Client Update – July 15, 2009

Our current view is more cautious than optimistic. Because the drop-off was so severe, there is certainly a likely case for a short-term recovery. However, the unwillingness of lenders to take on even typical risks will throw a road block in front of any potential recovery. So, where does that leave us? Probably with an economic and financial roller coaster for the next several years! A sustained vibrant economic expansion needs free-flowing credit. Until that occurs, the odds favor a sub-par recovery. The massive amount of credit taken on by consumers this decade needs to be unwound at the very time that banks already have too many loans on their books and are in no hurry to boost lending – especially given the rising trend in delinquency rates. The Fed has boosted excess reserves in the banking system, but banks are not using this to increase lending – they would rather hoard the cash and safely make money for themselves and not take the risk of lending it to others.

The initial stock market enthusiasm this Spring seems to be giving way to more realism. Historically, deep recessions are followed by strong recoveries. The thought is that with higher corporate growth rates, both profits and equity prices will rise. However, this financial crisis is far from typical, and we can not safely rely on past cycles to predict how this will turn out. Could stocks surprise on the upside in the coming year? Of course they could! Since there is still a lot of cash on the sidelines, earning virtually nothing, those investors are under the pressure to raise their stock exposure. Further, the economy could rebound more strongly than generally expected. Although these outcomes are all possible, we give them a lower probability and are staying with a strategy that places a higher weight on capital preservation than normal.

The viciousness of this economic and financial meltdown has frayed nerves, and left many investors deeply skeptical about the timing, strength and sustainability of a recovery. These concerns are justified since lurking just over the horizon is the threat of another economic/financial crisis—inflation. We do not believe the government will be able to remove the current extreme stimulus (see chart) in a timely and controlled manner without creating a devaluation of the dollar and consequentially higher inflation. The market dysfunction has, and will continue to create opportunities at the stock- and bond-picking level. This has helped many of our active equity and fixed income managers generate high levels of outperformance during this recent period.

As is often the case, thoughtful, active management is experiencing a period of outperformance. What is encouraging is the evidence that these periods can last several years when following a time of market dysfunction. Data and manager feedback suggests that valuation discrepancies still remain and that it should continue to be a good environment for our management philosophy for some time.

To conclude, the financial nature of this cycle will have lasting repercussions and it will be a difficult climb back to any semblance of normality. The outlook is highly uncertain, and that argues against taking on too much exposure to stocks. Therefore, our preference is to remain focused on the varied opportunities we continue to find in the fixed-income markets around the world. We are working diligently to continue to find great opportunities amongst the markets’ wreckage.

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