economic & capital market outlook |...

Winthrop Capital Management | www.winthropcm.com | 317.663.7510 | 50 E. 91st Street, Suite 210 Indianapolis, Indiana 46240

Economic & Capital Market Outlook | 2011

There is little doubt that investors are feeling better about things. Many of these people have good paying jobs, have been able to refinance their mortgage this past year and have seen their investment portfolio and retirement savings increase in value. Similarly, corporations across the country are flush with cash and have posted record profits. For the year, the equity market posted a 15.06% return measured by the S&P 500, and the bond market, measured by the Barclays Aggregate Index posted a solid return of 6.54%.

However, as fundamental capitalists who believe in free markets, we recognize the rules for investing have changed over the past few years given the more transactional role of banks and extensive government intervention in our capital markets and financial system. We have argued that the United States has moved from a system of capitalism to Nationalized Capitalism in which the government invests alongside the private sector and, at the same time, provides regulatory oversight. Yet, the gaps in regulatory oversight have become apparent and the debate over whether any company is too big to fail remains unresolved.

As a result, we believe that the inherent risks to investors are deceptively high in today’s markets given the extended government intervention in our capital markets, the huge budget deficit, the muted outlook for job growth and the lack of business formation that currently exists. The Fed is hopeful that the economy can grow its way out of these excesses and generate enough demand to drive tax revenues and consumption to absorb the slack resources in the system. Our concern is that a massive global debt crisis has already formed and, left unaddressed, will ultimately threaten the fragile economic recovery that is taking place. Thus, our investment theme for 2011 is again focused on conservatism and principal preservation and less on extended risk strategies.

At the height of the Financial Crisis in early 2009, we summarized a list of 23 problems that required attention. Remarkably, we have seen progress on many of those issues including the major banks paying back the TARP money, AIG and Citigroup producing a plan to pay back the government and a restructured General Motors coming out of bankruptcy. However, there are still issues that require attention including recapitalizing Fannie Mae and Freddie Mac, addressing the unfunded pension liabilities in the public pension plans and the regulation of derivatives trading.

We will not experience sustained economic growth until we have a stable financial system. While we believe we are on a solid path toward stability through better regulation and higher capital levels, ultimately we need to see the excessive compensation and moral hazard abuses addressed in order to have a healthy sustaining financial system. Sustained economic growth and business development is correlated with the expansion of credit. We believe the banks are now in a position to increase lending which will lead to additional credit growth and an increase in the velocity of money. This will prove to be a bright spot for the economy next year. With the economy showing some signs of sustained growth, and progress toward a more stable financial system we offer our key investment themes for 2011.

Gregory J. Hahn, CFA President and CIO


Key Investment Themes

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Opportunistically harvest gains in equitiesThe S&P 500 posted a 15.06% return for 2010 after a strong 23.5% return for 2009. With 2011 earnings estimates of $94.80 and a dividend yield of 1.87%, we believe the equity market is fully valued. However, we believe the equity market has the potential to still post returns in the 6% to 10% range through 2011. While improvements in operating margins have been strong over the past two years, prospects for increasing revenue growth have not been readily apparent given reduced demand and restricted flow of credit. Retained earnings of over 70% are at an all-time high and we expect excess cash will be used to support stock buy back programs and increase dividends. In addition, increased merger and acquisition activity will provide a further catalyst for price appreciation. In addition, fund flows from individual investors and hedge funds from bond funds to equity funds will add further support to the equity market. Yet, given the back drop of slower economic growth, we are inclined to selectively reallocate away from equities as the opportunity to harvest gains presents itself. We are looking at opportunities for investment in the health care, technology and energy sectors.

Disciplined risk management will protect principalLast year, the Fed lowered interest rates to zero and flooded the capital markets with liquidity. Ironically, at the same time that the risk free rate approached its lowest level historically, the risks for investors in the capital markets neared their highest levels. We believe the experiment the Federal Reserve is conducting with its asset purchase programs is masking many inherent risks in our capital markets while, at the same time, supporting asset prices and economic growth. If any one of these risks escalates into another crisis, we could likely experience another sharp selloff in the securities prices. These risks could include the risk that the AAA rating of the United States is ultimately downgraded, the risk that the Chinese real estate boom turns sour impacting global banking and trade flow, or the risk that Europe can no longer bailout its weakest countries, jeopardizing the Euro currency and global trade. Markets never move in straight lines and “hope” is not a strategy. Whether you are managing a foundation portfolio or your own personal wealth, the discipline of measuring risk and managing risk are critical to meeting long term investment objectives. We are strong advocates of appropriate risk management in conjunction with prudent asset allocation in order to achieve the stated investment objective.

