Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
Fourth Quarter: October 2011

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Soft Patch?

Definition:

Soft Patch [pach]

Noun

  1. A period of economic slowdown, usually amid a larger trend of economic growth.
  2. The space between a politician’s ears, where a brain would normally be found.
Kicking the Urn

After the most recent quarter, there can be no doubt that the world economy has hit a soft patch, in economic terms, but more importantly, in terms of political leadership, common sense, and effectiveness.

What started out as a routine Congressional vote to increase the debt ceiling, turned into a shameful display of partisan brinkmanship and dysfunction. Enormous economic damage was done in the process, including a downgrade of U.S. sovereign debt, and a loss of confidence that our political leadership can agree on anything, let alone come together to address the serious challenges we face as a nation.

Meanwhile across the Atlantic, an even more worrisome train-wreck of political ineptitude continued to unfold in the face of growing sovereign debt problems there.

As various leaders continued to insist that all was well, that bad debts were good, and that the impossible was possible, financial markets continued to signal otherwise. Credit spreads spiked, assets flowed out of suspect banks, the Euro took a drubbing and Global financial markets swooned.

In the face of mounting debt problems and with the absence of credible leadership here and abroad, investors became increasingly pessimistic and defensive, pulling money out of risk-oriented assets, and buying U.S. Treasury bonds and gold.

Where do we go from here?

As we wrote in our last Commentary, the global economy was already in fragile condition at the end of the second quarter. A number of measures of domestic industrial output and business and consumer confidence were trending downwards, but still positive.

We were inclined to give the recovery the benefit of the doubt. Corporate profits and balance sheets were strong and there were important areas of strength, such as in the industrial, technology, energy, and consumer sectors. Although developing economies were slowing, they were still growing strongly.

Since that time, things have deteriorated on several fronts. One of the most broad and reliable indicators of economic activity, published by the Economic Cycle Research Institute (ECRI) just slipped into negative territory (Chart I). A number of other economic and market indicators have also deteriorated.

Chart I

The mounting debt problems in Europe and the lack of timely and effective political response, combined with the debt ceiling debacle here, the S&P downgrade of U.S. Treasury debt, and the poisonous political environment have pushed the global economy into dangerous territory.

How it all plays out will depend largely on the effectiveness of political leadership and decisions here and abroad. Ongoing dysfunction in this area could easily turn the economic soft patch into quicksand.

For the moment, we see the problems in Europe as significantly greater than those in the United States in terms of immediacy and scale.

Europe’s problems are several-fold. First, debt to GDP levels and debt-service costs have increased to a point of unsustainability relative to the ability and willingness of the Euro-zone economies to support that debt load. Chart II shows the Gross Debt to GDP of Euro-zone countries as well as the United States and Japan.

Chart 2

Greece is effectively bankrupt and Portugal, Spain and Italy are facing rising borrowing costs while enacting sweeping new austerity programs. (Chart III) below shows the growing cost of insurance against default on European sovereign debt.

Chart 3

Second, the European banking system is bulging with bad sovereign debts and is woefully undercapitalized to deal with them. The banking system needs a massive injection of new capital similar to what we achieved with T.A.R.P. (Troubled Asset Relief Program) three years ago.

Finally, there is a lack of coherent leadership between the national governments, the European Central Bank, and the International Monetary Fund. Multiple parties are communicating conflicting messages, there is a divide between national and Euro-zone interests, and major solutions, such as the establishment of the European Financial Stability Facility (E.F.S.F.), require all voting members to approve unanimously. It is bad enough getting Republicans and Democrats to agree on something with a majority vote, but imagine getting 17 nations to come to unanimous agreement.

Even if there was broad agreement on what to do and how to do it, we question whether the current Euro-zone leadership structure, prone to denial, procrastination and incrementalism, has the willingness and ability to do what is necessary fast enough to check and reverse a rapidly deteriorating situation.

In a best case scenario, all the European kings horses and men, perhaps with assistance from the U.S. and China, will endeavor to leverage the ?440 billion E.F.S.F. to create a ?2 to ?3 trillion Euro-style TARP program. It will presumably be used to inject capital in to European Banks, allow Greece to default and restructure its debt, and allow Portugal, Italy and Spain and other countries breathing room to refinance their debt on a longer-term, lower-cost basis.

In the meantime, with most of the Euro-zone countries embarking on austerity programs to cut spending, it is highly likely that European growth will contract in the coming year. The combination of a large debt-load, with a slowing economy and a fear of inflation more than deflation makes for a potentially very risky and unstable situation, not just in Europe, but around the developed and developing world.

With growth slowing in the United States and Asia, politicians behaving badly, and the possibility of a new global credit crisis, this time emanating out of Europe, the mood of the global financial markets moved from hope to fear during the quarter.

Money rushed out of global stocks, commodities, and bonds, and retreated to the relative safety of U.S. dollars, Treasury bonds, and gold.

The sell-off in global stocks and bonds was dramatic. While the S&P 500 index lost approximately 14% for the quarter, the MSCI EAFE (Europe, Australasia, Far East,) index - largely a proxy for Europe - declined by more than 20% and the MSCI Emerging Markets Index declined by over 26%. There were not a lot of good hiding places to be found other than Treasury bonds, gold and cash.

