Byron Wein Sept 2013

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Market Commentaryby Byron Wien

09/05/2013

A Complacent Group without Table Pounders

Every August for the past several decades I have organized a series of Fridaylunches for serious financial professionals who spend their summer weekends ineastern Long Island. What started as a single lunch for half a dozen people hasgrown to four lunches at different locations for more than eighty. Participantsinclude many well-known names, of whom some are billionaires, but others,though widely respected for their intellect and insights, have a net worth that maybe more modest. They are a reasonably diverse group and include hedge fundmanagers, private equity people, activists, buyout specialists and venture

capitalists. This year I tried to include some younger people who I thought mightbring a fresh perspective to the discussions. Last year the tone of the lunches wascorrectly positive about the rest of 2012 and 2013 this far, so I was particularlycurious about how they viewed the outlook from here.

I would say that the general mood of all of the lunches was one of complacency.The market had treated all the attendants well during the past 21 months, in spiteof meager Gross Domestic Product (GDP) growth, Europes recession, a slowing inChina and other emerging markets, instability in the Middle East, legislativeintransigence in Washington and the prospect of less monetary easing by theFederal Reserve. Everyone knew that the Feds accommodative policy contributedto the performance of the stock market, but there was some debate about howimportant it was. There was agreement that whatever tapering did take placewould put some pressure on equities, but, offsetting this, the economy wasexpected to pick up its momentum in the second half of 2013 and 2014, helpingearnings.

There was some discussion of who would be the next Federal Reserve Chairman.

Most agreed that President Obama favored Larry Summers, but there wassignificant opposition to his appointment both in Washington and on Wall Street.Janet Yellen was likely to continue Ben Bernankes easy money policy which hadbeen good for the stock market. Larry Summers was viewed as more of a wildcard in terms of monetary policy. At one lunch the group was unanimous inthinking that if Larry Summers were appointed, the market would go down.

Nobody expected the Fed to totally stop its bond buying program. As long as theFed was easing, Congress could feel it was off the hook in providing fiscalstimulus even though the United States budget deficit has declined from 10% ofGDP in 2010 to 4% this year and is expected to trend lower over the next twoyears. There could be some federal stimulus if Congress had any appetite for it, butit does not. Because of low yields in the fixed income market and reasonable equityearnings, stocks were viewed as the most attractive asset class. Real estate hadalready appreciated significantly and cap rates were low except for specialsituations like warehouses. Commodities had been trending lower for more than ayear and showed little chance of reversing that, so you had to be in stocks,

particularly U.S. stocks.

Most of the participants thought the market would be higher at year-end, but notsignificantly. I had some takers for 2000 on the Standard & Poors 500, but mostwere at 17001800. Only a few thought the market would be down at year-endfrom its August level, but there were no real bears. Federal Reserve policy wasconsidered key to market performance. While it is true that U.S. stocks have beenstrong since November 2012, the multiple on 2014 earnings was very moderate byhistorical standards at about 14x. Individuals have yet to invest in the stock marketin any serious way and that should be a positive going forward.

On the economy many believed the absorption of the sequester in 2013 would

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enable GDP to do better next year, but most thought real growth of 3% or morewould be a struggle. The slow growth in hourly earnings was keeping inflation lowand this was good for fast food companies and soft goods retailers. There wasconcern that the Affordable Care Act would encourage companies to move moreworkers to a part-time status, and nobody had any convincing solution to thelonger-term structural unemployment problems in the United States. Autos,housing, energy, technology and agriculture were doing well, but jobs were stillbeing cut at the state and local government level. Some felt that the undergroundeconomy was vibrant and that the unemployment rate was overstated. Regardingmanufacturing, there was considerable enthusiasm about the importance of lownatural gas prices, but low labor costs in the emerging markets were moreimportant.

Most agreed that economic conditions in Europe were improving and that therewould be some growth in 2014 led by Germany and France. While the continentcontinued to muddle through, there was disappointment in the lack of progresstoward structural improvement, but it looked like the European Union and theeuro were here to stay. The Greek restructuring of debt didnt go far enough andthe failure to reach agreement on either a banking union or some form of fiscalconvergence underscored the reality that politics is standing in the way ofprogress. A plan to forgive some or all of the sovereign debt of the weakercountries was viewed as necessary to a long-term solution, but would be politicallyunpopular. With overall unemployment in Europe at 12% and youthunemployment much higher, the potential for social unrest is a serious concern. Inthe United Kingdom there is evidence of more political flexibility, but growth isslow there as well. Europe is not expected to be a negative for U.S. equityperformance but it is not likely to be much of a positive factor for earnings oroverall world growth. There was agreement, however, that there were a lot of

cheap stocks in Europe.

