Macro Environment Comments – Quarterly excerpt March 30, 2012

Equity markets rebounded strongly in the first quarter of 2012, particularly in the U.S. as investors finally shifted at least some of their attention away from the Euro zone to the resurgence in American corporate performance. On March 15, 2012, the U.S. market, as measured by the S&P500 closed above 1400 for the first time since 2006.

In the hope of gaining additional perspective on both market risks and opportunities, we decided to compare the current economic and corporate environment with those halcyon days of November 2006 as part of an informal reality check. Not surprisingly, we found some important differences between the two eras and while we remain constructive on the global economy, especially outside the Euro region, risks remain.

On the plus side, corporate fundamentals are arguably better now than in 2006. We identified and have discussed these steady improvements in our last few letters but to repeat, equity valuations are more attractive on a variety of measures including trailing and forecast earnings, book value and dividend yield.

Corporate balance sheets are very healthy and many companies have also secured attractive new financing by capitalizing on the generationally low interest rate environment. In fact, the ratio of liquid assets to total assets on nonfinancial corporate balance sheets recently reached a 48-year high.

On the downside, the U.S. equity market is more concentrated now than in 2006. That is, fewer companies are driving the positive performance of the overall market and there has been a shift in the importance of certain sectors. In 2006, healthcare and financials were market heavyweights while in 2012, technology, energy and staples have emerged as the force du jour.

Perhaps the most significant difference between now and then is the level of government debt, especially U.S. government debt. The U.S. Federal Reserve has tripled its balance sheet to nearly $3 trillion through the purchases of mortgage securities and Treasuries as referenced in the chart at the top of the next page.

 The Fed’s Balance Sheet Has Grown Rapidly Compared to Corporate Debt

Source: FactSet, Morgan Stanley Research

Eventually, this debt must be reduced. Worryingly, U.S. policymakers have yet to outline a sustainable plan to do so. U.S. state and city debt levels are also unsustainable and unlike in 2006, we may see local debt defaults before the year is out.

 Liquid/Total Corporate Assets Highest Since the Early 1960’s.

*Nonfinancial corporate liquid assets* to total assets

There are other important differences. Unemployment is higher in 2012 compared to 2006 and key benchmark commodity prices such as gold, crude oil and gasoline are more than twice their 2006 values.

Global Economic Growth Reasonable

We continue to expect reasonable growth beyond the U.S. and Euro regions in 2012. Credit Suisse forecasts global economic growth of 3.4% this year, including 5% to 6% growth from emerging economies.

Retail Gas Prices

This projected growth rate sends an underlying message to European leaders: while the Euro region remains an important component of the global economy, it is less important than it once was. Europe’s share of world imports has declined over the past decade and has dropped precipitously since 2009 as shown in the next chart.

Euro Area Shares of World Imports

*12m ma; excludes intra euro zone trade


Despite the amount of attention the Euro zone debt crisis received from capital markets, it appears that the global economy can successfully withstand an economic slowdown in the region.

Macro Summary

What can we take from this? While the U.S. equity market was up over 12% in the first quarter of 2012 reaching a level not seen since 2006, we recognize that risks remain. U.S. unemployment is improving but remains historically high. Crude oil and gasoline prices are on the rise which could slow growth. While the Euro region’s debt

restructuring and austerity programs seem to be providing some regional stabilization, and economic growth elsewhere appears unfazed, global contagion risk remains.