Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
Fourth Quarter: October 2012

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The Chairman and the Chair

Clint Eastwood once famously remarked that “A man’s got to know his limitations.” Turns out, Clint is better interrogating a stoolie than interviewing a stool. Still, his now famous and somewhat bizarre interview of an empty chair at the RNC convention became the unintended high point of the event.

Meanwhile, back in Washington, Federal Reserve chairman Ben Bernanke is dealing with his own empty chair, this one reserved for Congress.

The Chairman and the Chair

In the face of deteriorating global economic conditions, the upcoming “fiscal cliff,” and an apparent lack of urgency on the part of Congress and the President to do anything about it, the Chairman stepped in and did what he does best. He reopened the Fed’s medicine cabinet and prescribed a large new dose of “quantitative easing” to help stimulate the economy, committing the Federal Reserve Bank to keep interest rates low, and to buy in mortgage and other debt through the end of 2014.

And he is not alone. In Europe, Japan, China, and elsewhere around the world, his counterparts at foreign Central Banks have been doing all they can to keep the global economy aloft with their own monetary stimulus.

Their actions have so far helped to stabilize and lift the financial markets in spite of a somewhat foreboding macroeconomic outlook and large uncertainties lurking ahead. During the third quarter, global stock markets turned in strong results. The S&P 500 marked a new post-crisis high, up 6% for the quarter and 16% year to date. Europe and emerging markets also turned in strong performance for the quarter. 

Just where global stock markets and long-term interest rates would be without aggressive central bank intervention is a good question.

It is very likely that stock markets would be lower and interest rates would be higher.

The latest dose of monetary meth, along with open-ended commitments of future support have helped to ease near-term concerns about large risks to the financial system, especially in Europe. The Central banks have made it clear that they will do whatever is in their power to stabilize and support the global economy despite the best efforts of elected officials to do as little as possible, for as long as possible to avoid dealing with the difficult problems at hand.

And so, despite the host of uncertainties facing them, and perhaps because the markets are in a highly medicated state, investors have bid up stock prices.

Given the run-up in the market year-to-date relative to the current state of affairs in the world, we think global stock markets, especially in the U.S. are vulnerable to a pullback.

We do not expect a major downturn in the stock markets unless economic fundamentals deteriorate significantly from here, but we do think that at current valuation levels it makes sense to realize some gains and reposition portfolios towards areas of greater value and opportunity, and adopt a more defensive posture overall.


Global growth is slowing. Europe, the world’s largest economic zone in terms of aggregate GDP is in a deepening recession.

Charts I and II show the Purchasing Managers Index for manufacturing and services for the U.S., Europe and China. Any number above 50 on the PMI indicates expectations for growth, and below 50 indicates contraction.

Chart 1
Chart 2

The developing and emerging economies which are heavily reliant on exports to Europe have seen growth slow, especially in the manufacturing sector. The services sectors have declined but remain resilient.

The U.S. is the relative bright spot, the smartest kid in the slow class. After a weak second quarter, we have seen economic indicators here pick up in the third quarter especially in the consumer and services sectors.

For the time being, we are most concerned about Europe. Mario Draghi boldly said in July that the European Central Bank would go where no European Central Banker had dared to go, and do “whatever it takes” to keep the Eurozone together. This was a major positive shift in policy. European leaders have also been uncharacteristically supportive of moving towards greater political and fiscal union in their rhetoric.

These are all steps in the right direction and have had a remarkable calming effect on financial markets, making an imminent collapse of the Eurozone seem unlikely, and causing Spanish and Italian bond yields to fall and European equities to rally.

But besides not falling apart, the Eurozone faces a more fundamental challenge of generating sufficient economic growth and revenue to offset its growing expense obligations. Thus far, the European approach is to close the fiscal imbalances through austerity measures - cutting costs and raising taxes. But it is very difficult to generate robust new growth through austerity. And austerity measures tend to result in social unrest and animosity between creditor and debtor nations, haves and have nots.

At the same time, Europe is experiencing a flight of capital – both financial and human, and especially in Spain, Italy and France. Global businesses are redeploying capital investment from continental Europe into the United States and emerging markets. Talented Europeans are leaving in search of better opportunities elsewhere. This makes the economic hole from which Europe must climb all the more challenging. We think Europe is in for a long and hard economic landing.

Ironically, the term “hard landing” is most often applied to the emerging economies and especially China rather than Europe, even though the emerging economies are in much better economic shape. China is still growing at a 5% to 7% rate. Even if these numbers are overstated, China and the emerging economies have significant financial resources to stimulate their economies and large potential for future growth.

China in particular, has a burgeoning urban middle class, equal in size to the population of the United States, who are driving more and more internal growth and consumption. We view the current downturn in the developing and emerging markets as a temporary rather than chronic condition.

Here in the U.S. economic growth is plodding along at a slow but positive pace. It is not as fast or uniform as it needs to be, but it is improving. The bright spots include the consumer sector and housing. Housing looks to have bottomed (Chart III) and is heading higher. If lending standards would ease, housing would rebound even faster. Retail sales have also been strong. The consumer seems much less worried about the Fiscal Cliff than the pundits on Wall Street.

