Big Tail Wags Dog, or A Tale of Two Continents
Dear Investor –
At some point, you’d think that investors engaged in the world’s stock exchanges are just going to take their balls and go home. The broadest markets for the better part of the year have left equity investors whipsawed, and with the markets spooked from one episode to another, monsters seem to be lurking under every bed and in every closet. While Japan and China, and even the Arab Spring, have faded into the headlines twilight, the nations of Europe are finding a way onto the headline pages daily. As Ireland and Greece faced major bailout challenges, the contagion and distrust has spread -- to Italy, Spain, and perhaps as far as France. If you think the politics in the US are bizarre, don’t try to fathom what Papandreou, the former Prime Minister of Greece, or Berlesconi, in Italy had to contend with. As someone suggested to me recently, “if you think we’re nuts in the US, you haven’t been to Italy or Greece.”
Take heart, however. The US equity markets, with pretty much everything thrown at them, at least until November were pretty much where they started this year. A heck of a ride to nowhere, some will say, and the nearly 18% descent mid-year chased many who remained in the markets out forever. And despite the five substantial drops already in 2011, it could have been much, much worse. The resilience of the US economy, frankly, remains impressive. With growth expected to continue, albeit slowly, some real upside in the investment markets may be within sight... if Europe doesn’t implode.
All Eyes on Europe. The prognosis for Europe remains in doubt, at least for the short term largely because Europe lacks what little decision-making capacity the United States has. Getting the nations of the Euro to agree to bailouts is more than a challenge, and getting individual nations to buy into devastating slashes in government services and benefits and the attendant political hari-kari is more difficult, still. The European Central Bank has limited ability to raise the cash it needs to bailout even Greece. How can it begin to handle Italy, Spain, or dare we mention…. France?
From our perspective, the upshot is simple to see: even though Europe en toto accounts for less that 16% of the exports of the United States, the massive uncertainty of what could happen there is providing all the needed grisly news to keep the markets here perpetually spooked. Frankly, what Europe is experiencing now is not unlike the anxiety and helplessness we in the US experienced through much of September 2008, when daily we were looking for the next awful shoe to fall. A year from now, Europe may paint a very different picture: the nations that participate in the Euro may be very different, or the Euro, as a currency, may even be history. The torturous drama of Europe’s woes and rehab will undoubtedly dominate the headlines for the foreseeable future. Europe will still stand, however, and like now, there will be both strong and weak economies among them, much as today.
The real irony here, and what’s missing from much of what the investor typically sees, is the continuing, sustained (albeit slow) recovery of the US economy. Take the noise of Europe out of the investors’ headphones, and voilŕ, things might even begin to sound upbeat. But despite the fairly small impact the anticipated European slowdown might ordinarily have on the US, the markets continue to struggle with a disheartening roller coaster ride, with not much end in sight.
A Tale of Two Continents, or How Perception Becomes Reality
How to put this in a nutshell? Let’s back up 10,000 feet and look at the big picture in the simplest terms. Three major economic spheres emerge on today’s world economic headline stage: Europe & the Eurozone, the United States, and the Emerging Markets, dominated by China and India. Europe, simply, is a mess both in real and perceptual terms, as everyone knows, and will likely head into recession. The United States, meanwhile, is in recovery – as slow and perhaps as tenuous as it -- but it is very real, and more real than is perceived. China, India, and the other emerging market economies continue to grow, at a slower pace than in the past given the developed world’s reduced ability to purchase their products and services as well as a desire to keep inflation and growth moderated. But in the show of headlines, Europe and the US have been taking the lead roles. The critical question for US domestic investors, then, is just how insulated from the European mess will the US be?
From a fundamental basis, the US should be mostly insulated. Corporate profitability is at high levels, earnings generally outperformed expectations and expectations remains generally upbeat, consumer confidence is up, and growth has taken hold in regions across the US. In other words, two continents on very different tracks. Were we to remove Europe from the picture right now, and with emerging markets still in a growth mode and able to purchase US manufactured goods, now might be an ordinarily excellent time to begin investing in the growth of the US economy, particularly in US equities with valuations attractive. If Europe, in fact, accounts for a mere 16% of US exports, what’s the problem?
Perception. The lessons of behavioral finance are clear – ignore the irrational behavior of investors at your own peril. The concerns of uncertainty, otherwise known as f-e-a-r, instill trigger-happy behavior in investors. What’s compounded this problem is that machines, not normally known for their emotional dynamic range, are now programmed to react in nanoseconds to observations of fear in the marketplace: Aunt Mabel’s minor anxiety episode about overcooking the turkey instantly transformed into fire in the kitchen and subsequent lockdown. That’s why Europe matters. And all that happens before a human trader can say “sell”. So whatever dangers are perceived, they are magnified not only by a highly sensitized investor still sporting scars from 2008, but a robotrader capable of creating massive disruption and evisceration of investors’ account values.
