2011, Quarter 3
Summary
The financial markets breathed a sigh of relief in late June as Greece’s parliament passed austerity measures, thereby unlocking the latest round of aid from European authorities. The possibility of financial contagion in Europe is real, and a disorderly default by Greece could have unpredictable effects on Europe’s banks, financial markets, and would threaten the (already fragile) real economy. That said, Europe’s leaders are working assiduously to address the issue and Greece’s parliament has taken an important step back from the abyss. The economic recovery in the US has proven more sluggish than we predicted earlier this year, but the economy is still growing and a fall back into recession is unlikely. China is still growing healthily, and high commodity prices are driving growth across the rest of the emerging economies.
Europe’s Debt Crisis
The austerity bill that passed Greece’s parliament in late June did not solve Europe’s crisis, but it has given European leaders crucial time to work through the difficult issues confronting them. The problems are obvious: Greece’s debt, at around 150% of GDP, is so high that to pay it back on present terms would crush the Greek economy, while default would ruin Greece’s banks and would have unpredictable consequences on Europe’s financial sector. Some inside Greece (and outside too) argue that the austerity demanded from Europe’s leaders is too severe for Greece to bear, that default is the best option, and Greece should leave the eurozone and revive the drachma. This might boost Greece’s exports in the short run, but a default would cripple the country’s banking system and the country would be shut out of international credit markets for years, as happened with Argentina when it defaulted in 2002 (Argentina still can’t borrow in international credit markets). A Greek default would be very risky for the rest of Europe as well. Most of Europe’s largest banks hold Greek debt and a default could require them to raise additional capital in a difficult environment, and might require bailouts from European governments. In a worst case scenario, banks could stop lending to each other as they begin to fear each other’s exposure to Greek bonds, similar to what happened in the financial crisis of 2008-2009. Additionally, a disorderly Greek default could bring down other vulnerable countries including Portugal, Spain, and even Italy, which would roil global financial markets and would likely push the world economy back into recession. It could also doom the euro and destroy the decades-long dream of European integration born after World War II.
Things look bleak but all is not lost. European leaders – led by German chancellor Angela Merkel and French president Nicolas Sarkozy – are working to ensure that the euro survives the crisis, the financial sector is stabilized, and that economic catastrophe is averted. Any political bargain acceptable to German voters will have to impose new fiscal restrictions (this time with teeth) on all countries within the eurozone. The austerity bill passed by Greece in late June was important because it showed Europe that Greece is willing to do what it can to stay part of the common currency, will try to honor its obligations, and wants to maintain its links with the broader European community. A few plausible fixes to Greece’s debt crisis have been suggested in recent weeks. France has suggested that private bondholders “voluntarily” roll over maturing Greek debt into longer-term Greek bonds, and for this European authorities will continue to provide Greece aid. Dutch officials are calling for a forced rollover of Greek debt held by European banks, though such an operation would likely be seen as a default by the ratings agencies. The European Central Bank is resisting any plan that would result in Greece being declared in default, but time is running out and avoiding default may be impossible at this point.
The negotiations between Greece, Europe’s larger countries, and the banks will be tense and complicated, especially since in important ways all involved have some degree of leverage over all other parties at the negotiating table. Crucially, all involved in the negotiations also have a lot to gain from a long-term and viable solution, and much to lose from default and the chaos it would surely create in the global financial markets. The situation is obviously fluid and negotiations will be difficult, but the most likely result will be a carefully managed rollover of Greek debt, combined with continued austerity in Greece and, eventually, increased oversight and control of eurozone countries’ fiscal spending by a eurozone-wide agency. Europe has been working to achieve increased economic and political integration since it began rebuilding after World War II in the 1940s. Its leaders will do all they can to prevent a reversal of that integration.
The United States
The economic recovery in the US has proven to be somewhat more sluggish than we predicted earlier in the year, but growth is still positive and a return to recession is unlikely. Credit markets remain tight and consumers are still rebuilding their damaged balance sheets, but their finances are slowly improving. The housing market is still a drag on the economy, though there are flickers of hope for recovery as rental rates are rising and housing is becoming more affordable. Construction of new houses is very low and the market is slowly burning through its oversupply, which bodes well for a recovery in the sector during the next year or two.
The slow economic recovery is making the government’s fiscal position increasingly tenuous, as tax revenues remain depressed and, consequently, the budget deficit remains disappointingly high. Unless the economy roars back to life and tax receipts rise substantially in the coming years, public debt in the US will hit staggering levels and interest payments alone will dwarf major federal programs. The most likely result of this dilemma is increasing inflation, as the Federal Reserve “monetizes” government debt by printing dollars to buy Treasuries. Inflation is costly, of course, especially to the poorest members of society who are likely to see their incomes continue to stagnate in real terms in coming years. Politicians and Federal Reserve members will almost never publically embrace higher inflation, since its costs are well-known and to do so would be politically unpopular. Nonetheless, looking at their policies – increased deficits on the fiscal side, and continued easy money on the monetary side – it seems clear that the leaders in Washington see inflation as the least costly way out of the dilemma. This will result in a further depreciation of the dollar, which will lower Americans’ living standards, albeit in a way that is not highly visible to the average voter (at least in the short run) and, therefore, is likely to be politically acceptable.
