Economic Outlook

The ongoing debt crisis in Europe triggered an equity market correction of (17.9)% from the S&P 500 high of 1,363.61 on April 29 to its 1,119.46 low on August 8. Investors’ fear that defaults in Greece could trigger a domino effect through Ireland, Italy, Portugal, Spain and possibly France underlayed the market decline. The fallout, according to some observers, could exceed the financial and economic damage following the Lehman Brothers failure.

U.S. equity markets have reacted as if Europe’s problems are our own, although the potential impact is far from clear. The amount of European sovereign debt owned by U.S. banks is described by Federal Reserve Bank Chairman Bernanke as “manageable”. Also, U.S. banks are more strongly capitalized than European banks and better able to withstand credit defaults.

While a financial collapse in the European banking system would have devastating economic consequences across the European Union, its effect on the U.S. economy is debatable. When the Japanese economy entered a 20-year malaise in 1990, it was our second largest trading partner yet it had no discernible negative impact on the U.S. economy. Still, the European problems contributed to the growing number of economists predicting a “double dip” recession in the U.S.

Clearly, the U.S. economy has enough of its own domestic issues without importing Europe’s problems. We have yet to resolve budget deficits which, if not addressed, are programmed to increase over the next 10 years to Greece-style levels. Whether the policy approach to reduce deficits is through spending cuts or tax increases, there is a potential drag on economic activity. Weak housing markets and high unemployment are ongoing drags on the economy.

Despite the slow economic growth, corporate profits are strong. While the U.S. economy grew at nominal year-over-year rates of 4.1% and 3.8% in the first and second quarters, respectively, our portfolio holdings had year-over-year earnings per share growth of 26% and 22% in the respective corresponding quarters. Lean cost structures and sales to “emerging markets” contributed to these favorable earnings results. Although we expect earnings growth to moderate toward its historical norm of about 7%, it demonstrates that corporate earnings are not tied to U.S. economic growth as closely as many investors fear.

The strong earnings growth in our equity portfolios, if achieved in more normal times, would be accompanied by relatively high price/earnings ratios. Due largely to the macro uncertainties discussed above, our portfolios have P/E ratios of about 12x based on 2011 expected earnings and 11x on forecast 2012 earnings. Equities appear to offer exceptional value, especially relative to record low yields on fixed income securities.

We continue to favor equities over fixed income and high quality, large-cap stocks over small-cap.

^{Note: This commentary contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast; the opinions stated here are subject to change at any time and are the opinion of FAMCO’s Strategy Committee. The data is obtained from sources we deem reliable; it is not guaranteed as to its accuracy. Past performance does not guarantee future results. Investing in Master Limited Partnerships may require tax filings in multiple jurisdictions. This report is not an offer or the solicitation of an offer to sell or buy any security, service or investment strategy.}