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Our Place in the World, Financially Speaking

To gain insight on what to expect from the markets in 2012, it’s important to examine the events of 2011. Although a difficult year in terms of returns, the macro events such as the tsunami in Japan, the European sovereign debt crisis and the Arab Spring weighed heavily on the markets. These major global events swamped micro decisions making it a very difficult year for money managers.

Japan

One of the major economies in the world, Japan plays an important role in the global supply chain. Yet, they have the highest level of debt versus GDP in the world. Because of the damage caused by the tsunami, they’ve had problems with the speed of money turnover in the economy. However, their debt is internally financed; they own their debt. As they continue to rebuild their infrastructure and money starts to move more freely, we may see the Japanese economy strengthen in 2012.

Mideast

The uncertainty of the Arab Spring caused the markets to react unfavorably, primarily due to the worries it created around the price of oil. Additionally, analysts discussed the possibility of the uprising spreading beyond the Mideast and reaching China. Concerns were raised regarding what types of government will be put in place. It’s always difficult to invest for tail risk, and the Arab Spring/Mideast in general, may be the biggest tail risk issue in the world. Although democracy may be a great thing for the world, any transition period is tough for the markets considering the Mideast is the major source of the world’s oil.

China

A dominant driver of global growth, China slowed its economy in 2011 to prevent the economy from overheating. This decision caused concern as to whether they could actually engineer a soft landing – which it appears they did. Their importance to the global markets should not be underestimated as they contribute largely to geopolitical issues and global economic growth.

Contrary to popular belief, the Chinese economy is only 25% driven by exports. Exports, as a percent of China’s GDP, have dropped 15% in five years, which demonstrates the strong rate of consumption within the country. Fortunately, the government has the ability to offset the decrease in exports with the build up in retail demand, infrastructure spending, and public housing, all of which will continue to drive the economy in the short term.

United States

The 2011 political issues in the United States negatively affected the economy. We managed to almost technically default on our debt because the two parties couldn’t agree on a course of action. In the past, extending the debt ceiling has been fairly mechanical. However, the political dynamic nearly caused the Federal Government to shut down. Furthermore, the idea of a double dip recession was still on the table and the U.S. debt rating was downgraded for the first time in history which, contrary to what most investors would have expected, led to a rally in the government market.

Europe

Europe was weighed down with its own share of issues last year with severe debt problems in Southern Europe, specifically, Greece, Spain, Portugal and Italy. The major issues included worry of countries defaulting, the viability of the Euro and the European Union, financial contagion (meaning who actually owns the credit risk), counter-party risk (financial system shutdown), and the possibility of a severe recession or even depression. This led to a highly volatile market atmosphere worldwide.

Measuring Volatility

When measuring market volatility, it is important to consider the VIX, a Wall Street index that tracks volatility for the S&P 500. The VIX index ran very high last year, with the volatility reaching the 2008, 2009 levels. This was caused by the lack of delineation between stocks. The vast majority of the 500 stocks in the S&P 500 were performing in a similar fashion. When people were opposed to owning stocks they all went down and when they thought things were getting better, all stocks went up. During this time period, there was little reward for doing appropriate fundamental research to decide which stocks were better. This led to a difficult year for equities.

On a global basis, the world’s markets were down about 7% for the year. If you take the strength of the U.S. out of that equation, the world’s markets were down about 16%. While the S&P was flat on a price basis, it was actually up about 2% with dividends.

Looking Forward

As of today, 2012 has been a strong year for equities. Yet, there is still uncertainty as to whether we will experience a continuation of 2011. Looking at the VIX, volatility has gone down dramatically and according to CNBC, Bloomberg and various money magazines, the recent activity in 2012 is considered a relatively “normal” market environment. With several macro issues moving towards resolution, the market has stabilized, resulting in a more typical investing environment.

In the United States, the talk of a double dip recession has subsided. The recovery, although slow and sustained, is progressing. Unemployment, a lagging market indicator, is coming down and housing seems to be reaching a bottom. Political risk is subsiding in the U.S.; Europe has addressed the two big issues: financial contagion and the likely resolution on the Euro staying intact. We’re seeing good value in large cap equities, emerging markets, and credit within fixed income and commodities.

Macro events and micro decisions will continue to impact short and long-term investment strategies. Fortunately, trend line growth in the global economies is aiding the U.S. market to perform better than expected. And we hope that trend continues.

This article is a summary of the economic update provided by First Western’s Chief Investment Officer, Warren Olsen. If you missed Warren’s presentation and would like to listen to the audio recording, click here.

 

 

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