June 19, 2012
30,000 Foot View
To every action there is an equal and opposite reaction. Such is the case in physics. Such is also the case on Wall Street, Main Street and Washington. From the markets recent upswing and subsequent swoon, from the Tea Party’s rise to Occupy Wall Street’s sit ins, from Bush to Obama to Romney, the Housing Crisis, Apple’s ascension to the largest company by market cap and unemployment there remains a dichotomy between where we are and what we want. The controversy over the recall elections in Wisconsin, the Supreme Court decision about Obama’s Health Care Law and Dodd-Frank clearly shows how the United States is in the throes of deciding the relationships the institutions of our country have to each other. Are we up to the task of solving the problems of our nation?
Gale Force Headwinds
The issues are clear. A large out of control national debt, high unemployment, a housing and banking crises, the fate of the social safety net as embodied by Social Security, Medicare and Medicaid, a complicated tax system, high energy costs and a well maintained military need to be balanced against the essential requirements to update our infrastructure, clean up the environment, educate the country, create jobs and regulate the financial system to compete in a global 21st century economy. The nation’s debt now stands at 16 trillion dollars with threats of yet another credit downgrade should we fail to get our fiscal house in order and reduce the national debt.
Europe’s fiscal and monetary crisis has erupted as a socialist backlash against austerity and has raised serious reservations and fears around global systemic risk. A falling Euro, a rising dollar, low trading volumes, credit downgrades, steep intra and inter day market swings, falling bond yields and rising gold prices show how the events in Europe affect our markets here at home. Europe remains mired with economies that could fail. The Eurozone and China effectively demonstrates global connectedness underscoring the importance of large economies to the world. Greece’s possible exit from the Euro and contagion to Portugal, Spain and Italy gives life to these fears.
The interconnectedness of the world’s financial system raises serious issues for the United States banking system as the recent multi-billion dollar loss at JP Morgan Chase demonstrates. The restructuring of the nation’s financial and banking system can be seen in the capital requirements of Basel III, the Volcker Rule and the regulations of Dodd-Frank as they are implemented.
Add to this the technological revolution of the glass age revolving around the internet. Smart phones, tablets, social media such as Facebook and robotics is disrupting and changing the economics of business. Ask Best Buy, K-Mart, Sears, Barnes and Noble, Amazon, Circuit City, Ebay, Pay Pal, Visa, MasterCard, the newspaper business and the manufacturing industry how technology has affected them. Technology is changing the nature and meaning of what constitutes commerce, taxation, employment, privacy and what type of speech is constitutionally protected. Is the equilibrium that holds the fabric of our society together tearing or will we as a nation come together to create stability? Has scarcity led us to the politics of inaction?
The Context Surrounding the Numbers
Is it any wonder economic malaise rules the day? This is where the United States finds itself. Much better than financial crises but not good. We no longer have credit markets that don’t work. Bank lending has increased. Markets rose in the 1st quarter of 2012. Yet, quantitative easing is back on the table. Slow anemic growth has been the watchword for several years now. In the quarter ending March 31st of this year GDP (Gross Domestic Product) after its first revision came in at 1.9%. GDP for all of 2011 was 1.7%. In 2010 it was 3%. So what is holding us back?
In one word uncertainty. The election this November is a referendum on the direction the country will take. Political gridlock in Washington has effectively put the recovery on hold. Remember last summer’s debate over extending the debt ceiling. The loss of the United States AAA credit rating. The failure to reach the grand bargain. The political arguments over every piece of fiscal, tax and stimulative piece of legislation. It may be time to make your voice heard at the ballot.
