It is a somewhat sobering commentary on the state of things that the stability of the global financial system hangs on the balance of how the Greek Parliament votes on austerity measures, or anything else for that matter.
Or that the ratings agencies, who were once criticized by politicians for failing to do their job leading into the credit crisis, are now being criticized by politicians for doing their job and downgrading government debt.
It shows how sensitive the global financial markets are to seemingly remote problems. In a highly leveraged and interconnected system, the economic chain is only as strong as its weakest links.
And it underscores the reality that the functioning of the capital markets is currently based on the continued public pretense that bad sovereign debts are good, not only in Greece, but also in Portugal, Spain, Ireland, Italy, Japan, and even here in the United States. Much of the developed world is becoming more Greek by the Day.
It is becoming increasingly difficult to maintain this pretense, especially with those pesky ratings agencies suddenly taking their job seriously.
Yet the system can’t handle the truth. At least not now. There is simply too much troubled debt on bank balance sheets in Europe and around the world, and this debt, in turn has been used as collateral for other lending and commitments, from construction and real estate loans, to derivative products, to money market funds.
The sudden loss of foundational value and trust, and the ability to trade sovereign debts and other credits between governments and banking institutions, risks causing a repeat of the 2008 credit crisis.
The routine solution has been to suspend disbelief and kick the proverbial “can,” (or Grecian Urn in this case) down the road as long as possible, prolonging the inevitable and buying time to find a better solution. This is what politicians do best.
The challenge is that without a dramatic change of course, down the road the problems only compound. They are driven by growing imbalances between these economies’ ability to grow and the burden of their obligations to their people and creditors.
Within the Euro-zone, there are also growing structural imbalances between stronger nations, such as Germany, and the weaker ones. These imbalances both within and between individual countries threaten to tear apart the economic reality and political ideal of a unified Europe.
Meanwhile, the sovereign debt problem is spreading with increasing vigor, confounding attempts by European financial leaders with divided political interests to get ahead of it.
As seen in Chart I, the financial markets smell blood in the water and the value of insurance on the sovereign debt of Greece, Portugal, Ireland, Spain, and now Italy, otherwise known as Credit Default Swaps (CDS) has continued to escalate despite the efforts of the European Central Bank to stave off the problem.
It underscores the gulf between the public myth and the private reality of value, and the fact that the policy makers are behind the problem rather than ahead of it at this point.
We still think that they will find new short-term solutions to put some more duct tape on the urn and kick it down the road a bit more, but time is not on their side.
The situation is fluid and we are watching it closely.
Meanwhile, elsewhere in the world, investors have also found a host of other things to worry about including:
- Growing signs of economic slowing in the U.S., Europe and elsewhere and worries about a “double dip” recession.
- A hard landing in China brought about by a residential and commercial real-estate bubble.
- The end of Quantitative Easing.
- An impasse on the U.S. debt ceiling.
These worries led to a sell-off in global equity markets during May and the first half of June as investors shunned stocks, commodities and other risk-oriented assets and bought U.S. government bonds. By mid June, after suffering a 5% - 10% decline, investors returned to stocks, lifting the markets back into slightly positive territory for the quarter. Despite the rebound, the worries remain at the forefront and the financial markets are skittish, moving between hope and fear with each new 24-hour news cycle.
Innocent Until Proven Guilty:
In the near-term, we think investors are over-worrying about the challenges while not focusing enough on the positive factors. It’s not that the challenges aren’t real, but they are widely known and somewhat reflected in prices. In our experience, the biggest risks are not the ones you know, but the ones you either don’t know or ignore.
Conversely, we think investors remain overly complacent about the longer-term risks and consequences that public debt poses, not only in Europe and Japan, but here in the United States.
But for now, we are maintaining a presumption of innocence about the recovery until proven otherwise. Thus far, we see evidence of a slow-down, which we believe is temporary rather than permanent. Most of the vital statistics we watch are still in positive territory.
Chart II shows the ISM (Institute for Supply Management) Purchasing Manager’s Index for the manufacturing and services sectors.
Although both fell sharply from their levels in January, they declined from peak historical levels and are still in positive territory. Readings above 50 indicate growth and both indicators moved higher in June. The U.S. economy is still growing, albeit at a slower pace.
