iron harbor us economic outlook_march 2012
TRANSCRIPT
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View from the HarborUS Economic Outlook
March 2012
Portfolio: Based on our interpretation of
the fundamental trends in the US economy,
we have been assuming an aggressive risk
profile which favors a healthy exposure to
equities relative to bonds. At present, we
think that relatively modest equityvaluations are bounded to the downside by
steady earnings growth, improving
confidence, and easing credit standards.
More broadly, the current negative real US
rate regime should drive capital into higher-
yielding assets.
Economy: Although the last six quarters
have been a little bumpy, underlying
momentum suggests that the US has
regained its footing and is making
meaningful progress in its recovery. We
believe that the US economy is securely in
the middle of the Early Upswing, and will
likely remain in this phase through the first
half of 2013. We are very optimistic on US
prospects as the economy progresses
through the business cycle.
Housing: We are fairly confident that the
worst is over for the US housing market andbelieve conditions for a recovery are
decidedly favorable. The facts clearly reveal
that the elements necessary for a
sustainable recovery in housing are coming
together. The balance of risks to housing in
such an environment is firmly to the upside
and few in the market are paying attention
to what we believe to be a paradigm shift.
avelle Pierre, CFA
is Nicholson, [email protected]
ti Thapar, PhD
queline Hayot
Yun
ww.iharborcap.com
Sales price-to-rent near long term
averages
The US Economy: All Systems Go!
10
15
20
25
1988 1993 1998 2003 2008
Asking Sales Price to Asking Rent
Average since 1988
20
40
60
80
100
120
Jan-06 Jan-08 Jan-10 Jan-12
Conf. Board Consumer Confiden
UMich Sentiment
Strong gains in confidence will
support growth
Source: Conference Board, Reuters/University of Michigan
Index Value
Source: US Census Bureau, Our Calculations
Ratio
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In the last ten years, investors have been
burned during the equity busts of 2001-2002
and 2008-2011 and have faced an environment
of sagging confidence and loss of dollar
primacy. It is perhaps natural for the global
investor to give pause at the idea of now
charging into dollar assets. This back-testedattitude, however, misses a few key
fundamentals of the US economy that are now
coming into focus. First, the US economy is
clearly the most balanced and growth-friendly
large developed-market economy. At a
reasonable valuation, this alone demands a
notable allocation.
Second, growth in the US has little
dependence on international trade in
comparison to other developed markets. In a
weaker European and Chinese economic
scenario, it is still realistic for US growth to
remain firm if the domestic economy is in a
favorable place. The converse is strictly not
true. The US shows notable strength in
innovation, connectedness to the global
markets via the English language and
immigration, and more favorable demographic
trends than other developed markets. For an
investor seeking long-term performance with adegree of prudence, we suggest a near-term
orientation to China-neutral Asian markets,
select value-based purchases elsewhere
around the globe, and a US equities core.
As we go deeper into US economic
fundamentals herein, the case for core US
exposure will become clear.
Iron Harbor, March 2012
The US Economy: All Systems Go!
…the US economy is clearly the most balanced and growth- friendly, large, developed-market economy
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Underlying the global economic system are the
collective decisions by market participants to
put capital at risk in search of return, or to hold
back. The sum of these decisions, and the
supply and demand balance that results,
normally produces a seven- to ten-year global
business/investment cycle that can becharacterized in distinct phases which inform
price movements in different asset classes.
Where we are in the cycle. Our analytical
framework is based on five distinct phases of
the business cycle1:
Although the last six quarters have been a little
bumpy, and at times the economy’s
progression through the business cycle
appeared to have stalled, underlying
momentum suggests that the US has regained
its footing and is again making meaningful
progress in its recovery.
We believe that the US economy is securely in
the middle of the Early Upswing, and will likely
remain in this phase through the first half of
2013. While this phase can be thought of as a
sweet spot because of low interest rates and
excess production capacity – i.e., activity can
be robust without the threat of higher inflation –
growth typically continues on firm footing
throughout the Late Upswing. We are thus
very optimistic on US prospects over the next
several years.
