Investment Commentary: Second Quarter 2011
June 30, 2011By Chris Dardaman, CPA, CFP®, CIMA®, CAIA®
Thoughts on the Investment Markets - June 30, 2011
After floundering for much of the quarter, stocks rebounded sharply in late June and were slightly positive for the quarter. Stock markets around the globe rallied due to the temporary resolution of the Greek debt crisis. The S&P 500 rose 0.1 percent for the quarter and is now up 6.0 percent year-to-date. Manufacturing activity slowed during the quarter due in part to supply chain disruptions from the tsunami in Japan. Consumer sentiment weakened as home prices declined and unemployment ticked higher. High gas prices during the first part of the quarter contributed to the economic slowdown as consumers spent more on gas and less on everything else.
Looking forward, the recent soft patch appears temporary and we believe economic growth will likely increase in the third and fourth quarters as some recent drags on the economy continue to improve. The supply chain disruption appears to be abating, which should lead to a rebound in manufacturing activity and GDP growth. Consumers are now benefiting from falling gas prices. High oil prices had already declined when it was announced the United States and other countries would release 60 million barrels of oil from their strategic reserves. The surprise move drove oil prices down to a four-month low and should help consumers during the peak summer driving season. Lower oil prices should also ease inflationary pressures, which have risen in recent months.
International stocks, as measured by the MSCI EAFE, gained 1.6 percent for the quarter and are now up 5.0 percent for the first half of the year. Concerns surrounding the debt situation in Greece pushed stocks lower in Europe and around the world in May and for most of June. However, international stocks rallied strongly the last few trading sessions of the quarter as the Greek Parliament took the steps necessary to receive another round of bailout money and avoid default for now. Emerging market stocks declined slightly as emerging economies tightened monetary policy in an effort to rein in high inflation due to rising energy, food and raw materials cost. China’s economy is slowing but should still show strong growth relative to the rest of the world.
Softer economic data was good news for bonds as yields fell across the yield curve. The yield on the benchmark 10 year U.S. Treasury bond fell from 3.5 percent to 3.2 percent at the end of the quarter. Declining yields helped the Barclays Capital U.S. Aggregate Bond Index gain 2.3 percent for the quarter. It is now up 2.7 percent so far this year. In spite of the doom and gloom prediction from some analysts and financial media personalities, municipal bonds also performed well and are now up 3.4 percent for the first half of the year. Even with the performance for the quarter, we do not expect strong bond returns to continue. Low yields, increased inflationary pressures, and the end of the Federal Reserve’s QE2 program of buying treasuries are likely to lead to higher interest rates and more modest bond returns in coming quarters. We have positioned our bond portfolios in light of this with shorter duration, flexible bond managers and exposure outside the U.S. interest rate cycle.
Over the past few months returns for alternative investments varied by strategy and manager. The HFRI Fund of Funds Composite Index was flat for April and May and is up 0.9 percent year-to-date through the end of May (most recent data available). Alternatives usually do well relative to equities during volatile market environments and this is one of the primary reasons we have them in client portfolios.
We anticipate increased volatility in the financial markets this summer as the two political parties in the United States play a game of chicken with the debt ceiling. Both parties know they have no choice but to increase the debt ceiling and cut expenses. While it is unlikely that tax rates will increase in an election year, we would not be surprised to see some loopholes and tax subsidies, like ethanol, eliminated. We do not expect to see significant tax reform until after the 2012 election.
A Cure for Greece's Debt Problem — Ouzo, Anyone?
In late spring and early summer, the debt problems in Europe, especially Greece, have come back to the front page of the news cycle. The fact that anyone is surprised is surprising to us. Greece is essentially in the same rough shape as it was last year. While Greece only makes up about 2 percent of the overall European economy, there are several other countries in Europe in similar situations, though not as severe. For a number of years, Greece and other European countries were able to borrow at lower interest rates than what they should have, effectively drafting on the creditworthiness of Germany and its triple A status. The Greek government has used most of the money to pay excessive wages, pensions, and other social benefits for workers, especially government employees. Forces of economic gravity have taken over, as they always do, and investors have repriced Greek debt to reflect a much higher risk of default (see chart). Standard & Poors has downgraded Greece’s debt seven times since 2004, from A+ all the way down to CCC.