We have a bias toward high interest ratesWe expect to see an increase in interest rates next year for three reasons: some improvement in economic growth and job creation, investor shift out of bonds and into equities, and the curtailing of asset purchase programs by the Federal Reserve. Ultimately, we believe the Federal Reserve is hoping for economic growth to increase to a level that will allow it to begin to reduce the $1.7 trillion in securities it has purchased onto its balance sheet. We would expect the Federal Reserve to target a range between .5% and 1.0% for the fed funds rate later in the year. As short term interest rates rise, we would expect the yield curve to flatten.

Credit markets offer excellent market value, but “event risk” is growing This past year has experienced near record amounts of issuance from both investment grade and high yield issuers. At the same time credit spreads are near the 52 week averages and default rates are trending lower. With corporate balance sheets at their strongest levels since the 1950’s, we expect next year to be positive from the rating agencies where the number of issuers upgraded in rating exceeds the number that is downgraded. Both investment grade and high yield credit should outperform this year. However, the risk of levered stock buy back programs and mergers and acquisitions which utilize higher levels of leverage are increasing.

Municipal Bonds will continue to offer excellent relative valueThe municipal bond market has become much more complex for investors to analyze after the demise of the bond insurance industry. This complexity includes analyzing the many types of issuers and structures with often limited ongoing financial data. We expect the municipal bond market will experience challenges next year with a growing number of defaults and restructurings. However, these defaults will be limited to specific project financings, tax increment financing districts and smaller municipalities. Because of the fragmented nature of the municipal bond market, we do not see a wholesale contagion spreading through the entire municipal bond market. As a result, we expect there will be excellent investment opportunities for high quality municipal debt for the patient investor willing to do their homework on the underlying credit. Several large issuers, including California and Illinois, will ultimately require some form of Federal assistance and we recommend investors refrain from adding those issuers to their portfolios at current levels.

Preferred Stocks offer excellent risk/rewardOne of the themes for 2011 is the continual improvement in the credit quality of the banks. As a result of the Dodd-Frank Act and Basel III, banks are required to increase their Tier 1 capital levels and hold excess reserves in case of emergency. There is a push to reduce the use of certain hybrid securities in the capital structure of the large banks. With the improvement in capital ratios, both the bonds and hybrid securities of the banks offer excellent risk/reward for investors. Ultimately, we expect certain banks to retire their expensive hybrid securities over the next three years through open market purchases and scheduled calls. The headwind for investors in bonds and preferred stocks in the financial sector will be the undoubted push by management to reinstate their dividend and start to buy back their stock.


Economy

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In order to reduce the deficit we need to experience both prosperity and austerity and right now we have neither.

We believe this statement is as relevant today as it was this time Although we are seeing positive signs of growth, structural barriers in the economy will inhibit sustainable growth in the economy. We expect the economy has the potential to grow 3 to 4% in the first half of the year, but will slow in the second half of 2011 as austerity measures designed to reign in the deficit begin to take effect.

Even though the economy has been expanding for the past 18 months, it has structural problems which will ultimately impede the rate of growth. These structural problems include high levels of federal and state debt, a large unemployed labor pool, uncertainty in tax policy, uncertainty in healthcare reform, a massively underfunded pension system and impaired capital in the banking sector. While some of the structural problems are beginning to improve (such as the improvement in bank capital), the effects still linger on the economy.

After growing by 1.7% in the second quarter of 2010, the economy measured by Gross Domestic Product (GDP) grew at a revised 2.6% for the third quarter of 2010. We expect stronger growth in the fourth quarter based on increased consumer confidence, strength in the manufacturing and government sectors, and an increase in exports.

Consumers have spent the past 18 months shoring up their balance sheet. With an increase in the personal savings rate to 6.6% and meaningful reduction in credit card debt, we expected this the holiday shopping season would be strong. We are seeing a modest wealth effect as individual investors experience an increase in retirement and investment portfolios. However, the consumer sector is still faced with lower home valuations, tight credit, and high unemployment. In order for there to be sustained economic growth, the consumer sector (which represents 70% of the economy) must be engaged. However, the lack of job growth, further declines in housing prices and the potential rising tax burden looming on the horizon could dampen consumption.

