World headlines continue to be mostly negative and rotate between the crisis in Europe, the economic slowdown in China, the ongoing unrest in the Middle East, and the upcoming U.S. election and “fiscal cliff”. In addition, the recent declines in retail sales and slowing in manufacturing and business spending has heightened fears of a double dip recession. As the U.S. experiences the slowest recovery from a recession in the last 70 years, it is not surprising that investors have little confidence in investment markets.
With all of the focus on what can go wrong, it is hard to see the pockets of strength. Importantly, we have now had six months of improving housing market data and declining gasoline prices which have been helpful to household budgets. Though this data is not enough to offset a slowing economy, we would not be surprised to see some short-term rallies as investor sentiment is very pessimistic (which is often a good contrarian indicator) and the Federal Reserve is hinting at another round of quantitative easing.
More than two years into this crisis, the situation in Europe remains dire. Though the problems are complex, they all can be tied back to the formation of the EU as countries accepted being a monetary union without conceding their fiscal independence. Ironically, just last month, the Euro Cup was juxtaposed with the ongoing European negotiations on a greater integration. Sports fans waved their country flags with pride while their politicians were aggressively negotiating away their nationalism.
Regrettably, even though European leadership has had numerous economic summits and has committed to “using all the means necessary” to support the euro crisis, investors (and European citizens) have become weary of rhetoric. It is often only days after each summit before investors pick apart the proposals and any short term market rallies are quickly muted. This is exacerbated by slowing economic growth, increasing unemployment, mounting debt burdens, and rising borrowing cost.
Though it is the sovereign debt crisis that has put Europe in this situation, it is now only one of the problems they face. Banks in a number of countries (Greece, Spain, Italy and others) are insolvent and in dire need of capital. Although there is a proposal to recapitalize the banks, the near term consequence is that there is very little credit creation which, in turn, will also inhibit growth. In addition, unemployment rates across the continent have risen to levels not seen since the 1930’s. Finally, productivity varies dramatically from country to country. Germany, once one of the highest cost producers in the world is now the most productive (and efficient) country in Europe. Given the common currency, it continues to be more economically attractive for a foreign company to open a plant in Germany where employment is near 4% than in Spain where unemployment is closer to 25%.
In the face of this crisis, European leadership has chosen to take an incremental approach to the problems, which has only exacerbated them. With Spanish sovereign rates bouncing around 7%, it seems clear that Spain can’t continue to service their debt and will soon need a major bailout. However, even as everyone talks about the expanding list of countries in trouble, the real attention should be on Germany as they are the source of the solution. Are they going to agree to a collective responsibility for the debt of these nations? The sovereign-debt crisis will only be over when investors believe that euro-zone government bonds are safe which means debt pooling and the formation of a Euro bond. Whether Germans are willing to accept this outcome or accept some aspect of a breakup is still unclear, leaving investors with significant uncertainty.
The political climate in Washington remains bleak. The fear that politicians will only make hard decisions in the face of a crisis might be tested as we approach a critical year-end. Though we started 2012 with improving economic indicators, recent data on employment, manufacturing, and earnings reports have led many economists to question the strength of the recovery. In addition, it appears to be a close and contentious election and the “fiscal cliff” kicks in at the end of the year. Without action, legislated spending cuts combined with tax increases could significantly reduce GDP growth, and likely would push the economy into a recession.
Given the uncertainty in Europe and slowing GDP growth in the U.S., the assumption is that the Federal Reserve will act to stimulate the economy. What form this action will take is still unclear, but it will provide the perception of stimulus and may propel stocks, at least in the near term. However, as we have seen from previous actions, each round of stimulus has had a diminishing effect on the overall economy, and many feel the benefits may already be incorporated into valuations.
Given the difficult global economic and geopolitical environment, we believe that long term investors will be rewarded by constructing conservative, well diversified, portfolios that are focused on fundamentals and designed to mitigate market risk. Though the recent volatility has been unnerving, we remain disciplined and focused on business fundamentals as opposed to headlines.
Even as fears of slowing U.S. GDP growth increase, the U.S. markets have performed well this year. Much of this has come from companies that drive earnings growth though productivity gains. However, as recent earnings reports have highlighted, this trend appears to be coming to an end as many companies are not immune from the global environment and are facing slowing revenues and pressure on profit margins which will eventually weigh on stock valuations.
Though the market appears to be fairly valued based on our work, we are still identifying quality companies with predictable businesses, good cash flows, and strong balance sheets, that continue to rewarded investors with healthy dividends and/or accretive buybacks.
Though the European crisis (as well as the prolonged Japanese recession) could continue to strengthen the dollar near term (and potentially benefit US stocks), fundamentals and valuations in emerging markets remain compelling. We have reduced our exposure to China given the uncertainty around their slowdown; however, Brazil, India, and other emerging market countries are attractive. Most are resource rich and benefit from generally healthy national budgets, foreign exchange reserves, and improving domestic consumer demand. Given the market declines, we have been able to gain exposure to both equity and fixed income investments in these regions at very attractive current yields. Finally, with the exception of a few unique European companies whose revenue is driven primarily from non-European sources, we remain comfortable generally avoiding direct equity and fixed income exposure in Europe. As we mentioned above, the crisis is far from over and we anticipate that the European leadership will continue to focus on the symptoms rather than the cure. How deep and how long the recession will last in Europe is still unclear leading us to remain very comfortable minimizing our exposure to that region and its currency.
As for our fixed income portfolios, we are reluctant to commit client capital to long-term bonds. With the 10-year treasury yielding less that 1.5%, we don’t see how the actions of central banks to re-inflate their economies make these good long-term investments. Though difficult to predict today, there will be a point in the future when the velocity of money (a precursor of inflation) again begins to pick up. That said, we are very comfortable owning high quality short term municipal bonds, as their tax exemption is very compelling, as well as corporate bonds, as balance sheets have never been healthier. We have also chosen to complement these positions with floating-rate bank loans, mortgage debt, and emerging market sovereign debt as these asset classes offer attractive yields and total return potential.
Though we exited our broader commodity exposure earlier this year due to concerns over China’s economic slowdown, we maintained our investment in gold. It provides stability when equities have declined and we remain confident that it will provide absolute returns as central banks print currencies as a means to spur economic growth and fight off deflation.
Overall, this remains a very challenging investment environment as the problems facing Europe, as well as the global economy, continue to persist. Given the headwinds, we anticipate a volatile environment and recognize that diversification, ongoing portfolio rebalancing, and patience are going to be required to achieve moderate returns. To that end, we continue to focus on asset classes and individual securities that can provide more predictable returns and we recognize that income will be a critical component to total return.