The stock market rally from the March lows has been both powerful and remarkable. Supported by stabilization in the credit markets, most asset classes are well along in the process of normalization.  It appears that concerns have shifted as both the bond and commodities markets are “pricing in” higher inflation in the future.  Meanwhile, the stock market is attempting to return to the levels that existed prior to the Lehman bankruptcy in September 2008, implying significant additional upside potential for US equities.  In order for the rally to prove sustainable, however, we believe volatility needs to normalize.  Further, validation of the economic recovery will be derived from definitive improvement in certain indicators such as single family home prices and the unemployment rate.  Given the enormityof the systemic challenges brought about by excessive leverage on a global basis, we remain cautious, however, of a market test later this year.   

Fundamentally, more “green shoots” of economic recovery become evident each month.  Yet, the economy remains buffeted by considerable headwinds.  This tension will persist for the foreseeable future. On balance, however, there is ample justification for a growing sense of optimism.  Moreover, the largest impact of the Obama fiscal stimulus will be felt later this year and in early 2010.

Last year’s overriding concern – i.e., systemic market/economic collapse – is no longer “on the table”.  For that, we owe a debt of gratitude to our policy makers.  While some of their actions have been controversial, we believe that their responses were appropriately aggressive.  We believe the market has now shifted its attention away from stabilization efforts and toward renewed growth.  As the markets continue a process of “normalization,” investors will debate the unintended consequence of policy measures implemented to avert crisis – namely, inflation.  

In 2008, political pressure was exerted on the Fed to raise interest rates in response to surging oil prices.  Thankfully, the Fed resisted those entreaties.  Likewise, in 2009, there is growing concern that the Fed and other central banks should remove stimulus and, perhaps, raise interest rates to pre-empt inflation.  While we acknowledge that inflation expectations have risen and that certain policy actions are inflationary, the global GDP output gap is a compelling reason not to fear inflation at present.  Further, we feel that global efforts to reflate economies must contend with ongoing deleveraging (a deflationary force).  We believe inflationary pressures will likely not emerge until 2011 or 2012, if then.  Thus, we express our concern over a premature “unwinding” of many of the government’s support programs, and we remind investors that such actions in late 1936 arrested a nascent recovery and prolonged the Great Depression.

From a long term perspective, we remain fascinated with how the global economy will perform in an environment of considerably less leverage and substantially more regulation.  While this prospect might discourage many investors, we look forward to a world of more sustainable, higher quality economic growth.  We recommend that investors remain well diversified, and we look forward to discussing with you the reasons for our growing optimism.