Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
Third Quarter: July 2015

View a PDF of this commentary

Sign Up

to receive our Commentary and other updates:

Send us an email about this commentary

Of Monsters, Markets and Men:

The monster you see is rarely the monster that gets you. Rather, it is the one sneaking up behind you that you never see coming.

A rule of the markets that we have learned over the years is that your greatest fears and hopes rarely come to pass as imagined.

Most widely predicted catastrophes tend to be so thoroughly anticipated, extrapolated and completely blown out of proportion ahead of time that they often pass with minimal or no apparent impact.

Remember Y2K? Exactly. Bad things can and do happen, but most of the time, the world doesn’t end and life goes on.
Monsters and Men

In our experience, the bleaker and scarier things seem in the moment, the less risky they usually are. Actual and perceived risk tend to be inversely proportional to one another, and the moments of greatest fear and perceived risk tend to be the moments of greatest opportunity.

Conversely, during periods of rising exuberance, there is a growing tendency to see silver linings behind every cloud and to pretend that if you close your eyes, the monsters you know are there don’t really matter. Investors exhibit an ever greater willingness to suspend disbelief, and to eschew traditional risk and valuation practice in favor of a “new” and ever more optimistic view of the world: “New World Orders”, “New Paradigms”, and “New Economies.” These periods are often spawned during points of significant economic, geopolitical or technological change and disruption (think collapse of the Soviet Union, the Internet, the Cloud, etc…), and are marked by sharply rising asset prices and the gathering triumph of greed over fear. These periods always end in disappointment and significant capital loss.

Over time, the longer-term cycles of economies and markets are marked by large swings between extreme and pervasive pessimism and unbounded, best-of-all-possible-world optimism. But in between these cyclical peaks, one can usually find pockets of misplaced fear and optimism, often coexisting at the same time.

Which is a good description of where we find ourselves now.

Currently, Greece is, once again, dominating the 24 hour news cycle. The situation there is dire, especially for the Greek people. Regardless of whether Greece stays in the Eurozone, or the Syriza party stays in power, Greece cannot possibly pay back most of its outstanding debt. And, lending Greece more money is not a workable long-term solution. A country cannot borrow its way out of debt. Moreover, even with a significant forgiveness and restructuring of its debt burden, lasting damage has been done to the Greek economy. It may be years before it is able to fully recover.

The natural tendency for the news media is to draw a parallel between Greece’s current crisis and the collapse of Lehman Brothers in 2008, and to question whether Greece will serve as Europe’s “Lehman moment,” sparking the flames of a larger global economic contagion that could end in the potential unraveling of the Eurozone.

We don’t see this happening.

First, Greece’s problems are fairly contained in the big scheme of things. Greece’s total GDP is a little over $200 Billion, relative to the GDP of the Eurozone of over $13 trillion. Greece’s total outstanding debt is about $380 billion. Not a small amount, but fairly small relative to the economic size of the Eurozone.

Second, unlike Lehman Brothers, which unraveled quickly and took people largely by surprise, Greece’s problems have been in the headlines for several years, rivaling the Kardashians for media attention. Moreover, the European Commission, the European Central Bank (ECB) and the International Monetary Fund (aka “the Troika”), have had time to build in safeguards to stabilize the broader financial system. Just by virtue of the fact that so many people are comparing Greece to Lehman Brothers provides some solace that Greece will not be like the next Lehman Brothers. Things may get messy for a few weeks, but the problems should be manageable for Europe as a whole, even if very difficult for Greece by itself.

While all eyes are on Greece, economic activity in most of the rest of Europe continues to improve, supported by robust monetary stimulus from the ECB, a more competitive Euro, and cheaper energy prices. Our current view is that Greece will likely create a near-term speed bump in the European recovery, but that the problems can be managed and that the overall recovery in Europe should endure for the time being.

Taking a longer-term view, Greece is symptomatic of the larger existential challenge for the European Union, where the lack of fiscal and political union, and mobility, create structural inefficiencies and imbalances that provide huge advantages to some member economies at the expense of others. Unless the Eurozone can move to full economic, fiscal and political integration, including a critical provision for debt forgiveness, as we have in the U.S., at best the Eurozone will be hampered by declining competitiveness and slower economic growth. At worst, the problems we see in Greece today will metastasize and the Eurozone will start to unravel as countries head for the exits to regain control over their sovereign destiny.

Monsters in our own backyard.

If eyes on Europe are focused South and East on Greece, eyes on the U.S. market have drifted South and East towards Puerto Rico, which, like Greece is collapsing under the weight of its own debt burden. Puerto Rico’s problems have also been known for some time, but there has been a general complacency towards risk among Puerto Rican bondholders who have been attracted by their high, tax-free yields in a low yield world. It was too tempting for investors not to close their eyes and pretend that the monster didn’t exist, until Governor Padilla recently announced that Puerto Rico cannot possibly pay back all of its debt.

This will likely lead to some more turmoil in the bond markets, but like Greece, the problems are relatively small and manageable. Puerto Rico has a GDP of $120 billion and $70 billion in outstanding debt relative to a U.S. economy with a GDP of $14 trillion. As with Greece, the only viable solution for Puerto Rico is debt forgiveness and restructuring.

Unlike Puerto Rico, the rest of the U.S. economy is doing quite well, having recovered after a slow and frosty start to the year.

The consumer and healthcare sectors are showing strong growth in particular. Consumer confidence is near an all-time high, housing has rebounded, and retail sales have picked up.