We’ve seen a general improvement in average household financial The unemployment rate, after reaching 10.2% in the fourth quarter of 2009, is hovering around 9.8% in November. In the United States, there are roughly 15.1 million people unemployed today and an additional 11 million that are underemployed or marginally attached to the workforce. We calculate that the economy needs to produce roughly 120,000 jobs a month for three years before we can move the rate of unemployment below 7.0%. While jobs in education and healthcare are growing, job growth in the rest of the economy remains dismal. Historically, job growth occurs first in the small business sector which helps lead the economic recovery. However, the uncertainty

in healthcare and tax policy combined with the inability to access credit has suppressed any expansion in the small business sector. We expect the extension of the Bush tax cuts for two years to provide a modest stimulus, but more incentives directed at the small business sector need to be implemented in order to meaningfully address the structural high unemployment problem.

The corporate sector has been the bright spot in the economy over the past year. Corporations moved quickly during the financial crisis to cut expenses and sustain operating margins. With the uncertainty in the economy, tax policy and healthcare reform, companies stockpiled cash rather than reinvest in their businesses. Today, corporate cash as a percent of capital is at the highest level since 1959, underscoring the healthy position of the corporate sector. Rising raw material prices this past year will start to erode those robust margins in 2011.

We expect to see a contraction in the government sector in the second half of 2011 which will negatively impact economic growth. Most municipal budgets have a mid-year fiscal year end. Faced with the requirement to balance their budgets, we expect that more job cuts are coming and will be implemented in the second half of 2011.

The ineffectiveness of monetary policy in this economic environment has lead to an increase in the Federal Reserve’s asset purchase programs. Operations of the Federal Reserve have increased bank reserves by approximately $1 trillion since the end of 2008. Substantially all of this growth is held in excess reserves at the Federal Reserve earning a killer rate of 10 basis points. In effect, the Fed has provided substantial new reserves to the banks, yet they have, in turn, deposited the funds back with the Fed instead of making loans. Loans are made based on a bank’s capital level which has continued to erode over the past two years. However, we expect to see an increase in lending in 2011 as bank capital levels appear to be stabilizing.

In order to sustain the economy during the Financial Crisis, the government entered into a massive leveraging of its balance sheet in order to buy securities in the open market to support its asset purchase programs. The result of this Keynesian-style fiscal initiative is a deficit now in excess of $1.4 trillion and an increase in the debt ceiling to $12.4 trillion. With short-term interest rates near zero percent, excess resources in the economy and the velocity of money running at an historically low level, we are not concerned with an immediate increase in the rate of inflation.

However, we believe that we have traded one problem for another. Deficit spending may help stimulate growth and jobs in the short run, but running huge deficits to finance these programs will have unintended consequences. Ultimately, it will result in the deterioration in the US dollar, a rise in commodity prices, a risk of inflation and a rise in interest rates which will push mortgage rates higher, further slowing the housing market. With the sea-change that took place at last November’s elections, we believe we are nearing the point where the huge debt needs to be addressed. And, in order to reduce the deficit we need to experience both prosperity and austerity and right now we have neither.

The total debt outstanding as a percent of GDP in the US (as well as other countries) has continued to grow following the Financial Crisis. The huge federal debt burden is compounded by the growing debt of state and local governments. Further, when we add in the hidden debt which includes unfunded pension liabilities, the debt figures rise dramatically. Without a plan to address the growing deficit, we believe that we have the potential for a looming debt crisis, placing the AAA rating of the US government at risk of a downgrade. Obama’s nonpartisan Deficit Commission released its recommendations in November but failed to get the necessary votes to move it in front of Congress.


We believe 2011 will be a crossroad in the recovery of our economy and capital markets. As long as the financial system remains in a fragile state, the Fed will keep interest rates low and money flowing through the system. However, with the improving capital position of the major banks and the tighter spreads in the credit markets, we expect that the Fed is nearing that time where it will begin to withdraw a portion of the massive liquidity that it pumped into the capital markets last year. Also, we are nearing the time where Congress will begin to place caps on spending with an effort to reduce the massive budget deficit.

