A few comments on the markets…
Financial Research, Inc.
January 2012
“Up Periscope” is the aptly-named title of this year’s Goldman Sachs outlook report. On the cover, there’s a picture of a submarine periscope cutting through open waters, with a caption that reads “scanning the horizon in pursuit of safe harbors and attractive investment opportunities.” I like the fact that Goldman is putting emphasis on “pursuit of safe harbors,” but believes the investment opportunities will surface, although we may first see some stormy waters.
Given today’s uncertainties regarding the Euro debt crisis, investors must be positioned to ride out downdrafts and be ready to capitalize on longer-term opportunities. This means knowing what you’re looking for and being prepared to move into investment strategies that may be contrary to popular opinions prevailing at the time.
Indeed, it’s interesting how often conventional wisdom can be so wrong. Of course, the “experts” pretty much were blindsided by the demise of two consecutive bubbles, technology stocks and home prices. And, one year ago, experts called for a robust economic recovery pushing the stock market up to the highs set back in 2007. The Euro debt crisis sidetracked that scenario, with near-record levels of volatility making it a tough year for many market gurus. Last January, Barrons listed its “10 Favorite Stocks for 2011,” a group of stock picks led by General Motors, which subsequently fell by 45%. The ten favorite stocks ended the year with an average loss of 5.9%, which compares with the S&P 500’s total return of 2.1%. Even Warren Buffet had an off-year, with Berkshire Hathaway down 4.7%. At the extreme end, investors in hedge-fund giant John Paulson’s Advantage Plus Fund lost a jaw-dropping 51% in 2011.
Perhaps the most notable consensus miss last year was in Treasury bonds. A year ago, it was common knowledge that owning Treasury bonds was the dumbest thing an investor could do. Of course, Treasurys went on to have a stellar year, with ten-years posting a 17% return. At this point, buying what everyone says you should avoid may be starting to look smart. So, our candidate for this year’s “buy-the dumb investment” award would be European stocks. And today’s hot investment play to avoid: emerging market small-cap stocks, currently being hyped by every fund-company wholesaler on the planet. We’ll
check back in a year to see how things played out.
Jay H. Cowles, CFP
Financial Research, Inc.
More of the same?
Most of Wall Street now believes the US economy will muddle through 2012, looking pretty much the same as what we saw in 2010 and 2011. So, following on our contrarian theme, that probably won’t happen. If we instead see big moves in the financial markets, they will likely be linked to the imminent endgame stage of the Euro debt crisis. In the end, the financial markets may ultimately decide how the crisis is resolved, forcing policymakers to stop their delay tactics and make the tough decisions.
The European debt crisis has become critically important to the global economy. Forget about talk of decoupling and how the US or Chinese economies are insulated from what happens in Europe; there will be meaningful ripple effects on everything from exports to the solvency of major financial institutions. PIMCO’s Mohamed El-Erian puts the odds on Euro outcomes as follows: a 50% chance that Euro policymakers successfully manage transitioning to a smaller currency union (weak countries get spun off), 35% chance the eurozone breaks apart and triggers a financial crisis, and a 15% chance that the
eurozone stays intact. Clearly, the Euro debt situation is today’s #1 wildcard for the financial markets.
Euro debt mess: the early years
The European Union (EU) was formed in 1993, with 27 member nations. Six years later, the European Monetary Union (EMU), usually referred to as the “eurozone,” was established as a subset of the EU. At the time, the eurozone concept had many critics; countries like the UK and Denmark wisely opted out. Today, the eurozone is comprised of 17 members that all share a single currency (the euro), with monetary policy administered by the European Central Bank (ECB). Investors viewed the eurozone as a solid economic bloc, with strict guidelines that prohibited eurozone countries from having debt burdens greater than 60% of GDP. As a result, the sovereign debt of eurozone countries was considered to be risk-free and banks in countries like France and Germany banks began making loans to weaker eurozone countries. For years, the banks made good money on these loans, which helped the weaker countries to finance housing booms (Spain and Ireland) and buy things like
German BMWs (Greece and Italy).
Toxic assets: the second wave
It all worked well enough until the 2008 financial crisis came along. Housing bubbles imploded. Greece admitted that it had covered up the actual size of its budget deficits. The illusion of growth had been broken and uncompetitive economies, tax evasion, and corruption became increasingly visible problems. Weaker eurozone countries struggled to service their debt payments and, as liquidity concerns rose, investors started demanding higher interest rates on loans to the “PIGS” nations (Portugal, Ireland, Greece, and Spain), which made debt servicing even more difficult. Ominously, Italy was later added to
the list of problem nations, now referred to as the “GIIPS” countries.
As the situation worsened, the value of sovereign bond holdings at European banks began to deteriorate. Similar to our subprime mortgage fiasco, Euro banks watched as their “risk-free” assets morphed into toxic assets. By last July, bank capital had eroded to the point where banks stopped lending to each other, amid rising concerns about counterparty risk, the risk you won’t get your money back. Today, the eurozone economy is in recession (eurozone unemployment hit a record-high 10.3% in November), pushing many European banks to the edge of insolvency.
Shock and awe? No, stall and delay
As the crisis unfolded over the past three years, Euro policymakers basically did nothing. In contrast to the “shock and awe” TARP-based approach seen here in the US, Europe’s response was tentative and inconsistent, what the financial press has referred to it as “dithering” and “kicking the can down the road.” There have been five major summit meetings on the Euro debt problem since early 2009 – each one ending in announcements of a grand solution, each of which were soon seen to be unworkable.