Chart 3

Export-driven sectors are having a tougher time, as they feel the effects of the slowdown in Europe and Asia. Employment growth remains positive but sluggish. As shown in Chart IV, we are adding about 120,000 private sector jobs a month on average.

Chart 4

Although the stock market has been strong, a lack of leadership and clarity is holding our economy back from operating at its full potential. Individuals and businesses are staring at the empty chair too, wondering what if anything Congress is going to do about it. Will Republicans and Democrats allow the economy to drive off the cliff, like Thelma and Louise, or shed their partisan ideology and take responsible steps after the election to avoid it?

We think that either in the 11th or 13th hour, they will strike some kind of bargain. (A reason to allow the current tax cuts to expire and then vote to reinstate them is that Congressmen can all be on the record as having voted for another tax cut. Ingenious!)

We also think that the fears of the fiscal cliff and the election are overstated relative to the reality.

Even if the Bush era tax cuts are not reversed, and the mandated spending cuts go into affect, we do not expect the economy to grind to a halt at midnight on New Year’s Eve, or for every person making over $250,000 a year to suddenly leave the country and take up residence in the Republic of Tonga.

In our experience, the things that everyone is worried about rarely turn out as badly as feared, largely because they are already so heavily focused on and widely anticipated that by the time they happen they are no longer news. They have already been planned for. The greater risks are almost always the ones about which you are blissfully complacent or ignorant.

Although an extension of the current tax code would be a benefit to the economy in its current condition, in our view, it is the lack of certainty and confidence about the future that is a larger impediment to future growth. A little leadership could go a long way.

Current Environment:

Which brings us back to the Chairman and the Chair.

Extraordinary monetary policy is no substitute for sound fiscal policy, political leadership and action. It can provide a short-term boost to economies and markets, but it is primarily designed to treat the symptoms of the problem – anemic economic growth and deflationary pressure – rather than the problem itself – way too much public debt.

At some point soon, the world economy will have to find a credible way to function under its own power, without medication, and move towards fiscal and structural balance.

Moreover, quantitative easing and systematic currency devaluation can produce nasty side effects.

First, it can create a false sense of confidence and dependency among investors that future economic deterioration will be met with additional stimulus and that the stimulus will be effective.

In fact, each new round of quantitative easing has produced a diminishing benefit for a shorter period of time. It has helped stock markets to go up, but done little to create new demand and stimulate new economic growth.

Second, it can let Congress and the president off the hook from doing their job, working together, and making economically necessary but politically unpopular decisions.

Third, it will ultimately lead to higher rates of price inflation. Thus far we have seen some inflation in food and energy prices, which tends to stifle growth. We have seen little inflation in the price of other goods and services. The economy has plenty of excess productive capacity and labor and banks are tending to sit on money rather than make new loans.

Finally, through their actions, the Federal Reserve and other Central Banks have created an upside-down investment environment where interest rates are artificially depressed and where currencies and traditionally “safe” assets such as cash and bonds are being systematically devalued. Savers are being punished and investors are being gradually drawn out into traditionally riskier assets such as high yield bonds and stocks in search of income, inflation protection and higher returns.

It is not a strong foundation upon which to build an economy or an investment portfolio, but it’s likely better than staying parked in cash and bonds, relegated to death by a thousand cuts of inflation.

Our view is that over the long-term asset inflation will be the prevailing trend, lifting the value of real and productive assets like commodities, real estate and stocks, and eroding the value of cash and bonds.

In particular we think that high quality companies will continue to prosper, even in a slower growth environment. Equity ownership in these companies represents the best investment in which to build real value over time. Many of these companies are well capitalized, with little or no debt, do business in multiple countries and currencies and pay an attractive dividend, especially relative to a bond.

While this is the most probable outlook, with so much debt in the world, the economies and markets are highly sensitive to external shocks and setbacks. As always, we therefore feel that it is critical to structure and manage client portfolios balancing offensive, defensive and alternative strategies.

Current Strategy:

As we noted, despite all the worries, and with generous help from the Federal Reserve, equity markets have had a very strong year so far, led by the S&P 500.

We still think stocks offer good value and are a superior place to invest for the long-term. But we also feel that after such a strong run, some of which is the result of monetary doping rather than fundamental virtue, stocks have gotten ahead of themselves and are vulnerable to a setback.

Volatility, which is an indication of investor fear, is near historically low levels, reflecting investor complacency. Corporate earnings and outlooks for the final quarter of this year as well as next year will be cautionary, Europe is not out of the woods, and there will likely be volatility in the markets around the election and fiscal cliff discussions towards year-end.

We have therefore moved client portfolios to a slightly more defensive position for the time being in accordance with this view. We have also done some repositioning to rebalance equity portfolios towards areas of greater value and opportunity, including in emerging markets and technology.

As always, we think balance remains the key guiding principle for investing in this somewhat confusing and upside down environment.

We therefore maintain a prudent 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 the road ahead.

As always, we welcome your questions and comments.

Jurika, Mills & Keifer, LLC
October, 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.