RCM U.S. Strategic Outlook

Q3 2009

Corporate Profits

Consensus sell side analyst revision activity finally returned to a net positive position in Q2. By early Q3, bottom up analyst consensus estimates expect a 15% decline in 2009 and a 22% advance in 2010. At the macro level, increased fiscal deficits and smaller trade deficits are helping to cushion the profit damage, but household saving is rising rapidly and capital spending is being revised down. Costs are being cut, but revenue growth remains challenging. We expect S&P 500 operating earning per share near $50 in 2009 and $65 in 2010 as an economic recovery combines with high operating leverage.

Pricing/Inflation

Headline inflation, which had been above 4% at its peak last year, is close to zero. Core inflation pressures are likely to recede further as consumers try to rebuild their saving rate while unemployment climbs above 10% in 2009 and import prices are falling. The headline CPI should climb to 1-1.5% in 2010 as fiscal stimulus takes hold and banks begin lending reserves near $1 trillion.

Interest Rates

With the deterioration of credit conditions and employment, the Fed has imposed a near zero policy rate and moved to unconventional measures like outright purchases of MBS. The Fed’s objective is to force investors out the risk spectrum by lowering Treasury debt and mortgage backed security yields. We expect several emergency credit facilities to wind down in 2009, and no fed funds rate hikes until spring 2010.

Economic Activity

The severity of wealth losses, the overhang of unsold homes, and the widespread credit crunch all indicate this is not your typical recession. Nevertheless, massive fiscal stimulus and improved risky asset prices are stabilizing retail sales. New orders are beginning to perk up for capital equipment, and even export orders are improving despite weakness abroad. Q4 should mark the start of recovery, albeit one shallower than usual.

International

Housing, auto, and manufacturing supply manager survey results are improving abroad in response to policy stimulus, and the worst of the export and production contraction in the developing nations appears behind us. China in particular has aggressively pursued domestic demand led stimulus, and commodity prices and shipping results are showing some benefits. Europe and the UK are likely to be laggards in global recovery.

Dollar

The rapid expansion in the Fed’s balance sheet, still low Treasury yields, and the heavy Treasury issuance in 2009 may all weigh on the dollar. While shifting to a new global reserve currency is not likely until foreign nations are willing to let their currencies appreciate, discussions about new currency arrangements are unlikely to abate.

Valuation

The S&P 500 sports a forward P/E ratio in the 15-16 times range on consensus sell side analyst operating earnings estimates, which is near its historical average. While the unusually cheap conditions in Q1 have been priced out in the Q2 rally, there is still room for lower corporate bond yields and lower risk perceptions to encourage richer valuations as the recession abates.

Technical/Sentiment

For institutional investors, a lower Treasury yield environment plus losses on illiquid holdings in alternative assets may encourage asset allocation shifts towards equities. For retail investors, and low bank deposit, CD, and Treasury interest rates, plus continued home price deflation, will tend to channel higher personal savings into equities and corporate bond funds.

Fiscal Policy

Cap and trade carbon legislation will raise energy costs while encouraging exploration of alternative energy sources. Health care legislation appears hamstrung by the absence of identifiable cost savings to pay for public plans. A significant reregulating of the financial sector will proceed into 2010. The fiscal deficit has been financed with the issuance of short maturity Treasuries, which presents a significant refinancing burden, especially once short term interest rate are on the rise again. Tax hikes to reduce the deficit are likely to be in discussion after mid term elections. A second stimulus program is likely if the recovery flounders.

Past performance is no guarantee of future results. This document contains the current opinions of RCM and such opinions are subject to change without notice. This document has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.