We have only the Fed to steer the economy. After two rounds of quantitative easing the Federal Reserve initiated Operation Twist in the fall of last year. If you remember this is where the Federal Reserve sells short term treasuries on its balance sheet to buy long term treasuries. This is done for the purpose of keeping long term rates low to promote stability for long term planning. Operation twist has continued into this year. The yield on the 10 Year Treasury fell to an historical low of 1.45% as investors have looked for safety from the volatility of the markets. The yield on the 10 Year Treasury has since moved higher and now stands at 1.62%. The yield on the 30 Year Treasury stands at 2.73%. What is particularly troublesome is that the purpose of low yields is to stimulate capital investment, promote hiring and help to facilitate the purchase of residential real estate. Not only has this not happened but in fact quite the opposite. Business investment has slowed, real estate values as measured by the national composite Case-Shiller Home Price Index fell 2% in the first quarter of 2012 and was down 1.9% versus the first quarter of 2011. In May the unemployment rate rose to 8.2%. One can only conclude that capital has been parked in risk free assets as recent events have unfolded. Inflation as measured by the CPI (Consumer Price Index) was 2.3% in April. For May it was 1.7%. The CPI has been hovering between 2.9% and 1.7% for 2012. Therefore, the assets parked in risk free assets such as treasuries are either marginally above or below real rates of return when accounting for inflation.
At the same time the index of economic indicators had risen through March of this year. Representing 6 straight months of increases. In April the index fell. US companies are maintaining fortress balance sheets and do not see a climate worth investing in. From their perspective keeping their costs low has been a winning formula for making money. As earnings were reported for the 1st quarter of 2012 67% of those companies have beaten expectations. Companies are concerned about investing when the number of customers who can buy their products has shrunk. Individuals are concerned about the uncertainty that comes from a lack of jobs.
The recent run up in both the stock and bond markets have given way to the sustainability of such gains. The U.S. stock market through March 31st 2012 as measured by the S&P 500 gained 12.59%, The Dow 8.84%, and the Nasdaq 18.67%. The Russell 2000 illustrative of the small cap market was up 12.44% for the same period. The markets have since wiped out and retraced some of these gains. The S&P 500 now stands positive for the year at 7.98%, the Dow 5.07%, the NASDAQ 12.46% and the Russell 2000 6.14%.
Commodities
Commodity prices have risen and fallen this year. Oil spiked to over $100 a barrel and recently has fallen back to $84 per barrel. The National average for a gallon of gas is at $3.51 per gallon. At the same time the rise of emerging markets such as Brazil, India, China the Middle East and Russia and the competition that has evolved for the consumption of the world’s resources ranging from oil to gold to agricultural commodities continues to pressure the price of these commodities upwards. Only recession in Europe and slower growth in China and the United States have capped the rise in the prices of these commodities.
Analysis
Ordinarily low interest rates act as a catalyst for upward moves in the markets. Indeed, the Major market indexes such as the S&P 500, the Dow, and NASDAQ have risen. However, the combination of Greece’s potential exit from the Euro, the rise in US unemployment and political uncertainty has shocked the financial system causing a decline in major market indexes from their peaks in March.
Bond Holders have made money as interest rates have fallen as shown by the volatility of treasury yields. The yield on the 10 Year Treasury has dropped from a high of 2.45% in March to a low of 1.45% and now sits at 1.62%. Consequently, secondary market values have risen. The Investment Advisor believes while rates may not go much higher in the short term they will not fall much lower than the 1.45% low until we get clarity on Europe and further numbers on the direction of the U.S. Economy.
The Investment Advisor believes the Federal Reserve will continue the Twist past its expiration at the end of June. The Fed may inject more liquidity into the economy by adding additional quantitative easing. Numbers from the economic calendar being reported show both retail and manufacturing declining in May for a second month in a row. The recent drop in commodity prices suggests the potential for a deflationary trend. The recent rise in unemployment and the crises in Europe will prompt the Fed to action. This Fed has a history of reacting to problems with unemployment, deflation and systemic risk. Low interest rates are here to stay as Bernanke previously announced last year he would continue a low interest rate policy until 2014. The Issue still remains as Bernanke mentioned in his most recent testimony on the hill additional quantitative easing may not be as effective as the first several rounds as each successive round is less effective than the previous one.
From a macro- economic perspective Europe, China and the United States are the economic drivers of global demand for goods and services. The United Kingdom is in recession. Keep your eyes on the performance of each of these players. Their collective performance good or bad will set the backdrop for the performance of the U.S. markets and commodities for the immediate future.
