Dorsey D. Farr, French Wolf and Farr
In a normal recession, the decline in payrolls lasts approximately 16 months and roughly 2 million jobs are eliminated (adjusted for changes in the payroll base over time). During the most recent recession, the decline in payrolls lasted 24 months and the number of jobs lost was more than four times that of an average recession. After a typical recession ends, job growth resumes. In the 12 months after the trough, the economy regains all of the jobs that were lost during the recession and then adds more than 2 million over the course of the next 12 months.
Despite 20 months of economic expansion, the level of payrolls remains 7.7 million below the prerecession peak and 10.6 million below the level that would prevail in a ‘normal’ recession. Clearly, this time is different.
This Time is Different are the four most dangerous words in finance, because they typically are used in an attempt to persuade investors that they need not worry about some apparent imbalance such as excessive equity valuations or skyrocketing house prices. Today, we have 10.6 million fewer people working than would be the case if this time weren’t different. But it is, and Fed Chairman Bernanke pointed out in his recent 60 Minutes appearance that it may be different for quite a while.
The Federal Reserve cited the poor state of the labor market as one of the reasons behind its decision to proceed with another $600 billion of Treasury bond purchases – a policy now widely known as QE2. Noting undesirably low rates of core inflation and undesirably high unemployment, the Fed took cover behind its so-called dual mandate, which dictates that the central bank seek to foster both price stability and full employment. In our view, the reference to the dual mandate and the weakness in the labor market was cover for the true concern, which is stubbornly persistent disinflation (a falling rate of inflation). Despite two years of “exceptionally accommodative” policy, the core inflation rate continues to decline. In fact, after stripping out the volatile food and energy components, the year-over-year growth in consumer prices fell to an all time low (+0.59%) in October 2010 and has clearly raised concerns among central bankers that the United States is dangerously close to a bout with deflation. St. Louis Fed president James Bullard has written that the “U.S. is closer to a Japanese-style outcome today than at any time in recent history” and that the experience of Japan suggests escaping a deflationary state may be quite difficult.
So, while the Fed talked about low unemployment and its dual mandate, we see QE2 primarily as an antideflation measure – an insurance policy of sorts. Markets, in contrast, have interpreted QE2 as a license to speculate, driving the Russell 2000 up more than 30% in the past six months. How might markets have reacted if more people understood and shared Bullard’s concern about the possibility that the U.S. might get bogged down in a deflation and viewed QE2 as an effort to prevent the U.S. from venturing down the path that Japan has been stuck on for more than a decade?
Dual Mandate Blues
In this particular instance, the dual mandate proved convenient for the Fed, since it allowed for a further easing of policy without raising alarms about the Fed’s deflation fears. But the dual mandate has generally been something that central bankers could do without, since it charges the Fed with two objectives that are not always congruent with one another. Most central bankers have reconciled this dilemma by noting that the best way the monetary authority can promote full employment in the long run is through the pursuit of price stability. However, the short run is problematic. Efforts to stamp out inflation often have negative consequences for economic activity and employment, while attempts to alleviate the pain of the business cycle may produce undesirably high rates of inflation. Even today, many observers view QE2 as an attempt to alleviate a shortterm unemployment problem at the expense of longterm price stability. Indeed, if the Fed fails to unwind its QE1 and QE2 in a timely manner, the tremendous buildup of reserves in the banking system could result in a massive expansion of the money supply and an unwelcome surge in inflation. Such are the perils of serving two masters.
We sympathize with the Fed. Investment managers also are commonly tasked with a dual mandate: “Beat the benchmark, but don’t ever lose money.” This dual mandate creates a problem whenever capital markets produce losses or whenever benchmarks are uncorrelated with investor objectives.
While the true objective of most investors is characterized by some liability or planned expenditure stream, most investment managers are measured using some market benchmark. In theory, the market benchmarks chosen should be reasonably correlated with the actual objectives in the long run. However, that often fails to be the case in practice, especially during the short run when markets are driven largely by investor psychology. These swings in crowd psychology often lead to investor schizophrenia with regard to what risk matters. During bear markets, investors rightly emphasize capital preservation and grow concerned about their ability to achieve their objectives. During bull markets, investors become focused on “what might have been,” benchmark risk and the performance of peers (all of which are immaterial to their objectives).
