On Tuesday, June 5, 2012 First Western’s Chief Investment Officer, Warren Olsen, held a conference call with clients to discuss the current state of the financial markets. Below is a synopsis of the call.
Messes, Mediocrity, Mystery and Mistakes
Warren Olsen, Chief Investment Officer
The state of the global economy and its effects on the financial markets made for an interesting first half of the year. In the first quarter, the world’s equity markets, as measured by the Morgan Stanley Capital International All Cap World Index, were up 12 percent while the S&P 500 was slightly better on a total return basis – price appreciation plus dividends.
The second quarter, thus far, has surrendered the gains, and while the S&P 500 is still up for the year, the world’s equity markets are slightly negative. Financial news reporting, favorable in February and March, is now rather bleak. So, the question is, has the financial world radically changed in the last couple months or was the positive reporting perhaps a little too sunny and the current negative reporting a little too dark?
Messes – The European Union
Mess: A disordered, untidy, offensive or unpleasant state or condition usually because of blundering, laxity or misconduct.
The European Union (EU), comprised of 27 of Europe’s 50 countries, is in a recession and there’s significant speculation as to whether the Euro will survive. The Euro Zone, which includes 17 of the 27 countries in the EU, is experiencing historically high unemployment rates – over 11 percent. Comparatively, Spain’s unemployment rate is at 25 percent (50 percent for people under 30), Greece is experiencing a rate of over 20 percent and rising, France is around 9.5 percent and Germany, due to the strength of its economy, is near 7 percent.
By size, Greece’s sovereign debt market is nearly $500 billion, or about 1 percent of the total debt issued globally by governments. Spain is about $1 trillion, or about 2 percent of the world’s market and Italy, the fourth largest issuer in the world of government debt behind the US, Japan, and Germany, is $2.6 trillion, accounting for close to five percent of all debt issued globally by governments.
Europe’s debt crisis is exacerbated by trying to coordinate the actions of numerous countries, each with its own unique political and cultural issues. In addition, recent elections in several countries, in particular Greece and France, have added additional complexity to solving the crisis. The newly elected officials won in large part by campaigning against the current set of ideas being used to address the crisis, reinforcing the idea that there is no one clear solution to the current problems.
Greece has a long illustrious history of sovereign debt defaults. From 1932 to 1964, they issued a moratorium on paying back foreign debts. So, their current fiasco is not groundbreaking. Greece is currently faced with three major structural problems that are extremely difficult to fix.
First, the government plays too great a role in the economy. Second, they have unsustainable labor laws – they basically have the inability to fire people, and overly generous benefits, especially pensions. And third, tax laws are routinely flouted. In the U.S., while people complain about their taxes, we don’t experience widespread systemic cheating. Greece does, and that’s where the crisis, interestingly, is accelerating because people who previously were not cheating are now justifying why they shouldn’t be paying their taxes. These factors have led to an under-productive, overleveraged society that’s hit a tipping point.
Spain’s economy is about five times larger than the Greek economy. At $1.5 trillion dollars, it’s about a tenth of the US economy, and two percent of the world’s GDP. Although their economy is much larger than that of Greece, the sovereign bond market is only two times as large. The Spanish bond market is close to 68 percent of national GDP. As a reference, the German bond market is 82 percent of GDP and considered very safe and sound, France is 86 percent of national GDP and the U.S. is nearly 103 percent.
Whereas Greece’s issues reside primarily in the public sector, Spain’s issues are concentrated in the private sector but beginning to spill into the public sector. Ultimately, Spain is suffering the effects of a hangover from their own version of a sub-prime crisis with an unsustainable housing and construction bubble that eventually popped. The crash of the real estate sector has led to an economic recession with severe stress on the Spanish banking system and excessive unemployment, as an inordinate amount of Spaniards were employed in construction.
The EU as a whole is not insolvent financially. They have the financial capacity and strength to solve their issues, maybe even more so than the United States. And while individual countries can’t inflate their way out of these problems, the Euro can.
Mediocrity – The United State Economy
Coming into 2012, we (First Western) expected to see modest economic growth in the U.S. this year. Our prediction was that the economy would grow about 2.5 percent this year, however, first quarter GDP was just under two percent.
