Eking-Out Small Gains

Most clients’ portfolios enjoyed modest gains during the second quarter, reflecting weak performance in April, a solid comeback in May and the first part of June, followed by big drops in June’s final week. Small cap stocks, one of the weaker asset classes in the first quarter, were “best-in-show” this time around. Mike Fitzhugh’s article below on our recent portfolio rebalancing activity describes our efforts to capture (over the long term) the benefits of this kind of asset class performance change.

Despite the discomfort produced by spiking (and then retreating) and respiking (and then again, retreating) oil prices, economic fundamentals are strong and looking stronger. Consumer confidence is up, unemployment is down, GDP growth for the 1st quarter was adjusted upward to a 3.8% annual rate, and inflation remains tame. There’s good reason to believe that more good performance is to come. Business spending, slow to rebound from the market downturn of the recent past, is now coming increasingly on line, adding to the consumer spending impact. The slow pick-up in employment of 2003 and early 2004 many now have a silver lining in the form of increased productivity as more capital was invested per employee during that slow-to-hire era. Who knows for sure? Still, there seems little grounds for pessimism now that hiring has also picked-up.

As expected, the Federal Reserve raised short-term interest rates another 0.25% at the very end of the quarter. No surprise there. What disappointed many market participants was the absence of any change in the Fed’s tune. Many were hoping for a clue that the rate increases were about to cease. Frankly we’re not sure how that would be especially good news if it signaled a weakening of the economic fundamentals. Balancing the competing factors is a delicate and elaborate dance; thus far, Alan Greenspan and colleagues seem not to have missed a step.

In the article that follows, our CIO, Jason Thomas, discusses some of the longer range implications of the current interest rate scenario and also how the dollar’s performance can be expected to impact portfolio returns.

This quarter, the dollar was up 7.0% against the Euro, as the EU exposed some of its structural discord on top of its generally weak economic performance. Still, clients’ investments in developing economies overseas are producing respectable returns through the first half of 2005.

A Real Estate Bubble?

That is the question of the hour…for clients, and especially, the media. Some commentators are convinced that a bursting is virtually certain and imminent. If so, the impacts could be severe, both on direct real estate assets and other portfolio positions as well because of real estate’s many and extensive second and third level impacts. But, we’re not so sure. The still low interest rate environment remains very supportive, and numerous unique tax benefits apply to real estate. Its very illiquidity makes a bursting unlikely; at most, a slow deflating may be in store. Moreover, the phenomenon of substantial increases in residential real estate values is global. In fact, the run-up in home prices in both Australia and the UK was considerably larger than in the US, creating a bigger housing “bubble” which was potentially even more vulnerable to collapse. These increases are found especially in locales attractive to the world’s mobile rich, and, probably for similar reasons, are not so pronounced in some less desirable areas. The law of supply and demand does not seem to have been repealed. In the most desirable locations, there is great demand and not so much supply.

Nevertheless, as a hedging measure, we believe that where clients do make real estate investments beyond their personal residence(s), they should focus on categories (commercial/industrial/multi-family rental) and geographies that provide some diversification, just in case. Further, as Kacy Gott and Andy Hamilton discuss in a following article, reducing the long term cost of financing a real estate purchase is always a smart idea. Returns will be what they will be, you have no real control over that part of the equation. You can, however, control a large part of the cost.

Meanwhile, our best guess is that rather than a “crash” (15% - 20%(?) declines in average prices), the more likely outcome is a slowing down in the rate of increase. Short-term rates in both Australia and the UK were considerably higher than current US short-term rates when housing activity there began to slow in the first half of 2004. Even though both central banks even raised short-term rates a bit higher, the weakness in housing activity has not led to a collapse in home prices. Instead, in both countries, there are signs that housing turnover and home prices have stabilized.

While there is a lot of room between the prospective outcomes of crash and merely slower positive growth, we believe clients’ real estate holdings are likely to be quite safe over the longer term so long as they can afford the illiquidity in the event of a nasty short-term.

Tim Kochis,
Editor