This is a quarterly update of economic conditions and investment strategy.
For the first half of 2011, the global economy was characterized by slowing growth in the developed world. This lackluster performance continued through the 3rd quarter with economic indicators suggesting that the United States, Europe and Japan are all growing at annualized rates of less than 2%. In the wake of the financial crisis of 2008, Governments and central banks applied unprecedented amounts of economic stimulus hoping to kick-start a sustainable recovery. Now, with the recovery faltering, we are likely on the verge of a new wave of government intervention.
In the U.S., the job market has stagnated with unemployment at 9.1% and job seekers taking record amounts of time to find new employment. The housing market continues to be weak with construction and sales of new homes slumping from already low levels. Additionally, State and local Governments, forced to balance their budgets in the face of waning tax revenues, are reducing services and employees. Given these difficulties, it is likely that we will see new policy initiatives designed to spur growth. The Federal Reserve will likely return to purchasing assets in the open markets with newly created funds (known as quantitative easing). Ultimately, however, restoring growth and confidence will require more than temporary injections of liquidity. A long-term strategy to implement structural reforms to bring government finances in balance is required. While the recognition of the need for such a solution is growing, the political will to accept the required compromises has been absent.
The U.S. Deficit Commission is expected to recommend spending cuts by November. Last December, the Simpson- Bowles Commission issued its own recommendations, which, with its proposed revenue enhancements, spending cuts, entitlement reforms, and tough medicine addressing many sacred cows, gained no traction. While watching the political process is grisly, our view is that eventually a “grand bargain” will occur, likely spurred by continued tepid economic activity and fear of the consequences of no action.
Europe is struggling with profound difficulties that threaten its common currency (the Euro), the cohesion of the European Union, and the global financial system. While countries in the Eurozone share a currency, the individual sovereign states are in control of their own spending and borrowing. During the last decade, the peripheral countries (Greece, Portugal, Spain, Ireland and even Italy) have taken advantage of their ability to sell bonds in the strong European currency to finance spending well beyond what their economies could service. The bond markets have reacted to the weak financial positions of these countries and are requiring higher yields to refund debt, making it difficult for these Governments to issue new debt to finance services and to pay off maturing bonds. Some of the member countries are at risk of defaulting on their debt payments. The prospect of defaults is alarming because banks across Europe hold large amounts of government debt, the value of which would be adversely affected by a default. Some banks—it is not clear which ones because of a lack of transparency—would be at risk of failing if forced to take large enough write-downs of the value of their assets. Large European banks are deeply integrated into the global financial system and a lack of confidence in their ability to fulfill obligations as counterparties could lead to another global financial crisis. At the moment, Greece is most at risk. We believe a default by Greece, which we view as inevitable, would be manageable, if orderly.
Solutions to the European crisis are complicated by the political structure of European institutions and the different economic prospects of member countries. The core countries (Germany and France) and the European Central Bank recognize the need to act decisively to prevent a contagion, but their citizens by a large margin resent footing the bill to bail out profligate neighbors and saddle their economies with more debt. Various schemes have been used to purchase debt and shore up bank capital but thus far these efforts have been slow, piecemeal, and too small to restore confidence in the Euro markets.
The unifying themes across the developed world (Europe, U.S. and Japan) are too much debt, too many promises, and not enough revenue to support the promises.
In the face of a steady stream of disappointing economic news, equity markets were very weak in the third quarter. The S&P 500 fell 13.9% and the broader MSCI World Index declined 16.5%. Shares of financial companies as well as energy and material stocks were some of the weakest performers. Emerging markets indexes also suffered despite more robust economic growth and stronger government finances of their member countries.
With the Federal Reserve signaling continued low interest rates, strong companies have an unusual opportunity to lock in attractive long-term funding. Also, high quality companies with generous dividend policies become attractive not only to stock investors, but to bond investors, frustrated by years of low rates on their savings and bond portfolios. We are taking advantage of this state of affairs.
In time, several quarters or more, we expect attractive values in areas of long-standing interest and conviction. Should the world slip back into recession, prices of energy and other materials (fertilizer, base metals) will come down. Given our thesis of a fundamental long-term supply/demand imbalance, we would be buyers at, perhaps, generation-low entry points. Economic emergencies create opportunities and we expect this one to be no different, if one does not act too hastily. Price is a very important determinant of value.
Note: even in this weak world economy, prices of energy and food are increasing at rates faster than personal income. This is a signal that when normal growth resumes, these markets will be tight.
Disruptions in Europe also may provide opportunities in world-class European blue chips which have for decades been part of client portfolios. Europe as the home market for these companies typically accounts for 50% or more of revenue. A heightening of the Euro Crisis would cut revenues and profits from their local operations; a commensurate fall in stock prices would provide a good entry point for a number of these rock-solid companies. In short, we are watching global events with enormous interest; we will be ready. As noted, this may take time to play out.
Fixed income markets were mixed with US Government bonds benefiting from a flight to safety that pushed yields temporarily below 2% for 10 year treasuries. Prices of lower-rated corporate bonds and financial company bonds declined because they were seen as being most at risk from a slowing economy and the pressures emanating from the sovereign debt crisis in Europe. Prices of municipal bonds, although offering relatively attractive yields, were held back because of anticipation of a large supply during the remainder of 2011. More broadly, we continue to emphasize short durations for most client accounts following from our ongoing assessments of the risk-rewards of seeking higher yields.