It is impossible to serve and advise the investor whose objectives are blown by the wind. Advisors know this but try anyway. Rather than challenge clients to remain focused on objectives, the investment advisory industry often placates client demands to shift objectives at the most inopportune times. This is, of course, a recipe for investment failure … but it keeps the clients paying fees.
Herein lies the tragedy of benchmarking: a useful tool has been transformed into a weapon of financial mass destruction. What is easy to measure is not necessarily all that should be measured. Benchmarks become an investor’s worst enemy during booms, pulling them into richly valued assets as “opportunity cost” (expost) increases. In most instances, the timing turns out to be precisely wrong.
In our view, the current exuberance over the economic recovery will ultimately be met with disappointment just as the exuberance about a “V-shaped” recovery in the early months of 2010 proved misplaced. That doesn’t mean the world is ending, but ignoring valuations and sending investors back to the old “don’t fight the Fed” playbook will likely lead to frustration, because this time is different.
What isn’t different is that those old rules of valuation ultimately still apply. If you pay too much, you suffer.
Investors learned this with tulip bulbs in 17th century Holland, oil and gold in the 1980s, technology stocks in the 2000s, and real estate just a few years ago. At present, Wall Street would like you to ignore the fact that the S&P 500 trades at 24x cyclically adjusted earnings. The sad truth is that recent performance too often dictates investment decisions, and will likely tempt investors to ignore the fact that buying at these levels generally leads to poor results. How did we forget this lesson so quickly?
Anshul Pradhan, Barclays Capital Market Strategies America
We discuss the recently released Q4 10 flow of funds report in light of the supply/demand outlook beyond June 2011 when the Fed is scheduled to end QE2. We do not envisage these dynamics to have a significant effect on rates, as net fixed income supply should decline from the high levels of 2010. In addition, we expect demand from foreign investors and households to remain strong, with the potential for pickup in that from banks.
On March 10, the Fed released the flow of funds report for Q4 10. We discuss supply and demand trends in the overall fixed income universe, ie, Treasuries and spread products, in light of the outlook beyond June 2011, when the Fed is scheduled to end the second round of large-scale asset purchases (LSAPs).
Overall fixed income supply in 2010 was roughly in line with pre-crisis levels, with Treasuries accounting for almost the entire amount. Spread product issuance was close to nil and well below the pre-crisis levels. Over the 1y period beyond June 2011, we expect net supply to decline, due to lower Treasury net coupon issuance. On the demand side, foreign investors were the largest buyers of fixed income securities in 2010, along with domestic households, as the Fed stepped back from its very high involvement in 2009. After June 2011, we expect net supply to be mainly absorbed by these two groups as well. The banking sector is likely to increase the pace of purchases to offset the tightening pressure on NIMS from rising cash on balance sheets.
Hence, we do not envisage supply-demand dynamics to have a significant effect on rates, which should be determined mainly by the evolution of the economic outlook. We remain neutral on long-term rates and continue to prefer long duration views in the front to intermediate sector, though with slightly less conviction than a week earlier, with 2y and 5y yields approaching our quarter-end targets of 0.5% and 1.95%, respectively.
Treasury supply has replaced spread product supply
While Treasury supply has picked up dramatically from pre-crisis levels, that of spread products has declined, offsetting this. In Figure 1, we tabulate annual net supply of fixed income securities across sectors. A few points of note:
In 2010, overall net supply fixed income supply was $1.66trn, lower than the peak in 2007 and roughly the same during the pre-crisis years (2004-06). Net supply of Treasuries alone accounted for $1.58trn in 2010, up dramatically from the pre-crisis average of ~$285bn.
Net supply of spread products was close to nil, as positive net issuance in corporate bonds, agency MBS and municipal securities was offset by negative net issuance in agency debt (partly due to the shrinkage of the discount notes universe) and other securitized products such as private label MBS, commercial MBS and other asset-backed securities.
Spread product net issuance in 2010 was still substantially below pre-crisis levels, due mainly to lower securitized issuance; net supply of private label MBS/CMBS/ABS was ~$970bn lower.
Hence, while Treasury supply is $1.3trn higher than pre-crisis levels, supply of spread products has declined enough to offset that increase.
What is the supply outlook beyond QE2?
