Thoughts on the Current Outlook – October 2011

Markets dislike uncertainty. Unfortunately, uncertainty has been the only thing we have been able to count on for the last couple of months. From the perils of European sovereign debt, to concerns about slowing in China, to dire forecasts for the US economy, markets were faced with uncertainty at every turn. Not surprisingly, investors marked down the prices of any “risk” asset severely, including stocks of all types, corporate bonds and currencies.

Even though the quarter started with the self-inflicted wounds of the US debt ceiling debate, by quarter end, investors focused on the US as the safe haven. As a result, US Treasury bonds reached record low yields and the US dollar rallied strongly.

Focus continues to be on the events in Europe as the daily remarks from French and German officials are parsed for the latest indication of a possible path toward resolution. There are several sets of complex issues that require a solution and the Eurozone is simply not built for delivering them.

The most immediate issue is dealing with the financing needs of the weakest states – Greece and Portugal. While the markets view default as almost a foregone conclusion, government leaders do not as they view an “uncontrolled” default as their “Lehman” moment, which could give rise to a credit crunch that would be reminiscent of 2008.

The credit crunch scenario is a realistic possibility because of the European banks’ exposure to the sovereign debt of the weak countries. Memories of the questionable viability of US banks in late 2008 are still fresh in the minds of policymakers and rightfully so. It is clear that a coordinated plan to recapitalizing the banks is critical before a default is allowed to happen. German Chancellor Merkel and French President Sarkozy have been in close contact about this issue as their countries need to take the lead. However, the rub is that bank regulation is not region-wide. Rather, it remains the responsibility of each government. So, Germany and France can lead, but they can’t force others to follow.

These debates inevitably lead to the question of whether the Euro structure is simply too flawed to fix. As some commentators have pointed out, the structure worked so long as economic growth was strong and debt levels manageable. But with weak economic growth, high debt levels across the region and austerity likely to make the situation worse in the short run, serious questions have been raised about the whole common currency experiment. It is little wonder then that stocks, bonds and the currency fell precipitously in the third quarter.

Germany and France have pledged their support for the currency union and all of its trappings. The resolve of the political leadership, facing tepid taxpayer support, will certainly be tested. For now, we remain cynical and expect that the politicians will do only the minimum required by the markets to put off the next crisis. This isn’t a recipe for less uncertainty in the short term.

Meanwhile, speaking of politicians doing the least amount required, here in the US we have moved into full election mode. This is surely a path toward no progress. Unfortunately, there remains serious work to be done. The Super Committee spawned by the debt ceiling deal is about to start its work and absent action from Congress, payroll taxes will rise and unemployment benefits begin expiring in the new year.

The presidential candidates are all about “jobs” as if their election could turn a tide of high employment on a dime. If only that were so. More likely, regardless of who sits in the Oval Office, we face several more years of a sluggish economy and frustratingly high unemployment. This is simply a result of the need to work off excessive debt accumulated by consumers over the two decades preceding 2008. We have made a good deal of progress but there is still a long way to go.

We expect unemployment to stay high for several years. Even as the private sector is showing modest but consistent new employment life, the public sector – mostly state and local governments -- is cutting jobs to make sure budgets balance. These offsetting trends are likely to persist for a while.

After the failure of a number of ill-advised programs designed to keep people in their homes, policymakers have taken a break from trying to “help” the real estate market. Longer term, we need to let market forces determine home prices, without artificial props from the government. As existing home prices drop to a significant discount to replacement value, buyers will begin to step in. This bodes poorly for new home construction but recovery in that sector will likely need to wait until existing home prices have found a solid base.

Employment and housing are typically strong drivers of GDP growth in a traditional post-recession recovery. Without their fuel, it is not surprising that growth is sub-par. Business capital spending is likely to continue at a good pace as corporate profits and liquidity are solid. But this isn’t enough to drive the economy forward at a faster pace.

There has been much talk of whether the US is headed for another recession later this year or early next. Recent economic reports have been a bit stronger than expected so it looks like recession beginning this year is unlikely. However, absent action from Congress to renew or expand existing stimulus programs, the risk of recession in 2012 is pretty high. We expect a 2012 recession, if it occurs, will be modest and the impact muted as most Americans believe we have never come out of the Great Recession. And, indeed, we still haven’t recovered all of the economic output lost in 2007-2009.

The wildcard remains Europe. A credit crisis there could quickly spill over to the US and cause real dislocations in our markets. While our banks are much better capitalized and corporations far more liquid than they were in 2008, the effects of credit crisis emanating from Europe are hard to gauge.

Even though yields on Treasury bonds reached record lows in the third quarter, spreads on investment grade corporate, non-US sovereign and high yield bonds widened significantly. As a result, yields on these types of bonds look pretty attractive but we need to be mindful of the risks. So we have stayed with a broad mix of these types of bonds (using funds), slanted toward higher quality issues.

In an uncertain economic climate, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth. Technology and health care are two areas where we are finding companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.

We are also overweight international equities, with a significant exposure to Asian stocks, and continue to be under-invested in small capitalization stocks as they are more directly affected by weakness in the economy. Finally, we continue to add to absolute return-oriented strategies such as hedged equity and managed futures which we believe can provide solid returns with controlled risks.

October 11, 2011                    © Essential Investment Partners, LLC