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October 10, 2011 Bill Hackney, CFA (404) 876-9411 www.atlcap.com gloom, Despair and Agony on Me ! “Gloom, despair and agony on me Deep, dark depression, excessive misery If it weren’t for bad luck, I’d have no luck at all Gloom, despair and agony on me.” Song from the TV show “Hee Haw,” 1969-1992 After nine months of contentious battles on Capitol Hill, Americans have reached a new level of disgust toward congress . . .Whether Republican, Democrat or independent, more Americans disapprove of Congress than in more than two decades of Washington Post-ABC News polling. ~ Washington Post, October 5, 2011 Attention shoppers! Are you worried about financial collapse, riots, earthquakes, and other assorted forms of pestilence? Well, the retailer Costco has a deal for you. For a limited time only, they are offering a 20% discount on “THRIVE 1 Year Food Supply.” According to the Costco website, for only $799 you will receive 84 one gallon cans of grains, fruits, veggies, etc. which have a shelf life of up to 25 years. Said one satisfied patron, “We purchased the supply as a standby. There are too many possibilities of problems on the horizon, civil unrest, inflation, strikes and shortages in food . . .” The constant drumbeat of bad news has put many Americans in a deep funk. Some are going into survival mode and stocking up on freeze-dried food. Others are dumping their stocks in fear that another protracted bear market and recession might be right around the corner. Most see no way out of the intractable problems confronting the world economy. Over the last three months: The US lost its AAA bond rating. Congress came perilously close to causing a Treasury debt default. The US housing market showed few signs of recovery despite herculean efforts by the government to prop it up. Ditto for the labor market. The European sovereign debt crisis worsened with rioting and strikes breaking out in several European capitals. The emerging market economies of Asia and Latin America—heretofore the engine of a global economic recovery—began to slow under the weight of tighter monetary policy. Everywhere it seems nothing is headed in the right direction. Given all this bad economic news, the markets have acted in a traditional and predictable fashion. Stock and commodity prices plunged. Even gold—often touted as a hedge against both inflation and deflation—declined sharply in price during September. A flight-to-quality took place in the bond market: yields on lower grade bonds rose (bond prices declined) and the yields on higher grade bonds declined (bond prices rose). Bond investors, however, didn’t pay much attention to the Treasury debt downgrade. Treasury bonds rallied during the quarter and were probably the best performing asset in most portfolios. OPINION AND ANALYSIS OF KEY ECONOMIC AND INVESTMENT ISSUES Page One At this juncture, the key question for investors is whether a recession is near or the recent slowdown in growth is a transitory soft patch. If we’re going through a temporary slowdown in growth, then the stock market has overshot to the downside. The gloom and despair will dissipate and stocks will rally. If a recession is right around the corner, then the market has got it right: things are as bad as they seem. In this case, there is further downside risk to the stock market. We believe that the US and the emerging market economies will avoid recession at least through 2012, so we expect the stock market to rally in the months ahead. Europe, about 25% of the world economy, is likely to drift into recession, but it shouldn’t be severe enough to drag down the rest of the world. “Animal spirits” is the term John Maynard Keynes used in his 1936 book The General Theory of Employment, Interest and Money to describe emotions which influence human behavior and can be measured in terms of consumer confidence. ~ Wikipedia, October 5, 2011 Pay attention to what people do, not what they say It appears to us that what Americans are saying about our economy is out of sync with prevailing reality. For example, recent surveys of consumer and business confidence are at recession levels. Yet, the latest data on retail sales, industrial production and capital spending portray an economy that’s experiencing moderate growth. Noted market technician John Mendelson often points out that, in trying to figure out the direction of the markets, he pays attention to what people do, not what they say. Here’s what the American people are doing about the economy. They are spending money. Retail sales are currently growing about 7.2% yearover-year according to recent surveys by the Commerce Department and the International Council of Shopping Centers. September auto sales were up 9.9% from year ago levels. These numbers are not what you see in a recession. Luxury retailers are growing sales about twice as fast as the discounters, but all major categories are showing growth. In fact, the Victoria’s Secret chain just reported a whopping 13% sales gain for September—apparently the “animal spirits” of the economy are still alive and well in the consumer sector. They are still producing. Manufacturing production in August rose a respectable 3.8% over the prior year. The gains were led by autos and business equipment. The value of manufacturers’ unfilled orders grew 8.2%, suggesting that industrial production should continue to increase in the months ahead. The biggest contributors to GDP growth during this anemic US recovery have been capital equipment and exports. These are manufacturing intensive activities. For example, 70% of what we export is manufactured goods. And exports now represent almost 14% of US GDP, a record peacetime high. Donald Trump frequently mouths the myth, “Everybody knows we don’t make things anymore.” Nothing could be further from the truth. They are investing for the future. Despite growing concerns about the European debt crisis and a slowing world economy, American businesses are still investing for the future. Non-defense capital goods orders for August (a good leading indicator for capital investment in our economy) showed a healthy OPINION AND ANALYSIS OF KEY ECONOMIC AND INVESTMENT ISSUES Page Two annual increase of 25%, thanks largely to Boeing aircraft. Even without the volatile aircraft component, capital goods orders grew 11%. While some of these capital goods orders are due to foreign demand, their recent strength belies the gloomy business sentiment shown in the confidence surveys. When you get beyond the rhetoric of despair found in the confidence surveys, the popular media and in Washington, what you see is a US economy that is growing steadily and does not appear poised to fall into recession. US economy not solely dependent on Washington