Equity MarketsThe deterioration in the economy and deleveraging of the capital markets will likely keep equity valuations range bound until there is better clarity on earnings. We expect to be more opportunistic in the implementation of our investment strategy with shorter investment horizons and more conservative valuation metrics.

The S&P 500 posted a 15.06% return for 2010 after a strong 23.5% return for 2009. Earnings for the S&P 500 for 2010 should come in near $83.66, up significantly from $56.87 in 2009. With 2011 earnings estimates of $94.80 and a dividend yield of 1.87%, we believe the equity market has the potential to post returns in the 6% to 10% range during 2011. The S&P 500 is currently trading at 13.5 times next year’s earnings, which is not excessively overvalued given the median multiple of 16 over the past decade. However, we believe the rally in equities has largely been supported by government intervention and stimulus as the banks pulled back on lending and earnings expectations were adjusted lower. Nonetheless, equities should outperform bonds in 2011.

The recent improvement in the economy will help consumer confidence to improve. Household debt has declined by over $1 trillion in the past two years and the savings rate is now over 6%. This translates into more spending power for the consumer which bodes well for equity prices. Also, with the lowest level of interest rates in history, the cost of borrowing has never been lower. And, by most measures the rate of inflation has never been lower. At the same time, company balance sheets have never been stronger. When we look at the market in light of this tailwind, we believe the opportunity for earnings growth is real.

While improvements in operating margins have been strong over the past two years, prospects for increasing revenue growth have not been readily apparent given reduced demand and restricted access to credit. We expect excess cash will be used to support stock buy back programs at the same time merger and acquisition activity picks up next year. Both will prove to be strong catalysts for the equity market. In addition, private equity should be active in bidding for companies which will help support current valuations.

Given the momentum in the economy, we expect companies to increase investment capital in their business which includes adding employees. Ultimately, increased headcount and rising raw material costs will put a slight negative pressure on operating margins this year.

In addition, fund flows from individual investors and hedge funds from bond funds to equity funds will add further support to the equity market. Yet, given the back drop of slower economic growth, we are inclined to selectively reallocate away from equities as the opportunity to harvest gains presents itself. We are looking at opportunities for investment in the healthcare, technology and energy sectors. In particular, the evolution of technology in the consumer space, and the convergence in wireless and broadband will help drive new products over the next several years.

Fixed Income Credit Market - Investment Grade While muted economic growth will help place a ceiling on how high rates will move, we believe the bias is toward higher interest rates and the 30-year bull market in bonds has come to its end.

Following a great year in 2009 in the bond markets, investors were rewarded again in 2010 as interest rates declined and credit spreads tightened. The total return of the Barclay’s Aggregate Index of 6.54% for the year was largely driven by the Fed’s orchestrated move toward lower interest rates and the improved health of the credit markets. While muted economic growth will help place a ceiling on how high rates will move, we believe the bias is toward higher interest rates and the 30-year bull market in bonds has come to its end.

Our themes for fixed income investing over the next year include a bias toward rising interest rates, a continuing compression in credit spreads and a growing concern of higher event risk which could negatively impact credit quality.

The first quantitative easing program orchestrated by the Fed resulted in the purchase of $1.2 trillion in securities and brought interest rates to their lowest levels in history. As a result of the Fed’s second quantitative easing program announced last quarter, the yield curve steepened significantly coming into the year end. The spread between the 2 year and 30 year Treasury reached 390 basis points reflecting the Fed’s desire to purchase securities with shorter maturities.

We expect to see continued improvement in the credit characteristics in the bank, finance and insurance sectors. In the wake of the Dodd-Frank Act and the Basel III accord, higher mandated capital levels will bode well for fixed income investors. In addition, the overall improvement in the financial markets resulted in the improvement in the portfolios of banks and insurance companies. We are seeing fewer writedowns and better capital ratios.

Economy

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Fixed Income

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However, we have a growing concern with event risk in the fixed income credit market. With corporations sitting on huge cash balances, interest rates still low and credit spreads tight, there is an environment for increased mergers & acquisitions which may be negative for credit quality.

Corporate net new issuance should come in near $650 billion for 2010 according to data from Barclays Capital. This is just behind the record net new issuance of $700 billion reached in 2009. Lower interest rates and tighter spreads allowed those companies that could access the public credit markets to borrow at extremely low rates, helping to lower their overall cost of capital. Ironically, this is in contrast to smaller companies that rely on other sources of capital including banks and private lenders where liquidity and credit is scarce.

