Euro Drama Drags On

We have long thought of Europeans as much more advanced culturally than the US. If for no other reason than having a history that spans a few thousand – rather than a few hundred years – it seems entirely appropriate that European tastes in all things cultural – theatre, art, food – should be more refined. Until this year though, we hadn’t appreciated how far the Europeans might take their appreciation of theatre.

Since early 2010, the tragic story of the debt problems of southern Europe has been on stage. With only a few short breaks, this play has dragged on despite repeated (and mostly half-hearted) attempts to end it. Today, we remain, like most others, wondering what the next plot twist will be. The European Central Bank has stepped forward most recently with three year liquidity arrangements for the banks – this provides the politicians the window needed for structural reform. But whether they will seize the opportunity is an open question.

We continue to believe that ultimately the choice will be unity but only after (1) strong, centralized fiscal authority is established; (2) debts of the weakest countries are restructured with private participation; and (3) the European banks appropriately value their debt holdings and raise sufficient capital to operate safely going forward. Until these things happen – and we seem only marginally closer as the months roll on – we are stuck here. We find it ironic that after two world wars that defeated Germany’s military aspirations, the Eurozone finds itself desperately in need of Germany’s economic leadership. Knowing that the Eurozone is about promoting prosperity while preserving peace, Germany will ultimately provide the leadership needed but only once it is certain the right structure is in place.

In the meantime, fiscal austerity measures being implemented across the Eurozone virtually assure a recession in 2012. The only question is how severe it will be. This is very difficult to assess as the outcome is so dependent on the actions of governments the course of which is just not very predictable. As a result, we have consciously reduced our weightings in international stocks dependent on the European economy and are focusing instead on opportunities in the US and Asia.

The big story in Asia continues to be China’s struggle to maintain strong economic growth while increasing domestic incomes and consumption, reducing its reliance on exports and limiting inflation, particularly in the housing market. For a large, complex economy, this is a very difficult set of tasks. It appears that China’s policy actions are having the desired effects on inflation and housing prices but the impact on growth – both from policy and reduced export demand from Europe – remains to be seen. We are encouraged that China continues to move its economy in the right direction but a patient, dedicated approach to investing here makes sense to us.

Three Years and Counting: Great Recession Healing Continues

Here at home, the economic news of late has been mostly positive. The employment picture has turned more positive, consumer confidence is up and holiday sales were strong. We have a few short term concerns for 2012 though. A small business tax incentive – that encouraged capital investment in 2011 – has expired so the recent strength we have seen in business investment may have been front-loaded. And, Congress just extended the payroll tax break and unemployment benefits for two months so we will be right back into the debates about further extension when Congress reconvenes later this month.

For some time, we have been talking about the legacies of the Great Recession: high unemployment, consumer savings and debt payoffs, reduced bank lending and the housing drag. Even though the employment picture has become more positive lately, we are still a long way from making a significant dent in the millions of jobs lost. We have made only a few steps on our journey of a thousand miles.

Conversely, consumers’ progress on their debt load has been nothing short of monumental. With interest rates so low, consumers’ monthly debt service requirements are now below long term averages. We still have a long way to go in reducing the aggregate debt levels, compared to income. But with aggregate indebtedness growing slowly and the savings rate having stabilized at a more healthy level, we expect continued progress on this front as well. We think one of the best ways government could help is to put in place a program that would allow those with government guaranteed mortgages who are current to refinance without re-qualifying for the loan.

Speaking of housing, we have seen some encouraging signs in new construction and existing home sales recently. With vacancies dropping and rents rising, it is not surprising to see a flurry of activity in multi-family residential construction. We expect this to continue for some time as the demographics continue to drive greater young household formations. And, for those with the income and savings needed to be active in the home purchase market, today’s existing homes offer exceptional value, relative to new construction. With lending standards still exceptionally tight, we think progress here will be slow and tied to continued employment progress. However, we are not optimistic that new single family home builders will see much demand until the overhang of existing homes gets cleared.

The fourth legacy of the Great Recession – reduced bank lending – continues on. Banking is not a good business to be in today. Heightened capital requirements (fewer loans per dollar of capital), extraordinary volume of new regulations (higher costs), diminished income opportunities (reduced interchange fees, no proprietary trading) and a bad public image, all add up to a bad banking environment. Expect tepid loan growth and less support for the economy.

Bottom line, we are cautiously optimistic about the US economy in the short term and we are making progress on the long term legacies of the Great Recession, albeit slowly. However, more self-inflicted wounds, like those surrounding the debt ceiling debate, could easily derail us. In particular, the lack of any progress on our structural debt issues remains a major long term concern. We believe Congress and the Administration made a major error in not acting on Simpson Bowles Deficit Reduction Commission framework. We can only hope that in the course of the presidential election cycle, this plan or something similar gets revitalized. Otherwise, we could see our debt downgraded again and the dollar’s status as a reserve currency come seriously into question.

2011 was a year of small returns and big volatility – the reverse is much more attractive but we don’t expect that result for 2012. Europe in flux, US presidential politics, China in transition, Iran and North Korea re-emerging as potential hotspots. Any one of these could emerge as the dominant theme of 2012. But whether it is one of these themes or something else completely unexpected, we do expect volatility to continue at a high level.

From an investment perspective, we still like the prospects for large multinational companies with diversified revenue streams. And, with US economic prospects a bit better, we are warming up to small caps after a long period of dislike. Finally, even though hedged strategies did relatively poorly in 2011, we continue to like a mix of absolute return oriented strategies combined with fixed income focused on corporate debt.