To put this in perspective there have been three periods in post war history that have combined recession with a crises in the banking and financial system. Specifically, the Latin American Banking Crises of 1975-1982, the recession of 1990-1992 which coincided with the Savings and Loan Crises and the current problems we find ourselves in which showed their first rumblings in 2006 and 2007.
The Latin American lending crises was created by bank over lending to Latin American countries who could not pay their debts. This, combined with the spillover of high oil prices from the 1970’s created economic stagflation (high interest rates, inflation and falling Gross Domestic Product) with interest rates approaching 20%.
The Savings and Loan Crises resulted in the need to recapitalize investment banks, the market crash of 1989 following the crash of 1987 and the formation of the Resolution Trust Corporation to restructure the balance sheets of the savings and loan institutions. This episode contributed significantly to the recession of 1990-1992. Recession combined with or caused by systemic issues with the banking system take much longer to heal than cyclical recessions.
The recession of 1973-1975 caused by a shock to the economy from the dramatic rise in the price of oil as a result of the Arab Oil Embargo and the rise of OPEC resulted in wage and price controls. The Price of oil went from 3.00 per barrel to about $12.00. Gasoline went from 25 cents a gallon in 1973 to $1.35 by 1981.
This malaise we find ourselves in combines elements of all these periods. Balance sheet issues for the Banking Industry resulting from poor mortgage lending decisions and losses in proprietary trading and derivatives creating counter party risks. Large spikes in the price of oil, gasoline and other commodities of which the price of gold is a symptom. We also know we have extracted half of the world’s oil. The last half will be more expensive to obtain. This is what is fueling the demand for natural gas and alternative energy sources such as wind, solar, geothermal and nuclear.
The one real difference is Globalization. The degree to which economic performance in one country or region ties the fate of all the countries of the world together. How political gridlock in any one country can hold the world hostage.
Hence assets move in the same direction together as opposed to moving in different directions at the same time. A classic break down in the asset allocation model and the idea of investing in uncorrelated assets. This happens during times of economic volatility and extremes. We have seen this before in modern history. Once for a 3 month period during the Long Term Capital debacle in the 90’s and the internet bubble which burst in 2000.
From a national view of the United States volatility will be much higher for at least the last half of the year. The low valuation of the market as a whole has the potential to create buying opportunities in individual securities. With regards to real estate the large number of foreclosures in the pipeline will continue to act as a cap on the price of real estate. We have yet to deal with the government sponsored enterprises of Fannie Mae and Freddie Mac. Prior to their extraordinary losses these organizations provided liquidity by creating a secondary market for mortgages. This type of market has yet to be re-created.
Investment Strategy, What this means for Your Investment Portfolio:
Given this backdrop The Investment Advisor recommends a market neutral strategy for your portfolio. This is not the time to attempt to pick a direction of the markets or interest rates. Political decisions are much too unpredictable. High volatility may create inefficiencies in the prices of individual securities and reveal bargains with solid fundamentals. Many companies have either raised their dividend payouts or have begun paying dividends. Historically low interest rates have created buying opportunities in the stock market, real estate and assets generally for both growth and income investors. For those with long time horizons these investments may pay off over the longer term.
The Investment Advisor recommends higher levels of cash and cash equivalents over the short term to preserve capital and take advantage of bargains as they appear. Given the uncertainty surrounding the Fiscal Cliff The Investment Advisor recommends putting in place a strategy to help you decide whether to take unrealized gains or losses this year or push them into the following year. The Fiscal Cliff comprises the expiration of the Bush Tax Cuts (capital Gains, dividends, the alternative minimum tax), the payroll tax cut and the sequester of domestic and defense spending amounting to 1.2 trillion dollars of spending cuts. The Investment Advisor will work with both you and your accountant to form and implement this strategy.
The Investment Advisor believes account types that offer tax deferral such as IRA’s, 401k’s and retirement plans generally will continue to be protected despite the move towards Tax Reform as a consequence of the election. The only caveat to this being if your level of income exempts you from taking full advantage of this deferral regardless of who wins the election this fall.
The Investment Advisor seeks to help you navigate these currents and headwinds in ways which will empower you in making decisions about your investments and finances. We believe providing you with information across multiple disciplines will help you put events in context and will help you leverage information to achieve your investment goals.
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