At Riggs, we spend significant amounts of money on independent and think‐tank style research. It is, in essence, the raw material that we use for our production of a long‐term strategic investment approach. On a daily basis we sift through reams of information to distill the critical data that will inform the investment markets now and in the future. Global monetary policy continues to be the driver of today’s investment markets and it is our topic for this quarter’s Riggs’ Report.

The U.S. Economy and Monetary Policy

The U.S. economy has begun to deteriorate. After three years of a muted recovery and slow economic growth, signs that the U.S. economy may be rolling over are on the rise.

• 1st Quarter 2012 economic growth slows to 1.5%
• 2nd Quarter 2012 economic growth slows to 1.3%
• Household income declines by 4.8% in 2012 and is now at recession levels
• The Labor participation rate continues to decline and now stands at a 31 year low. (The Labor participation rate is a statistical ratio which measures the proportion of the country’s working‐age population that is employed. With nearly 40% of Americans in the working‐age population giving up looking for work, this may be the most telling jobs statistic out there).

A recession is a lagging indicator that measures two consecutive quarters of negative economic growth. While we have not hit a negative quarter yet, the trend is going in the wrong direction. With fear of the economy rolling into recession, the Federal Reserve has now implemented its third round of Quantitative Easing (QE) in four years. In QE3, the Federal Reserve has stated that it will purchase $40 Billion of Mortgage Backed Securities every month until the employment picture “substantially improves.”

By purchasing Mortgage Bonds in the open market, the Federal Reserve is essentially trying to accomplish two things. First, they want to keep interest rates low to support an improving housing market.  Second, by adding $40 Billion to the economy each month they hope to push up asset prices—from hard assets like gold and real estate to stocks. With an increase to individuals’ investment portfolios and home values, the hope is that consumers will feel more comfortable spending money creating demand for goods and services.

Unfortunately, the effectiveness of Quantitative Easing is facing a diminishing returns scenario.  First, interest rates have been at historic lows for several years now so its effectiveness to spur economic growth is likely to be pretty mild. Pumping $40 Billion into the economy each month will certainly help prop up asset prices in the short term but at what cost to the longer term health of the U.S. economy?

The frustration and pressure at the Federal Reserve can be seen in the recent remarks by Federal Reserve Board member, Richard W. Fisher before the Harvard Club of New York City on September 19, 2012.

If you want to save our nation from financial disaster, may I suggest that rather than blame the Fed for being hyperactive, you devote your energy to getting our nation’s fiscal authorities to do their job. …

Just recently, in a hearing before the Senate, your senator and my Harvard classmate, Chuck Schumer, told Chairman Bernanke, “You are the only game in town.” I thought the chairman showed admirable restraint in his response. I would have immediately answered, “No, senator, you and your colleagues are the only game in town. For you and your colleagues, Democrat and Republican alike, have encumbered our nation with debt, sold our children down the river and sorely failed our nation. Sober up. Get your act together. Illegitimum non carborundum; get on with it. Sacrifice your political ambition for the good of our country—for the good of our children and grandchildren. For unless you do so, all the monetary policy accommodation the Federal Reserve can muster will be for naught”.…

While the Federal Reserve can create money and manipulate interest rates they cannot create demand. As you can see from the remarks, the frustration with the gridlock in Washington is growing. While the United States faces an economic slowdown, Europe is trying to avoid an economic meltdown.

The European Challenge

With Europe’s summer vacation ended and politicians back at their desks once again the Eurozone countries are back on the front pages. While the experiment of the European Union (EU) which currently consists of 27 countries and its common currency, the Euro, used by 17 of these countries was laudable, it is now facing a severe test. The original concept of the EU and the Euro had two major goals:

1. To bind the countries of Europe together through economic ties thus creating a single powerful economy that could compete and prosper on the global stage; and
2. To make those economic bonds so strong that never again would the world experience the pain of a Pan European War.

The Euro has provided a huge tailwind to northern European countries like Germany whose economies are largely industrial and export driven. By providing them an undervalued currency when compared to the Deutschmark, German products became more affordable to the rest of the world spurring demand for German cars, machinery and other manufactured products. Unfortunately, the opposite is true for southern European countries which are largely agrarian and import dependent. For those countries, the Euro is a huge headwind. The undervalued Euro makes importing products more expensive thus eroding the quality of life
of import‐driven Southern European countries.