On China most agreed that real growth would be around 7% this year, but the newleaders had some real challenges ahead. The banking system needs to beimproved. There are too many non-performing and potentially non-performingloans on the books. This is true of the shadow banking system as well. Thegovernment may have to renationalize the private banks. Debt as a percentage ofGDP is too high. The Chinese economy has been growing by providing credit forreal estate development, state-owned enterprise expansion and infrastructureprojects. Efforts to rebalance the economy in favor of consumer spending have notbeen successful, but consumer products companies and technology are the placesto invest. The government must attack the widespread corruption problems. Overthe next decade the renminbi is likely to rise in value. There was some convertingof currency through the gambling casinos in Macau; general convertibility would bean important positive. All of these factors are likely to put some pressure on theeconomy, but China is still likely to grow at 6% real or more over the next fewyears.

There was a positive attitude toward Japan. Everyone agreed that Shinzo Abe hadembarked on a high-risk strategy, but it seemed to be working. The increase in thesales tax from 5% to 8% next year would hurt the economy, but it can probably beabsorbed. Going the next step to 10% (which is planned) is probably a bad idea.The big question is whether Abe will move forward on the third arrow. The firsttwo were fiscal and monetary policy. The third is regulatory reform, which wouldprimarily be directed at diminishing the power of agricultural interests.

In contrast to previous years there was little interest in the developing markets.Brazil was thought to be uncompetitive, India dysfunctional, Russia dangerousunless you can operate in a remote area away from government attention. Somefrontier markets are attractive, like Vietnam and Colombia. Many liked Mexico inspite of its poor equity market performance this year.

On commodities, the unsettled conditions in the Middle East had driven oil priceshigher, but reduced demand and increased supply might bring West TexasIntermediate oil down to $90 a barrel over time. Marginal production (fracking) is

high-cost, perhaps $75$80 a barrel, and the half-life of fracking wells is short andthat will keep prices from falling further. Demand from China and India will offsetthe reduced consumption in Europe and the United States resulting fromconservation and slow economic growth. Low pricing for natural gas in the UnitedStates compared to the rest of the world was an important positive, especially forthe chemical industry. There was not much enthusiasm for gold even at theselevels.

I thought one conversational sequence in the sessions was particularly notable. Amajor real estate developer talked about a project he has underway in theWilliamsburg section of Brooklyn. He said that young professionals are livingdifferently today; they use their apartment as a closet and a bedroom. They live


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their lives outside of their home; they work late, exercise at a gym, go to a culturalevent, eat at a restaurant with friends and go home to sleep. They dont accumulatepossessions, so they can live in 600 square feet rather than 1200. At the office theyonly need 200 square feet because files and other information resources areaccessed from their computer. The computer reduces the need for supportpersonnel as well. As a result more people are being crammed into less space,putting strains on elevators and other service functions. They also have littleinterest in working in suburban office locations, reversing the trend of thirty yearsago. This phenomenon may not be relevant everywhere, but it is clear in New York,Chicago, Boston and San Francisco.

Following his remarks, a technology expert commented on the entrepreneurial zealof young people. They dont see themselves building a long career over time with abig corporation. They want to get some experience and then start something oftheir own like a small business, a hedge fund or an Internet company. One of theirgoals is clearly to achieve financial success at an early age, but another aspiration isto have a more flexible lifestyle. These changes are bound to have an impact onconsumer spending.

Almost everyone agreed that education was the most serious problem in the UnitedStates but it had proven almost impossible to fix. Charter schools had helped, butour public school system, particularly in large urban areas, was not performingwell. Graduation rates were low and many of those who did graduate could not doserious college work. The teachers union was part of the problem, but probablymore serious was the breakdown of the family unit which created circumstances athome that made it difficult for the child in school. Middle class education was stillgood, however, and we still had outstanding institutions of higher education, sothere was hope for our ability to maintain innovative leadership in a competitive

world, but the gap between the haves and the have nots was likely to widen.

I always try to devote some time to a discussion of cosmic issues. The violence inEgypt and Syria was on everyones mind. One participant said that he worriedabout the potential friction that he saw developing between the Moslem world andthe Judeo-Christian world of the West. The root of this is youth unemployment,which was one of the key triggers for the inception of the Arab Spring in NorthAfrica. If a good part of the Moslem world continues to live in desperate economiccircumstances while Europe and the United States enjoy a high standard of livingand moderate growth, tensions are likely to grow. Where China, India and SaudiArabia fit into this is an open question, but it is clear that the world has pockets ofinstability that have investment implications.

