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First Quarter, 2011

June 30, 2020 will mark the termination date of the Fed's current economic stimulus program commonly known as QE2. As with every significant economic policy there are vast differences of opinion regarding what the end of this program will mean for our stock and bond markets and for the economy in the months and years ahead. Some fear, for example, that without the stimulative effect of this program the country could slip back into recession. As discussed in greater detail below, we continue however to maintain a bullish economic viewpoint both domestically and globally.

  • Employment gains are accelerating; the global economic recovery continues, albeit at a below average pace.
  • Corporate profits and cash flows continue at or near record levels and are expected to remain so for the next 3-6 months.
  • U.S. stocks are reasonably priced from a valuation standpoint.
  • Interest rates are low enough that when they do begin to rise, any moderate increases during the remainder of 2011 shouldn't be detrimental to corporate profits.
  • Treasury securities are expected to suffer low, or perhaps negative, returns for the remainder of the year.
  • Oil prices are still below the tipping point for a future economic recession.
  • Many commodities appear to have entered a unique and possibly prolonged period of increasing shortages of supply coupled with growing global demand.
  • Many emerging market economies are continuing to boom, a positive indicator for ongoing global growth.

Where We Are in the Economic Cycle

Over the course of an economic cycle from recession to the peak in GDP growth and then back to recession the Federal Reserve attempts to counter the extremes of the cycle by its monetary policies. Thus, during recessionary periods the Federal Reserve pushes short term interest rates down primarily through the vehicle of its Fed Funds rate in an effort to stimulate economic growth. As a recovery gains traction government stimulus is withdrawn. "QE2" serves as an additional example of a tool the Fed has been using in its attempt to stimulate the recovery by forcing down interest rates. Where we are in the economic cycle is a critically important factor in how SIMI structures the asset mix of client portfolios. The chart and table below, courtesy of BCA Research, illustrates how the Federal Reserve alters the Fed Funds rate as it attempts to influence the U.S. economic cycle. According to the chart we are at the bottom of phase 4; the cycle trough. Phase 4 typically corresponds to the latter part of a recessionary period in the economy coupled with strong stock, bond and commodity performance. While a weak economy and strong investment markets appear contradictory and illogical, markets are anticipating that government stimulus efforts will soon be successful in improving corporate profitability and investment liquidity.

We are now entering Phase 1of the economic recovery, which historically has also generated reasonably good stock market and commodity performance. In fact, our recent passage through phase 4 has coincided with some of the most extraordinary stock market performance of our investment careers spanning the past 35 years! (S&P; 500 Index is up 95% to date since March, 2009.) By observing the power of Fed actions over investment markets we can apply some perspective in our assessment as to whether other specific shocks to the economy ($120/barrel oil, possible nuclear meltdown in Japan, rising government deficits, etc.) are of sufficient menace to overwhelm secular trends. For now we have determined to stay the course with your equity exposure above the midpoint of your range.




Please note the stylized nature of this cycle chart. In reality the length of time corresponding to each phase is extremely variable and the actual timeframes during each economic cycle look nothing like the simple symmetry of our chart. What is important is to get a sense of the investment ramifications of whatever phase we are in and to get a sense of where we are headed next. We then adjust client asset allocations as we move from one phase to the next.

Summing up the message gleaned from the chart and table above, the U.S. is approaching the point in the economic cycle where further improvements to our economic health are on target to become self-generating and will eventually lead to rising interest rates. Numerous indicators reveal that the economic recovery, both domestically and globally, is still on track, but at a slower pace going forward from today because of the economic drain caused in large part by escalating oil prices. Should oil prices spike higher from today's level, global growth could slow to zero, which in turn could then cause oil prices to plunge.

Some Additional Thoughts About Oil

There is no doubt that further sharp increases in the price of oil will eventually choke off the economic recovery, but is it possible to identify "the final straw"? Studies of past oil price spikes reveal an interesting relationship between the stock market and the price of oil. During the past forty years, the stock market experienced a series of major breaks on six separate occasions when oil prices doubled within a rolling 12 month period of time. One year ago, oil was in the $75-80 per barrel price range, and so it is possible that prices would need to rise towards the $150-160/barrel range before global growth would again screech to a halt, if these past relationships continue to be a guidepost to the future.

Since the 1970's every 12-month oil price spike of 100% or more has carried within it the seeds of its own destruction, as global demand for oil subsequently experienced strong declines. Most recently, for example, after the 2008 oil price spike to $146 per barrel, the price of oil subsequently collapsed over the next six months to a low of $40/barrel, a 73% decline from its peak.

Finally, while there is no question that emerging markets are consuming rapidly increasing amounts of oil, today's price also reflects an additional risk premium due to the Mid East / North Africa oil disruptions. Futures markets, it should be noted, forecast modestly declining oil prices over the next few years from today's levels.

We wouldn't remain complacent to the risks of a stock market debacle in the face of continuing oil price increases and thus we continue to monitor this situation closely.

Agricultural Prices

We are in the midst of a period of dramatic price increases for a significant number of agricultural products, including grains, beans, rice, corn and livestock among others. In previous quarterly letters we have mentioned that while some of the causes for rising prices are cyclical, such as dramatically adverse weather patterns experienced with distressing regularity in recent years, other causes of a more ominous secular, or very long term, nature seem to be growing in magnitude. First among secular causes are the dramatic population increases in less developed countries. Global population is presently estimated at 7 billion people and is projected to increase by an additional billion people over the next 15 years. Virtually all of this growth is coming from the less developed countries.