With the Fed engaging in large-scale asset purchases (LSAPs) via Treasuries until June, we look at net fixed income supply for June 2011 to June2012. We expect net issuance of coupon Treasuries to be $1trn (+$200bn in T-bills), compared with $1.6trn in 2010, roughly $600bn lower. The supply outlook for spread products is not likely too much different: agency debt issuance should still be negative (but not as much as in 2010), due to the reduction in portfolio caps and lesser bank reliance on home loan advances. Corporate supply could decline, providing an offset, given the high level cash equivalent instruments on corporate balance sheets.
Private investors would therefore have to absorb $1-$1.25trn in annual net fixed income supply if QE2 ends in June.
BlackRock Municipal Markets Update
"Munis' Five-Month Downturn Ends in February"
Municipals reversed an early-February downturn to post gains for the month, with yields declining (and prices rising) across the curve. The 10- to 20-year sector saw the greatest yield change, with rates declining roughly 30 basis points (bps) for the month. Ratios to US Treasury issues, while declining sharply for all but the longest maturities, remained attractive. With yields exceeding those of comparable Treasuries, municipal valuations are historically attractive, drawing the interest of non-traditional and hedge fund buyers.
A senior analyst for Municipal Market Advisors remarked that, “Non-traditional buyers, who could buy anything, are buying municipals.” This source of demand was supportive of the market at a time when tax-exempt mutual funds continued to experience withdrawals.
In fact, by the end of February, tax-exempt mutual funds had experienced 15 consecutive weeks of outflows. While it is encouraging that the pace of outflows has slowed, total assets hemorrhaged since mid-November has been reported at $39 billion.
February new issuance was a meager $16 billion, 40% below the same period last year, according to Thomson Reuters. Issuance for the first two months of the year is down 52% from 2010; some are now lowering their estimates for total 2011 supply. One factor believed to have contributed to the lower new-issue volume was the amount of financing executed in the final quarter of 2010 as issuers sought to use Build America Bond (BAB) financing prior to the program’s expiration at year-end. The program enabled issuers to sell taxable bonds with a federally subsidized interest cost. According to The Bond Buyer, municipalities sold $44 billion of BABs in the fourth quarter, effectively reducing the need for financing in the current year. President Obama proposed reauthorizing the BAB program on a permanent basis, but reducing the subsidy to 28% from 35%. BAB-related legislation is expected to meet resistance in Congress, leaving the future of the program in doubt.
Municipal credit concerns continue to lead news stories as state and local governments attempt to balance their budgets. Although credit concerns are heightened, the market appears to be recognizing that municipal defaults are a lessening concern.
Tensions escalated in the Midwest as newly elected governors proposed aggressive reductions in salaries and benefits for state workers. In Wisconsin, Governor Walker announced Plans to terminate collective bargaining agreements, while also requiring public employees to contribute to pension plans and doubling their healthcare premiums. The measure was approved in the Assembly, prompting a political circus that involved 14 Democratic senators fleeing the state and preventing a final vote. Protestors assembled at the state capital of Madison, setting off similar protests in Ohio and Indiana.
As noted last month, Moody’s revised its ratings methodology to include pension funding gaps as debt when calculating state debt ratios. The agency believes this will make for better comparisons between municipal debt and corporate and sovereign debt. Fitch followed suit, indicating that it was reassessing the impact of pension liabilities given the fiscal problems experienced by states.
By the Numbers
The S&P/Investortools Municipal Index returned 1.56% in February, ending a five-month run of negative performance. Returns were positive across the curve, with the 15- to 20-year sector posting the strongest performance at 2.60%. Credit spreads continued to widen as higher-quality names gained favor. Ultimately, the high yield index was positive, but underperformed the broader market by 29 bps. Meanwhile, the high-quality general obligation and water & sewer indices each provided roughly 30 bps of excess return.
Strategy and Outlook
Fundamental challenges will continue to be met with negative press, prompting us to maintain a neutral view for the market. We currently favor a high-quality bias, as credit spreads are moving wider for issuers that are not addressing their fiscal challenges.
Against this backdrop, we continue to believe that careful credit analysis and selectivity are critical to investment success.
The Outlook for Technology
Cash on the books and low debt
Technology companies hold record levels of cash on their balance sheets, having successfully emerged from the economic downturn by slashing costs. Elevated cash levels have afforded technology companies a more defensive quality amid macroeconomic uncertainty. Moreover, stronger cash positions have created a competitive advantage for many large tech companies that have been acquiring smaller, innovative businesses or considering dividend payouts to shareholders.