Initial Recovery
Early Upswing
Late Upswing
Slowdown
Recession
Tracking the Global Business Cycle
1. As set forth by John L. Maginn, et al., Managing Investment Portfolios (New York: CFA Institute, 2007).
Early Upswing
Increasing confidence
Increasing household spending
Inventory builds
Falling unemployment rates
Short-term rates increase
Late Upswing
Confidence is high
Unemployment is low
Inflation pick-up, wages accelerate
Rapid economic growth
Restrictive monetary policy
Exhibit 1: Phases of the business cycle
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The biggest known-unknown and the
primary risk to this outlook is the lingering
impact of the credit bust which introduces
unique factors to consider. On the upside,
the easing of credit underwriting standards by
banks, which we discuss below, is likely to
provide a very meaningful boost to theeconomy. Conversely, banks’ exposure to
commercial real estate loans is a source of
ongoing downside risk. Beyond the impact of
the credit cycle, there are other areas worthy of
close attention. We are keeping a close eye on
key input costs, which can undermine profits
and confidence. Gas prices, in particular, are
up 14% since the beginning of 2012 (Exhibit 2).
The role of commodities as a store of value
also bears consideration. Conservative
investors facing inflation-adjusted negative
yields seem to be rotating from debt
instruments to commodities. This could be a
factor driving inflation and in turn, pressing the
need for higher rates as the economy
progresses through the Early Upswing phase.
Although no two business cycles are the same,
the one outstanding difference between the
present cycle and every other post-WWII cycle
is the presence of an ongoing drag on final
demand due to credit cycle deleveraging.
From 1995 to 2007, the combination of low
concerns about financial distress, optimistic
future income expectations, and financial
deregulation, prompted US households to
leverage their balance sheets by assuming
increasing levels of debt. According to the
Federal Reserve, during that period the
financial obligations ratio rose from nearly 17%
to almost 19% per cent of disposable personal
Moving Past the Credit Bust
1.00
1.50
2.00
2.50
3.00
3.50
4.00
4.50
Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
AAA Reg. Gas/Gallon
Exhibit 2: Gas prices making anunwelcome comeback
…the easing of credit underwriting standards by banks …is likely to provide a very meaningful boost to the economy
Source: AAA
$ per gallon
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income. Since 2007 we have seen the
reverse: households have cut back on credit
and de-levered as financial distress concerns
increased and pessimism regarding future
income expectations increased. Over the
course of the recession and recovery, the
financial obligations ratio dropped to nearly
16% by 3Q2011—the lowest level since 1993
(Exhibit 3/4). At the same time, banks both
reduced the supply and increased the cost of
lending. These factors amplified the severity of
the
deleveraging cycle and are the primary
reasons the present recovery-expansion
process has been so lethargic. Of course,
everyone already knows this.
What many market participants have not yet
considered is the credit-cycle recovery and its
impact on how quickly the US economy moves
through the business cycle. The key to a
sustainable recovery in credit is dependent
upon households’ perceptions of their debt
levels and expectations of future income as
well as the health of the banking system. That
the academic literature is somewhat divided on
which factor plays the leading role in credit-
driven household demand is almost irrelevant
since both household debt levels and income
are improving. In the past four years,
households have made significant progress in
reducing debt levels, and low interest rates
15
16
17
18
19
20
Mar-80 Mar-85 Mar-90 Mar-95 Mar-00 Mar-05 Mar-10
Financial Obligations as % Disp. Pers. Inc.
Exhibit 3: Households make progress onbalance sheets
1%
2%
3%
Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
Int. Pymnts % of Disp. Inc.
Exhibit 4: Households interest paymentsare also at decade lows
Source: Federal Reserve
Percent
Source: BEA, Our Calculations
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have reduced the cost of servicing household
debt.