To stabilize the Euro currency and avoid, or at least delay, a Greek default, the EU came to the rescue last year with an overall Euro zone bailout package of approximately $1 trillion, including $147 billion for Greece. To keep the Greeks afloat, the EU appears close to appropriating part of that cash to be distributed now. The Greek Parliament has passed two austerity votes paving the way for the latest round of bailout money. French and German banks agreed to rollover most of their Greek debt holdings. As of the date this was written, all the details were not yet finalized, but the EU appears to be close to providing the resources to allow Greece some breathing room for now. The financial markets rallied around the globe in response to the agreement. However, the EU will continue to keep a close eye on Greece to see if both Greek politicians and the Greek people will live up to the austerity measures their Parliament has passed. As before, the politicians can vote yes and then come back later and say they didn’t really mean it. Getting the Greek people to actually live with the plan over a number of years is much easier said than done, as evidenced by the past and recent riots in Athens.
While these bailout plans address the short-term issues, uncertainty remains about the Euro currency and how this debt situation will ultimately be resolved. Austerity measures taken by some EU governments are likely to reduce economic growth in Europe in the years ahead. The big concern is over the balance sheets of the PIIGS countries — Portugal, Italy, Ireland, Greece and Spain — and the extent to which the Greek contagion might spread. If Greece were to default in a disorderly fashion, the reaction of investors could cause interest rates for other PIIGS to spike higher, which could lead to more defaults. Other financial institutions, including ones in the United States, could also be negatively impacted through their exposure to derivatives tied to Greek and other PIIGS’ sovereign debt. If several of the PIIGS countries were to default, it would put significant pressure on the European banks — primarily French and German — that hold most of this lower-quality debt. If the European banks stop lending, it would likely cause a shortage of liquidity, which would slow economic growth in the Euro zone even more. For now, it seems that the European countries will keep doing what is needed to hold things together.
Last month at a conference in New York, I had the opportunity to speak with Gordon Brown, former Prime Minister of the United Kingdom for three years and former Chancellor of the Exchequer for the previous 10 years. I asked if he thought the Euro currency would hold together and he said, “definitely yes because the European countries have too much invested to let it fail.” Note that this answer was from the man widely considered the most influential person in the U.K. government who kept them from adopting the Euro currency.
The prescription for Europe is tough, especially for the PIIGS. They need to overhaul their economic foundation to get on solid long-term footing. This will require politicians to convince their citizens to accept tough austerity measures. This will end up significantly lowering their quality of life including higher taxes, lower pay, longer working years, longer working hours per week, less vacations, lower pensions, less health care, etc. The good news is that they can do this and maintain a nice quality of life, but it will take a resetting of their expectations. Many of the government-run businesses will need to be privatized, and this will likely cause workers to be laid off as many of these companies are not run efficiently.
Germany is the largest European economy and has a strong manufacturing base. Keeping the Euro as their currency helps boost Germany’s export-based economy, but politically, the German people are not enthusiastic about having to bail out their less financially disciplined neighbors to the south. They already had to do this once before when a bankrupt East German economy had to be reintegrated with the West German economy. The patience of the German people will be one of the keys to watch. If their economy continues to grow and things are good, the Germans will be more likely to give this time and money. If the global economy does not grow, a stagnant or shrinking pie could cause a political shake up in Germany, which could throw the brakes on and create a potential train wreck for the Euro. While this would create a number of problems, it would likely cause the U.S. dollar to strengthen significantly.
We expect pressure from their voters will eventually cause the political leaders of Europe to get their financial house in order. For now, it appears that the Europeans will continue to manage the problem, kicking the can down the road as they did last year. Eventually Greece will default or maybe more likely, restructure its debts. We think the Euro currency will most likely hold together, but the continuing debt problems of the PIIGS will put pressure on the Euro. At some point over the next few years the Euro could potentially reach parity with the U.S. dollar. Like a submarine, expect to see the Greece story surface on the top, and then disappear for a while. If all the negative media coverage stresses you out, then consider a cure that the Greeks have used for centuries: a glass of ouzo, anyone?
