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Mechanics Bank investment chief predicts “long hard road to recovery”

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RICHMOND, CA, October 26, 2010 -- The National Bureau of Economic Research (NBER), the keepers of the official US recession time clock, have declared the Great Recession over as of June 2009, but to small businesses and millions of unemployed it doesn't feel that way. Subdued aggregate demand is choking small businesses and optimism has dropped to levels consistent with recession. That's according to the latest Duke/CFO Magazine Global Business Outlook Survey, long considered a leading indicator. That means that a long hard road to recovery still lies ahead, says Brian Pretti, SVP and chief of investments at Richmond-based Mechanics Bank.

“Housing starts are near all-time lows,” says Pretti, explaining his own lack of optimism. “Auto demand is still 33 percent below the highs seen a number of years ago. And consumer credit has declined every single month over the past two years with only one exception, a pattern we've never seen before.”

The bank’s allowance for loan losses totaled $35.7 million at June 30th, 2010 ($13.9 million more than one year ago) and represented 2.00% of total loans. At June 30th non-performing loans totaled $47.1million, which was 2.64% of total loans, but the majority of those non-performing loans are secured to some degree by real estate or other forms of collateral.

Pretti points to a year-end slowdown in the economy, now that the bulk of government stimulus is spent. “Businesses and people are still deleveraging their balance sheets—as well they should,” he says. “At the end of the second quarter, US household debt was down almost $500 billion from levels four years ago. What's particularly interesting is that this deleveraging corresponds almost exactly to $500 billion in US bank loan defaults—suggesting that most of the deleveraging at the household level was accomplished by default, not actively paying down debt. It's no surprise, given that job and wage growth have been non-existent. Until we see job and wage acceleration, households simply will be unable to heal their balance sheets.”

Interest Rate Outlook: How Low Can It Go?

“I never thought I'd see a two-year US Treasury note with a .37 percent yield—or a TIP with a negative yield—but both are making history today,” says Pretti. “These historical lows reflect the unprecedented monetary stimulus measures of the Fed. From March 2009 through April 2010, they printed $1.5 trillion in new money to buy bonds, thereby increasing bond prices and lowering bond yields. They call it 'quantitative easing'—a polite term for printing money out of thin air. But even after driving mortgage rates to a record low it hasn't spurred housing or other domestic consumption in any meaningful way. Consumers recognize they need to pay down debt, not borrow more.”

Despite this reality, experts expect the Fed to try again in coming months. “Simply put, the Fed has run out of policy options,” Pretti points out. “With short-term interest rates already at zero the only option left is to print more money and buy bonds to keep interest rates low—while hoping lower rates will spark borrowing.”

Currency Devaluations: Nobody Wins the Race to the Bottom

Pretti also points to “a new world war” that has begun in the global currency markets as each country joins the “race to the bottom” in devaluing their currency.

“As every developed and developing country desperately tries to stimulate their economies, lack of aggregate demand is a defining global problem,” Pretti says, “Central bankers worldwide have embarked on 'beggar thy neighbor' policies of currency devaluation, hoping to gain an export advantage. But when everyone is trying it at the same time, no one can win.”

Pretti points out that currency interventions have had a powerful effect on US interest rates. Central bankers worldwide are printing money to purchase two-year US Treasury bonds. Theoretically, this should depress the value of their currencies relative to the dollar—and encourage the US to buy more of their exports. But since the Fed's dollar-printing binge is depressing the value of the dollar it becomes a zero-sum game. “No one wants to back down, though,” says Pretti. “Central bankers don't care what yield they're getting on Treasuries; depressing the value of their own currencies is the goal. The net effect of their bond-spending spree is to lower US interest rates.”

These government-fueled interest-rate depressants may keep rates very low for an extended period, benefiting bond prices, according to Pretti. But he cautions that investors must recognize that the bond market is being driven by artificial and anomalistic forces that cannot last forever. “At some point central bank buyers will walk away and let free market forces take over. Nobody knows what will happen next, but risks are growing for those holding longer maturity bonds in the bond market is one scenario,” Pretti warns.

For Equities, “Buy” May Be the Operative Word

September and October are traditionally weak calendar months for stocks. So, why did the S&P 500 rise 8.75 percent in September on a price-only basis—the greatest gain for this month since 1939? Does it mean the economy is about to get a whole lot better?

Pretti doesn't think so. “Investors are reacting to the Fed pumping liquidity into the market in September and promising that it will respond again to further economic slowing,” Pretti says. “When the Fed printed a total of $28 billion on 11 of 20 trading days in September, those 11 trading days drove 80 percent of the month's total stock market return.”

With that in mind, some prominent hedge fund managers have said they believe stocks are a win-win for the foreseeable future. “Stocks benefit if the economy improves and they also benefit if the economy worsens, since the Fed will print more money,” Pretti says. But he cautions against over-enthusiastic equity buying.

“Investors need to assess the amount that stock prices already reflect expected future Fed money printing,” he points out. “Excess money can create 'asset bubbles' when it finds its way into financial markets rather than the real economy—as has already been demonstrated. Pay attention to the possible consequences of government intervention—it's no time to be dogmatically bullish or bearish. Flexibility, vigilance and respect for risk—along with an understanding of the unusual forces that are shaping investor behavior, are paramount.”

Safety in Blue Chips and Commodities?

Pretti recommends focusing on yield-oriented equities and undervalued blue chips. “In an environment pockmarked by deflationary tendencies, income is a scarce resource,” he says. “Additionally, the decade-long bear market in equities has caused the valuation of large, globally oriented blue chips to contract substantially. Ten years ago investors could not buy Intel fast enough when it was selling at 50 times earnings. Today, no one wants it at 10 times earnings with the price down close to 75 percent over the prior 10 years. I think many of the large brand-name global companies are currently at very reasonable valuations—not bargain-bin prices, but reasonable.”

He also recommends purchasing commodities priced in dollars but traded globally. “Longer-term protection of purchasing power is a dominant investment theme. From June of this year until the present, the dollar has lost 13 percent of its value relative to foreign currencies. Oil, cotton, corn, soybeans, silver, wheat, and platinum—these commodities jumped meaningfully in September.”

“As I said last quarter, it's not the end of the world,” Pretti concludes. “But whether you're a consumer simply trying to hang on until there's real job and income growth or an investor trying to figure out a safe landing place, it's important to realize that the forces at work in today's economy are unlike anything seen in the past 50 years. It will be a long time before anything is 'back to normal.' Understanding and managing investment risk has never been more critical.”

About Mechanics Bank

For more than a century, Mechanics Bank has been committed to helping people build prosperous communities as a trusted financial partner, forging lasting relationships through teamwork, respect and integrity. The $2.9 billion independent bank, headquartered in Richmond, California, offers personal banking, business banking, trust, brokerage and wealth management services through 33 offices across Northern California.

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