The pressure on the Eurozone is mounting. Southern Europe is in a depression. Unemployment rates in southern Europe continue to rise ranging from just over 10% in France to over 25% in Spain.  Violent protests are on the rise. Capital continues to flee from southern European banks and corporations are scaling back or canceling projects in the region. Anecdotally, we have read that shops outside the large tourist destinations are no longer replenishing goods and many shelves in grocery stores are empty. Catalonia an autonomous region of Spain (and its wealthiest region) will hold a referendum on independence on November 25th, creating a constitutional crisis for the country. This begs the question, if the richest region in Spain does not want to be responsible for its countrymen’s debt, why should the Finnish?

Southern Europe is stuck in a negative feedback loop. Trapped in the Euro they will never be able to compete with their northern neighbors. Conversely northern Europe will be forced to make continuous massive transfer payments to keep its southern neighbors afloat.

A Coordinated Response

With a slowing U.S. economy and Europe facing economic chaos, Central banks around the globe have initiated the largest coordinated intervention since the financial crises in 2008.

• The Federal Reserve has initiated QE3;
• The European Central Bank has initiated a new program called Outright Monetary Transactions (OMT). If a Eurozone country asks for financial assistance, through OMT, the Eurozone’s central bank can buy government‐issued bonds that mature in 1 to 3 years, provided the bond issuing countries agree to certain domestic economic measures. This is intended to lower the borrowing costs for countries facing financial distress and provide investors with confidence in the Euro;
• China has lowered its rates and begun a form of Quantitative Easing;
• Japan and the UK have expanded their bond buying program; and
• India, Brazil and Australia all have lowered their interest rates.

All of this in combination amounts to the largest global monetary stimulus since the financial crises in 2008. So what does this mean for investors?

The Investment Markets

With central banks around the world printing money, asset prices and the investment markets should move higher. In the bond markets, we should see Treasury yields rise as money moves away from Treasuries to other fixed‐income investments. Higher yielding bonds such as mortgage‐backed securities, high yield bonds, and emerging market debt should all benefit in this environment. It is worth noting that yields are at historically low levels, therefore there are practical limits to the upside in any fixed‐income investments.
QE3 should help support property values across the board. With the real‐estate market already improving, the actions of the Federal Reserve should further support residential and commercial real estate and their related industries.

Commodities in general should benefit, in particular, precious metals. Gold has historically been a store of value and it would not surprise us to see gold break out to new all‐time highs as countries around the world devalue their currencies. Further, industrial commodities such as oil and copper should also benefit and with them their related producers and miners.

Finally, stock markets around the globe should benefit with the U.S. and Emerging Markets leading the way. While printing money on a massive scale can drive asset prices higher it cannot solve the structural problems effecting the U.S. or Europe. We are concerned about the long‐term effect this unprecedented approach will have on the health of our economy.

As you know, your bond portfolios are well positioned for this environment. We have over the last few years augmented some of the traditional holdings to enhance returns and reduce risk. We have been holding Gold in your portfolios for over a decade now. We have added corporate and international bond funds to enhance yield and we have purchased government bonds of resource‐rich nations with conservative fiscal policies and stable political systems. All of these positions are benefiting from actions of activist Central Banks around the world.

Your equity portfolios have performed well and are positioned to take advantage of this environment. As you know, we have built up positions in the home building industry, gold and gold miners, energy, financials, and high‐dividend paying companies, all of which should continue to benefit from this globally coordinated Central Bank intervention.

While all of our major stock market indicators remain positive and point to further price advances, the one concern we have is the Dow Jones Transportation Index (DJTI). The DJTI has not participated in this most recent rally. In fact, it peaked in July of 2010 and since that time it has been in a gradual downtrend. This index is made up of companies in the airlines and air freight, trucking, railroads and shipping industries. Essentially, these are the folks that move stuff. The DJTI has historically led the markets and the economy both to the up side and the down side. So this is a troubling trend.

Additionally, it is worth noting that we are reaching levels where the equity markets peaked in both
2000 and in 2007. Below is a 20‐year chart of the S&P 500 which provides some historical context. While we do not believe this chart is necessarily predicative it does indicate a degree of caution is warranted.

Click to view

However, as we stated above all of our major indicators remain positive and currently point to a continued rally in the equity markets. As we are now entering the heart of the U.S. Presidential Election, it would not surprise us if the U.S. equity markets took a breather and moved sideways until the election outcome is made clear.