The Torch Is Lit

It has been our practice to send out quarterly market updates, but given the anxiety about the economy, we are breaking practice and sending out more regular updates. As a quick aside, our portfolios in July remained relatively neutral showing us that the global economy still has strength even in the midst of a bear market. While there are certainly more surprises hiding in the dark corners of the market, we think we have seen the worse and are now focused on the timing of a recovery, whether it be months or years from now.

Ironically, the quadrennial event that starts this evening provides a useful analogy for our general economic condition. As the world turns its telescopic lens on Beijing for the Olympics, we are given a unique view into China and their economy. At once memorable, starting on auspicious 08.08.08, and controversial, the torch coming in on a tide of protests; the Games are a chance for China to fashion itself a new world image and lay bare its strength and weaknesses.

What China is experiencing economically can be seen as a microcosm of the conditions the global economy is struggling with. Intense inflation has pushed the consumer price index to over 7% in the first half of the year, making it hard for the country’s population to purchase necessities. Pollution, one of the worst in the world, has induced the government to take extreme measures to clear the sky for the Olympics. Half of all cars in Beijing have been ordered off the roads in the weeks leading up to the opening ceremony and rainmaking rockets have been utilized to clear away the smog. All this to no avail-the skies are still heavy with the weight of pollution. Oil supply is a major concern for China as it is for the rest of the world and the Chinese government has resorted to hoarding oil to ensure a steady supply when it takes center stage.

The Games are a source of pride for any host country, for any country sending a delegation for that matter. For the Chinese especially, it is a time to show the world that it has progressed socially, politically, and economically-all areas that would help the global economy as well as their own. We eagerly await the Games of the XXIX Olympiad.

As with the Chinese, the themes of inflation, pollution and energy dominate our thoughts as well. In our quarterly market update, we spoke of how these forces, combined with a housing collapse, came together to create the perfect economic storm. We believe that that storm has raged its worst and is now showing signs of abating.

Housing Market

The first force is the plight of the housing market. We have discussed extensively the short-term causes and long-term effects of the flawed subprime lending practices that has mired the housing market in foreclosures and defaults. The effects of these practices have rippled through the financial industry and have affected institutions that had little to do with the subprime collapse. As these institutions work to correct themselves, there are signs that the housing market is stabilizing, even strengthening in affluent communities. Weaknesses are still evident in developments and low-income housing and will take many years to recover; but, at the very least, the horizon looks a whole lot brighter.

Unfortunately, the two Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac, are the latest casualties of the real estate collapse. While they did not extensively engage in subprime lending (by definition, subprime is a loan that does meet the standards of the two GSEs), the follow-on effects of the subprime collapse have driven up defaults on all types of mortgages. As a result, both GSEs are now projecting enormous losses that could jeopardize their capital base.

Historically, neither GSE has maintained high capital under the belief that the US government can provide emergency backing. That belief is now being tested. Our opinion is that both GSEs will survive intact with the need for a government infusion in the form of common or preferred stock purchases. While the final amount will be minor given the government’s other obligations and the prospect eventual profit from this infusion, it will lead to significant changes in the way they are regulated in the future.

Economic Downturn

The second force is a general economic malaise exasperated by a disastrous deficit, the weakening dollar, and rising inflation. Out-of-control governmental spending for the last eight years has detrimentally slowed our growth and contributed to the decline of the dollar. With a total debt approaching $10 trillion, we have spent our savings for at least a generation. Generating enormous interest costs and driving down the value of the dollar, Americans are paying more and getting less.

The Federal Reserve aggressively cut interest rates seven times since the end of 2007 bringing it down from 5.25% to 2%. But now the Fed is in a quandary. Its primary policymaking tool has not been able to spur the US out of an economic downturn despite the fact that interest rates are at a three-year low. Inflation, however, has risen to 4.1% in the last year, the largest rate in 17 years. Herein lays the problem-interest rates are decreased to stimulate growth, but increased to battle inflation. The Fed is, in essence, immobilized in an economic Catch-22 and hard pressed to choose a solution. Its decision then is to hold steady at 2% with the likelihood that it will not change interest rates if the economy continues as it has.

The Price of Oil

The third force is the omnipresent price of oil. After hitting record highs this summer at $147 per barrel, oil prices have dropped to a three-month low in August at $118. It is still undetermined whether this is merely a short respite or an indicator that oil prices will return to what has been deemed as normal. The hope is that the price of oil will stabilize around this level, but anything short of the sharp rise from the past two years will be a relief.

Alternative energy is painting the town green. Or maybe just a patina of green. Everywhere from politics to even oil companies, green is the catchphrase that lends a sense of conscientious credibility. The push for fuel-mileage regulation is gaining momentum in Congress as the US flounders for a solution to its energy crisis. Perhaps soaring oil prices have finally been able to imprint into our national consciousness the need for sustainable energy. Automakers are already feeling added pressure to meet the demand for more gas-efficient vehicles and Americans are driving on average 4% fewer miles since the onslaught of the oil price increase. Given that Americans account for 11% of global consumption, this is a significant decrease and a sure sign that good consumer behavior can positively affect global oil demand.

Change on the Horizon

The most important change about to occur, and frankly one that we desperately need, is the Presidential administration. As the race moves forth towards the national conventions, economic concerns top the agenda for Barack Obama and John McCain. Neither candidate has an economic platform that truly addresses the situation-all of the economic stimulus packages to date are little more than crowd pleasers. We hope that behind closed doors it is a conversation about changing the shortsighted, destructive policies of the past eight years. We will look for sound, long-term economic policies that emphasize sustainability and global responsibility. While this is an extremely tall order, we are optimistic that any change will help the situation.

To conclude, we have a guarded, yet optimistic outlook for the coming months. We view oil prices and the housing market as the keys to eventual recovery and will closely monitor them. Throughout this entire process, our investment strategy remains the same-careful and adaptive selection of equities and fixed income with an emphasis on cash flow. As the clouds begin to clear, we will stay in regular contact regarding any changes or fluctuations.

As always, feel free to call or email us with your thoughts.

Regards,

David