The US is set to reach its debt limit in early August, and the talking heads are constantly warning that the government might actually default if a political solution cannot be found to the present impasse. The debt limit is virtually guaranteed to be raised on time, however. The only question is what concessions the two sides will be able to extract from one another, and how long it will be until the debt limit will need to be raised in the future. A US sovereign default would shock the global financial system and would have unpredictable and perhaps disastrous results. President Obama and Republican leaders both have much to lose from such an outcome.
We are lowering our forecast of US GDP growth to 2.5% for 2011, and expect it to increase to 3.2% in 2012. Unemployment is likely to stay high through this year and next, as millions of discouraged workers will reenter the labor market as the economy slowly improves. Unfortunately for policymakers (and for the American people) this growth will not be fast enough to avoid continuing fiscal crisis in Washington.
Emerging Markets
China’s economy continues to grow prodigiously, which is pushing commodity prices higher and propelling growth in other emerging markets. China’s leaders have raised interest rates and increased banks’ reserve requirements to cool the economy and rein in inflation, and so far their moves have had some success. They continue to allow the yuan to appreciate against the dollar, albeit slowly and cautiously to avoid any major disturbances in the Chinese economy and financial markets.
A stronger yuan will help China transition from export dependence to an economy driven more by internal demand, and will increase the Chinese people’s living standards. The biggest risk for Chinese policymakers now is the country’s real estate market, which has boomed in recent years, and could threaten the broader economy if prices fall. The real estate market in China appears frothy, but the country’s rules on savings make real estate one of the only avenues available for ordinary Chinese to save, which may support higher prices into the future. The Chinese leadership has shown itself adept at sidestepping potential pitfalls, such as the Asian crisis of 1997 and the recent global economic slowdown of 2007-2009, and it seems likely they will be able to once again guide their economy through a challenging environment. The Chinese economy’s growth rate is likely to slow down to 7-8% in coming years, slower than the 9-10% of recent years, but China’s economy will remain the fastest growing major economy in the world.
Rising commodity prices are driving growth in most of Latin America, southeast Asia, and many countries in Africa. High commodity prices are raising virtually all boats in the emerging world, which has us cautious on the growth prospects of some specific countries. Brazil, for example, continues to see its currency appreciate as investors from around the world invest in the country in the search for higher yields. Prices in Brazil have risen 6.7% from a year ago, which is forcing policymakers to further tighten monetary policy. This has the perverse effect of causing the Brazilian real to appreciate even more, which is further hurting Brazil’s competitiveness. Many policymakers in the emerging economies find themselves facing the same dilemma (Turkey, Colombia, and Chile, for example), and are carefully managing increased inflation and appreciating currencies, a job made more complicated by ultra-loose monetary policy in the US. Troubles exist, but even if economic growth in the emerging world slows it will still be much higher over the next few years than the growth rates in the US, Europe, or Japan.
Interest Rates
The very low interest rates in the US and around the world deserve special comment. Low interest rates are a global phenomenon, with French 10 year bonds yielding 3.48%, Dutch 10 years yielding 3.31%, and UK 10 years yielding 3.30%. Low rates can be largely explained by a few factors: loose monetary policy in the US and (to a lesser extent) Europe, the “flight to quality” trade which bid up bond prices during the financial crisis of 2008-2009, and, importantly, the aftermath of a “balance sheet recession”, in which previously over-indebted consumers (especially in the US) have increased savings and are rebuilding their damaged balance sheets. Loose monetary policy has helped keep interest rates down, especially on the short end of the yield curve, but if this leads to increased inflation and inflation expectations (as we’re forecasting) nominal interest rates will rise even as real rates remain low. Also, the “flight to quality” trade that has helped fixed income – and especially Treasuries – will dissipate if economic growth picks up more than the financial markets currently anticipate, or if the financial markets change their opinion about the creditworthiness of the US government. Such a change could be driven by a sudden downgrade in US debt by one of the ratings agencies, or if public debt in the US approaches 90-100% of GDP, as it is now on pace to do.
Equities
Equities struggled in May and most of June, as the financial markets reacted to disappointing economic growth numbers in the US and increasing fears of a sovereign debt default in Greece and contagion in Europe. The major indices rose the last week of June, however, as the Greek parliament passed an austerity bill and the immediate crisis in Europe was averted. The stock market was unfazed on June 30 (the last day of the quarter) as new applications for unemployment benefits in the US came in at 428,000 – slightly worse than economists expected and above 400,000, which most economists view as the breakeven number for jobs in the economy. Similar data drove stocks lower in May but at the end of the quarter the market yawned, showing that slower growth had already been priced in. The S&P 500 ended the second quarter up 6.0% year-to-date, while the EAFE index (developed countries ex-US) was up 5.4%, and the MSCI emerging markets index rose 0.9%. All three of these indices performed similarly in the second quarter, but emerging markets underperformed in January and February, which has held back year-to-date results. The DBF Diversified Core composite was up 6.19% year-to-date through the end of the second quarter, while the DBF Diversified Passive composite was up 4.77%.
