Capital Markets Committee Q&A

July 2, 2010

David Joy — Chief Market Strategist, Columbia Management

Capital Markets Committee Q&A

David Joy is Chief Market Strategist at Columbia Management and serves as Chairman of the Capital Markets Committee, a group of investment professionals at Columbia Management that meets quarterly to discuss emerging themes and opportunities. The most recent meeting was held Tuesday, June 29, 2010. The following Q&A with David Joy provides readers with a summary of the discussion:

Q:   There was a lot of discussion around the uncertainty of the global recovery. Is the committee concerned that the recovery is in jeopardy? How likely is a double-dip recession?

A:    There are certainly questions about the pace of the global recovery. The primary concern centers on Europe. Sovereign debt worries and stress in the banking system suggest that growth in the European Union will be tepid at best. In addition, the imposition of austerity measures throughout the E.U. is also likely to dampen growth further.

China is also slowing. Government efforts to reduce the pace of growth from 12 percent year-over-year in the first quarter have resulted in a moderation in construction and manufacturing activity recently. And in the U.S., first-quarter gross domestic product (GDP) was revised lower, to 2.7 percent, and it seems clear that the second quarter was not as robust as hoped, as both housing and employment remain weak.

However, the chances of a double-dip recession seem remote. In the U.S., although the recovery is still narrow and fragile, industrial production is strong, jobs are being created in the private sector and personal income is growing. We anticipate that the U.S. will expand at roughly a 3.0 percent pace over the second half of 2010. In the E.U., growth is likely to be in a range of 1.0 to 1.5 percent. A possible catalyst for improved credit availability and rising confidence in the E.U. is the expected release of bank stress test results later this month. This proved to be a catalyst in the U.S. in the spring of 2009. And, while China is slowing, it is an engineered slowdown and is likely to result in a growth rate in a range of 9 to 10 percent, making it more sustainable and less inflationary. So, while there are a number of questions about the pace of the global recovery, and it remains somewhat fragile and subpar, it does appear to be sustainable.

Q:   How realistic are the G-20's deficit-cutting targets?

A:    At the recent G-20 summit in Toronto, world leaders agreed to cut their budget deficits in half by 2013. For some, this is possible. But, for others, it is unrealistic and may be counterproductive.

The U.S. approached the summit with a cautionary warning about the risks of reducing fiscal stimulus too quickly and derailing the still fragile recovery. Others, including Germany, the United Kingdom and Japan have taken the view that a decisive reduction in budget deficits is the fastest path to a restoration of confidence and recovery. The G-20 pledged to pursue "growth-friendly fiscal consolidation plans," suggesting that the U.S. view was generally discarded.

In the U.S., the Congressional Budget Office projects that as a percent of GDP, the deficit will shrink to 3.2 percent in 2013 from 9.2 percent in 2010, well within the pledge. However, this projection also assumes growth in real GDP will average 3.8 percent between 2011 and 2013. The UK deficit is close to 10 percent of GDP, and the recently released budget assumes average GDP growth over the next four years of 2.3 percent. In France, the deficit is 8 percent and in Germany it is 5.5 percent. Whether these deficit reduction targets are achieved will depend largely on the pace of the economic recovery, with no major setbacks.

Q:   What is the potential impact of the European banks stress testing? Will it have the intended effect?

A:    How investors react to the bank stress tests depends both on how strenuous the tests are perceived to be, as well as what they reveal. Assuming that the tests are determined to be sufficiently severe, and that the results are determined to be either comforting or at least manageable, they may well allow for the restoration of confidence in the European banking system. Without the transparency this process could provide, investors remain wary of the system's health and remain skeptical that Europe can avoid anything better than anemic growth, or possibly even a double-dip recession. Banks themselves remain wary of lending to each other, perpetuating the lack of credit extension within the system. The release of stress test results in the U.S. in the spring of 2009 provided a catalyst for the recovery that followed, and could do the same for Europe.

Q:   Is the Federal Reserve truly "out of bullets?"

A:    In his famous "helicopter" speech before the National Economists Club in November 2002, then Federal Reserve Governor Ben Bernanke said, "...a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition." He then went on to outline the various policy options that would remain available to stimulate aggregate demand. They included: liberal availability of the discount window to protect the financial system; the printing of money, or its equivalent, through asset purchases; low interest rate loans to banks with an expanded list of acceptable collateral; committing to keeping short-term rates low for an extended period as a means of reducing longer-term rates; setting specific rate ceilings on securities of varying maturities and enforcing them through open market operations; currency devaluation; and financing tax cuts with money creation. The latter two options would, of course, require coordination with other parts of the government.

While these options were outlined in a hypothetical way at the time of the speech, most should now be quite familiar to Fed watchers.

Q:   What do investors need to know about the financial reform coming out of Washington? How are the markets responding to the changing regulations?

A:    The financial regulatory landscape is changing significantly. But many of the details have yet to be finalized and potential impact on financial service company profitability is still uncertain. The bill was approved by the House on Wednesday, June 30. The Senate has postponed its vote until after the July 4 holiday and there is some nervousness that support could erode in the interim. If passed basically intact, then banks are unlikely to be as profitable as before and some suggest that credit will be less available and more expensive. On the other hand, the bill could have been even more onerous. Regulatory oversight of the entire financial system should be improved and the system should be sounder.

During the second quarter, financial stocks fell 13.6 percent versus a loss of 12.9 percent for the S&P 500 Index. In the week of June 21, bank stocks fell less than the market. For the year, they are actually higher, while the broader market is down.

Q:   Stocks are in the midst of a significant correction. Are valuations becoming more attractive as risk aversion persists?

A:    Equity market valuations are historically attractive. Price /earnings multiples are not the cheapest they have ever been, but they are below long-term averages by most measures. This is true in most geographic regions. Of course, whether this proves to be an indicator of future returns depends on the ability of companies to deliver on the earnings that Wall Street expects. If the economy falters, those earnings expectations could prove to be too optimistic. But corporations have prepared well for the economic slowdown and have good operating leverage that could translate into strong earnings performance, even in a subpar recovery. We find stocks attractive in this environment, and are emphasizing quality companies, with strong balance sheets. We are also attracted to dividend-paying companies, while having reduced our exposure to sectors that are more sensitive to the economic cycle.

Q:   Retail investors continue to direct mutual fund flows toward fixed income. Does the Columbia Management Capital Markets Committee believe that bonds are attractive?

A:    We do not see a lot of value in Treasury yields at current levels. With the two-year Treasury note yielding 0.62 percent and the 10-year note yielding 2.93 it seems that investors have overwhelmingly concluded that the global recovery has taken a turn for the worse and that equity markets are at risk. It has proven to be a wise course of action historically to pay attention to what the bond market is saying. But it seems that the pessimism that has driven yields this low is unwarranted. It is our expectation that the economic recovery persists, albeit at an historically subdued pace. If so, bond investors could be at some risk of loss as this extreme pessimism is unwound and yields rise.

On the other hand, we are finding good value in the corporate bond market, both investment and below investment-grade, where yield spreads to Treasuries have widened recently and yet where credit quality is improving.

Q:   Your forecast at the start of the year was for the S&P 500 to reach 1200 by the end of the year. Does that remain your forecast given the current level uncertainty in the markets?

A:    It does. Although, right now it seems that few others agree.