Also, we generally like the prospects in the Natural Gas, Energy and Oil sectors. We believe the cable, media and telecom sectors are less attractive given the saturation level and lack of pricing power and tight credit spreads.

Fixed Income Credit Market - High YieldThe lush liquidity in the capital markets has been a huge benefit to high yield investors this past year. The Barclays High Yield Index returned 15.12% for investors last year. Given strong earnings growth, a continued decline in default rates and the access to credit afforded by the high yield market, we are cautiously optimistic with high yield for 2011. However, with the high average dollar price of most issuers, we are managing to expected returns that are more in the range of 5% to 6%, rather than the previous year’s double digit returns.

We expect ratings migration to be improving with net upgrades higher the downgrades through the year. High yield issuers including Ford Motor Credit and International Lease Finance have the potential to be upgraded into investment grade over the next 12 to 18 months. These opportunities have the potential to provide investors with some excess return in a low interest rate environment.

Last year saw a record issuance of high yield deals and the trend that causes us discomfort has been toward weaker covenants than in the past. Several companies held by private equity firms that were unable to access the IPO market instead releveraged their balance sheet and issued debt in the high yield market. HCA, one of the nation’s largest hospital operators, raised $1.5 billion in junk bond sales and upstreamed a $2.0 billion dividend to its investors which include KKR and Bain Capital.

Fixed Income - Municipal Bonds The municipal market totals over $3.0 trillion and is one of the most diverse and complex group of securities. Municipal bonds can be taxable or tax-exempt, backed by revenues or taxes, enhanced by guarantees or insurance, and issued in so many forms that it takes a skilled analyst to read through hundreds of pages of disclosure to understand. While the vast majority of municipal bonds are very safe, many municipal bonds were issued under bad advice and with poor fiscal discipline. And, it is these municipal bonds in particular that will receive the attention and risk disrupting the entire municipal bond market.

The investment theme for 2011 is the continued deterioration in the credit quality of municipalities across the United States. The higher profile problems are states like California and Illinois that simply can’t balance their budgets. California now spends 80 cents of every dollar collected to pay compensation and benefits for its state employees. To pay its bills and meet budgets in the past, California has borrowed money. The state is now saddled with $550 billion in retirement debt alone. As investors require a higher rate to compensate for the higher risk, the states borrowing costs continue to rise. The cost of servicing the debt has increased 15% annually over the past decade. We expect that a federal bailout of California, Illinois and other troubled states will be a topic for this next Congress.

The unfunded pension liabilities are one of the cancers eating away at the credit worthiness of municipalities. As the costs to support the benefits promised to retirees have escalated, the underlying investments have underperformed. The result is a growing problem with the unfunded pension liabilities. And, while unfunded pension liabilities do not show up directly as debt on the financial statements of the municipality, that is effectively what they are. The Pew Foundation estimates the unfunded pension liabilities total over $1 trillion which represents one-third the size of the entire municipal bond market.

Historically, housing and healthcare projects run the highest risk of default in the municipal market. In a study by Moody’s rating service, of 54 municipal defaults from 1970 to 2009, 78% were in stand-alone housing or healthcare projects. Last year, Menasha, Wisconsin steam plant, Buena Vista, Virginia municipal golf course and Harrisburg, Pennsylvania incinerator project were among the municipal bonds that were either in default or on the verge of defaulting. We expect an increase in the restructuring of this type of municipal bond in 2011.

But, we recommend you not be too quick to “throw the baby out with the bath water.” Not, all municipalities are deteriorating under the weight of declining tax revenues and over extended spending.


Disclaimer

This report is published solely for informational purposes and is not to be construed as specific tax, legal, or investment advice. Nor is this document intended as a solicitation or an offer to buy or sell securities or related financial instruments. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. The comments are based on current market conditions. Different market conditions and assumptions could have materially different results. Neither Winthrop Capital Management nor any of its affiliates, directors, employees or agents accepts any liability for any loss or damage arising out of the use of all or any part of this report.

Winthrop Capital Management does not own securities of General Motors or Chrysler for its own accounts or the accounts managed for its clients. Winthrop Capital Management does own securities of HCA, Ford Motor Credit, International Lease Finance, AIG, and Citigroup for its own account or the accounts of its clients.

© Copyright Winthrop Capital Management 2011

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