Quarter 3, 2011

As this quarter’s newsletter goes to print, the headlines are dominated by stories about the looming potential U.S. debt default. Once a subject that financial advisors always reacted to with a grin as it could never be conceivable, the very real potential now exists only hours away if our legislators cannot come to terms on a temporary solution or “stop-gap” measure to preserve the country’s credit standing. Naysayers, “permabears”, and gold salesmen are pitching the event as the end of the world, and in my opinion, a U.S. Treasury default would be right up with the “Worst-Case Scenario” when it comes to our country’s financial independence. As this is (I hope) a once-in-a- millennium situation, I beg your indulgence for an extra page or two to this quarter’s diatribe.

Fortunately, I have it on good authority (cnn.com) that our legislators are working tirelessly on a compromise that will accomplish their two primary objectives: 1) The government will not default on its obligations, and 2) debate over this issue will not interfere with the next round of election campaign advertising. I do have great confidence that a last- minute, landmark solution (with the commensurate media hype) will be announced, and we will be saved by our leadership on global television. Unfortunately, I do fear that by choosing this long, ugly route to a temporary solution rather than facing the all too obvious problems, we have cast our country’s Congress and executive leadership in an embarrassing light, both domestically and around the world. Certainly, in no boardroom, of any company, in any country in the world could discussions and accounting tricks like this seriously be given consideration…unless, of course, that company was Enron…

As I review the news today, different options for “Kicking the Can” are resounding in the headlines once again. While I am confident a working solution to prevent default will be reached, I only ask that in the next election, you take the advice of the senators and representatives of the bipartisan National Commission on Fiscal Responsibility and Re- form, (www.fiscalcommission.gov) and support the leaders who work to bring a long-term solution to the table, punishing the politicians who back down from the “politically difficult” decisions we elected them to face.

Source: BEA, FactSet, J.P. Morgan Asset Management.

Source: BEA, FactSet, J.P. Morgan Asset Management.

Again this quarter I have had the opportunity to travel extensively in each of the markets Cascade operates in, and held a series of meetings with our advisory boards in each market. These advisory boards are comprised of business leaders, other wealth management experts, clients and even some competitors. I treasure the re- source these meetings have become, as they force us to step away from looking at the investment world from the inside out, and allow us to see our industry from the position of the consumer. Two messages are extremely clear this time: 1) Investors are very concerned about the path of the U.S. and global economies, and are concerned that there is no economic recovery 2) Their local economy has improved dramatically, and many of them are facing growth-management issues in their own businesses.

Source: Census Bureau, FactSet, J.P. Morgan Asset Management.

Source: Census Bureau, FactSet, J.P. Morgan Asset Management.

This quarter’s view of the economic numbers would seem to support exactly that…the economy is gaining ground but consumers are still feeling a bit sick to their stomachs. Let’s look first at the recovery in GDP. As the figure to the right shows, GDP continued to grow at a rate of 1.9% in Q1, which is not robust but certainly a move in the right direction. Indeed, the economy has recovered over $634bn of output, significantly more than was lost in the recent recession. We continue to see significant growth in corporate balance sheet strength, and are now finally starting to see some of this cash being deployed to capital goods orders. In the most recent quarter we saw these orders move to the plus-side of aver- age, indicating that we are now under- taking a rebuilding of corporate infra- structure and inventories.

Source: BEA, FRB, J.P. Morgan Asset Management

Source: BEA, FRB, J.P. Morgan Asset Management

Likewise, the U.S. consumer has continued to get their own balance sheet under control, with the continuing decline in household debt service ratios at lows we have not seen since the mid-90’s. With a better balance sheet comes a higher credit score, with the average Equifax score continuing its rise. Overall, it seems the only ones that can’t get their financial house in order are our elected officials.

Source: FRBNY Consumer Credit Panel, J.P. Morgan Asset Management.

Source: FRBNY Consumer Credit Panel, J.P. Morgan Asset Management.

Thus, it would appear that our economic growth is being held back by one primary is- sue…the lack of consumer confidence. It may be argued that much of this is driven by the inability of congress to do the job they were elected to do…but I’ve talked about that enough already. Whatever the reason, consumer confidence remains very low, and consumer spending is rising at a rate significantly lower than GDP. To find consumer sentiment this low, we’d have to look back to 1992, when the Clinton campaign was victorious by focusing on the economy (which had just experienced a recession) and coining the phrase, “It’s the Economy, Stupid”.

Source: University of Michi- gan, FactSet, J.P. Morgan Asset Management.

Source: University of Michigan, FactSet, J.P. Morgan Asset Management.

So do I sell it all and buy gold?

If that thought has crossed your mind, you wouldn’t be the first. If the unthinkable were to happen and the U.S. did default on our debt, that may prove to be the wisest solution. For obvious reasons, I choose to ignore the hype and, for the most part, allow the current gold rush to blow on past me. While gold may be an appropriate sliver of a portfolio’s allocation, I am clearly not in the “sell it all and buy gold “ camp.

Instead, I believe that it may be prudent to evaluate what types of investments perform well in various investment environments, then build a portfolio of selections from the strongest performing groups. Consider the chart below:

 

Source: BLS, Barclays Capital, Robert Shiller, Federal Reserve, Strategas/Ibbotson, Standard and Poor’s, FactSet, J.P. Morgan Asset Management.

Source: BLS, Barclays Capital, Robert Shiller, Federal Reserve, Strategas/Ibbotson, Standard and Poor’s, FactSet, J.P. Morgan Asset Management.

This chart reviews the performance of four asset classes – bonds, equities, cash and commodities – in four different inflationary scenarios. I’ve included all four scenarios so that you can make your own determination as to where we are and where we might be headed, but I tend to feel as though we are currently in the “Low and Rising Inflation” sector. Thus, my investment preferences should be given to both stocks and commodities, as they are historically the strongest producers in this type of environment. Given the recent run up in the prices of several commodities and the reasonable valuation of many sectors of the global stock market, (see our Q2 2011 letter) my preference today is clearly to favor equities. While the idea is not with- out risk, it is my opinion that the investor who accumulates equities in the face of the turmoil surrounding the debt issue will stand the possibility of being rewarded upon the resolution of the crisis.

I look forward to watching as the debt ceiling crisis fades into obscurity over the next few weeks, and hope our congress does not drop the issue once the immediate pressure is off, but carries the current momentum through to a permanent resolution. To close, I’ll turn to an excerpt from the Fiscal Commission’s bipartisan report, issued last December:

Our challenge is clear and inescapable: America cannot be great if we go broke. Our businesses will not be able to grow and create jobs, and our workers will not be able to compete success- fully for the jobs of the future without a plan to get this crushing debt burden off our backs…As members of the National Commission on Fiscal Responsibility and Reform, we spent the past eight months studying the same cold, hard facts. Together, we have reached these unavoidable conclusions: The problem is real. The solution will be painful. There is no easy way out. Every- thing must be on the table. And Washington must lead.

I wish you all a fantastic rest of your summer!