Credit Crisis, Redux? Moreover, there remains a nagging unease revolving around banks. MF Global, the Corzine-led brokerage firm that recently imploded in spectacular fashion in part to oversized bets on the Europe’s deteriorating debt. No one knew. Sound familiar? The “who’s drink has the poison” issue that was so much at the root of the subprime-based credit crisis of just three short years ago remains on everyone’s minds today. With the international banking world so interconnected, faltering governments and failing banks in Europe could wreak very real havoc with US banks and multinational institutions, as banks begin to suspect their trading partners may be the one holding the Greek debt.
Strengths, Weaknesses, Threats
Bigger picture: corporate profits are up and the economy is growing – perhaps at only a 2% annualized rate for the third quarter, but growing. (And even that mere 2% growth is a bit misleading and might be higher, in that it reflects a drop in inventories – a good thing. Final sales – GDP minus change in inventories – grew at a semi-robust rate of 3.6%.) In fact, we’re looking for a 3% plus rate of growth next year. On the employment front, hours worked has gone up, unemployment claims are down, and the private sector continues to add jobs. In terms of trade, exports are up again, capital goods orders and retail sales are increasing. Even the auto industry is on a decent upswing. Housing, one of the most challenging and critical sectors, is also showing strong signs of life with housing starts way up over this time last year, and new building permits are up as well. Credit costs are low, and inflation remains well below historic levels, even with increasing costs of oil.
There are plenty of negatives to go around, however. The government sector is laying off on all levels, and this is not something that is likely to turn around anytime soon. Unemployment remains stubbornly high, with the US having lost millions of jobs over the last several years. Many will run out of their benefits, putting increased drag on social services and economic growth. While borrowing costs are low, banks are reluctant to lend, so individuals and particularly small businesses – where economic growth is so important – are having a tough go. Even the improvement in consumer spending (retail sales) has a downside: it’s come at the expense of saving, as the domestic savings rate has dropped significantly.
Threats aplenty. Current austerity-minded efforts in Congress and Europe, perhaps appropriate in high growth periods, is precisely what is not needed at this time. Additional massive cuts in spending, social services, should they kick in before the economy has picked up a head of steam would be highly problematic. Another major European crisis that puts another major nation into deep distress and endangers bank positions could present tidal force impacts on US banks and investor sentiment. Furthermore, geopolitical uncertainties abound: from paralysis in DC, further perceived dysfunction in Europe, massive unrest in the Mid-east, or strong downturns in the economies of China or India. Ironically, the low, stimulative interest rates that can help spur economic growth are providing ever more miniscule yields to fixed income investors, many of whom are in their retirement years who’ve have already seen their home values plummet. Living off a 10 year Treasury bill at an interest rate of under 2% is just a hard way to go.
Moreover, while inflation, per se, is not a problem, the continuing high price of oil, even in these grayish times, remains disconcerting and reflective of continued manipulation of the oil markets by speculators. Prices should be much lower. Even a minor boost in GDP growth could quickly drive oil prices, currently hovering around $100 per barrel, back up to $125 or even $150 per barrel, which would add another major drag to growth.
Further paralysis in DC (or worse, masochistic self-destruction), remains an ever present threat. I’ve already mentioned the potential for a hysterical turn to austerity. Refusal to extend the current payroll tax reductions which are truly helpful to small and mid-sized business would be problematic, for example.
The Opportunities
From a longer term perspective, the US and even European economies will undoubtedly improve (some, like Germany, are already doing quite well), and many higher risk-tolerant investors are looking to these markets now. Emerging market economies also represent opportunities over the longer term.
In the more immediate and intermediate term, however, we think a more cautious approach makes sense for most. We believe that even investors seeking growth but with little tolerance for risk may be well-served by stepping in cautiously into the equity markets, keeping funds available on the sidelines, and focusing on short and intermediate bonds, which continue to perform adequately during this challenging period. The economy, we believe, is positioned to do reasonably well and equities will catch up. But perception trumps reality in the short and intermediate term, so unless an investor’s time frame is long and risk tolerance moderately high, now is not a good time to throw caution to the wind.
Fixed income investors will continue to struggle to find acceptable yields. With money market rates essentially zero, investors are increasingly looking to banks as just a place to keep their money safe. Investors have to work harder than ever to find yields that provide a higher enough income stream without incurring enormous risks in the process.
But even here, caution is in order. Should global interests tick (or shoot) up, existing bonds across the spectrum could see drops in value, although longer term instruments remain most at risk. (You may recall that the US 30 year Treasury lost 20% of its value at one point in 2009 and is currently at near record low interest rates.) Once again, then, vigilance is essential. Diversification and alternative vehicles – real estate, master limited partnerships, closed end funds -- can help provide additional streams of income, if carefully researched and monitored.
For our clients, while we see good value in US equities, given the current circumstances we are looking carefully for good entry points for dividend paying stocks, and providing a diverse basket of interest generating investments and hedges until we feel more comfortable with the investment climate. Our theme of cautious optimism, one we’ve adhered to for well over a year now, remains the operating approach.
Happy post-Thanksgiving,
In Peace,
Ron Stein
Good Harvest Financial Group
631.423.6501
rstein@goodharv.com