From one day to the next, the markets can’t seem to decide whether the European debt crisis or the US debt ceiling debate is potentially more damaging. If you think the former, you want to own US Treasury bonds as a “safe haven.” If you think the latter, then US Treasury bonds are the last thing you want to invest in. No wonder that rates on the benchmark 10 year note have bouncing around a lot lately!
The European debt crisis could be the world’s slowest train wreck in progress. However, it is possible to conclude that the Europeans are actually taking a much more logical approach to their problems than we are in the US. The so-called “PIIGS” have put in place or are considering forms of government austerity programs either as a condition to debt relief from the central bank and the IMF or to hold off the need for such relief. While there is a long way to go, the momentum is shifting toward fiscal responsibility and away from debt-financed public spending. There is still the risk that the markets grow impatient with the slow process, the Euro comes under great duress and the credit markets malfunction.
In the US, it seems clear that we do not have the political will to make the tough choices needed to get our fiscal house in order. The “debate” over the debt ceiling has been little more than both parties reciting their principles and the President wondering why no one will compromise. We think the President missed a great opportunity by not using the report of the Bipartisan Deficit Commission, co-chaired by Erskine Bowles and Alan Simpson. If we were really serious about a grand compromise, this report provides a great starting point. Instead, the current process is likely to drag on until the August deadline when a “mini-compromise” will get done to put off real debate until after the 2012 elections.
As we look at these debt problems, it is important to understand that they will take time and sustained effort to resolve. There is no “immaculate solution,” as one commentator recently described policymakers’ goal for a quick and painless way out of problems that are decades in the making. Because the Great Recession exposed the unsustainable levels of debt throughout developed economies, we will ultimately be forced to “eat our peas” as the President said recently. Until now, we have been able to do what my sister did growing up – scatter the peas around the plate so it looked like most of them were gone. Unfortunately, this time the markets recognize that the problems are too big to scatter around until they disappear. Europe may not have good means for resolving their debt problems, but they have the advantage of starting to address them ahead of us.
In the meantime, the debt debate is a side show to the continuing drags of unemployment and housing on the US economy. As we have said many times before, we expect unemployment to stay high for several years. Even as the private sector is showing some new employment life, the public sector – mostly state and local governments -- is cutting jobs to make sure budgets balance. These offsetting trends will persist for a while. The unemployment rate has now climbed back up to 9.2%, after hitting an artificially low 8.8% a few months ago. Because of the great number of people who left the workforce during the Great Recession, even the 9.2% rate understates the unemployment problem.
After the failure of a number of ill-advised programs designed to keep people in their homes, we are hopeful that policymakers take a break from trying to “help” the real estate market and let the market forces correct their imbalances. We believe that 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 should not be too surprising that growth is sub-par. We can expect business capital spending to continue at a solid pace as profitability remains very strong. And, perhaps surprisingly, led by autos, the US manufacturing sector had also staged a bit of a comeback until it was sidelined for a few months by the effects of the Japan earthquake.
First quarter GDP growth was 1.9% and most economists expect a similar number for the second quarter. Whether we get a boost in the second half of the year is the subject of much speculation. Optimists point to lower gas prices, a stronger rebound in auto manufacturing as supply chain issues resulting from the Japan earthquake are resolved and consumers’ continuing progress in reducing their debt. Pessimists point to employment, housing and the lack of government stimulus (both monetary and fiscal) as reasons for an even weaker showing.
For our part, we think any second half boost in the US will be modest – not enough to get anyone excited. We expect a continuation of the bifurcated global economy, with the developed economies of Europe, Japan and the US growing very slowly. Meanwhile, developing Asia and the resource-rich economies of Brazil, Australia, Canada and Scandinavia will likely continue to post very solid growth.
We have also believed for some time that the US dollar will remain weak for the foreseeable future. Recently, we added a dedicated currency manager (in mutual fund form) to many client portfolios. That manager has illuminated our thinking on the role of the US dollar in the world economy and we expect to cover this topic in more detail in an upcoming publication.
With the yield on the ten year US Treasury note right at 3% and spreads on corporate and high yield at tightened levels, it is hard to get excited about the return prospects in fixed income. In their search for yield, investors have also driven down the discounts on fixed income closed end funds to very low levels, leaving relatively few trading opportunities in that space.
On the positive side, we have seen an increasing trend of bringing hedge fund strategies to mutual fund form. Recently, we completed due diligence on and invested in several new funds of this type. A couple of these are managers whose hedge funds we were quite familiar with so the investment decision was easy. In many cases, however, the fancy strategies have given rise to high fees and low returns – not a combination we are interested in pursuing for our clients!
While hardly cheap, we continue to like stocks of companies that can continue to deliver strong returns on equity and consistent earnings growth despite the slow growing economy. Technology and health care are two areas of focus where we can find companies with an attractive combination of revenue growth, strong profitability and reasonable stock prices.
Unlike the markets’ almost daily shifts between “risk on” and “risk off,” we have kept asset allocation in client portfolios relatively stable. We are overweight international equities, with a dedicated exposure to Asian stocks, and also have a significant non-dollar weighting in fixed income. In addition, we have maintained the investments in absolute return-oriented strategies in client portfolios. Finally, we continue to be under-invested in small capitalization stocks, in favor of more reasonably priced larger companies with greater exposure to the world’s growing economies.
July 13, 2011