Operation Re-Boot
By Jude Bedell & Mike Frazier

The second half of 2010 can be viewed as a do-over. After a strong start to the year, a late Spring sell-off has erased the gains and left investors unclear about what lies ahead.

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Dividends are again a yield-seeker’s best friend. With blue chip stocks paying over 2% and the bluest companies able and willing to raise dividends, investors are falling in love with dividends again. It is the total return which attracts us: a stable dividend above 2% with a chance to raise the dividend to 2.5%. Factor in the added attraction of collecting cash premiums by writing covered calls against the stock and the investor has the total return package: lower risk and higher cash flow. Life is good! Greedy investors often make the mistake of ignoring the quality of the dividend. They see a high dividend yield and jump in, but more seasoned investors look to make sure the dividend is sustainable and suitable.

U.S. Treasury bonds are historically the safe haven with their coveted AAA credit rating. Worries about the global recovery have added stress to credit markets creating a dramatic bull market for U.S. Treasuries, which are enjoying their best year since 1995. Investors around the world seek alternatives to Europe – where the EURO is down 14% – so U.S. Treasury bonds are the beneficiaries. When the U.S. government auctions off its Treasury bonds, it is in effect borrowing money at ridiculously cheap rates. This is the first step to achieve the ultimate goal of the Group of 20 countries to reduce deficits.

China Flexes Its Currency By Mike Frazier China remains the focus of all things economic in 2010; it is the decisive growth engine of the global economic recovery. Period. Many skeptics challenge the accuracy of data released from the Chinese government, but the growth trend is undeniable. China has averaged 10% annual growth for the last 30 years. China’s outstanding growth brings natural concern about inflation from an economy that could again overheat.

The Chinese government has begun taking proactive measures to cool things down by tightening lending standards and making money more expensive. This tightening of credit aims to slow down consumer spending, particularly in real estate. With a population of 1.3 billion people and growing – that’s 20% of the world’s population – China has to continue to grow its economy to support its population and provide jobs. While the Asian culture rightfully values the aged, an astonishing 92% of the Chinese population are under 65 years old.

The big news out of Bejing was the Chinese government’s decision to loosen up its currency. Its value will still be pegged to the Dollar, but will move more freely. The floating Chinese Yuan could be the dénouement of globalization as we have known it for the past decade. Personally, I never thought I’d live to see the day China abandoned its rigid policy of pegging its currency to the U.S. greenback. We’re still not there yet. But this point of departure in monetary policy is very significant. A weaker Yuan will make the rest of the world’s goods more competitive than China’s. Multinational companies selling goods to China will win. Losers will include companies like Wal-Mart who became heavily dependent on Chinese goods to undersell its competitors. This should increase export revenues worldwide.

Chinese stocks traded down 23% this Spring, so the timing of this devaluation leads us to affirm that the new China, which has been overly-cautious in its monetary history, is learning some of our American appetite for risk. The revaluation
move is a total game changer as it diffuses a potential trade war with the U.S. while attracting and accelerating more foreign investment in China’s retail sector. Most significant, the Chinese government would not be doing this if it were worried about a relapse to recession.

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U.S. consumer confidence fell more than anticipated in June and erased two months of prior gains. This forward-looking indicator has increased anxiety among retailers and economists alike. Some blame this hiccup on expiring housing credits, others on high unemployment. One thing is certain, the consumer is not out of the woods yet and remains under pressure.

What has the consumer in a funk? In a word: employment. There is a great dichotomy in the U.S. between the haves and have-nots, between the employed and the unemployed. The old adage rings true here that the definition of a recession is when your neighbor loses her job. It is a contagion case for consumers who tend to empathize with the unemployed even though they are themselves gainfully employed. For the employed, personal income has never been higher with wages and salaries rising for the past five months.

Budget-conscious consumers have been scrimping and saving wherever possible. This is a positive for discount retail stores like Target and Costco, and restaurants like McDonald’s. We expect to see consumer spending increase, albeit at a snail’s pace over the Summer, but expect the consumer’s natural optimism to return long before the Autumn leaves fall.

Technology goods remain sizzling. Shoppers are snatching up red-hot smart phones like Apple’s iPhone 4, which went on sale last week, and Google’s Droid-X. But it’s not just must-have phones that have consumers running to electronics departments and specialty retailers. Apple sold over three million iPads in the last three months. Video game systems still attract teens and adults alike.

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Congress finally has a Financial Reform Bill on the table. The stripped-down version passed in the House and now heads to the Senate. It appears less onerous than initially anticipated. Most banks can rule out their worst-case scenarios. Investment banks would be the hardest hit. They would be constrained by the “Volcker” rule, which would remove a bank’s ability to invest in speculative investments. Banks would be limited to a maximum of 3% direct exposure to private equity and hedge funds. This is considered a hit to the “Too Big to Fail” banks, and a win for the consumer. Goldman Sachs would see the greatest negative impact, but Bank of America and JP Morgan would also feel it.

The overhaul legislation clarifies that banks should hold more capital. However, the verbiage leaves open to interpretation the actual numbers constituting “more capital.” An unintended negative to this legislation might cause banks to hold onto more capital, resulting in less lending. Economic growth needs banks to continue lending to prolong the global economic recovery. We’ll be reporting more details as they become available.

The U.S. Treasury market is the most liquid, efficient and safe in the world so it’s back in the spotlight again. The 10-year treasury yield just broke below 3% for the first time since the spring of 2009. Back then, we were still in a credit crisis and the whole financial system was at risk of failing. Today, the financial system is not on the brink of disaster although it is still under stress. The current risks around the world are smaller in size but are much greater in number.

The G-20 nations met in Toronto. Trade and financial reform was the agenda. All 20 nations unanimously pledged to cut their deficits in half within the next three years. The Bond Market is pricing-in global crises causing interest rates to remain historically low. Cheap and accessible money stimulates economic growth. Global demand for U.S. bonds is quite strong since aversion to risk is high. When you add subdued inflation into the mix, you have a recipe for extended low interest rates and a wonderful time to be a bond investor.