Client Communications

Third Quarter, 2011

Presented below is our third quarter, 2011 report for your portfolio. The overall tone for the report is set by the bullet points below.

Economic developments in Europe have taken a turn for the worse during the third quarter.
Market volatility has ratcheted up in the equity and fixed income markets both at home and abroad.
Europe is now the focal point for a possible global recession via the mechanism of financial contagion

Western Europe has become the epicenter of the economic universe during the past three months as daily news releases from that region move U.S. and European stock and bond markets. When Greece recently declared that it would not be able to meet the required criteria to receive its next loan from European lenders, stock markets panicked. In the past few days, in contrast, Merkel and Sarkozy announced that they will reveal a plan by November 3rd that will allow Greece to receive its next loan, and write-off (default on) 21% of its debt while protecting Europe’s banks from succumbing to future market panics. U.S. and European stock markets have rallied strongly on the news (S&P 500 up 9% in 5 days).

Cynics are convinced that Greece needs to write off anywhere from 50-90% of its outstanding loans and that this latest plan is just one more “kick the can down the road” proposal. Europe’s banks however might collapse under a debt write off of that magnitude and the fear of future inflation is keeping the European Central Bank from simply printing all the money necessary to cover the losses. Compounding these concerns are the contagion effects to Italy and Spain, each of which has its own precarious banking system that is often described as too large to save. Both countries recently experienced multiple levels of debt ratings downgrades, with warnings of additional downgrades to come. In sum, it appears that the economic situation in Europe is nowhere near a final resolution.

Global stock markets have stabilized since the second week of August, leading us to conclude that some degree of Greek default is already priced in and now word comes that the Greeks will receive their next loan payment despite not meeting the conditions which were required to authorize the disbursement. Ireland also appears to be at the early stages of an economic recovery, further placating markets in recent weeks. This is all good news. Unfortunately the austerity measures being taken throughout almost all of Europe insure that the economic pains will be considerable and will continue for a protracted period of time.

The interconnectedness of all of Europe’s major financial institutions means that virtually none of the banks in any European country are safe from future downgrades or bank runs if a panic mentality sets in. Furthermore, we believe that if a larger scale financial panic were to emerge, then the rest of the world will be sucked in. So, we are faced with a decision to either hunker down now and prepare for the worst, while hoping that European officials will be given enough time by markets to make it through the next couple of years, or, bet on an ultimately successful resolution to the crises and take full advantage of the equity bargains which abound in the cheapest European stock market since the early 1980’s.

Here at home the economic situation for the moment is considerably less grim than that of Europe. The economy is not double-dipping into recession (not yet, anyway). The manufacturing and service sectors are holding up, consumers continue to both spend at a reasonable rate and reduce their debt loads. A number of economists are now actually raising their estimates for economic growth for the second half of the year as the negative supply chain effects of the Japanese tsunami dissipate and gasoline prices continue to decline from recent highs. In addition, Congress has just approved free trade agreements with South Korea, Columbia and Panama, all of which should help increase U.S. exports.

With the notable exception of these three free trade agreements, we are politically in the gridlock mode with each political party’s actions governed more by desire to make the other look bad than to accomplish good for the benefit of the country. We expect this behavior to continue through next year’s elections, making it difficult to imagine much of an improvement in the American mood for the next fifteen months. It’s a real stretch to think that American businesses will open up their purse strings for domestic investment or new hiring at this present level of economic uncertainty.

The U.S. continues to not experience any degree of a liquidity crisis although the bond markets have become increasingly skittish. Money is abundant, as evidenced by near-zero treasury yields, and foreigners continue to purchase our new debt issues. What is needed to ignite a recovery is: 1) sensible fiscal stimulus that deals with severe national infrastructure defects and 2) long-term adjustments to massively downsize unaffordable entitlement programs. As stated above, neither Congress nor the President is willing to show leadership regarding these issues prior to the 2012 elections. Thus, we continue to drift uncomfortably close to the edge of an economic recession. Our economic consultants sum up the situation as follows:

“It’s a lousy, stinking time to be a money manager. In the short run, either a melt-up or a melt-down could occur, with the outcome dependent upon the political process, which is extremely difficult to predict.”

Until there is greater clarity with respect to resolving the European crises we are opting for reducing your exposure to global equity markets. As of September 30, after factoring in the effect of our hedging activities, your equity exposure has been reduced towards the lower end of your allowable range.

Equity Markets

U.S. stock markets declined less during the third quarter than did other global markets, but it was nevertheless a very bad quarter. An investor seeking “safety” through equity diversification across the global stock market would have suffered a portfolio decline of 17% virtually all of which occurred in a brief 9-day period.

The predominant investment theme in our client accounts has centered around ongoing global growth and we have emphasized sectors such as energy production, industrial manufacturing and mining industries. The global slowdown which began during this year’s second quarter however has resulted in disproportionately large price declines in those areas as the year progressed. In addition, all of our country funds have underperformed U.S. equity markets on a year-to-date basis.

As the economic news out of Europe worsened during the quarter we continued to employ different hedging strategies seeking to protect client equity portfolios from possible market collapse. Since then equity markets have not collapsed a la 2008, and thus none of our strategies resulted in added value of any consequence to your equity portfolio during this time frame.

Fixed Income

Your bond portfolio contains a broadly diversified group of individual foreign and domestic bonds and bond funds from both the corporate and government sectors. In addition, you own other fixed-income type investments which give your exposure to particular narrow segments of the bond markets for the purpose of further diversifying your overall bond portfolio.

During the third quarter the decline in global stock markets had a spillover negative effect on lower quality corporate bonds and on foreign bonds. Since all of our clients have a portion of their portfolios invested in fixed income instruments in both of these sectors, your account was negatively impacted by declines in prices of those investments. Our view throughout this year has been that these investments have been appropriate for your account. Depending upon how the situation in Europe continues to unfold, we will assess the continuing appropriateness of these securities for your portfolio, taking into consideration your risk-taking capability.

Furthermore, bonds of longer-term maturities outperformed shorter-term maturity bonds. Our client portfolios consist of primarily of bonds maturing within a one-to five year time frame. In a falling interest rate environment, as has occurred throughout most of 2011, your bond investments will underperform a bond index which contains bonds having longer-term maturities within its overall asset mix.

Other Investments

Fear of possible global recession hit the commodities markets hard during the third quarter. In addition, markets have become increasingly concerned about the possibility of a severe growth slowdown in China. Given its voracious appetite for raw materials needed to support ongoing growth, virtually all commodity markets are sensitive the Chinese consumption patterns. Any uptick in global growth expectations should raise commodity prices from this point forward.


Gold’s price gains for the third quarter and the nine months through September were strong, making it one of the very few areas of profit. There is a growing threat to future gold production around the world caused by a combination of factors such as rising royalties and taxes to host countries. In addition, resource nationalism and extensive labor problems are also adding to the cost of gold mining operations. It is presently estimated that the global “all in” cost of producing gold is approximately $900 per ounce, meaning that if the global market price of gold falls below that threshold level, new production will begin to decline, thus creating something similar to a floor to support its price around that level.

Our policy with respect to gold ownership in your portfolio has not changed. It remains an appropriate investment in the current unsettled investment environment. Recently your gold investment has fluctuated between 5-7% of the value of your portfolio.


There has recently been a surprising uptick in the CPI inflation rate. However, the various components which comprise this number are expected to decline over the next few months given our overall continuing economic weakness.

As always we look forward to discussing with you any thoughts or questions you may have regarding the contents of this letter.


Sheffield Investment Management, Inc.