Other issues that the participants considered important were environmentalpollution, corruption by authoritarian governments, a lack of availability of waterfor drinking and agriculture, global warming causing the oceans to rise andadversely affecting the weather, epidemics, and a lack of food for a growing worldpopulation. The advent of 3-D printing was believed to put more pressure on job

growth. One participant quoted a chief executive survey which found their greatestconcerns to be taxes, terrorism, cyber security and regulation. Clearly the peoplerunning companies are worried about issues that are likely to have a moreimmediate effect on their day-to-day operations. Perhaps they are tired of hearingabout the major problems facing the world with so little being done about them.

There were concerns that the big American cities couldnt afford to maintain theirinfrastructures and would become dependent on the federal government. Somewere frustrated that they couldnt repatriate their profits that had accrued abroad,but they already had plenty of cash on their corporate balance sheets waiting forprofitable investments in the U.S. to appear. It made sense to keep the moneyabroad because thats where the opportunities were likely to be. One participantsuggested that the government could provide tax relief to companies bringingprofits back if they invested in domestic infrastructure projects. Anothercomplained that the government had set up too many hurdles to repatriation.

My conclusion, reflecting on the four lunches, was that there were some significant

tail risks lurking out there. The unintended consequences of sending missiles intoSyria or not sending missiles into Syria may be one of them. The inability ofEurope to make the structural changes necessary to ensure the long-term survivalof the European Union and the euro could be another. Irans nuclear threat mightbe a third. The major long-term problems had not held equities back over the pasttwo years and most of the attendees thought the downside risks wereovershadowed by the upside opportunities. A dull market rather than a difficultone was more likely. Greater-than-expected downside risks could be thenon-consensus surprise.

* * * * *

Please save the date for future Blackstone webcasts featuring Byron


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Wien.

Click here to register for the Thursday, October 3, 2013 11:00 am ET BlackstoneWebcast: Can Macro Problems Scuttle The World Recovery?, featuring ByronWien, Vice Chairman, Blackstone Advisory Partners.

Click here to view the replay of the Thursday, July 11, 2013 11:00 am ET BlackstoneWebcast: Bond Yields May Hold The Key, featuring Byron Wien, Vice Chairman,Blackstone Advisory Partners.

Click here to view the replay of the Thursday, March 28, 2013, 11:00 am ET

Blackstone Webcast: Money is EverythingSo Far, featuring Byron Wien, ViceChairman, Blackstone Advisory Partners.

Click here to view the replay of the Thursday, January 10, 2013, 11:00 am ETBlackstone Webcast: Byron Wiens Ten Surprises of 2013, featuring Byron Wien,Vice Chairman, Blackstone Advisory Partners.

Click here to view the replay of the Thursday, October 25, 2012 11:00 am ETBlackstone Webcast: Is the 2012 Market Ahead of 2013 Reality? featuring ByronWien, Vice Chairman, Blackstone Advisory Partners.

The webcast presentation is downloadable from the interface.

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The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Partners L.P. (together

with its affiliates, Blackstone) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the

current views of Mr. Wien as of the date hereof and n either Mr. Wien nor Blackstone undertakes to advise you of any changes inthe views expressed herein.

This commentary does not constitute an offer to sell any securities or the solicitation of an offer to purchase any securities. Such

offer may only be made by mean s of an Offering Memorandum, which would contain, among other things, a description of the

applicable risks.

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indirectly referenced in this commentary and may also perform or seek to perform investment banking services for those

companies. Blackstone and/or its employees have or may have a long or short position or holding in the securities, options on

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Investment concepts mentioned in this commentary may be unsuitable for investors depending on their specific investment

objectives and financial position. Where a referenced investment is denominated in a currency other than the investors

currency, changes in rates of exchange may have an adverse effect on the value, price of or income derived from the investment.

Tax considerations, margin requirements, commissions and other transaction costs may significantly affect the economic

consequences of any transaction concepts referenced in this commentary and should be reviewed carefully with ones investment

and tax advisors. Certain assumptions may have been made in this commentary as a basis for any indicated returns. No

representation is made that any indicated returns will be achieved. Differing facts from the assumptions may have a material

impact on any indicated returns. Past pe rformance is not necessarily indicative of future performance. The price or value of

investments to which this commentary relates, directly or indirectly, may rise or fall. This commentary does not constitute an

offer to sell any security or the solicitation of an offer to purchase any security.

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