Cash-rich technology companies seeking growth and innovation via acquisition
Mergers and acquisitions (“M&A”) continue to be a dominant theme supporting technology companies, especially within the fast-growing software space. Both software and hardware companies are attracted to the high-growth, high-margin profile of software targets. On the heels of the growing urgency among technology companies to build positions in innovative technologies such as cloud computing and software as a service, we believe an accelerated consolidation among small vendors is likely to continue. Premiums on M&A deals within technology are now at record levels for the sector.
Technology’s global reach: Revenue streams from developed and emerging markets
Technology companies are increasingly tied to multiple economies due to the diversification of their revenue streams. Most technology companies now source a significant amount of business through several product and service offerings, and in the case of U.S. technology companies, also derive sales from many sources abroad. Within the S&P 500 technology sector, companies on average derive over 50% of their revenues from overseas.
Valuation and corporate health alone will not support favorable technology equity performance. We believe that innovation, new products and services, and upgrade cycles are key contributors to gains in technology spending, revenue growth, and market share, key data points that often effect appreciation in technology shares. Technology spending is in fact highly correlated to technology company revenues which, in turn has typically driven technology equity price performance.
Revenue growth is often the result of new product cycles in conjunction with strength in enterprise and consumer spending. We see near and long-term trends improving as technology continues to alter the behavior of consumers and enterprises alike. New product cycles such as cloud computing, virtualization, cybersecurity and social networking are several of the expansive opportunity sets we believe offer the potential for durable growth.
Businesses now have the ability to boost spending on technology given record profits in absolute terms and as a share of GDP. Additionally, after declining for several quarters, technology’s share of capital expenditures** is increasing, hovering close to 45%,4 a trend we believe will gain traction as companies experience pressure to increase their operational efficiency.
As IT is a pure cost for a firm, companies need to manage their technology to stay competitive. On the heels of innovative solutions such as cloud computing and virtualization, they have several incentives to do so.
To gain perspective into the magnitude of these incentives, in 2007 for example, company computer servers recorded average utilization rates of only 10% to 15% of total capacity, meaning firms likely maintained $140 billion of excess computing capacity.5 Low utilization levels not only meant higher capital expenditures but also increased operating costs as the glut of physical servers resulted in added power, cooling, and facilities costs. New technologies can save companies billions and, as a result, are expected to grow significantly in the coming decade.
Investing in the cloud
Corporate data center efficiency can be one of the most significant measures for companies evaluating internal costs, productivity, and competitiveness. As a result, we see significant growth potential in this segment.
The most noteworthy and “game-changing” innovations, in our view, exist within enterprise cloud (or web-based) computing and virtualization. Using virtualization software, a company can create a “private cloud” to manage its workforce’s computing requirements. One server can handle the workload that previously required ten servers. Further adding value, setting up a virtual machine on an existing server can be done in as little as 15 minutes as opposed to the typical four weeks. According to Paul Maritz, CEO of virtualization company VMWare,†† for every $1 spent on hardware, $6-$8 is spent on operating that hardware.5 Given its advantages, it is estimated that 50% of typical server installed base workloads will be virtualized by 2012.
Beyond “private clouds” are “public clouds” which are managed outside of the company by a central server. Public clouds are incredibly cost-efficient, more so than private clouds as they typically follow a “pay per use” model, thereby eliminating virtually 100% of hardware costs. We believe that as corporations become more comfortable with an outside entity hosting their data-sensitive IT workloads, growth in public cloud computing should continue well into the next decade, providing a long growth ramp for technology companies in this space.
With the proliferation of the internet, cloud computing, and mobile devices, IT security threats are growing more complex. 2010 was notable for cyber attacks, ranging from the Stuxnet virus that infiltrated Iranian nuclear power-plants to the Wikileaks scandal involving the publication of classified diplomatic cables. Such highprofile cybersecurity incidents are likely to continue, in our view, causing increased focus in the private and public sector on protecting sensitive data.
The consumer continues to be a driving force behind technology spending, notably on the theme of mobile convergence, where a single device now provides internet, applications, social networking, and other features.
While an uncertain 2010 kept the consumer somewhat weak with respect to spending, signs of economic recovery combined with innovative, lowerpriced mobile items such as smartphones and tablets provide support for this growth segment of technology.
Apple, for example, sold more than 2 million iPad tablets within the first two months of release and opened up an entirely new growth market.
