Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
Third Quarter: July 2012

View a PDF of this commentary

Sign Up

to receive our Commentary and other updates:

Send us an email about this commentary

The Leadership Cliff

On a sunny morning in early June, Newark, New Jersey Mayor Cory Booker gave a compelling commencement address at Stanford University. Besides calling upon graduates to embrace difficult decisions and make a difference, he also commented on the challenge we face as a nation that has become “so politically polarized between left and right that we are losing the ability to move forward.” At a time when forward motion and effective solutions are critical, a spirit of shared sacrifice, compromise and bipartisan cooperation are in short supply.

Wedding Bell Blues

The absence of effective political leadership and governance in the face of large and growing problems is not unique to the United States. In Europe, the situation is arguably worse. There, they have a system of 17 governments that doesn’t work. Here, we only have one!

The necessary solutions here and in Europe are well understood but economically difficult and politically costly to achieve. In the U.S., the solution is something along the lines of the Simpson Bowles Commission recommendations, involving major spending cuts, tax increases, and new strategic investment. In Europe, the solution involves full fiscal and political union, including the mutualization of existing debt and future debt issuance, and the subordination of national economic authority to a centralized European authority.

These solutions involve facing reality, abandoning ideology and embracing pragmatism. They require shared compromise and sacrifice. But, although we say we want leaders who can work together to get things done, that’s not who we vote for. More than ever, we support those who appeal to our self, rather than collective interests. And so, we get what we pay for, and we end up paying for what we get.

We still believe that political leaders will ultimately do the right and sensible thing. But this is often at a point of crisis, when there is no alternative and the threats to collective interests outweigh the threats to individual ones. And, this is also at a point of crisis that is largely of our own making; the result of doing too little, too late, rather than acting soon enough and forcefully enough to prevent the accident before it happens.

This is precisely the problem. In the face of deteriorating economic conditions, of impending “Fiscal Cliffs” here, and the ongoing Euro-zone crisis abroad,the absence of credible leadership and effective action creates an environment of fear, uncertainty and doubt (aka “F.U.D.”) that causes individuals and employers to de-risk, defer and disengage, only exacerbating current conditions.

As great as our economic challenges may be, our greatest challenge is a crisis of leadership and confidence. This can be overcome in time, but the question of whether things need to get worse before politicians act to make them better is giving consumers, business people and investors legitimate pause.

This chasm of uncertainty between now and then results in an evermore challenging, albeit interesting investment environment: the tail risks are greater, growth is depressed and markets are more volatile. But expectations are low, pessimism is in abundance, and good assets - such as high quality stocks and real estate - are for sale at reasonably attractive valuation levels, and “safe” assets - such as U.S. Government bonds - look expensive.

These conditions may persist for some time, and even move to greater extremes. But, over time, the most likely path to investment success is, as it has always been, to invest in high quality productive assets when they are cheap – which is usually when things look scary - and hold on. Conversely, the most likely path to investment failure is to buy overvalued assets – including seemingly safe ones like bonds – or to panic out of the markets when the going gets rough. Over the years we have learned that good investment decisions rarely feel comfortable, and investment decisions that feel comfortable are rarely good.

Review and Outlook:

Global economic growth slowed markedly in the second quarter and financial markets declined as fear and uncertainty displaced the more sunny optimism that characterized the first quarter.

After a solid but somewhat underwhelming quarterly earnings season, big picture fears from Europe, here in the States, and in the developing markets took center stage. Investors turned “risk-off,” selling their stocks and heading to the sidelines and the ostensible safety of dollars and Treasury bonds.

In the U.S., the S&P 500 declined 2.8%. European shares, as measured by the MSCI EAFE (Europe, Australasia, Far East) index, were down 6.9%, and Emerging Markets, as measured by the MSCI, Emerging Markets Index declined nearly 9%. Beyond the benchmarks, many individual stocks and sectors performed considerably worse. Technology shares, one of the star performers in the first quarter, were down over 5%, and commodities were down over 10%. Gold also declined over 4%.