The second secular pattern stems from rapidly rising wealth in Asian and South American countries where dietary improvements, especially meat consumption, adds exponentially to the demand for corn and other grains. Furthermore, the trend towards higher protein diets is in its early stages, setting the stage for escalating food demand for years, if not decades, to come. On a more personal note, here in Georgia we love our pecans. Back in 2005, the U.S, exported one percent of its pecan crop to China, according to a recent Wall Street Journal article. In 2009, 28% of the national crop was exported to China and prices have now doubled in the past two years. As the Chinese do not mind outbidding their competition for a desired product, we Georgians have to endure pecan pie and fruitcake sticker shock.

Finally, there is the astounding rate of diminishing capability within China to provide for its own basic food needs. Massive destruction of arable land and unpolluted sources of water top the list of reasons for reduced food production in that country. These unfortunate trends are expected to continue for years to come as China continues down the path of increasing industrialization.

In the U.S., ethanol made from corn has been a major contributor to a growing global shortage of this food product for animal and human consumption. Approximately 40% of the U.S. corn crop has now been diverted to ethanol production as a sop to the agribusiness industry. The list of reasons goes on but we think enough has been said here. The bottom line is that we believe the world has entered a new and ongoing phase of global food shortages creating long term profit opportunities in both the commodities and agricultural manufacturing sectors of your portfolio.

The Budget Deficit

"You can count on the Americans to do the right thing, but only after they have exhausted all the alternatives."   
   Winston Churchill

Most people accept the notion that our current path of deficit spending in the U.S. is a roadmap to eventual financial disaster. We are rapidly tracking to become another Greece but the ultimate point in time when bond markets finally rebel is indeterminate. Until just recently politicians refused to address the twin entitlement budget killers of Social Security and Medicare spending. Earlier this month however, Congressman Paul Ryan issued his "Roadmap Plan" for deficit reduction and thereafter President Obama presented his 2012 budget together with his own vision for long term deficit reduction.

While we were initially hopeful that the beginning of a discourse regarding the problem would be seen as a positive sign by investment markets, it has instead quickly degenerated into political posturing and class warfare rhetoric. To sum up the present state of affairs, we now believe we may be heading into a 2-year period of budget gridlock thereby preventing an honest dialog of concrete measures to improve the country's financial stature. According to newspaper reports, Standards and Poors has reached a similar conclusion. As a consequence, on April 18, 2020, S&P; announced that it is putting the U.S. government on notice that it risks losing its AAA credit rating unless policy makers agree on a plan by 2013 to reduce budget deficits and the national debt. For now, the AAA rating is maintained but the outlook has been changed to "negative" for the first time, reports Bloomberg. S&P; is calling not only for an agreement, but also "meaningful implementation" within 24 months to preserve the AAA rating.

For implementation to be meaningful by 2014, the 2012 budget debate now underway will need to yield a stunning degree of cooperation among the politicians.

By the end of the day on April 18, the initial shock of Standard & Poors' announcement had evaporated as treasury securities recouped their initial losses and ended the day higher than the previous day's closing price. For now, the bond market remains unconcerned about our growing deficits. Eventually a threshold level of debt will be reached where creditors rebel and interest rates sharply increase. We are just not there yet.

Performance Analysis

Stocks

Across most client accounts, the first quarter resulted in outperformance of stocks relative to the MSCI All World Stock Index.  As noted in various prior letters and again emphasized in this quarterly letter, we continue to invest heavily in the theme of growing global shortages of many products across a variety of industries.  We believe this theme will remain attractive until the global economy succumbs to some external shock such as a significant spike in oil prices or a rise in interest rates to a level above current global GDP growth rates.

Bonds

During the first quarter the bond market was under no stress.  U.S. treasury yields remained virtually unchanged in spite of greatly increased concern about the unaffordability of our growing deficits and rising concerns about budding inflationary pressures.  Furthermore, fears regarding whether foreigners will continue purchasing U.S. treasuries were also unfounded.  Demand from investors all over the world for treasury securities remains strong.  We are prepared to shift gears with adjustments to client portfolios if and when the bond market enters its much anticipated downward spiral.

Client bond portfolios performed well during the first quarter relative to the broad U.S. bond market. We continued our strategy of owning a combination of relatively short-to-intermediate term corporate bonds and bond funds augmented by a select group of international bonds and bond funds which benefit from dollar weakness.

Other Assets

In the first portion of the quarter's letter we presented our case for ongoing strength in agricultural commodities. The theme across the entire sector of agriculture is growing scarcity of supply in the face of relentless growth in demand. Mineral commodities are also experiencing their own set of supply/demand imbalances which continue to favor high prices as long as global growth continues. We certainly would expect that any growth slowdown would result in steep price declines among mining companies, but we also believe that an eventual return to global growth would place mining companies once again at the forefront of future portfolio price appreciation.

The Other Assets portion of client portfolios underperformed the broad commodities market because gold, our single largest commodity position, experienced a temporary plateau with no price appreciation during the January March, 2011 period.

Sincerely,
Sheffield Investment Management, Inc.

 
 

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