At the same time, the housing market,
employment growth, wage and salary earnings,
and consumer confidence have each stabilized
and in some cases are showing modest
improvement. In this context, we believe that
the balance of risks is to the upside for each
the US economy, US asset markets (except for
Treasuries), and the US dollar in the near and
medium term. The storm is dissipating.
We are fairly confident that the worst is overfor the US housing market and we believe
conditions for a recovery are decidedly
favorable. Household formation has bottomed
out and is again rising at the same time that
starts and permits have stabilized. The ratio of
median US sales-to-rent prices is back near
the 20-year average and vacancy rates, while
at historically high levels, are beginning to
move lower. Foreclosure and delinquency data
looks favorable, but there can be meaningful
differences between states which are not
reflected in the headline numbers. Another
indicator that we have closely monitored is the
rate spread between jumbo and conforming
mortgage loans. This spread suggests that
private financing channels are now healthier
than at any point during the past five years.
We remain excited about the trend in
construction jobs growth which has now been
positive for five consecutive months and is near
its best year-on-year growth rate since October
2006! Residential construction job growth, in
particular, is making remarkable progress andis one more reminder that that this sector of the
economy has not been permanently impaired.
This growth gives us more confidence that
demand is again picking up and soon will be
more fully reflected in new residential
construction figures.
As we mentioned earlier, commercial real
estate (CRE) will likely continue to be a source
of broad uncertainty going forward. Anecdotal
evidence suggests that banks are being
somewhat more aggressive in writing down the
carrying value of CRE assets. Moreover,
delinquency rates have moved steadily lower
Housing: On the Mend
…the balance of risks is to the upside for each the US economy,US asset markets (except for Treasuries), and the US dollar in
the near and medium term
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Figure 1. Housing: On the Mend
-20%
-15%
-10%
-5%
0%
5%
10%
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
NFP Construction % YoY SA (LHS)
0%
1%
2%
3%
4%
5%
1970 1975 1980 1985 1990 1995 2000 2005 2010
Total Households % YoY
Avg % YoY since 1990
Avg % YoY 1965-1985
10
12
14
16
18
20
22
24
26
1988 1993 1998 2003 2008
Asking Sales Price to Asking Rent
Average since 1988
0
1
2
3
Jan-00 Jan-03 Jan-06 Jan-09 Jan-12
Jumbo/Conforming Spread
Household formation rebounding from multi-decade low could create stepwise change in housing activity…
…at the same time that sales price to rents are near
the 20-year average.
Construction jobs growth is making steady progress and suggests demand is again picking up.
Private financing channels are now healthier than at anpoint during the past five years.
Source: Census Bureau
Percent
Source: Census Bureau
Ratio
Source: BLS Source: Banxquote
Percent
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for the past twelve months and vacancy rates
have shown modest improvement though they
remain near historically high levels. This
recent data has been encouraging, but risks
still remain.
Finally, we are cautiously optimistic that there
will be a policy-driven boost to the recovery as
policymakers have communicated a renewed
interest in providing assistance to underwater
homeowners through loan modification and
principal reduction. There is, perhaps, ongoing
risk for home prices in the near term as
illustrated by the December S&P/Case-Shiller
data. Beyond the near term, however, the facts
clearly reveal that the elements necessary for a
sustainable recovery in housing are coming
together. The balance of risks to housing in
such an environment is firmly to the upside and
few in the market are paying attention to what
we believe to be a paradigm shift.
In the context of the ongoing recovery, we are
devoting some time to developing a better
understanding of what will be the “new
equilibrium” in housing. From 1970-2000, US
residential fixed investment benefited from
relatively high household formation led by thebaby-boomers. By 2000, the boomer effect on
household formation and home purchases was
winding down and the data is quite startling.
From 1970-2000, household formation was
increasing 1.7% a year (Exhibit 6). Since
2000, household formation has been running at
1.1%; approximately two-thirds the growth rate
of the earlier period!