Meanwhile, as European credit spreads expanded in peripheral countries like Spain and Italy, the yields on “safe haven” sovereign bonds in German and the U.S. fell to record low levels. The 10-year U.S. Treasury yield fell to 1.6% by the end of the quarter, and German 10-year yields fell to 1.33%, in sharp contrast to Italian and Spanish 10-year yields which moved above 7% and 6% respectively. (Chart I)

Chart 1

Here in the U.S. most data indicate that overall economic growth is slowing. The ECRI Leading Indicators Index (Chart II) which briefly went back in positive territory in February and March, has turned negative again. The Institute for Supply Management (ISM) Manufacturing Index fell below 50 in June, indicating slowing growth. The Services Index is also declining, but remains above 50. (Chart III). Finally, employment growth continues, but at a tepid and slowing pace.

Chart 2
Chart 3

There are a few bright spots. First, housing, as measured by both new and existing home sales (Chart IV) and prices (Chart V) continues to show signs of bottoming and slow recovery. This makes sense to us as real estate valuations are generally low and attractive, inventories are being depleted without significant new home construction to replace them, and the stigma of owning real estate is dissipating. In a low return, low interest rate world, owning a home looks pretty good, especially if you can get cheap financing. Imagine how much better housing would be with a little more confidence and a little easier access to credit.

Chart 4
Chart 5

Energy and other commodity costs have also declined, resulting in extra savings for consumers, and lower input and transportation costs for manufacturers.

In the U.S., the $14 trillion question is whether our economy is suffering a temporary setback or is rolling over into another recession, and whether there are policy actions, whether monetary or fiscal, that could reverse this course.

For now, we still think the probabilities are that the U.S. avoids falling into another recession, but the global slowdown does appear to be accelerating, and at any rate, the level of growth in the U.S. is suboptimal. It is not enough to generate sufficient new jobs or allow the economy to sustain its current debt burden.

If things do get materially worse, we would expect there to be additional monetary policy actions taken to help, such as an additional round of “Quantitative Easing.”

The problem with these monetary policy responses, both here and abroad is that they are no substitute for good fiscal policy. Moreover, they are realizing diminishing returns in terms of their effectiveness. They do not cure the underlying illness: too much debt, too little leadership, and a growing imbalance between spending and revenues.

Europe’s Wedding Bell Blues:

Europe remains the largest risk to the economic outlook. For years, the Euro-zone has operated on an Economies with Benefits basis, sharing a common currency and enjoying its economic benefits, without having to commit to the full sharing of obligations and responsibilities. Well, the romance is over and it’s time to fully commit, in sickness and in health, ‘til death do us part!

Interestingly, the country at the center of this imbroglio is no longer Greece or even Spain, but Germany, with Angela Merkel playing the part of the reluctant bride.

This is quite understandable given the position that she and Germany find themselves. Germany is the largest and healthiest economy in Europe and there can be no effective solution to the European debt problem without Germany agreeing to underwrite the debt obligations of its profligate neighbors to the South. This is very unpopular among the proudly industrious German people. Why should they work until the age of 67 to subsidize Frenchmen to retire and drink Bordeaux at 60?

And yet Germany cannot easily walk away from the altar either. They have benefitted greatly from their membership in the Euro-zone, which has allowed them to price their exports in Euros, making them cheaper and more competitive than they would be in Deutschmarks. Also, German banks own an enormous amount of problem debt from troubled countries. If the Euro-zone falls apart, Germany will suffer as well.

So, Merkel and Germany and the rest of the Euro-zone find themselves in a quandary. It is doubtful that the Euro-zone can work without full fiscal and political union, requiring Germany and other creditor nations to assume large liabilities incurred by others, and all countries to cede fiscal control to a centralized European authority.

And yet this is politically difficult to do and only growing more so. Voters say they want membership in the Euro-zone, but they don’t want to make the difficult sacrifices to make the marriage work or subordinate their national identity and interests for a European one. In fact they are moving further apart. Northern Europe doesn’t want to subsidize the South and Southern Europe doesn’t want the North telling it what to do.

And as Europe falls into a fairly deep recession, which is our base case assumption, the fiscal imbalances, economic hardships, political tensions and nationalistic tendencies will only increase.