Emerging market growth
Many of technology’s “gadgets” are seemingly ubiquitous in the United States, but global market penetration for many of these products is still quite small. For example, Apple,† has only 17% of the global market share in the smartphone category and it is just rolling out its iPad tablet device. The reality is that emerging countries have the potential to drive much of the volume growth in consumer technology. In fact, in the last 12 months, the four BRIC countries (Brazil, Russia, India, China) have driven two-thirds of incremental handset growth. Given the immense growth of the middle class in many of the emerging markets, we see opportunities for a number of Western companies to penetrate these markets.
Social networking revolution
Fast becoming a mainstay of popular culture and society, social networking is entirely internet-based and often accessed via mobile device. Unique users of the popular social network Facebook grew more than 600% during 2009, and the site currently has more than 500 million users. Given that the company is nearing 500 shareholders, it will soon be required to file financial results with the federal government. We believe it will have little choice but to go public. Twitter, another popular site, saw its usage increase more than any other social network, surging more than 2800% in just one year.
This massive shift in communications makes this nascent growth segment potentially enormous.
eCommerce growth ramp
The internet continues to be a venue for innovation, with online retail extending its penetration into new markets. Despite strong multi-year growth, eCommerce in the United States is still in its early growth stages, accounting for roughly 7% of all retail sales as of year-end 2010.12 Industry observers believe penetration rates could reach 15% of overall retail sales by 2020.
With the seemingly insatiable hunger for efficiency, new products, and dynamic features among technology offerings, bandwidth challenges will drive the need for heightened management of copious amounts of data.
Consumers and enterprises alike continue to increase their use of bandwidth-heavy applications such as video, and often access these applications remotely via laptops and tablets. Streaming media or real-time video accounts for 43% of peak period traffic in the United States.14 In fact, Netflix,†† one of the major streaming video providers, alone accounts for nearly half of the bandwidth used between 8 p.m. and 10 p.m. in the United States, and that usage comes from only 1.8% of the service’s subscribers. The explosive growth of media makes a strong case for the myriad companies that address bandwidth and related issues.
With the expanding use of bandwidth-heavy applications, internet browsing, as well as 3G and now 4G wireless capabilities, updated infrastructure is required to support it. We compare this overall trend of increased data usage to the updating of a country’s highway system – from two lane roads to five lane superhighways – capable of handling increased capacity at greater speeds. In technology, this equates to new switches, routers, and optical systems just to name a few. While this infrastructure upgrade has begun in the United States, it still has significant headway to make in emerging markets.
Further, new methods of storing the copious amounts of data that will traffic the global technology system are emerging to address the increasing size and cost of bandwidth-heavy files. Enterprise storage costs, in particular, eat up 30% to 50% of a typical IT budget. On the consumer side, the need for data storage continues to grow as venues such as social media and on-demand video sites expand their media capabilities.
Opportunities across the Capitalization Spectrum
Within technology, and throughout each of the themes outlined in this paper, we see unique investment opportunities that exist across the market cap spectrum: small, mid, and large.
Large Caps: Growing slower, but positioned well While many large technology companies are maturing and experiencing slower growth, we believe that a number of large firms offer access to established and continuing growth stories through new product innovations and durable revenue streams.
Management teams of certain large cap technology companies are actively approaching how to deploy their growing cash horde. If they elect to pay dividends, it could give rise to an entirely new investor base and support higher valuations. They may also decide to buy back shares, also in support of potentially higher valuations. Additionally, we may see many large cap companies with strong cash positions acquiring other companies in an effort to absorb innovative competitors and maintain their competitive positions.
Small- and Mid-Caps: Fast-growth and constant innovation
Many of technology’s growth leaders come from small- and mid-cap companies that are creating new products and new markets. Among the most successful of these are those that increase productivity and efficiency. For example, SalesForce.com offers a solution which allows companies to manage their sales forces on an outsourced basis using a “pay as you go” model.
This scenario, which saves expensive setup, maintenance, and servicing costs, was unheard of just a few years ago and is now deemed a “mission-critical” application by many firms.
This previously small cap company began with 1,500 customers, and after an explosive growth trajectory, now has over 85,000 customers as well as a high rate of recurring revenue given its subscription-based business model. Small cap technology companies can thus potentially offer investors a “pure play” on clean business models and innovative technologies, and while they can certainly carry greater risks in terms of volatility and the potential for failure, they also have the potential to tap into significant growth opportunities.