Source: Federal Reserve, CB Richard Ellis
Percent Percent
6
8
10
12
14
16
18
0
2
4
6
8
10
Mar-00 Mar-04 Mar-08 Mar-12
CRE Delinq. Rate (LHS)
US Office Vacancy Rate (RHS)
…the facts clearly reveal that the elements necessary for a sustainable recovery in housing are coming together
Exhibit 5: Keep a close eye on CRE loans
1947 -
Present
1947 -
1970
1971-
2000
2000 -
Present
Household
Growth YoY 1.75% 2.13% 1.69% 1.12%
Exhibit 6: Household growth slowing
Source: US Census Bureau, Our Calculations
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Although the dramatic decline in household
formation had been fundamentally changing
housing’s role in the US economy, the collapse
certainly accelerated this change. Again
looking at the period 1970-2000, residential
fixed investment and the large array of housing
services comprised, on average, 18.4% of real
GDP. Since the housing bust, that contribution
has been 15%; housing is unlikely to be aspowerful a force in our economy as it had been
previously. Nevertheless, we expect a
meaningful uptick in household formation as
the economy progresses through the business
cycle. A resulting stepwise change in housing
activity could quickly create a virtuous cycle of
wealth-effect induced consumer spending,
business optimism and investment, asset price
increases, and wage growth.
Payrolls Steadily Coming Back. The latest
US employment numbers are solid, even
beyond the oft-cited non-farm payrolls and
weekly unemployment claims. First, state and
local government payrolls are declining at
much slower rates and are much less of a drag
on headline numbers. Second, both weekly
hours and real wage growth are advancing
convincingly. Third, job openings and temp
payrolls are showing steady progress. To be
sure, there are a few data series that require
careful attention such as the number of “part-
time workers for economic reasons” and “jobs
hard to get”; neither of which have shown really
meaningful progress. Over the next several
months, it is possible that the recent trend in
payroll expansion may slow a bit, but the
overall pick-up in the labor market is a deepenough story to make us fairly confident
regarding the likely trend over the upcoming
quarters. The primary beneficiaries of the labor
market pick-up will be personal income and
confidence.
What the Numbers Reveal
A resulting stepwise change in
housing activity could quickly create a virtuous cycle of …consumer spending, business optimism and investment …and wage growth.
…the overall pick-up in the labor market is a deep-enough story to make us fairly confident regarding the likely trend over the upcoming quarters
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Figure 2. Payrolls Advance Convincingly
Growth in aggregate hours underlines US payroll trends…
…and the government sector is much less of a drag
in recent data.
Temp help payrolls trending lower at same time payroll expansion continues means that…
…companies are hiring. This is for real!
Source: BLS
Percent
Source: BLS
Ratio
Source: BLS
Percent
Source: BLS
Percent
90
92
94
96
98
100
102
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Index Total Aggregate Hours % Chng YoY (LHS)
Index Total Aggregate Hours (RHS)
Index Value
-6%
-4%
-2%
0%
2%
4%
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
NFP Total Government % YoY SA
Total Payrolls % YoY
-30%
-20%
-10%
0%
10%
20%
30%
-6%
-4%
-2%
0%
2%
4%
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
Payrolls % YoY
Temporary Hires % YoY -60%
-40%
-20%
0%
20%
40%
2000
3000
4000
5000
Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12
Job Openings (LHS)
Job Openings % YoY Chng (RHS)
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Understanding income trends. A data series
we closely track is personal income published
by the Bureau of Economic Analysis. In order
to have a better understanding of the
consumer-centric US economy, it is important
to first understand what is going on with
income because it drives confidence and
consumption. As we have noted previously,
real disposable personal income growth has
been collapsing: year-on-year growth was
negative for most of 2H2011. There is no way
around that data point; it is bad from every
angle. Yet, there is something going on with
personal income that portends good things for
consumption. A deeper dive into the BEA data
reveals that the main contributor to the collapse
in disposable personal income has beenshrinking government transfers to individuals.
