Monthly Update to Friends of the Firm.
The Bear Awakes in Europe
Global equities led by weakness in Europe and Asia are now officially in bear market territory (down more than 20% from the highs). U.S. stocks (as measured by the S&P 500) are approaching this level as they closed the month down 17% from the highs of late April. Volatility has increased dramatically, and market activity is being driven more by macro issues and poor investor sentiment than company-specific or economic fundamentals. Treasuries and high quality bonds continue to perform well as investors keep piling money into low-yielding, safe assets.
The key issues troubling investors have not changed: slowing economic growth, falling consumer sentiment, lack of federal stimulus, and weak housing and employment numbers. Unfortunately, we may be entering a new phase in the European debt crisis as more and more investors and politicians are expressing doubt that a positive outcome is economically, or politically possible. Policy makers may be running out of time to craft a plan that will not only address the issues that are at the heart of their problems, but also convince the markets that they have a plan to stabilize the banking system in the event of a major sovereign default.
|Index||3 Mo. Return
As of 9/30/11
|DJ UBS Gold||7.82%||13.67%|
|Barclays Capital U.S. Agg Bond||3.82%||6.65%|
|Citi World Govt. Bond non USD||0.95%||5.68%|
|BofA ML U.S. High Yield||-6.31%||-1.69%|
|DJ Industrial Average||-11.49%||-3.90%|
|DJ UBS Commodity||-11.33%||-13.62%|
|MSCI Emerging Market||-22.56%||-21.88%|
The Fed is Pushing on a String: The Fed announced that they will sell $400 billion in short-dated Treasury securities to purchase intermediate and long-dated Treasuries in an effort to reduce long-term rates and increase the demand for credit (mortgages). Even though these actions were widely anticipated by the market, intermediate and long Treasury prices rose dramatically (along with the dollar) and equity markets worldwide plunged after the announcement. What the Fed is telling us is that growth is slowing, and the options at their disposal to deal with a slowing economy are limited. We can’t see how this action to flatten the yield curve even more will rescue the housing market from its current doldrums. One of the main problems continues to be the large numbers of homeowners who owe more than their house is worth, and therefore are unable to sell or refinance at any interest rate. The equity markets voted on the Fed’s new policy by selling risk assets. Only a dramatic combination of fiscal and monetary stimulus will change the current economic outlook. The Fed is hoping to share responsibility with Congress and the President. Good luck.
Europe’s Walking Dead: Deleveraging is painful and given the influence of politics on the process, the solutions will take time and likely be suboptimal. The fear is that by recognizing substantial losses on sovereign debt, which is held to a large degree by European banks, we will see a Lehman-like impact on the credit markets across the globe. We are currentlyin the midst of a steady erosion of confidence regarding the global debt crisis and its resolution. There are a variety of policy-driven proposals that may bring stabilization to the issue of European bank capital, however the idea of stimulating growth through fiscal stimulus appears highly challenged as governments are hobbled by high debt loads. Austerity is not stimulus, just ask the Greeks! We think there is an increasing probability that the Eurozone membership will ultimately change, with weaker members leaving the union which will provide them the ability to devalue their currency. We do not expect a quick single solution to this mess as there are too many competing agendas. This issue will drive market activity and sentiment for some time.
Worldwide Economic Growth Slowing: Economic growth is slowing worldwide as market stress and uncertainty is spreading to even some of the fasting growing economies such as China and Brazil. While we expect the emerging economies to meaningfully outpace the growth of the developed world, they are feeling the impact of the global slowdown. The International Monetary Fund (IMF) recently reported that the global economy is in a “dangerous new phase.” They project that world output will slow to about 4% through 2012 from just over 5% in 2010. Built into these projections is an assumption that the European policy makers and the U.S. can successfully work through their current problems (big assumption!). Over the next year, the U.S. is projected to grow between 1 and 2%, Europe closer to 1%, and emerging economies closer to 6%.
Corporate Earnings Are Slowing: According to Thomson Reuters S&P 500 companies are expected to grow 3Q earnings in excess of 13%. While this is down from prior period estimates, these growth rates are still strong and represent the resiliency of Corporate America. Unfortunately, further earnings gains will come from expense reductions (layoffs), with the financial industry taking the lead. We expect earnings momentum to fall over the coming months, but are still looking for positive growth.
Given all of the uncertainty and the rise of nationalism within developed economies, we are now increasingly concerned about a global slowdown and the rising possibility of another recession. The growing partisan debate around debt reduction, taxes and stimulus will likely make this political season ugly. It remains to be seen whether falling oil prices, lower interest rates and the potential for more stimulus are enough to keep the economy growing.
The increased uncertainty in the Eurozone and the growing negative political environment in the U.S. are eroding confidence worldwide, resulting is delays in discretionary spending and business planning. This wait and see attitude is self reinforcing and feeding fears of another recession. The reality is that borrowing rates can go even lower, but if consumers and businesses are not confident, why would they borrow and spend? Waiting through the next election cycle appears to be the prudent thing to do. The unlikely timing of all of this couldn’t be worse.
We continue to manage our portfolios with a more conservative approach. We have reduced exposures to higher beta strategies and are comfortable maintaining our near-term tactical positions in cash and hard assets (gold). Within Growth strategies, we continue to see value in dividend paying equities and global managers with a flexible mandate. Dividends are becoming more of an important component to total return as now roughly half of all S&P 500 stocks yield more than Treasuries. Within Income strategies we have increased the credit quality of our income sources and are emphasizing a combination of U.S. Government, mortgage and intermediate-term investment grade debt. Given our outlook for slowing growth and manageable inflation, we have removed broad commodity exposure from our Inflation Protection investments, while maintaining gold as a hedge against uncertainty. Our Absolute Return managers provide a variety of hedged bond and stock exposures that helps to reduce market volatility on the portfolios.
As always, we enjoy having open lines of communication with our clients and friends, so feel free to call or stop by to see us. We appreciate all of your support and referrals.