Charts III and IV reflect a somewhat more cautionary prognosis for Europe, Japan, China and Brazil. They both show the ISM Purchasing Managers Manufacturing Index declining since January, without any subsequent rebound. With the exception of Brazil, the indicators are still positive.
There is no doubt that the developed economies are slowing, especially in Europe. The U.S. looks better by comparison, but still quite anemic. However, we think some of the slowdown in global economic activity is a direct result of weakness in Japan following the March earthquake/tsunami/nuclear disaster, and should therefore be temporary. We are looking for a pickup in overall industrial activity in the second half of the year as the Japanese economy regains momentum, and some of the current uncertainty is resolved.
Meanwhile, across the Pacific the Chinese are battling with a different set of challenges. In China, growth has been too strong, leading to higher inflationary pressures as well as a bubble in higher-end residential real estate construction. The government has been working aggressively to step on the brakes, to slow growth and curb inflation and speculative investment.
It is important to put the China problem in perspective. In the media, China is now depicted as a bubble economy; a vast sea of empty apartment buildings that will never be filled.
It is true that China is suffering from a growth spurt: too much growth too quickly, fueled in part by large-scale fiscal spending on infrastructure projects and easy lending standards. As such, China may be ahead of its current infrastructure needs, and has a bubble in higher-end residential real estate. But it is important to view these problems in the context of a $4.5 trillion dollar economy that has been growing at 9% a year. Some of this growth is unsustainable and has led to poor capital allocation decisions, but the majority of the growth has been driven by a robust manufacturing economy, serving not only a global customer base, but also a growing internal middle class. Growth in China is likely to be strong for years to come. At the same time, China has vast financial reserves and the ability to act quickly and decisively to address problems along the way. China now has reserves of over $3 trillion, more than half of its GDP.
Like a teenager, China may be stumbling around the global economy, knocking into things and constantly raiding the fridge, but we should not doubt the inevitable direction of its growth and power. China’s problems, unlike those of Europe and the United States, are likely to be temporary rather than chronic.
Back in the United States, after a strong first quarter earnings season where most companies surpassed analyst expectations, the focus has turned to the end of Quantitative Easing and the debt ceiling debate in Washington.
The second round of Quantitative Easing (aka QE2) officially ended on June 30th. This program, announced by the Federal Reserve last August, had the stated purpose of stabilizing the economy, while maintaining low interest rates and supporting the financial markets.
It certainly had a positive short-term impact on the stock markets, on the economy and on overall consumer and business confidence. Global stock markets rallied strongly in the fourth quarter of 2010 and economic growth rebounded.
But Quantitative Easing, the mystical process of issuing short-term debt or printing money to buy longer-term debt, is another form of artificial life support for an economy that ultimately needs to function under its own power. It is both unsustainable and harmful to health over time, leading to currency devaluation, inflation, and higher interest rates.
Now, as the economy slows again, investors are worried that without additional support from the Federal Reserve, the economy and markets will falter.
While we do think the end of Quantitative Easing will lead to near-term uncertainty, it will be a gradual weaning process rather than a sudden “cold turkey” stop. There are many things that the Federal Reserve can do, both under the guise of phasing out Quantitative Easing and otherwise, to ease the transition. And if things really do appear to be falling apart, additional measures, perhaps in the form of QE3 will almost certainly be found.
The debt ceiling debate is another one of those “better than it seems and worse than it seems” events. Unlike Greece, the United States is not currently dealing with a solvency issue. If Congress fails to raise the debt ceiling, the U.S. will still have ample funds to service its current debt load and, unlike countries in the Euro-zone, we can always print more dollars. Conversely, even if Congress raises the debt ceiling, the U.S. will still have enormous fiscal imbalances to contend with for years to come.
But a failure to extend the debt ceiling would trigger a “technical” default that would force ratings agencies to downgrade U.S. Debt, and likely force many institutions to sell Treasury Bonds for statutory reasons. A failure would also further tarnish the reserve status of the dollar and Treasury Bond. As such, the debt ceiling is not an issue to be trifled with, in the name of budgetary reform, political posturing, or for any other reason.