Everyone knows that the government gravy
train is drying up. What most observers have
not considered is that the main reason
disposable personal income has been recently
negative is because government transfers to
individuals have declined faster than wage and
salary growth has increased. The good news
is that wage and salary growth has solid
momentum and is increasing at its fastest pace
since last April. If job growth broadens as we
expect, disposable income should also begin
again to move higher. So, it is not enough to
simply look at disposable personal income and
note that it has been negative; the real story is
that wages and salaries have been rapidly
expanding and that jobs growth is the key to
the ignition. Households are already
communicating this sentiment.
-4%
0%
4%
8%
12%
16%
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Gov't Transfers % YoY (LHS)
33.7
33.9
34.1
34.3
34.5
34.7
-8%
-6%
-4%
-2%
0%
2%
4%
6%
Jan-08 Jan-09 Jan-10 Jan-11 Jan-12
Real Wage Growth YoY (LHS)
Avg Weekly Hours (RHS)
Exhibit 7: Government gravy train isdrying up…
Exhibit 8: …but wage growth will soon
kick-in.
Source: BEA, Our Calculations
Source: BEA, BLS
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Confidence: “10% hard work and 90%
delusion”. US households are more confident
now than they have been at any point over the
past twelve months. Prior to the recent pick-up
in jobs numbers, wage and salary growth, and
the stunning rally in US equities over the past
three months, we believed that there was a risk
of a false bottom and households were
deluding themselves. We now believe that the
improvement in confidence has legs and is
communicating a significant turn in household
sentiment that could ignite the virtuous cycle of
greater demand – jobs growth – wage
expansion – greater demand.
As one would expect during the Early Upswing
stage of the cycle, confidence is steadily
increasing and consumers are borrowing and
spending more. Data from both
Reuters/University of Michigan and the
Conference Board confirms the general trend
in confidence. Moreover, both surveys show
expectations to be improving relative to present
conditions. While we appreciate the fickle
nature of households and consumers, they are
better positioned now than at any point in the
last four years to unleash a torrent of pent-up
demand into the US economy. Better sentiment
combined with a continued expansion in
consumer lending by US commercial banks
could be the catalyst for a powerful andenduring expansion. Very few market
observers are considering the inflationary
consequences of such an expansion.
20
40
60
80
100
120
Jan-06 Jan-08 Jan-10 Jan-12
Conf. Board Consumer Confidence
UMich Sentiment
…[households] are better positioned now than at any point in the last four years to unleash a torrent of pent-up
demand into the US economy
Exhibit 9: Households are feeling good
Source: Conference Board, Reuters/University of Michigan
Index Value
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Inflation Concerns. Inflation expectations as
measured by both the Cleveland Fed and the
University of Michigan remain at multi-year
lows and are little changed since 4Q2011.
Nonetheless, there is trouble in the form of
core CPI brewing in this economy which
expectations do not yet capture. Core CPI has
been trending higher for the past 15 months
and is now at 2.3%. The rise in core inflation
should make it increasingly difficult for the
FOMC to justify its current interest rate outlook
given its 2.0% inflation target. Of course, it is
always possible that the recent trend in core
either reverses or moderates over the next
several months. This, however, is an unlikely
scenario because the largest component of
core inflation is owners’ equivalent rent, the
rent paid to oneself as an owner-occupant. It
has also been steadily rising and is now at
seventeen-month highs. The law of supply and
demand will eventually drive lower rental prices
and owners’ expectations of for what their
home would rent as additional rental capacity
comes on line. New construction, however,
takes time. This makes it extremely unlikely
that core inflation will magically start to
moderate within the next few quarters.