The industrial and manufacturing sectors have seen a more sluggish rebound, mostly impacted by the strong dollar, which has made U.S. goods less competitive internationally. The slowdown in the energy sector has also put a damper on U.S. overall industrial growth.

The employment situation continues to rebound with steady job growth of over 200,000 new jobs a month. The unemployment rate is down to 5.3%.

There has also been a robust level of mergers and acquisitions, with the total value of deals rivaling the prior peak in activity in 2007. We are also seeing larger and larger deals being consummated. With access to cheap capital, companies are finding that mergers are an economical way to boost growth, competitive position and profitability.

Overall economic growth levels in the U.S. are trending at about 2%-2.5%, which is suboptimal, but still respectable.

When combined with a low and declining unemployment rate, it seems likely that the Federal Reserve will start to raise short-term interest rates some time this year.

Although the specter of rising interest rates has caused significant trepidation among investors, this too is a well-known monster. He may be hiding in the closet, but the door is open, the lights are on and he really isn’t all that scary. The Federal Reserve has been careful and very deliberate to signal what it is going to do for well over a year. It should come as no surprise whatsoever.

Moreover, interest rates could move considerably higher and still be considered low by any historical standard. They would certainly not be high enough to inhibit sensible investment and risk taking.

Rising interest rates are unequivocally bad for bond prices, but they are not necessarily bad for the economy nor for the stock market. We have spent most of our lives with interest rates significantly higher than they are today. During that time, people borrowed money, started businesses, bought cars and houses, raised families and prospered. Economies flourished and grew, and life went on. We may have become accustomed to cheap money, but it should not be a necessary precondition to a healthy economy. The Federal Reserve’s bet is that the economy is now healthy enough to sustain the return to normal monetary policy. We agree.

If there is a scary monster in the bond market, it is not rising interest rates, but declining liquidity.

Although the notional value of bonds outstanding has grown over recent years, the amount of bonds held in inventory by dealers to provide liquidity to buyers and sellers has declined substantially. Put another way, if the bond market is a movie theater, it is now an IMAX theater, but only has two small exits and they are only two feet wide and five feet tall. If people come and go one at a time, everything is fine, but if everyone heads for the exits at the same time, things can get ugly quickly.

The loss of liquidity will tend to exacerbate any near-term move in bond prices and yields, creating higher levels of volatility that could easily spill over into the equity markets as well. We think this would be more of a temporary phenomenon, but it is a risk that investors need to take into account.

The Wild, Wild West

Moving our gaze from the southeast to the wild, wild west, we are naturally drawn towards a third area of recent turmoil; the Chinese Stock Market. After more than doubling between last November and June, the Shanghai and Shenzen stock exchanges have fallen by over 30%, wiping out over $2 trillion in value. Much of this value was illusory to begin with, fueled by record borrowing and rampant speculation rather than any dramatic improvement in underlying economic fundamentals. In fact, to the contrary, economic fundamentals in China continue to deteriorate.

Does the Chinese stock market represent yet another monster to fear? We do not think so, except as a symptom of a larger set of longer-term challenges facing the Chinese economy and political leadership.

Most of the turmoil has been contained within the mainland Chinese markets, and most of the damage has been borne by retail Chinese investors who represent a small percentage of the overall population. The Chinese Government has the ability to intervene to stabilize the markets as well as to stimulate the economy overall. But, the crazy Chinese stock markets are a telling reflection of a growing but immature and often dysfunctional economy going through significant growing pains.

As we have written in the past, it is important not to take a monolithic view of regions or even of countries. China has a vast and diverse economy which is, in turn, an important part of a much larger developing world including the rest of Asia, India and South America. Despite their well-known challenges, we think the developing world will still account for the majority of marginal economic growth in the world in the coming five to ten years. We want to be invested in this growth, with diversification among countries and regions, and with a focus on consumer-oriented companies.
Investment Strategy:

Putting it all together, although media attention is currently focused on scary monsters in Greece, Puerto Rico and China, these monsters are well-known and therefore not as dangerous as they appear on television.

The more important story is that global economic growth is positive and, in most cases, improving. This is particularly true in the U.S., but also in Europe and parts of Asia. In almost all cases, the aggregate growth is suboptimal, muted by massive amounts of debt, dysfunctional political leadership, and excess capacity.

But underneath the aggregate numbers, there are important areas of more robust growth, innovation and change, including technology and healthcare. There are many companies around the world that are doing very well.

Which brings us to valuation.

Equities around the world are fully valued, especially in the U.S., but are still the most attractive asset class for long-term investment. European, Japanese and developing and emerging markets offer greater relative value, although with more problems attached.

Equity markets can stay expensive for extended periods of time and even become more so. Given current valuation levels, they are also more vulnerable to shocks and disappointments. We therefore expect higher levels of volatility going forward.

By contrast, most bonds look unattractive and offer poor prospective value as investments. There are some pockets of relative value to be found in the corporate and Municipal bond market, but our main focus is to use bonds as a safe and defensive bulwark in client portfolios.

With both stocks and bonds looking overvalued, we have beefed up the middle of our client portfolios – the part we call the “defensive core”, primarily with a significant allocation to long/short strategies that can help portfolios defend against market declines, and then become more aggressively invested when markets are cheaper.

As always, we welcome your questions and comments.

Jurika Mills & Keifer, LLC
July 2015

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.