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AFC Investment Outlook: The Dreaded "R Word"

Dear Clients and friends;
I am not happy to report to you that I believe we are in recession NOW.

This is most likely the first time that you have heard this assertion. That is because a recession is only apparent many months after it begins. However, after analyzing all available information including the negative direction of economic data revisions, reasonable foresight leads me to conclude that we are already in the midst of a recession.

Keep in mind that a typical stock market reaction to a recession will include a 30%, 40% or 50%+ drop in stock prices. However, by ‘seeing the writing on the wall’, AFC has actively managed risk in our portfolios to initially minimize exposure to losses, and subsequently to move to a ‘market neutral’ position.

We are also evaluating potential opportunities to increase returns relative to the desired risk of our clients, even if the market continues its rapid descent.

The worst part of a possible decline now is that we have no support for any of the tools typically used to soften the decline, such as stimulus or FED intervention. Further, we are starting this potential downturn with extremely high unemployment above 9%. This is likely to lead to a deep, prolonged economic decline most closely resembling what was experienced during the Great Depression. The depth of a recession from such a poor financial position is likely to be catastrophic.

We knew that fiscal stimulus, printing money and low interest rates are not sufficient to create a lasting reprieve from the over-leveraged condition that we created through the 2000’s housing and credit boom. Further, deep down we all understand that such an unbalanced balance sheet and budget can only be righted by contracting debt to reasonably match assets, and reduce expenses in a relative range to income. This applies to both US households and to each level of US and State government.

Quite simply, we have not repaired our personal and national balance sheet or income statement. The volatility of stock and debt markets will be high and the likelihood of significant investment declines remains increased until we show individually and collectively that the US can manage its finances prudently.

The recent data has exposed that without the driver of government spending (the end of our stimulus package) and the end of the latest Federal Reserve monetary expansion (QE 1 and 2), our economy is no longer growing. Last week, the Bureau of Economic Analysis (BEA) revised the first quarter 2011 GDP annual growth rate from an initial estimate of 1.9% to 0.4%. Further revisions may push this number lower, or perhaps show contraction. Further, the initial estimate second quarter 2011 GDP has been marked by the BEA at 1.4%. A similar revision to this second quarter estimate would put the GDP growth rate to 0%.

So, what is the math behind this assertion of recession? Let us first review the definition of recession and the drivers of Gross Domestic Product (GDP):

• Recession is generally defined as two consecutive quarters of decline in Gross Domestic Product
• Gross Domestic Product (GDP) is composed of personal Consumption, Government Spending, Investment (business investment and growth) and net Exports (exports-imports).
  • In terms of what drives GDP, personal consumption accounts for 70% of GDP. Of the remaining 30%, government spending is 20%, net investment by businesses account for 13% net exports is a negative -3% of GDP (more imports than exports)

To determine whether GDP is growing (economic expansion) or contracting (recession), let us look at the current state of each aspect of GDP:

• Consumption: US personal income and spending has slowed to a standstill.
  • Personal consumption expenditures decreased -0.2% in June
  • Personal income growth is nearly flat, with average hourly earnings of private-sector production and nonsupervisory employees declining by 1 cent to $19.41 in June
  • Personal saving as a percentage of disposable personal income was 5.4% percent in June, compared with 5.0 percent in May (a good sign for the long term, but a bad sign for the current economy and GDP growth)
• Investment by businesses: Uncertainty and a focus on expense reduction leading to very low levels of business investment.
  • The July 2011 Manufacturing ISM Report On Business showed that the New Orders Index registered 49.2 percent, indicating contraction for the first time since June of 2009
  • July 2011 Non-Manufacturing ISM Report On Business indicated that, “business conditions are flattening out”
• Government Spending: Federal and state governments are shedding employees and cutting spending dramatically, lowering government’s contribution to GDP.
  • Employment in government continued to trend down over the month of June (-39,000). Federal employment declined by 14,000 and state employment dropped by 25,000. Employment in both state government and local government continued to trend down over the month and has been falling since the second half of 2008.
• Exports: The US is a net importer, largely due to our consumption of foreign oil. This portion of our GDP has been and will remain a drag,
  • Lower oil prices and demand may result in an easing of this negative number, but not in sufficient dollars to offset declines in C, I and G.

Considering the state of each of these components of GDP, the likelihood that we are already in recession is very high. This is most certainly not welcome news to those entering this new recession carrying the burden of high debt, an underwater home or insufficient employment income.

As the stock market declines, do not just sit and watch your portfolio decline with it. Investment risk is very high in US equities and is elevated in global international equities. Very few global stock markets, if any, would be able to weather the shock of a US recession at this point

There are excellent investment opportunities offering beneficial risk-adjusted return potential in the US and international bond markets, and through certain alternative investments:

• A continued ‘flight for safety’ buoys US high-credit quality bonds, including government guaranteed pass-throughs, CMOs and municipals
• The opportunities that existed in international, emerging country corporate and sovereign bonds before the recent stock market declines have remained intact. We continue to recommend avoiding most Euro-denominated bonds and those of unstable political regimes
• It is also important to note that several types of precious metals have sparkled even more brightly in the face of recent negative US economic data and drooping stock values. There may be bubbles forming in certain precious metals, but for the most part, the bubbles have yet to pop. In fact, there is not been a more consistent performer over the past weeks, months and 10+ years

At AFC, we take risk-management very seriously. As active investment managers, we feel that we are well positioned to execute on these opportunities for our clients.

Please share this information with friends, colleagues or family members that are in need of professional assistance given what we believe is in store for the economy. By the way, we do not charge for an initial consultation.

As always, we welcome your calls and emails. We want to hear from you.

Sincerely,
Jim Young
Vice President, AFC Asset Management Services, Inc.
Jim@AFCAssetManagement.com
301-588-5000
18310 Montgomery Village Avenue, Suite 440, Gaithersburg, MD 20879
www.afcassetmanagement.com

Disclaimer This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Investment strategies mentioned herein may not be suitable for all investors. Any opinions expressed are given in good faith and are subject to change without notice. All investments are subject to risk of loss.
Where an investment is described as being likely to yield income, please note that the amount of income that the investor will receive from such an investment may fluctuate. Where an investment or security is denominated in a different currency to the investor’s currency of reference, changes in rates of exchange may have a positive or an adverse effect on the value, price or income of or from that investment to the investor. The information contained in this report does not constitute tax advice. This material is not intended for any specific investor and does not take into account your particular financial situation and is not intended as a recommendation of any particular security or strategy to any individual. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and seek professional advice. This document does not constitute an offer of services in jurisdictions where AFC Asset Management Services, Inc. or its affiliates do not have the necessary licenses.