After nearly two full quarters of uncertainty last summer and fall, the financial markets settled on the conclusions that (1) the US economy was recovering from the summer soft patch; (2) China’s slowing growth rate was not likely to be a crash but an expected slowing due to a shift away from exports; and (3) the Europeans, with the help of their central bank, were likely to stave off default by Greece for the time being. From the peak in April of 2011 to trough in early October, US stocks dropped nearly 19%, just shy of the magic bear market line. Since then, they have rallied nearly 30%, bringing us to levels not seen since 2007.
Here at home, recent statistics on GDP growth, employment, manufacturing and housing have been positive, if not overwhelming. Bears point out that seasonal adjustments are out of whack because of the warm winter and that future reports are likely to be much weaker. They also point to slowing in Europe and China that will ultimately spread here. Finally, the “tax” of higher gas prices will ultimately drag down consumer spending.
Bulls counter that employment is showing sustained growth, with initial jobless claim numbers supporting solid growth in non-farm payrolls. Risks in Europe and China are well-known and likely to have only a moderate impact on us. The booming market for domestic energy is driving job growth, and that, combined with low prices for natural gas, more than offsets higher gas prices.
On a longer term basis, we are increasingly focused on four factors that we see as likely to help our economy over the next several years. We believe these four trends will help lead us away from some of the nearly four year old legacies of the Great Recession, particularly high unemployment and excessive debt.
- the push for energy independence, supported by major discoveries and new technologies in North America as well as a moderately favorable regulatory environment;
- the petering out of the housing debacle – with foreclosures concentrated in a few severely depressed markets and affordability at an all-time high, we believe the stage is set for stabilization of home prices nationally;
- a new wave of business productivity enhancements, sparked by the convergence of highly functional, user friendly mobile devices and an explosion in software targeted at these devices;
- the overarching theme is the emergence of the echo boom generation as the driver of each of the three themes above. Think energy efficiency, housing needs, mobile productivity – we think those six words succinctly summarize the mindset of current 20- and 30-somethings.
Expect us to expand on these themes in future publications as they come increasingly to the fore.
Coming back to what is directly in front of us, we remain in the slow growth camp, and believe there remains a relatively high risk (but likely less than 50% chance) of recession. 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 may also taper off a bit this year after so much was front loaded into 2011 because of advantageous depreciation rules. One recent bright spot has been cars – auto sales have been strong, boosting employment and incomes.
So why is there such a high risk of recession? Politics and debt. We believe the political environment in Washington is as poisoned as we have ever seen it. No compromise is too small to refuse, no position too unimportant to make a principled stand on. When you layer this poison atmosphere on to the burning need for political compromise to solve our long term fiscal problems, you get self-inflicted wounds like last summer’s debt ceiling fiasco. At the end of 2012, we face monumental fiscal constraints as the Bush-era tax cuts expire, other stimulus programs run out and mandatory spending cuts kick in. To us, this has the makings of more self-inflicted harm. And, no amount of liquidity from the Fed will be sufficient to offset the fiscal drag we will see if Congress can’t or won’t act.
As if all of this wasn’t enough, we are in full presidential election mode so absolutely nothing but posturing will get done between now and November. So put us in the short term cautious, long term bullish camp.
Meanwhile, in Europe, the European Central Bank’s LTRO program provided a great deal of needed liquidity to the banking system, effectively forestalling a liquidity (not a solvency) crisis. The solvency problem remains and the austerity programs forced onto Greece, Portugal and Spain virtually assure a very deep recession in these countries. And with each successive round, the budget targets get harder and harder to meet. We can’t predict how or when this cycle will end but count on another crisis being necessary before politicians take any meaningful action.
In China, short term cautious and long term bullish is also apt. They are turning their aircraft carrier of an economy inward, focusing on wage growth and consumer spending, at the expense of export markets. Long term this is extremely healthy but in the short term, growth will slow markedly, with repercussions across developing Asia.
After nearly two decades of slumber, Japan’s economy is beginning to show some signs of life. What we don’t yet know though is whether this is a brief rebound from post-tsunami rebuilding or something more sustained.
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.
In client portfolios, we have underweighted international equities dependent on Europe’s economy and maintained exposure to Asian stocks. Early in the year, we added to small capitalization stocks as they will benefit from increased liquidity and an improving economy. In fixed income, we continue to like corporate bonds and high quality municipal bonds but have stayed away from US Treasuries because we believe their yields are artificially suppressed by the Fed and price risk is very high at the current low level of yields.
April 6, 2012 © Essential Investment Partners, LLC