Weekly Market Commentary 1-31-2011

Two Sides of the Same Coin

This week the news was dominated by the turmoil enveloping Egypt, the geopolitical center of the Middle East. What is occurring shares many of the same characteristics of the popular revolt in Iran during the 70's. In that instance, extremists hijacked the moderate populous and moved the country to the absolute fringe extreme. Let's hope that doesn't happen here. How does this impact us? The United States has a positive trade balance of approximately 4 billion dollars with Egypt (http://bit.ly/ePkehi) and we shouldn’t forget the 1.5 billion dollars we send them annually to buy their support on a host of issues. Maintaining this trade surplus (exporting more to them than we import) is always worth considering. Yet relative to our 14.9 trillion dollar GDP, it's not on the radar; notwithstanding the significant negative consequences that would occur if the country fell into the hands of the angry "Arab Street".

What has been lost in all the news surrounding the chaos in Egypt was our own GDP data. For the 4th quarter of 2010, real GDP grew by 3.2% in real terms and 3.4% in nominal terms, which was slightly below estimates. Consumption increased by 3% while inventories shrunk by -3.7%. If you took consumer and business consumption, and added back the draw down on inventories (assuming business will replenish that inventory) you can get an aggregate demand of 7.1%. This would be the largest quarterly gain since 1984 according to Moody's (http://bit.ly/aDecXC).

Test this against one of my favorite consumption indicators, the U.S. savings rate, and you can almost say the consumer is back. In May of 2009, the apex of financial fear, the US savings rate was 6.9% vs. a near 0% rate just years earlier. It is now down to 5.3%. This isn’t at the levels we saw that drove frenzied consumption but it is a strong signal the consumers are becoming more confident (http://bit.ly/hurAxF) (http://bit.ly/dIwiii).

We know our equity markets are structured around the anticipation of growth. In the current scenario this type of consumption plus the possibility of a GDP lift from replenishing inventories could bode well for the next quarter or two. Some of the "Wall Street Mafia" forecasts for the markets just might come true.

The Other Side of the Coin

I know I should wrap up here and leave on a high note. However, I get paid to demonstrate some balanced judgment. So let me throw some cold water on these growth flames.

Across the Atlantic, the GDP of the UK shrank 0.5%. Not a positive indicator. While pundits blame much of this on weather related issues, I would respectfully suggest that they are overplaying this convenient truth. Perhaps the "inconvenient truth" is that the austerity measures put in place by the current British Administration are having an impact on their GDP (http://reut.rs/girUs1).

• Increase in the Value-Add Tax (VAT)
• Bank Balance Sheet Levy
• Payroll taxes rise for employees by one percentage point in April 2011
• The Treasury plans to raise four billion pounds a year by cutting tax relief on pensions for about 100,000 higher earners.

While this fiscal responsibility is necessary, and our country should eventually consider a similar approach to curb runaway spending and ballooning deficits, this GDP play out can come to our shores as well. If the American consumer cannot get a strong lift before significant cuts are made....watch out.

With a 14.8 trillion dollar economy (http://bit.ly/eRJ0yb), a 3.5 trillion dollar Federal Budget (http://bit.ly/b7LpSH) and the 1.5 Trillion we still have to borrow (http://yhoo.it/hfbBMf) it's hard to see how a few hundred billion dollars cut here and there would tip our economic world over. Additionally, the track record of US Presidents and Congress delivering on real austerity is abysmal at best. I wouldn't bet on any earth shattering GDP shifting events from our home team.

I hope I'm wrong and that we do the right things for the long term. That being said, I believe that we will see both advances and pull backs in our market in the next few quarters. Ultimately, the balance should be in favor of the consumer and positive equity markets.

My equity themes continue to focus on the following:

• Consumer discretionary, specifically high end retailers
• Gas and Oil
• Business processing technology
• Media (Print that is adapting to on-line)
• Emerging Markets Debt and Equity that is driven by US dollars finding better investment environments
• Segmentation of emerging markets rather than broad based emerging markets exposure, specifically Brazil Energy and Telecom
• Mega Cap US companies that are finding great margins with little top line growth, especially exporters

Tim Phillips, CEO