The Quarterly - September 2011
Economic and Market Update
by: Investment Committee
A mechanic will often look at an automobile and come up with a list of concerns like the oil needs changing, the brake pads are down to some small number of millimeters, the tires are worn, or additional aliments. Even if left unaddressed, problems with the car can exist with performance seemingly unchanged until the issue goes from something to be overlooked to the inevitable. Financial markets can often operate in the same fashion.
Over the past couple years, we’ve discussed the reasons for increased portfolio diversification into alternative asset classes and have at times felt like the mechanic identifying concerns that sit in plain sight. Thus far in the third quarter, the problems associated with too much debt in the U.S. and Europe have gone from unthinkable to inevitable, and similar to early 2010 the market has decided to dwell on the issues versus ignore them. While the basic issue of too much debt is at the core of the problem, the issues that both the U.S. and Europe face are quite different.
The U.S. has done a much better job reducing bank leverage following the 2008 financial crisis with banks having been forced to reduce leverage from upwards of 30:1 in 2008 to about 10:1 today. Considering that mortgages make up a good portion of bank capital, this was way too much leverage for any period, much less when accompanied by a major downturn in home prices. The stress tests and forced capital raises that took place in early 2009 diluted many bank shareholders but added much needed stability to the system with less need to raise cash. The banking system is now in a better place to deal with a crisis due to less leverage. However, the U.S. government is now heavily leveraged and interest rates remain near zero, so the number of fiscal and monetary policy tools to offset economic slowdown are reduced. Likely making the U.S. more prone to cyclical ups and downs, which was the case prior to the Alan Greenspan Fed that tried to override the business cycle with monetary policy.
Contrary to the U.S., the European banking system in general is heavily leveraged with many financial institutions still in the 30:1 range. Just like much of the bank assets in the U.S. were stressed in 2008, European banks have sovereign debt issues and likely need more capital to offset potential losses from Greek or other countries’ debts. At the core of recent market volatility has been the instability of the European banking system. News favorable to banks avoiding sovereign debt losses cause markets to rise and bailouts of monetary union without fiscal union highlight the regions problems. Ultimately, it seems likely that some amount of increased capital and decreased leverage in the European banking system would add stability. From a fiscal standpoint, Europe is much more bifurcated on countries’ abilities to issue fiscal stimulus with many European nations still AAA rated and more favorable debt to GDP ratios. However, it is becoming increasingly obvious that citizens and political leaders in responsible countries don’t necessarily want to impair their countries credit rating to the benefit of uncompetitive and poorly positioned countries.
The issues facing the U.S. Markets are the side effects of some likely forced selling due to high leverage in Europe along with the slowing of the U.S. economy due to the structural issues of too much debt and few monetary policy options to accelerate growth and job creation. Businesses remain with strong balance sheets and very competitive in both the U.S. and Europe. While signs of sluggish demand are likely to make the current record profit margins regress slightly from their highs, even applying a substantial regression in corporate profits, stocks remain reasonably valued relative to bonds. The best positioned countries for the intermediate term still appear to be emerging markets where Latin America and the Far East have much lower debt levels and higher interest rates, leaving both fiscal and monetary policy options. Stock market valuations in these regions have moved back below the developed world, while growth remains elevated and fixed income yields are substantially higher. Thus making both stock and bond markets appear relatively attractive. In many instances, we have recently used the market weakness to rebalance assets into emerging market equity, while the fixed income in these regions has shown no real signs of weakness.
Many people may recall for periods of time in 2008, all asset classes whether it was stocks, bonds, commodities, and even precious metals all moved down in tandem on forced selling, thereby causing somewhat disappointing results from asset allocation and rebalancing. Over the past month, as the problems in the financial system engine have moved from improbable to inevitable, stocks have behaved in disappointing fashion while bonds and precious metals have performed quite well, allowing for asset allocation and rebalancing to mute a good portion of the market volatility.
With reduced bank leverage in the U.S. and broader portfolio diversification, our Investment Committee is confident that portfolios are well positioned to weather the uncertainty and volatility that may lie ahead as the issues of debt and leverage are worked through over the coming years. There will be times when it seems all is well despite the structural problems that remain, as well as times when complete collapse feels all but assured. However, at the core of the equity portion of a portfolio remains quality, well run businesses that over time manage to increase profits and subsequently their value. Our Investment Committee remains committed to proper diversification and rebalancing to provide discipline through what is likely to be a period of economic and financial ebb and flow.