1%
2%
3%
Jan-06 Jan-08 Jan-10 Jan-12
Cleveland Fed 5yr Expex
Cleveland Fed 10yr Expex
-1%
0%
1%
2%
3%
4%
5%
Jan-06 Jan-08 Jan-10 Jan-12
Core CPI
Owners Equivalent Rent % YoY NSA
Exhibit 10: Expectations do not capturethe risk of inflation
Exhibit 11: Core is unlikely to quicklymoderate
Source: Federal Reserve Bank of Cleveland Source: BLS
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Beyond the immediate signs of actual inflation,and perhaps more important, is the fact that
conditions exist for inflation to make a
substantial return. First, manufacturing
capacity (78.6) is now at 96% of its 2007 levels
and again very close to its forty-year average
of 80.4. There is much less slack in this
economy in 2012 and any unanticipatedincrease in demand from improved consumer
confidence, jobs growth, and income growth
could ignite price pressures. Second, the
Chicago Fed National Activity Indicator
(CFNAI), which provides a useful gauge on
future and current economic activity andinflation, suggests that US growth is again
modestly above trend. The CFNAI three-
month moving average is at its best level in
twelve months. Finally, we are keeping tabs on
the relationship between M2 and the velocity of
money in the US economy; we believe this will
likely be the single most important factor inforecasting the speed at which the US
economy progresses through the business
cycle.
0
1
2
3
4
60
65
70
75
80
85
Mar-00 Mar-03 Mar-06 Mar-09 Mar-12
Cap. Util. Qtrly SA (LHS)
Avg. Cap. Util. (LHS)
Core CPI (RHS)
-5
-4
-3
-2
-1
0
1
Jan-00 Jan-03 Jan-06 Jan-09 Jan-12
Chicago Fed NAI 3mma
Exhibit 12: Activity indicators illustratebroad momentum…
Exhibit 13: …which is captured in capacity data.
Source: Federal Reserve Bank of Chicago
Index Value Index Value Percent
Source: Federal Reserve, BLS
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Most market observers are aware that M2
has been expanding at its fastest pace in
more than twenty five years, courtesy of the
Fed. The exponential growth in M2 is believed
by many to have the potential to drive inflation
beyond the control of the Fed. What this logic
has so far failed to capture is the M2 growth isonly half of the story.1 The other critical factor
to consider is the velocity of money through the
economy. Two tangible determinants of
velocity are bank credit standards and loan
growth. To use an example, credit standards
and loan growth act as a dam that regulates
the huge reservoir of M2. Over the past
several years, the Fed has injected a massive
supply of money into the US economy, but US
bank lending standards have been exceedingly
tight; the banks were damming up the supply of
M2 and preventing it from entering into the US
economy. The velocity of money in the
economy depends upon the speed with which,
and the degree to which, banks ease credit
standards—similar to a dam gate release.
There is a huge reservoir of money supplywaiting to be released and banks’ willingness
to lend will determine how fast that supply hits
the economy.
Bank Standards Easing. We monitor the
Senior Loan Officer Survey as a means of
gauging credit availability and demand. Of
particular interest to us are credit standards
and demand for mortgage loans and consumer
loans. The trends in credit standards and
demand for mortgage loans, as one would
expect, have been steadily improving. The
percentage of banks indicating easing as
opposed to tightening standards for prime
loans is more favorable than any time in the
past two years.
M2 Supply is Only Half the Story
1. In fact, the Conference Board recently replaced M2 as a leading indicator noting the difference between the observed relationshipbetween real M2 and general economic conditions.
2. Banks’ reluctance to lend is one of the reasons that Treasuries outperformed equities in 2011. Banks parked QE1 & QE2 related
money supply back into bonds instead of increasing lending.
…[the] exponential growth in M2 …is only half the story. The other critical factor to consider is the velocity of
money through the economy.
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Figure 3. Money Supply and Bank Balance Sheets
The increase in money supply following QE1 and QE2 was previously held on US Bank balance sheets…
…and is now being released in the form of
consumer loans….
Source: Federal Reserve Source: Federal Reserve, Our Calculations1
Source: Federal Reserve, Our Calculations
0%
3%
6%
9%
12%
10%
15%
20%
25%
30%
Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11
Treasuries & Cash as % Total Assets (LHS)
M2 % YoY (RHS)
-20%
-10%
0%
10%
20%
30%
Jan-06 Jan-08 Jan-10 Jan-12
C&I Loans % YoY
Consumer Loans % YoY (adj.)
