Sentinel News

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

When trillions of dollars are wiped from the world economy, stock markets halve and housing falls to one quarter of its peak, no normal recovery can take place. It is a mistake to point to unconventional monetary or loose fiscal policy as inadequate or look to them as agents for recovery. Neither can repair the self-inflicted damage of the private sector. That is why the current debate over Fed policy and government budgets is so tiresome. We see the economy in a quite different light, where the big issues of output, inflation and employment will take many years to correct.

Investment returns so far this year show only punctuated gains, like a rock climber losing a finger-grip hold on every other pull. Stocks have gained over 6% but are flat from the February peaks; government bonds are flat year to date but up 2% from their lows. Make no mistake, this is the pattern for now and as long as we can see ahead. Since the beginning of 2009, we have seen seven distinct phases of the S&P[1], the dollar and GT10s gain and lose over 15%. Welcome to the era of volatility, switchbacks and high sides[2].

But therein lies opportunity to make money and we remain excited about what's to come. Let's look at economic health first and move to capital markets.

The three big questions for the US economy are: can we sustain manufacturing output? is inflation a concern? and will employment recover?

1. Output: We have had a manufacturing and production based recovery. This is unlike past consumer led recoveries that tend to suck in imports and create inflationary pressures. The numbers that matter are PMI and ISM surveys and their associated regional Fed indicators (we especially follow the Empire, Philly and Richmond measures). They matter because they capture real and expected economic activity, inventories, orders and employment. And while manufacturing is only about 15% of US GNP, it has a valuable multiplier effect. All started the year well but recently lost momentum. The headwinds are oil, at over $110 bbl, Europe and post-tsunami Japan. These probably won't last. Companies in these sectors are showing healthy utilization rates, strong balance sheets and benefit from a lower dollar. The trend remains healthy.
2. Inflation: The hawks are in their element, pointing to every micro tick in the CPI components and extrapolating every commodity nuance into a broad inflation run. They make two elementary mistakes: one, the feed through fallacy and two, the drivers of institutional inflation. On the first, a rise in oil and gasoline tends to subdue activity and prices. It is a tax for consumers. And as with any tax, it leaves less disposable income for other items. Less money chasing the same goods is not inflationary. Second, the ingredients for full-on inflation are rises in broad money (with unchanged velocity or GDP/M2), wage push, labor costs and fast rising nominal GNP. None exists. That's why inflation is lower now than at any time during the "Great Moderation" and likely to remain so.
3. Employment: The one stubborn statistic for the dual-mandated Fed. Lately, the labor market seems to be joining in the recovery. There were 230,000 new jobs created in March and the unemployment rate edged down to 8.8%. This is coming from real expansion, not just a fall in the participation rate. It's also a cyclical challenge, not a structural issue. This means it will repair slowly, will keep consumer activity subdued and so underpin low interest rates. Employment will continue to gain this year.

And good news elsewhere
European and Asian economies are in very different, but quite good, places. Europe is on a twin track: good performance from the old deutschemark core economies and mundane from everyone else. The former maintain strong exports, manufacturing and competitive wages. The latter are peripherals teetering on the edge of insolvency. Expectations from them are low and they are likely to meet them. The ECB rate hike was a response to Germany's super strong growth, not the region's 1.2% anemia. Total area output is 3% below its peak. The US is the same amount above. On balance, the worry from Europe is on the downside and its ability to contaminate the banking system.

In Asia, only China matters. Its move to prudent tightening, well in advance of credit and broad price inflation, has been positive. The cycle may not be over quite yet as Chinese nominal GNP was in excess of 18% in Q1. China's challenge remains moving from a capital/infrastructure economy to one where consumers drive the way to broader, higher living standards. This is underway and will remain a theme for years. In the meantime, China's FX accumulation continues at $50bn a month with total reserves of over $3 trillion. The obvious solution to solve Chinese excess saving, inflation and slow growth is to allow renmimbi appreciation. The authorities have long resisted the pressure but this seems to be waning. Expect some gradual appreciation...faster than the 4% since last June.

