RCM April07 Perspective

Volatility returns! Thanks anyway, we could have done without. In reality, markets are just getting back to normal. We came to expect low volatility over the past few years. The 2% one day drop in the Dow in March was a shock, but history shows that in the past we have averaged 8 such drops a year! These drops are sometimes precipitated by mini-crises. Each crisis seems important, but usually ends up being exaggerated in its ultimate impact on stock and bond prices. That seems to be the case with current concerns for the sub-prime mortgage market.

The catalyst to the March sell off was dramatic selling in the Shanghai market. You may ask, “What does the price in China have to do with prices here”? It is a good question, without a good answer. Sometimes selling begets selling, especially when there are other concerns in the background. It is important to put such events in perspective. For example, the 9% one day drop in the Shanghai market in February erased just the gains from the previous 6 days!

One of the current concerns centers on stresses in the housing market, and in particular homes financed with sub-prime mortgages. This includes concerns about the mortgage market in general and has lead to speculation that problems might lead to tightened standards for other forms of credit. Some investors, always quick on the draw, decided to sell first and then see what may happen later.

Oil prices also are not helping. Gasoline prices are over 20 cents per gallon higher since the beginning of the year, so an additional worry is, “How will the consumer hold up? Will the consumer faced with softening housing values, and higher gas prices begin to retrench?” The answer is not in, but we suspect the consumer will do just fine.

Toward the end of the quarter, geopolitical concerns came back to the fore. Iran captured 15 British sailors precipitating an international crisis. It seems that this move was by design. Now the world is on edge as events play out. At risk are oil supply and the transportation corridor out of the Persian Gulf.

Welcome to the world of money management in the twenty-first century. In reality, it is not much different from that of the last century. Just think of all the crises and major events over those 100 years. We just continue to focus on fundamentals. Here is our outlook and strategy for coming quarters.

As we have written for some time the economy is slowing. Our assessment remains that this should be a deceleration to a growth rate of around 2% - 2.5%. RCM continues to believe that growth will persist, although at a reduced rate, because interest rates remain historically low, ongoing fiscal stimulus from the war and deficit spending, corporate profitability with solid finances, high employment levels, and strong international growth.

The following are some risks to this scenario: One is that providers of credit overreact to the sub-prime mortgage problems. We see no evidence of this yet. Another is that oil prices spike to levels that shake consumer confidence. So far oil and gasoline prices have not reached last year’s highs. (Economic growth survived those prices too.)

Transitions to lower growth rates are never smooth: there are stresses in the economic system and some failures. At this point, it seems to be playing out relatively normally.

RCM anticipated increased market volatility in its January Perspectives. In the same issue, we said we expected another good year; we have no reason to change our minds. During the recent sell off we took the opportunity to increase certain positions and put new money to work.

Last year RCM adjusted portfolios just for this environment. We hope to reap the benefits in 2007.

A few months ago inflation appeared to be moderating. Recent measurements reveal a slight reacceleration. Some of this may be temporary or stem from flawed measures. Take for example, gasoline prices. In the spring, refiners switch the formulations of products in their plants from products needed in winter to a mix of products for the warmer summer months. This switch-over always causes some disruption, this year apparently more than usual. Housing expense is an important part of measuring inflation. Because statisticians can not easily measure this, (most consumers do not change homes that frequently), rent for apartments is used as a surrogate. During the housing boom of a few years ago, rents were held down as apartment dwellers left to buy their own homes. Now, in the housing bust, consumer demand for rental properties has driven prices higher. However as higher rents are measured, this increase is added to the inflation picture showing reacceleration.

As a result of these pressures, bond investors are caught in a quandary: will the clearly slowing economy call for lower interest rates or does the current inflation picture call for higher ones? The result is that interest rates, facing pressures for both higher and lower rates, are mostly standing still. RCM expects this to be the case for some time yet. Ultimately we expect that moderate economic growth will impact inflation and allow rates to decline. That may be in the latter part of this year.

“It is hard to get hurt falling out of a basement window.” With the S&P 500 trading at about a 15 P/E, and the ten year Treasury bond at 4.6%, stock prices are cheap. Therefore we are nearly fully invested. We currently have a couple of positions that we are upgrading, but that will be done soon.

International growth and expansion is a characteristic we continue to seek in our equity positions. This is because we see so much more opportunity in other parts of the world.

RCM has moved out its target maturity range for individual bond purchases to 3-5 years. Our next move will likely be to move that target out even further. However, that move will not occur until we are confident that inflation is indeed moderating and the yield curve begins to normalize. A normal yield curve is one where short-term rates are lower than long-tern ones. The opposite has been the case for about a year now, but we see signs of a return to normalcy.

“How is the Fed doing?” This is a question RCM gets quite frequently from its clients. It is a difficult question, but one that requires an answer. After all, so much investment is dependent upon a stable, healthy, and expanding economy. Times of stress might offer opportunities, but constant turmoil destroys the investment environment.

The Federal Reserve has a mandate to keep inflation in check and to encourage healthy economic activity and growth. When in reasonable balance, these two mandates are not in conflict with one another. Sometimes one or the other aspect of this mandate is so out of balance that the Fed has to choose one mandate over another. An example might be an economy that is growing so fast that it is creating inflation. Under that circumstance, the Fed would sacrifice economic growth in order to rein in inflation. The Fed’s goal is to maintain a balance between an extreme of either mandate.

The Fed presently is walking a fine line between trying to moderate the current inflation rate, while not going so far as to restrict economic expansion. Only time will tell if the economy comes into balance without extreme stress and dislocations. However, RCM believes that the Fed will be successful.

Some of the reasons we believe the Fed will be successful: The Fed started to work against inflation before it accelerated. Longer-term yields actually have declined since the Fed began acting, signaling that most investors are showing confidence. Even though precious metals prices have increased, they have not moved beyond an overdue adjustment after years of languishing. (Precious metals prices historically rise dramatically when investors lose confidence in paper money because of inflation.)

Equity markets around the world are showing more volatility, but are not far off their highs. The fact that world markets are acting closely in concert with one another, reinforces the global aspects of the current environment. This is a plus because it ultimately makes every individual economy more stable. (There is strength in numbers.)

Markets are among the best predictors of the future. They are telling us that we can expect moderating inflation and continued growth. So the answer from the markets is that Chairman Bernanke is doing a good job, and at RCM we concur. If you want to work with a firm that can put events into perspective and can separate real information from the everyday din, then Talk with Us.

Notice

We welcome Michael Allbee as Operations Manager in our West Coast office. He is already making significant contributions to Riverplace Capital Inc.