Women’s Wear Daily reports that Mary Kate and Ashley Olsen are struggling to meet demand for a $39,000 alligator backpack from their luxury line, The Row. The outrageously expensive backpack was “the first thing that sold off the shelf,” Ashley said at the Paris launch of the twins’ new handbag collection on September 30. ~ The Marquee Blog — CNN.com October 6, 2011 We believe that much of the angst that Americans are feeling reflects their disappointment with the way government is functioning. The bearish view is that the US government is out of monetary and fiscal options to stimulate the economy. It can’t increase spending or cut taxes because of debt and deficits. It can’t lower interest rates much further because they are so low already. Moreover, if government could come up with a plan to stimulate growth, gridlock among the Democrats and the Republicans would prevent its implementation. In short, there’s “no way out.” A recession and financial crisis, just like 2008, must be right around the corner. While events could play out this way, we would assign a 70% probability that they won’t. Fortunately, our relatively free-market US economy—operating in a global financial and economic system—is not solely dependent on what happens in Washington. Neither is our stock market or bond market. The US government played a crucial role in preventing a complete financial meltdown in 2008 and 2009, but the influence of the US government in promoting economic growth in 2010 and 2011 has been marginal at best. Other powerful and global forces are at work on our economy. One such force is the value of the dollar on world currency markets. This is the stimulus that nobody talks about. Over the last decade, the dollar has dropped over 30% in value. A weaker currency has made US goods more competitive on world markets and is one reason exports are at record highs. Another force is technological innovation. The US is a world leader in computer hardware, software and Internet applications. You won’t find too many Steve Jobs and Bill Gates abroad because most other countries don’t have the critical combination of venture capital, higher education, regulatory infrastructure and entrepreneurial spirit that we do. Technology has driven big increases in manufacturing productivity over the years. That’s why foreign auto makers have located their production facilities in the US. In the case of BMW, they make all their X3 SUVs at their Greenville, SC plant and export 70% of the output to the rest of the world. Listen up, Mr. Trump! Still another force is the global commodity markets. The broad-based CRB commodity index is now off about 17% from its high in May, reflecting the slowdown in global economic growth. Lower gasoline, heating oil, copper and corn prices give a much needed boost to consumer purchasing power. OPINION AND ANALYSIS OF KEY ECONOMIC AND INVESTMENT ISSUES Page Three Atlanta Capital Management Co., LLC 1075 Peachtree Street NE Suite 2100 Atlanta, GA 30309 Another scary bit of news out of the United Kingdom, which has been overtaken by riots in the past three days: The sale of baseball bats via the UK branch of online marketplace Amazon has risen over 5000 percent in the last 24 hours. ~ The Huffington Post, August 9, 2011 The real lesson from Europe is actually the opposite of what conservatives claim: Europe is an economic success, and that success shows that social democracy still works. ~ Paul Krugman, Nobel Prize winner in Economics, January 2010 The last force is foreign central banks. While the Fed doesn’t have much room to lower interest rates, many foreign central banks do. Most emerging market countries began to raise interest rates in 2010 as inflation pressures began to build following their rapid recovery from the 2008-2009 global recession. Now, with commodity prices weaker and growth slowing, these central banks are in a position to begin lowering their interest rates. When they do, it should have a salutary effect on both the US economy and stock market. (Recently the Fed announced Operation Twist which is a plan to lower longer term US interest rates. This should have a beneficial effect as well.) The positive impact of these four forces should help keep the US out of recession for the next year or so. We expect a moderate acceleration in US GDP growth in the final half of 2011 to about 2.0 % from the 0.9% “stall-speed” growth rate of the first half. Europe is key to avoiding global recession The wildcard in the global economic outlook is Europe. It is also the key to whether or not the rest of the world can avoid recession. The economies of Portugal, Italy, Ireland, Greece and Spain are at or near recession. Their GDPs total about 7% of global GDP. Greece will probably default on its sovereign debt any day now. The fear is that the others will follow suit and a rash of defaults will bring down the European banking system and eventually the global economy. The US banking system is much better capitalized than the European system and has limited exposure to troubled European sovereign debt. But we estimate that about 15 – 20% of S&P 500 revenues come from Europe, so trouble there will adversely impact the earnings of many US multinational companies. The European situation is difficult to handicap. Our view is that the European Central Bank will ease monetary policy and euro zone leaders will create a bank bailout plan akin to our TARP program. These measures are unlikely to prevent a recession in Europe, but they should reduce its severity and alleviate concerns about the stability of the European banking system. Any signs of progress in Europe should lift the spirits of US equity investors. All this, however, will require some political skill as well as luck. To paraphrase the singing hillbillies on Hee Haw, “if we have anymore bad luck in Europe, we’ll have no luck at all.” This information is not intended as investment advice or a recommendation to purchase or sell specific securities. The opinions expressed herein are those of the author and do not necessarily reflect the views of other employees at Atlanta Capital Management. These opinions may change at anytime without prior notice, there is no guarantee that any forecasts or opinions expressed in this material will be realized. While every effort has been made to verify the information contained herein, we make no representation as to its accuracy. Company names are used for illustrative purposes only and should not be construed as a recommendation to buy or sell any financial securities. Index and commodity changes are based on price-only percentage change. It is not possible to directly invest in an index. Past performance does not predict future results. OPINION AND ANALYSIS OF KEY ECONOMIC AND INVESTMENT ISSUES Page Four