Sentinel News

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The world economy twelve months ago looked over a precipice and took fright. After a short period of confusion during administration changes, governments unleashed the largest ever seen fiscal and monetary stimulus on world economies.

Some ideas were good (providing liquidity to the system, government investment), some bad (increasing debt in every major western economy), and some disastrous (providing lifelines to companies pleading special treatment). But we came through and capital markets nearly everywhere had a good year: domestic equities, international and emerging market equities, U.S. corporate and high yield bonds, and commodities. The only place where investors faired less well was in assets that performed well in 2008, namely money market, U.S. treasuries, agencies and OECD sovereign bonds.

So, we made it. We are about to enter Phase 3 of the "Great Recession" and the next twelve months are critical. Let's look at what happened to set the stage:

Phase 1: low interest rates from 2003 to 2008, and the ugly twin of excess leverage, spurred lending to poor quality borrowers. Bank trading desks packaged and sold the loans as exotica. The exotica became illiquid and difficult to price. The banks could not mark the exotica to market, their capital and equity slipped and confidence in financial intermediaries collapsed. The world saw a true liquidity crisis where the wheels of money, savings, and borrowing seized. Economic activity plummeted. The banks asked for special treatment and got it.

Phase 2: from 2008 to 2009, the banks took on special government loans to bust the liquidity dam. Central banks ran interest rates down to practically zero, governments everywhere passed a series of fiscal stimulus packages. Versions of cash-for-clunkers, special credits, and incentives appeared from Beijing to Bogota. The banks borrowed cheap and spent the money on trading assets with higher risk, and, this time, higher returns. Bankers breathed a sigh of relief and started to reward themselves in the ways they felt entitled. Economies stabilized but at a cost of huge government indebtedness and spiraling unemployment. Keynesians felt vindicated and a new era of benign government largesse arrived.

But the bad news is that today's stability is fragile. Much of it is highly dependent on government support. The economic signals remain irritatingly ambiguous. In the U.S. every major economic statistic seems to have its corollary: manufacturing and productivity up, store and housing sales declining, and jobless, unemployment and hours-worked numbers deteriorating.

So we are entering the critical Phase 3. This is where we need to see the following:

Economy: employment will be the only statistic that matters. Companies will be slow to hire and local and national government can only take up part of the slack. Confidence is stable. It could improve markedly in 2010 if uncertainties like healthcare, taxes, savings and housing ease.

On the whole we prefer to be optimistic and with good reason. The U.S. economy is remarkably resilient. We will not follow the Japanese example, nor will we move into European welfare statism. The engines of entrepreneurialism are just below the surface and companies have done a remarkable job in inducing productivity gains.

US credit: in 2009 there was a "flight to risk." Demand for higherincome assets meant that investors looked for yield. And they found it in corporate bonds, emerging markets, high yield bonds and even municipals. Spreads tightened and defaults turned out less than expected. But such was not the story in government bonds. The issuance of Treasuries and other government-backed securities soared 64% from two years ago. This has flooded the market to the point where the Treasury issues the entire yield curve (i.e. 2-year to 30-year securities) every month. The market does not like it. For confidence to return, we need to see less government borrowing or more revenues, or both. This could happen if the economy stabilizes and rates inch up to create a more stable yield curve. Non-government bonds look attractive. Pension funds, insurance companies, and individual investors all need current income from bonds and demand outstrips supply. So we feel confident there.

China has done well in 2009. We expected it and invested both directly in China in our International fund and indirectly in U.S.-based companies with China themes in our U.S. funds. China directed its stimulus to the consumer and saw its economy grow by over 9%. It should continue to do so in 2010. We expect the Chinese government to balance the needs for the domestic economy with demands for yuan revaluation. China's infrastructure needs, improving living standards, growing consumer and healthcare markets, and emerging nationalism will remain important. The worst that can happen to China is a western backlash toward protectionism. Unlikely, but philosophical commitments to WTO principles can evaporate when political expediency takes over. On balance, we think this a low risk and believe the theme of China and the benefits of its growth will be with us for many years to come.

There is much talk of the "lost decade" of investing. Indeed the 10-year returns on the S&P 500¹ look pretty awful when taken on a point-to-point measure. But this hides gains that can be made by judicious asset allocation and investing with a fund company that takes risk and the management of downside risk very seriously. We would also caution that "buy and hold" does not mean "buy and forget." We believe in active management and moving to where we think returns will come. We continue to believe in our investment style. We have practiced it for many years with some of the most seasoned and successful portfolio managers in the business.