austerity measures and debt deleveraging are deflationary threats in the advanced economies 3. Chances of a Double-Dip Recession Objectively speaking, there s about a 50/50 chance we ve seen the peak of this expansion If you overlay fundamental concerns, the chances go up 4. Impact on Valuations & Asset Allocation Expected portfolio returns have risen, but still don t look strong on an absolute basis They look great on a relative basis to risk free assets This probably won t be the last upward trend in expected returns we ll see 3

4 EURO CRISIS DISCUSSION 4

5 HOW IS GREECE IN A POSITION TO BRING DOWN THE EUROPEAN BANKING SYSTEM AND THE WORLD ECONOMY? This is not a sovereign debt crisis, it is a banking crisis. Policies that brought Greece & Europe to the edge: ECB policy encouraged banks to hold sovereign debt Implicit guarantee of sovereign debt encouraged too much lending at to cheap a price banks to take on too much leverage Table 1: Macro Data Greece Italy Spain Portugal Ireland Germany France Real GDP (2011E) 233b euros b Per capita GDP/EU Avg 73% 89% 79% 56% 121% 107% 107% GDP Growth (2010) 4% 1% Deficit to GDP (2011E) 8% 4% 7% % 6% Interest Burden (2011E/%GDP) 6.1 5% Debt to GDP (2011E) 169% % % 85% Share of public debt held Abroad % 48% 68% Domestically % 52% 32% Chart 1: Sovereign Spreads End of guarantee Creditors will have to share the burden, i.e., accept a loss of principal Markets began to realistically price debt at rates Greece can t afford, making default an option Sovereign default could lead to default of thinly capitalized banks 23% 2 18% 15% 13% 1 8% 5% 3% Spread to German 10yr Government Bond Greece 10 Yr Govt Spain 10 Yr Govt Italy 10 Yr Govt Portugal 10 Yr Govt 5

6 A DISORDERLY DEFAULT: A WORST CASE OUTCOME The Greek Domino Effect: Uncertainty & Contagion Greece Defaults, Markets React: What about Italy, Spain and the rest? What about the banks? Italy and Spain are next Markets refuse to roll-over Italian debt Banks are next Sovereign defaults leave banks insolvent Depositors withdraw assets Counterparties refuse to lend The Real Economy is next Access to credit dries up Business stops purchasing, start layoffs Real European Examples August ECB purchase of Italian debt September provision of dollars to European banks Morgan Stanley Table 3: Debt Burden External Bank Claims: Lending/Borrowing Country Greece Ireland Portugal Spain Italy France Greece Ireland Portugal Spain Italy Germany France Netherlands U.K U.S Japan All European banks All lenders Public Debt/Total Debt (Bank, Public, Private) Change in total exposure (12/2010 to 3/2011) Source: BIS (table 9B), March 31, 2011; $billions Claims by Banks on Individual Countries (Roll over Maturity needs) Claims < 1 year >1 yr to 2 yr > 2 yr Greece Ireland Portugal Spain Italy France Source: BIS (table 9C), March 31, 2011; $billions 6

7 BETTER SOLUTIONS: SOFT LANDING AND AN ORDERLY RESTRUCTURING Soft Landing Greece brings down its deficits & borrowing needs; markets react positively & there is no default Goal of 2010 rescue plan Likelihood: Low Recession overwhelmed austerity measures 2011 Rescue plan recognized creditor losses Orderly Restructuring A negotiated default between creditors, nations & EU Will also require: Recapitalization of banks Liquidity to support Italian & others debt Likelihood: Moderate to High Risks Officials can t negotiate a solution, markets force a default 2 15% 1 5% -5% -1-15% 1 5% -5% -1-15% -2-25% -3-35% Chart 2: Morgan Stanley % Change since Last week of September Morgan Stanley Stock S&P 500 Chart 3: Equity Market Behavior % Change since July 2011 Euro STOXX 50 S&P 500 7

8 IMPLICATIONS FOR MARKETS Crisis Creates Uncertainty Markets react by seeking safety Flight to risk free assets Equities sell off Credit spreads widen Volatility increases, correlations rise What happened? Sovereign debt falls European equities fall relative to US Euro falls & dollar gains 4% 2% -2% -4% -6% -8% -1 Chart 4: Euro-Dollar % Change since July 2011 Euro/USD Table 4: Valuation Metrics Implications of an Orderly Restructuring Certainty restored Asset prices reverse direction What has happened? Asset Allocation Are European Equities Attractively Valued? Move toward market weight in European assets? Valuation Metrics As of 9/30 10 year Avg Fwd P/E P/B P/CF Div. Yield Fwd P/E P/B P/CF Div. Yield EAFE France % Germany % UK % Switzerland % U.S % Source: MSCI, J.P. Morgan 8

9 MACRO DISCUSSION 9

10 GLOBAL ECONOMIC GROWTH DOESN T SEEM TO BE HEADING IN THE RIGHT DIRECTION 9% IMF 2012 GDP Estimates - Last Two Quarters 14 Major Economies Inflation & Real GDP - Jun. ' % 6.4% 6.1% % 2.6% 1.9% Advanced Economies GDP Est. As of June '11 As of Sept. '11 Emerging & Developing Economies 2012 GDP Est Advanced: 1 Yr. Inflation Emerging: 1 Yr. Inflation Advanced: Real GDP Advanced: Real GDP Source: IMF Source: Consensus Economic, Haver Analytics, IMF 10