For 2012, we expected unemployment to end the year at approximately 8 percent, aided by new job growth of approximately 150,000 per month. Through April we had seen the unemployment rate fall from 8.5% at the end of 2011 to 8.1 percent. However, the most recent report shows that unemployment has increased to 8.2 percent. Through May, monthly job growth has averaged nearly 163,000 jobs, though the last two months have averaged less than 100,000 new jobs. The desire to slow down public sector spending, has led to a net decrease in public sector jobs. On the positive side, net new job increases are coming solely from the private sector. When you put it all together and take out all the noise, it points to the fact that while there is a recovery, it continues to be weak.
Housing remains unclear with a consensus that we may be hitting a bottom. Business activity is currently the strongest part of the economy. Construction spending is rebounding off of its recent lows and is up seven percent on a year-over-year basis. The good news is public construction spending is actually down; the increase is being driven by the private sector.
The effect of the European Union’s economic problems on the U.S. is probably overstated. Although there may be some collateral effects in terms of confidence, the EU has done a decent job taking the counterparty risk off the table.
Looking ahead, the U.S. economy could experience a substantial drag if the “fiscal cliff” comes to fruition. The fiscal cliff refers to the mandated $100 billion in federal spending cuts, the potential end of the payroll tax holiday, and the sunset of various Bush-era tax cuts coming together simultaneously. If the fiscal cliff occurs, the Congressional Budget Office (CBO) estimates it would take nearly $500 billion out of the U.S. economy. If the U.S. were to extend the Bush-era tax cuts and the payroll tax holiday, and eliminate the $100 billion reduction, the CBO reports a potential 4.4% growth in GDP in 2013.
Mystery – China and India
China and India, the two largest engines of emerging market economic growth, are showing signs of slowing. The mystery lies in trying to determine the extent of the slowing. Data for these two countries can be difficult to ascertain and the accuracy can be questionable. For instance, last quarter India reported GDP growth of a little over five percent, the slowest growth in the last eight or nine years. Yet, consensus numbers show six to seven percent real GDP growth. Keep in mind India needs about a three percent growth in order to accommodate the rising population.
There’s an amazing amount of speculation on whether China is experiencing a soft or hard landing. When you look at China’s economy, about half is actually based on internal consumption and demand and continued growth. We believe this strong internal growth coupled with its strong exports lends itself to a soft landing; China will most likely experience 8.5 percent real growth this year.
Mistakes – Investments
What does the state of the global markets mean for investors and what are we seeing in terms of investor mistakes?
Investors need to be able to stomach substantial volatility. If large down days in the market or May’s nearly nine percent decline has investors questioning their asset allocation, their appetite for risk probably isn’t as great as they thought. On a positive note, stock volatility is nowhere near where it was in 2008. Good managers can still distinguish themselves by picking better companies, as opposed to last year and 2008 when all stocks seemingly moved together.
Below we’ve provided insight on major investment classes and a sample of investor mistakes:
Equities continue to see compelling valuations even in a weakening global economy. We still like mega cap stocks – large stocks that can generate revenues and profits on a global basis and are not too dependent on any one geographic area for their success.
We continue to favor U.S. global stocks and believe we’ll see compelling buys for some European multi-nationals.
Although High Yield bond spreads have widened pretty dramatically recently, valuations still look good, default rates are below average and you get paid for the risk.
We remain positive on commodities due to long-term secular drivers. However, in 2012 we may see negative returns due to the slowing of the global economy.
US government bonds are possibly the riskiest, most expensive asset class today. The yield on the ten year treasury recently hit an all time low. This means ten year treasury bonds are more expensive than ever and the risk/reward ratio is terrible. The European problems have led to speculation that the Fed may implement a third round of Quantitative Easing (QE3) or an extension of “Operation Twist”. Operation Twist is the Fed’s program of selling short-term bonds and using the proceeds to buy longer-term bonds. The intention is to drive down longer-term borrowing rates in an attempt to spur borrowing and economic growth.
Extreme market movements, often referred to as “tail” events are essentially impossible to predict with any regularity (hence the reference to a “tail” event) and many investors make the mistake of thinking they can avoid these events by being out of the market when these events occur or can effectively hedge away the risk.
This may be one of the largest mistakes that investors make. However, by establishing a proper strategic asset allocation, which takes into account an investors ability to bear loss, need for liquidity and sensitivity to inflation risk, an investor can “ride through” periods of extreme market movements. Although no one enjoys these periods, a properly designed investment strategy can weather these storms.
If you have questions about your portfolio or would simply like to discuss the topics above in greater detail, please contact your portfolio manager.