PRIME Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 Oct-11 Jan-12
Tightened
considerably 1.9 1.9 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Tightened somewhat 15.1 9.4 3.6 13.0 3.7 3.8 5.7 4.2 0.0
Unchanged 79.2 79.2 87.3 83.3 94.4 92.5 86.8 91.7 94.3
Eased somewhat 3.8 9.4 9.1 3.7 1.9 3.8 7.5 4.2 5.7
Eased considerably 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Eased - Tightened -11.3 0.0 5.5 -9.3 -1.8 0.0 1.8 0.0 5.7
…as lending standards begin to ease.
1. In 1Q2010, FASB Rules 166 & 167 changed how banks treated off-balance sheet special purpose vehicles (SPVs). In March, 2010,banks began to bring these SPVs back on to balance sheets and consumer loans recognized as assets on balance sheets ballooned.
Our adjustment for this increase affects year-on-year growth from March 2010 – March 2011.
Credit standards for approving applications from individuals for prime mortgage loans
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On the consumer lending side, the surveys
indicate softer demand among somewhat
easier standards. The takeaway is that banks
are loosening lending standards. If US activity
continues to gain momentum, as we expect, a
gate release of M2 by the banks could send the
US economy quickly into overdrive and force
the Fed to increase policy rates well before the
end of 2014.
Based on our interpretation of the
fundamental trends in the US economy, we
have been assuming an aggressive risk
profile which favors a healthy exposure to
US equities relative to bonds. In upcoming
weeks, we will more fully discuss the factors
driving these allocation decisions. While our
investment process is firmly rooted in
fundamental analysis, we do pay attention to
valuations. At present, we think that relativelymodest equity valuations are bounded to the
downside by steady earnings growth,
improving household and business confidence,
and easing credit standards. More broadly, the
current negative real US rate regime should
drive capital into
higher-yielding assets. Thus, while absolute
valuations are reasonable, relative valuations
compared to bonds are even more reasonable.
As we have seen over the last few months,
investors have been well-compensated for
going into cheap US equities in advance of
clearer positive economic data. Nonetheless,
the US equities trade has now been de-risked,
and while valuations are a bit less compelling
on an absolute basis, they are highly
compelling versus interest-rate instruments. In
addition, risk hedging instruments like VIX
futures and put options are now priced for low
volatility, which creates a unique opportunity to
construct long-term return portfolios with
dampened downside volatility profiles. For allof the reasons stated above, we believe
skepticism about the US economy and equities
are unwarranted, and we recommend fairly
aggressive positioning on this theme even in
fairly conservative portfolios.
Conclusion and Valuation
Note
…we believe skepticism on the US economy and equities are unwarranted, and we recommend fairly aggressive positioning on this theme …
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Iron Harbor Forecasts
Note: * represents forecasted values.
Gravelle Pierre, CFA is the Founder and Chief Portfolio Manager of Iron Harbor.
Chris Nicholson, CFA is the Senior Portfolio Strategist of Iron Harbor
Aditi Thapar, PhD is a Clinical Assistant Professor of Economics at New York University.
Her research focus is on Macroeconomics, Monetary Economics and Applied
Econometrics. Her most recent research paper, “Using Private Forecasts to Estimate the
Effects of Monetary Policy”, was published in the Journal of Monetary Economics, 2008.
She serves as Head of Global Economics of Iron Harbor.
Jacqueline Hayot is the Chief Operating Officer of Iron Harbor.
2011 2012
Q3 Q4 Q1* Q2* Q3* Q4*
Real GDP 1.8 2.8 3.0 2.9 2.9 2.7
Core Inflation 2.5 1.9 2.3 2.3 2.4 2.4
Federal Funds
Rate 0.1 0.1 0.1 0.1 0.1 0.2
Unemployment 9.1 8.7 8.4 8.3 8.2 7.9