Scott Migliori, co-CIO, U.S. Equities

RCM

We have seen an improving equity market in the US since early March, but you need to go back to February to appreciate the sentiment and dynamics behind the significant bounce we have been experiencing. In February, fear and uncertainty surrounded the new Obama administration, a newly proposed stress test, and the banking proposals, or lack thereof, which were expected as early as January and which did not get fleshed out until early March. There was fear of impending nationalization for many major banks, fear that equity holders would be wiped out as a result, and no clarity on which financial institutions would be spared. As a result, there was a huge selloff in financial services, in particular from the early part of the year to early March the KBW Bank Index¹ declined over 50%. Many of the banks in the US were trading at 30% to 40% of tangible book value – levels we had not seen since the late 1980s or early 1990s. On top of that there was a rising populist anger directed at recipients of TARP government financing, specifically AIG. If that wasn’t enough, from a macroeconomic perspective, all the economic data points appeared to be in free fall.

Improving sentiment

Since then we have seen a major shift in sentiment driven by better clarity and more certainty on the financial services side as well as some stabilization in some macroeconomic data points. In financial services, while we certainly don’t have absolute clarity, there is now more visibility as to how the current administration plans to deal with toxic assets. Treasury Secretary Geithner has laid out a public-private investment plan (PPIP), which is essentially designed, through heavy use of taxpayer backing and a significant amount of leverage, to incentivize private investors to pay - some would say overpay - for bad assets on the banks’ books.

PPIP has been welcomed as a positive surprise by many as it is much more Wall Street and bank friendly than the hard line rhetoric from the Obama administration in February suggested. It has led to a diminished fear of capital shortfall and nationalization. It remains, however, an open question as to how many banks will participate in the program given that a lot of the bellwether banks have already marked down many of their problem loans.

In terms of the stress test, there is a growing sense that this is not going to be nearly as onerous as feared. The New York Times has called it a ‘pass-pass test’ where even those financial institutions that do not meet the standards the government has laid out will be given an opportunity to correct their deficiencies in a more bank friendly manner.

In terms of quantitative easing the Federal Reserve has announced that they are likely to purchase $300 billion in Treasury securities over the next six months. Quantitative easing is designed, in part, to lower mortgage rates and in that respect it has been successful thus far. Thirty-year fixed rates in the US are now at roughly 4.8% --the lowest rate we have seen in well over a decade.

Not coincidentally, we have seen some stabilization from a macroeconomic perspective, and the common parlance these days seems to be ‘green shoots’, implying some growth, albeit small and insignificant at this point. Specifically, we have seen what appears to be a peak in the inventory to sales ratio in the US, and, quite encouragingly, an uptick in new manufacturing orders, and even seen some stabilization in automotive sales. We have also seen, not surprisingly, a big uptick in mortgage refinancing activities due to the lower rates.

Winners and losers

While the current environment is certainly tough for any company or industry, there are some that are more economically insensitive or counter cyclical in nature. For example, the best-performing areas in the US last year were consumer staples and healthcare, which tend to be less economically sensitive. In the case of healthcare, there were also some fairly interesting and powerful product cycles, especially in biotechnology. Going forward we are more concerned about healthcare given the price and margin pressure we may see as a result of efforts by the Obama administration and the Democratic Congress.

The not for-profit education space in the US also looks attractive. These are companies that are counter cyclical in nature so as unemployment rises, enrollments in education both for-profit and not-for-profit tend to accelerate. One somewhat counter intuitive area that also showed signs of improvement, both in the downturn and in the early part of the year, is technology. Technology in the US had been largely left for dead since the dotcom bubble, but there are now some companies with very strong balance sheets, and in many cases huge cash flow generation, and free cash flow yields well above historical averages. This sector could be a leadership area coming out of this recession.

What we have seen as a result of this improvement in sentiment, change in thinking towards the financial services sector, and some bottoming out in macroeconomic activity, is what I would call ‘a less bad’ rally, meaning that the market has been rallying for the most part and things have not been quite as bad as feared, as opposed to being actually good in any real respect. We are certainly still in a recession in the US, but the hope is that the worst may be behind us. Our view from a macroeconomic standpoint is that we are likely to see some uptick in GDP in the fourth quarter. In terms of the sustainability of the current rally, we have some concerns about the emerging consensus in the US that the third quarter will be a positive GDP quarter, as in our view this is a bit premature.