Equities look cheap relative to fixed income. The 10-year US Treasury ended the second quarter yielding 3.16%, while the 30-year Treasury yielded 4.36% and the 6-month Treasury yielded a paltry .08%. Fixed income yields have been held down by Federal Reserve purchases of Treasuries and increased risk aversion in the aftermath of the financial crisis of 2008-2009. The former ended in June and the latter is very likely to dissipate over time as the US and European economies and financial systems heal and the emerging economies continue to grow. Equity valuations are also compelling, with the S&P 500 trading at 13.6 times forward 12-month earnings, the EAFE index at 12.1 times, and the MSCI Emerging Market index trading at 11.1 times. Finally, dividend yields on equities are compelling versus the very low fixed income yields available in the market – the S&P 500 has a dividend yield of 1.9%.
The best prospects for economic growth still lie in the emerging economies, and our equity portfolios contain many companies poised to benefit from emerging market growth. These include fertilizer and lithium producer Sociedad Quimica y Minera de Chile, South American electric utility Enersis, engine maker Cummins, plane maker Embraer, and machinery maker Caterpillar. The DBF diversified core portfolio has roughly half of its positions in international equities (all listed on US exchanges), and a big portion of that consists of companies based in emerging economies. It’s especially important for investors to have a large allocation of their equity portfolios in international stocks today, as economic growth in the US is very likely to trail growth rates internationally, and money expansion in the US makes increasing inflation and a further depreciation of the dollar highly likely in the years ahead. Equities are volatile and difficult to predict in the short run, but for investors willing to withstand volatility over the next few years, prospects for equities are very bright and prospects for fixed income generally – and US Treasuries specifically – are dim.
Fixed Income
After declining steadily for most of the second quarter, Treasury yields jumped abruptly at the end of June. However, interest rates are still down significantly since the end of March. The 2-year Treasury yield fell 36 basis points over the last three months to 0.46%. The 10-year yield declined 31 basis points to end the quarter at 3.16%.The Federal Reserve ended its bond buying program (dubbed QE2) as scheduled on June 30th. Now the question on the mind of the bond market is when the central bank will begin tightening monetary policy. Given the softness of U.S. economic indicators, it’s likely the Fed won’t begin raising interest rates until sometime in early 2012. In the meantime, the Fed will debate how and when to reduce the size of its $2.9 trillion balance sheet. Most of the bonds on the Fed’s books will mature over the next 2-3 years, so the Fed can slowly reduce its holdings (and stealthily tighten monetary policy) by simply not reinvesting all the cash from the maturing bonds.
On the inflation front, headline CPI in the U.S. is likely to remain volatile along with commodity prices, which have bounced off their recent lows. Oil futures are back above $97, copper has rebounded to the $4.30 level, and cattle futures have jumped back above $1.10/lb. Import prices are rising very rapidly and are adding to inflationary pressures. The import price index is up 12.5% year-over-year and will likely climb higher as workers in emerging markets demand higher real wages.
In turn, those costs will be passed on to U.S consumers via exports. Year-over-year headline CPI is at 3.6% and the “core” reading has risen to 1.5%. As long as inflation data continue to head higher, the Fed will be reticent to engage in further monetary stimulus to boost the economy. Our short duration fixed income portfolios continued to handily beat their benchmarks during the second quarter due to our allocation to higher yielding short-term government mortgage-backed securities. Our clients’ intermediate duration fixed income portfolios slightly trailed the Barclays Aggregate for the quarter due to the underperformance of TIPS (Treasury Inflation Protected Securities) over the last couple months. Break even inflation rates have fallen and are once again at very compelling levels – just 1% for one year, 1.58% over the next two years, and 2.11% over the next five years. We expect headline inflation to exceed those levels by a wide margin over those time horizons, making our allocation to TIPS very worthwhile. We are remaining defensive and our outlook calls for moderately rising interest rates over the next year as the economy slowly improves. We expect the 10-year Treasury to hit 3.75% by year end and the 2-year yield to rise moderately to a range of 0.60% – 0.70%.
DISCLAIMER: This publication is for informational purposes only. This publication is in no way a solicitation or offer to sell securities or investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. Nothing in this publication should be interpreted to state or imply that past results are an indication of future performance. Information throughout this publication, whether stock quotes, charts, articles, or any other statement or statements regarding market or other financial information, is obtained from sources which we, and our suppliers believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the user. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION CONTAINED IN THIS PUBLICATION.