On a more positive note, the inflationary fears of the first quarter, have largely subsided for the time being. As we wrote last quarter, we thought that commodity prices had risen more because of speculation than enduring imbalances between supply and demand. Since April, oil and gas prices have fallen sharply, as have most other commodities, except for gold, which is acting more and more like a reserve currency than a traditional commodity.
With all this uncertainty, it is no wonder that the employment picture remains bleak. After a strong improving trend, we have seen the growth rate of temporary and permanent hiring fall back towards zero as reflected in Chart V below.
The growth is still positive and it is still possible that this is a temporary setback in a longer-term improving trend. When and if the economy regains momentum, we would expect to see the numbers improve, but it will take years to offset the 9 million jobs lost since 2007, many of which will never come back. Companies have learned to do more with less and are reticent to increase payrolls with so much uncertainty.
We have always maintained that confidence is a necessary ingredient for an enduring recovery. This requires effective political leadership, both of which are in short supply in Europe and here in the United States.
Now that the second quarter has ended, investor attention will tend to move from macro issues back to corporate earnings reports for the second quarter, as well as management guidance for the rest of the year.
In light of all the macro issues we have discussed above, there is a fair amount of trepidation going into earnings reports. We believe that corporate earnings results and guidance will generally surpass investor expectations. True, there is a lot of uncertainty to contend with, but we think that barring a further deterioration in Europe, most other problems are well known and largely reflected in prices. It is always easier to see the negatives than the positives and we believe investors are currently giving companies the doubt of the benefit, rather than the benefit of the doubt.
Major companies are in better shape than they have been in many years, having reduced costs and paid down or refinanced their debt on favorable terms. With the exception of the financial services sector, Corporate America is lean and well-capitalized. The global economy is still growing and transforming itself, especially in Asia, but also throughout the developed and developing world. Well-managed, well-capitalized and well-positioned companies are participating in that growth.
Meanwhile equity valuations for many of these companies are attractive, especially relative to bonds. Although they are perceived as riskier, they provide a superior cash flow and/or dividend yield with the ability to grow and appreciate in value over time. By contrast, domestic bonds pay a low yield, (unless they are junk) and are vulnerable to rising interest rates and inflation.
As we evaluate the current balance of risks and opportunities, our current strategic asset allocation is based on the presumption that the global economy is still on more of an inflationary rather than deflationary path. This path should be characterized by:
- Slow growth in developed economies and faster growth in developing economies;
- Rising domestic borrowing costs;
- Long-term devaluation of the dollar, euro and other fiat currencies;
- Increased competition for scarce resources;
- Elevated levels of market volatility with a higher probability of outsized market disruptions.
With this outlook, we think that balance among asset classes, and focus within asset classes is critical.
We are maintaining a moderate allocation to higher quality equities, primarily based in the United States. We are emphasizing companies that pay dividends, global capital goods companies that export to the growing part of the world, biotechnology firms, and technology companies, especially those tied to wireless mobility. We think these types of businesses should weather the storms fairly well while benefitting from cyclical and secular growth trends.
Conversely, we have minimal exposure to banks and other leveraged institutions that are most exposed to sovereign debt problems or an economic slow-down. Our client portfolios are also minimally exposed to European equities.
We are maintaining a strategic exposure to developing economies, including China, and will likely increase this allocation as we see the global markets stabilize. Our long-term optimism for China and the developing world remains intact. The U.S., Europe and Japan should be so lucky as to have China’s problems.
Our exposure to economically sensitive commodities has been at the low end of our target range since April and like emerging markets, we will likely add back as we see signs that the recovery is back on track.
Finally, the defensive portion of client portfolios is invested in gold and a range of domestic and foreign bond funds with managers that have the flexibility to “go anywhere” that they see opportunity. Almost all are focused on shorter term maturities, with the expectation that longer-term interest rates will eventually increase. The recent flight to the safety of U.S. Treasuries has worked against this positioning, but we are quite convinced that higher interest rates are as inevitable for the United States down the road, as they are for Greece today. It is not a question of whether, but only when. As we often say, things don’t seem to matter until they do, and then they can matter quite a lot.
As always, we welcome your comments, questions and suggestions.
Jurika, Mills & Keifer, LLC