11 THE EUROPEAN DEBT CRISIS IS TAKING ITS TOLL 1200 Euro Sovereign and Bank CDS and Market Cap. 10 Euro Sovereign Debt With CDS Spreads In Excess of 2% Change in CDS Spreads (basis points): 9/10 to 8/11 Change in Market Capitalization ( BB's): 9/10 to 8/ % 3,120 Percent of Euro Area Gov't Bond Market billions- Euro Area Gov't Bond Market Credit Default Swap (CDS) Sovereigns Banks Nominal Adjusted by Tangible Source: Bloomberg, IMF Common Equity 2 6% 390 Apr Aug Apr Aug Source: Bank for Int l Settlements, Bloomberg, IMF

12 THERE S MORE THAN ONE REASON TO BELIEVE GLOBAL GROWTH MAY BE UNDER PRESSURE 600 Major Commodity Prices (Jan. 2003=$100 US) - Jul. '11 12% US Worker Productivity & Real GDP Growth - Jun. ' % % Energy Food Agricultural Raw Materials Metals -4% -8% Worker Productivity: 1 Year Average Subsequent 1 Year Real GDP Source: Consensus Economic, Haver Analytics, IMF Source: BLS, Wurts 12

13 IT DOESN T LOOK AS IF THE ADVANCED WORLD IS POISED TO PULL US THROUGH THIS MESS 1 General Government Fiscal Balances as % of GDP 9% Country Contributions to Global Consumption Growth 7% 5% 1% 1% -1% -1% -2% -2% -5% -4% -3% -4% Advanced Economies -7% Emerging Economies -7% -9% Source: IMF 5% 3% 1% -1% -3% Source: IMF 3.4% 3.5% 3.7% Advanced Economies Other Emerging Economies China India % 2.4% 1.9% 13

14 UNFORTUNATELY, IT DOESN T LOOK LIKE THE EMPLOYMENT SITUATION IS HELPING EITHER 166 Civilian Labor Force & Not in Labor Force (MM s) Weekly Initial Jobless Claims (Thousands) - Sept. ' Civilian labor force Not in labor force Source: BLS Source: DOL 14

15 IS THE FEDERAL RESERVE PUSHING A STRING OR FORCING PRESSURE THROUGH A CLOG? 2 Federal Reserve Balance Sheet & Excess Bank Reserves as % of GDP 30 Velocity of Money & Consumer Prices - Sep. ' % 15% $2.7 trillion % % $1.6 trillion % 3% Federal Reserve Balance Sheet as % of GDP Excess Reserves of Depository Institutions as % of GDP 10 5 Velocity of Money (Nom. GDP/Monetary Base) Rolling 1 Year CPI (%) 0-2 Source: Fed, BEA, Wurts Source: BEA, BLS, Fed, Wurts 15

16 FORCES ARE LINING UP TO TURNAROUND IN HOME PRICES.JUST NEED SOME LENDING 2,000 New Single Family Home Sales (Thousands) - Aug. '11 8. Rental Income & Household Real Estate in Relation to GDP & GNI 20 1,750 1,500 1,250 1, % % Rental Income as a % of Gross National Income Household Real Estate as a % of GDP 75% 5 Source: Census Bureau Source: BEA, Fed, Wurts 16

17 BEING OPTIMISTIC ON CORPORATE EARNINGS EXPECTATIONS IS GETTING HARD TO JUSTIFY 15 Quarterly Annualized GDP Rates & ISM PMI Index 80 2 Corporate Profits in Relation to National Income 8% 18% 7% % 6% Nominal GDP Real GDP ISM Index Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Source: BEA, PMI 14% 60 12% % 6% 40 Corporate Profits as % of National Income - Jun. '11 4% Undistributed Corp. Profits as % of National Income 2% 30 Source: BEA, Wurts 5% 4% 3% 2% 1% 17

18 IS ANOTHER RECESSION ON THE HORIZON? 15% Relationship Between Real GDP, CPI & Subsequent GDP 10 Probability of Business Cycle Duration (Trough to Peak) % -5% -1 Source: BEA, BLS, Wurts Probability % 3 Probability Function 3 Cumulative Probability Function 2 9% 9% 12% 2 Annualized CPI Minus Real GDP 6% 6% 9% Current Duration from Previous Trough 1 3% 3% Sub. Quarter Annualized Real GDP 3% 3% 3% 3% 3% Source: BEA, PMI # of Months Since Last Trough (June 09)

19 HAVE MARKETS RATIONALLY PRICED THE IMPACT OF ANOTHER RECESSION? Year Scenario Analysis on S&P 500: GDP/Earnings Growth & Returns 8% Impact on Net Present Value (NPV) of 10 Year Equity Earnings Given Recessionary Scenarios 7% 12 6% 5% July-11 September % Real GDP 2. Real GDP 1.6% GDP 1.1% GDP Source: Wurts 4% Note: Each scenario has its own annual path of real GDP growth. 3% 2% 1% 2.75% Avg. GDP/ Baseline -1% 2. Avg. GDP/ NPV of Earnings: -7% -2% 1.6% Avg. GDP/ NPV of Earnings: -1-3% 1.1% Avg. GDP/ NPV of Earnings: -15% -4% Source: Wurts 19

20 SUMMARY OF OUTLOOK 1. Global Macroeconomic Conditions Major economic indicators imply the chances of a near term recession are high The catalyst to stimulate economic growth to head off a recession isn t apparent This quarter is an illustration of the heightened macroeconomic and capital markets volatility we ve been concerned about for some time 2. Unresolved Threats The threat of another recession will impede valuation expansion until it is resolved or realized Global inflation has been on the rise and may be impeding growth, especially for emerging markets which have a higher sensitivity to commodities prices The threat of higher inflation remains, especially for the US The Euro crisis is yet to be fully resolved 3. Valuations It s hard not to find good risk adjusted returns following a flight to safety Credit spreads are wider, equity valuations are cheaper The market appears to be pricing in a recession 4. What to Do? This is one instance of the types of shifts in capital markets we ve recommended waiting for to capture higher expected portfolio returns probably won t be the last or best chance for a while 20