Investable Conclusions: Where to from here?

As we evaluate the current balance of risks and opportunities, we think that the risks of deflation in the near-term have eclipsed the risk of inflation.

Over the past four years, we have written extensively about our concerns about public debt levels in the U.S., Europe, and Japan. In general, we have taken the view that in a best case scenario, these debt loads would be a chronic condition, causing slower growth in the developed world, and periodic episodes of instability and market volatility. Over time, developed economies would endeavor to inflate their way out of debt by devaluing their currencies and hoping to achieve nominal GDP growth in excess of nominal debt growth. Inflation, rather than deflation, was therefore the more likely challenge to address.

We still think this is the likely longer-term path for the debt-laden developed economies, but in the near-term, with European and the U.S. economies approaching stall speed, debt is trumping growth, and deflation, rather than inflation has become the prevailing risk.

As conditions deteriorated over the summer, we aggressively reduced our own growth forecasts and our allocation to risk-oriented assets. This involved raising cash and reducing or eliminating exposure to economically sensitive sectors, developing markets, and commodities. These moves helped to meaningfully cushion client portfolios against the full impact of the downturn.

Looking forward, we think that things will likely need to get worse before they can get better. Europe needs to address its sovereign debt and banking issues and time is running out. A large amount of debt is coming due and needs to be refinanced. The time of kicking the can - or urn - down the road is reaching the end of the road.

Kicking the Urn

In the U.S., the economy is slowing. Unemployment rates remain persistently high and the current political climate leaves little hope of progress before the next election, if even then. Monetary policy has exhausted its effectiveness and cannot create new demand, and there is little appetite for bold new fiscal spending initiatives.

There is also little agreement on how to solve our problems, even though the answers are fairly obvious. They were laid out in plain, non-partisan English last December in the Simpson Bowles deficit reduction plan. Now we have a twelve person, highly partisan deficit reduction commission attempting to recreate the wheel, this time finding $3-$4 trillion in savings without cutting spending or raising taxes. Good luck with that.

Gridlock vs. Deadlock.

Politics Inaction

The conventional wisdom is that political gridlock in Washington is good for the stock market, but not when the barn is on fire and there are major problems to solve. Regrettably, things may need to get worse here before politicians feel the resolve to put their partisan ideology aside and work together to find practical decision.

Silver Linings?

Looking around, there are a few silver linings to be found:

First, investor sentiment is very negative. This is a necessary, although not sufficient condition for a bottom in the stock market. Equity exposure levels are down, and everyone is fearful of another crash. In our view, this makes it less likely to happen, at least as expected.

Second, although stocks are not overly cheap as an asset class, they are also not expensive and offer reasonable value for investors with a longer-term time horizon. The earnings and dividend yields of many high quality global businesses are considerably higher than most bonds. Conversely, bonds are no long term safe haven, although they may feel that way today.

Third, companies are in better shape than they were going into the last downturn. Managements are also more cautious and have shored up their balance sheets, streamlined operations, and reduced head count and inventory.

Fourth, some industries, such as technology or biotechnology, continue to have strong secular tailwinds to support them, even in a global slowdown.

We think that some of the uncertainty gripping the markets will play out in the near future as companies report earnings and forward guidance, and the Europeans show whether they can get successfully ahead of their problems.

Until we have greater clarity on these issues, we are keeping client assets at the low end of their allocation ranges to stocks and other risk-oriented assets. We may see some sharp rallies on reports of progress, but we find that the investment markets are too easily swayed by the short-term news cycle relative to the longer-term fundamentals. Without real progress, the near-term risks are asymmetrically tilted to the downside.

We are maintaining a moderate allocation to higher quality stocks, primarily based in the United States. We are emphasizing companies that pay robust and growing dividends, “franchise” companies with global footprints and exposure to the developing world, biotechnology companies, and technology companies tied to wireless mobility and cloud computing.

We are also at the low end of our target allocation range to developing economy stocks. Although the developing/emerging markets will be the winners over the coming decade, in the near-term, they will be more volatile and subject to what happens in the U.S. and Europe.

As these markets decline and/or as conditions improve we will likely increase our developing market exposure. Unlike the U.S. and Europe, these economies, and China in particular have enormous resources at their disposal and can make effective decisions quickly, without worrying about getting reelected.

We eliminated our economically sensitive commodity exposure during the quarter. Like the developing markets, commodities are an area that we want to have exposure to over the longer term, but they will not perform well in an environment of global contraction.

Although we trimmed our gold position, simply because it had run up so much, so quickly, we are maintaining our core weighting. We think of gold as an alternative currency and a long-term hedge against the inevitable deterioration of developed economy currencies.

Our allocation to bonds increased during the quarter and is primarily focused on strategies that emphasize high quality shorter-maturity corporate bonds, Treasury bonds of various maturities, and developing economy bonds.

Finally, we are maintaining a significant allocation to cash and cash- like investments. This has helped to provide a cushion and a source of funds to redeploy as conditions improve, or as opportunities present themselves.

Given the significant cross currents in the world, many of which are more secular than cyclical, we expect the investment environment to continue to be volatile and challenging, but also to offer-up some extraordinary opportunities along the way.

As always, we welcome your comments, questions and referrals.

Jurika, Mills & Keifer, LLC
October, 2011.

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.