We still think that in time, when faced with the harsher consequences of inaction, politicians will take the necessary steps to act. But it will likely be a reluctant and incremental process. Meanwhile, time is running short, and it is unclear whether the actions will be enough to prevent economic conditions in Europe from deteriorating further.

It is likely that the European Central Bank, in coordination with other Central Banks and the International Monetary Fund will continue to try to play a supportive role, keeping financial markets stable and liquid, but as in the U.S., the effectiveness of these actions, without clear progress towards a lasting solution, will be limited.

In the mean time, we expect Europe to dominate headlines and weigh on the global economy and financial markets.

Emerging & Developing Economies:

Emerging and developing economies, led by China, are also slowing, although growth is still solidly positive, in the 7% to 8% range, at least according to official data. Part of the slowdown is a direct result of the slowdown in Europe and the United States. In China’s case, another part of the slowdown is the result of excess investment in real estate and infrastructure. A final part results from Government measures to deliberately curb growth and inflationary pressures.

Although people are worried about a “hard landing” in China, we are much less concerned about China than we are about Europe. China may be guilty of over-investment in real estate and infrastructure, but this is actually a high-class problem: one they can grow into, and one we wish we had. China is also sitting on well over $3 trillion in reserves and has a lot of room to restimulate their economy if desired. Finally, while the Chinese government, unlike the U.S. and Europe, tends to focus on longer-term strategic objectives, they have the ability to act quickly and decisively if and as needed.

Current Environment:

The economic and investment environment has admittedly deteriorated since last quarter. If there is a silver lining, it is that investor sentiment has turned so negative. The problems are well known and have been thoroughly analyzed. There is widespread pessimism, and money continues to flow out of stocks into bonds. Stocks are overly disliked and discredited and bonds are overly loved.

These conditions can continue and even move to greater extremes. Just because everybody knows or expects something, doesn’t mean that it won’t happen or matter. And, as we have discussed, there is a self-fulfilling inevitability about the current slowdown. Like characters in a Greek Tragedy, politicians cannot easily escape their fate to allow the accident to happen, even though it is in their power to prevent it. Last summer’s debt-ceiling debacle is a case in point.

But, in our experience, the greatest risks are not usually the ones you are focused on, but rather, the ones that you are not. Things rarely play out the way the majority of market participants expect: Governments and Central banks can take unexpected action, either individually or collectively to address problems; problems in one area can benefit another; novel solutions can be found; there can be unintended consequences of actions and inaction; things can come out of left field for better or worse that change the course of events.

And, when expectations are already very low, bad news is not a big surprise, but a little good news can do wonders.

The current investment environment is also increasingly characterized by a bi-polar, “risk-on” - “risk-off” culture which tends to exacerbate price movements as money sloshes around from one asset class and sector to another, without regard to the intrinsic value of individual investments.
This dynamic can lead to exaggerated volatility and valuation disparities between what is “hot” and what is not. It also affords the opportunity to avoid the crowd and make great long term investments at good prices.

Finally, ten years of lackluster returns, “flash crashes,” botched IPO’s, and banking scandals have done little to instill faith in equities, especially in the face of such large looming macro challenges. Rather, they have driven more investors out of stocks into the perceived safety of bonds and cash, despite a negative real rate of return. This may prove to be a fine strategy for the near term, but is likely to be a disastrous one for the long term.

Balance is the key:

We think balance remains the key guiding principle for investing in this confusing and conflicted investment environment, especially with these looming near term “cliff” issues to be resolved. Things may need to get worse before they get better, but then again, they may not. Expectations are already quite subdued. At the same time, strategies that are designed to mitigate near-term pain, are likely to minimize longer-term gain.
We are therefore maintaining a suitable balance between both short and long-term thinking, combining risk-oriented investments in high quality domestic and emerging market equities, with defensive and income-generating investments in bonds, and alternative assets that can help mitigate volatility and smooth what is almost certain to be, to paraphrase Bette Davis, a bumpy ride ahead.

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

Jurika, Mills & Keifer, LLC
July, 2012

Important Disclosures

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

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. 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..