The European Central Bank provided only modest support to battered banks and indebted countries. By November, the ECB had bought €203 billion of Euro sovereign bonds and lent €641 billion to eurozone banks – not enough to bring confidence back into the financial markets. Then, in December, they allowed 523 European banks to borrow another €489 billion at a 1% rate, in exchange for collateral largely comprised of toxic assets. The hope was that the banks would use this money to buy Spanish or Italian sovereign debt yielding 6% or more. Instead, banks parked most of the money back into ECB accounts paying out at a 0.25% rate, their equivalent of putting money under a mattress. On the positive side, the ECB’s new program may signal a willingness to supply liquidity to the European banking system in any quantity needed, a form of covert quantitative easing that financial markets have been wanting to see.
No crisis, no action
What happens next? It all comes down to Germany, the only eurozone country left with any real financial strength. Fighting inflation is at the core of Germany’s DNA – it’s not going to allow massive debt monetization (printing money that can be loaned to banks in exchange for toxic assets). Germany has also resisted the idea of raising capital by selling Eurobonds to the world; they’d be the ones taking the hit if things went bad. Likewise, German taxpayers don’t want to throw good money after bad by bailing out their Club Med neighbors to the south. However, Germany (and the ECB) might be willing to commit more bail-out capital and print some money if they felt their collateral would be protected.
Collateral protection can only be the result of countries like Italy and Spain getting their economic acts together. And herein lies a possible logic behind policymakers’ stall tactics, which may be part of an overall strategy to push the Euro debt crisis to the brink. Only under the cover of a full-blown crisis environment can German taxpayers be convinced of the need for expensive bailouts. And only then will Germany be able to get maximum fiscal control and concessions from the weak countries.
China’s landing: soft or hard?
China is the #2 wild card for financial markets this year. China’s economy is slowing and just how much slowdown occurs is a big question for the global economy. During the 2008 crisis, China injected massive stimulus, equal to a whopping 12% of GDP, into its economy. The resultant growth was astounding: China’s economy is nearly one-third larger than it was three years ago. Want infrastructure buildout? China added 300,000 kilometers (about 186,000 miles) of highways and 10,000 kilometers of railways in the last two years alone. This compares to the US economy, which only recently regained its pre-crisis levels (US real GDP declined by 5.2% and then had 5.4% cumulative growth).
However, the Chinese economy has cooled and is now running at an 8.9% growth rate, down from an 11.9% peak set in early 2010. Slowing export trade has been a factor, especially since Europe buys roughly 20% of China’s exports. Also of note is a weakening real-estate sector, with the Shanghai housing market down some 40% from its 2009 peak. Anything less than 7% growth lasting for a full year would be considered to be a “hard landing.” Other developing countries are especially vulnerable. China is a huge importer of commodities; in recent years, China has accounted for 40% of world copper demand and over 50% of world iron ore demand. So, a hard landing could directly impact commodity-exporting nations, such as Brazil.
Most analysts believe that any signs of a hard landing would prompt a strong policy response from the Chinese government. In late November, China cut its bank reserve requirements for the first time in nearly three years. With a low debt burden and massive cash reserves, China clearly has the financial means and flexibility to put significant support into its system.
The ECRI Call
Here in the US, 2011 ended on a more positive note, with a minor flurry of stronger economic reports. However, once you get past the headline numbers and peruse forward-looking data, the economy still appears sluggish and susceptible to external shocks. Lack of jobs creation continues to be the dominant story of this business cycle. Since the recovery began, the labor force has fallen by about 190,000 jobs. There are fewer jobs in the US today than there were in 2000, even though the US population has grown by about 31 million people. The quality of jobs is down as well; nearly 20% of the employed population is comprised of part-time workers.
Which brings us to the topic of the controversial recession forecast made back in October by the Economic Cycle Research Institute (“ECRI”). The ECRI predicted a recession, calling it “unavoidable” and saying that mild recession was their best-case scenario. People reacted strongly to the recession call, partly because it flies directly in the face of Wall Street’s bullish opinions (Morgan Stanley and a few others excepted). They also reacted because of the ECRI’s reputation as a business cycle analyst. It’s considered the official arbiter of when recessions begin and end and has successfully predicted each of the
last four recessions.
Has the ECRI backed off from its forecast? Not in the slightest. In fact, it’s been increasingly strong-worded and recently put its reputation on the line, saying the economy will be in recession by the second quarter of 2012 or “we’ll be wrong.” This violates a cardinal Wall Street rule for making forecasts: you can give them a price or you can give them a date, but you never provide both a price and a date.
Investment strategy
There’s a likelihood that, at some point soon, the financial markets (bonds in Europe, stocks in the US) will force structural reforms in developed countries. Resultant market declines would signal the time to consider incremental portfolio shifts into areas of longer-term opportunity.
So, we’re in “up periscope” mode for now: staying close to shore with our investment risk levels, but actively monitoring investment areas that may show attractive risk-reward tradeoffs in the future. As an example, it seems too early to be shifting into China and other developing markets, which may continue to underperform for much of 2012.
Our baseline strategy: determine target investment exposures and then use a three-stage entry approach, with shifts made on significant market declines, signs of market recovery, and any subsequent indications of sustained uptrends. For now, we’re staying patient and keeping an emphasis on capital preservation.
Jay H. Cowles, CFP
Financial Research, Inc.
jay@nwwealth.com