What this means for capital markets

Bonds

There are two camps: one states that the end of QE2 will lead to an inevitable climb in yield. It rests on a simple supply/demand equation that supported Fed buying will disappear and unremitting supply must lead to a price drop. The second, (yes, us) that other buyers will step into the breach and that credit demand, which ultimately drives rates, is very benign.

The Fed has deliberated the end of QE2 thoughtfully. It's very likely that they will i) end the $600bn buying program ii) continue reinvestment of MBS and Treasury maturities and coupons iii) start to neutralize excess bank reserves iv) drain excess reserves v) increase rates paid on reserves and vi) initiate a hike in the Fed Funds rate. And they will take from now to 2013 to do it making their intent and language very evident along the way. This gives the market plenty of time to react and position. Meanwhile household and foreign buyers of Treasuries, sidelined for the last few quarters, will return. Private sector household purchases of Treasuries averaged $70bn per quarter until QE2 when it dropped to $9bn. That demand will return. And institutional demand from liability matching pension and insurance funds to sovereign wealth accumulation, remain as high as we can recall. So expect rates to move around 3.2% to 3.8% for the foreseeable future and take the trading opportunities around that range.

Equities

Energy has done most of the running in the US equity market this year. Excluding energy, the market's 6% return is almost halved. This is a welcome breather. We have seen companies with quality measures like balance sheet strength, top line growth and higher ROEs outperform those with momentum, bid premiums and high PEs. For the next few months, there are four issues:

1. The end of QE2: Risk assets benefit from QE. It diverts flow from lower yielding risk-free assets into the risk pool investments. Stocks rise. And the Fed has been clear about the benefits of the wealth effect. But short of any change in Fed rhetoric, QE2 is not a negative for the market and so we do not expect much turbulence.
2. Earnings season: The year over year comparisons are tougher. Corporate earnings and margins are at peak levels and all with 8m fewer people employed. The market will look for top line growth on the assumption that productivity gains will ebb. Sales growth looks to be around 8% compared to 14% last year. The good news is that this is a very solid profit recovery from the corporate sector. And it's without recourse to leverage, real price increases or extended capacity utilization. This supports the medium term.
3. Valuations: The S&P still yields a little less than 2%, well ahead of two-year government rates and with dividend growth of 9%. The long-term numbers are very important: dividends have been 45% of returns for the last 80 years, 20% for the last two decades and 13% for the last two years. We prefer real cash dividends to dilatory buy backs and obtuse reinvestment programs. They're making a come back in investing and look attractive in a market trading at roughly 12.3 times earnings.
4. Animal spirits: M&A activity has picked up. Not just the headline mergers but the more important restacking of corporate assets, bolt-ons and portfolio clean up. Companies are casting a steely eye on deals and committed to fast accretion. So far, they have not disappointed.
   
   Markets should gain from reduced concerns about inflation. Valuations here and overseas provide some strong downside buffer. Intra and inter market correlations will remain high which presses for nimble and active allocation. Please don't buy and hold.

So putting it all together...

1. Bonds remain an attractive total return asset. A tight range and clear monetary policy are a gift to fixed income investors.
2. US equities are cheap. Large companies are a multi-year play on global demand. They derive over half their earnings from overseas and they can benefit from higher input prices.
3. China and its accompanying Asian themes will be in play again soon. The renmimbi appreciation is a secular affair.
4. No market will extend or trade in one direction for long. We have raised and lowered our fixed income/equity split five times this year and expect to do so again.
5. Invest in commodities as a growth accelerator but not through the physical markets.

[1]The Standard & Poor's 500 Index is an unmanaged index of 500 widely held U.S. equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

[2]High sides: physics of compression...try to change direction too quickly and you are launched into precisely the opposite direction. Rossi High Side.

Sources: Bloomberg and Sentinel Asset Management, Inc.

This article contains the current opinions of the author but not necessarily those of Sentinel Investments. The author's opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.