2011, Quarter 4
Summary
Stocks fell in the third quarter and investors rushed to the safety of fixed income as market expectations for global economic growth were ratcheted down. The ratings agency Standard & Poors downgraded U.S. sovereign debt to AA+ and changed its outlook to negative in early August. U.S. Treasuries rallied after the S&P rating change, as this much heralded event was quickly subsumed by more important news – a slowing global economy. The financial crisis in Europe is dragging on, with German, Dutch, and Finnish politicians moving hesitantly toward implementing a broad bailout of peripheral euro governments and greater fiscal union in the eurozone. The risk of financial contagion in Portugal, Spain, and even Italy is adding to the angst of global equity markets. Economic data in the United States were disappointing in the third quarter, as the housing crisis and de-leveraging of the U.S. consumer continued. Some data at the end of the quarter were more encouraging, however, and indicate that the U.S. economy is likely to avoid a new recession. Financial markets were also weighed down by evidence of slower growth in China – economically sensitive commodities were down significantly in the quarter – though investors have overreacted to this news. Chinese policymakers have been trying to slow the country’s economy to rein in inflation. This is a critically important issue for leaders in Beijing, since inflation could foster social unrest (inflation was high before the Tiananmen Square protests in 1989). Inflation in China is slowing down and, it’s important to remember, the Chinese government has successfully navigated multiple global financial storms during the last two decades.
Fear pervades the financial markets, as there is heightened uncertainty regarding economic growth in the short term. Over the longer term, however, Europe will fix its problems, the United States housing crisis will eventually end, and China’s path toward greater economic development is very likely to continue. With this in mind, equities are extremely cheap vis-à-vis fixed income, and are being held down by increased risk aversion which will prove to be ephemeral.
Europe’s Financial Crisis
It is painfully obvious that Europe’s Economic and Monetary Union was flawed from the beginning, and that a monetary union must be combined with significant centralized fiscal control. This is not in doubt, even among the euro’s most ardent defenders and proponents. What is much more difficult to discern, however, is the optimal path forward given the situation as it stands today, with peripheral governments teetering on the verge of sovereign default and contagion threatening too-big-to-fail giants Spain and Italy. All policy alternatives available to European leaders would be costly and each could prove politically explosive. A solution must be found, however, as time is running out and financial markets are forcing the politicians to act.
Some say Greece and possibly Portugal should leave the eurozone and revive their old currencies in an attempt to gain competitiveness through currency depreciation. This argument sounds appealing but crumbles under scrutiny. There is no legal mechanism for countries to leave the eurozone; any such move would be very messy politically and would roil already extremely fragile global financial markets. Second, the departing countries would still be stuck owing copious amounts of debt denominated in euros. Outright default would be inevitable, which would prevent the departed countries from accessing international credit markets for years to come. Third, any country contemplating an exit from the eurozone would see a debilitating run on its banking system the instant its plans are known. Citizens of the departing country who made deposits in euros would see their savings changed to a new, depreciated, currency, and they would be unlikely to pull even that out of the bank. This is what happened in 2001 when Argentina ended its peg with the dollar, and it led to a sharp economic contraction and social unrest as millions were dragged into poverty.
If a country announces its departure from the eurozone the financial markets will immediately sell off the debt of other peripheral countries in the monetary union, which will force either their own departure and currency depreciation or a massive bailout by the stronger members of the eurozone. If this contagion spreads to Spain or Italy the repercussions would be disastrous (Italy is one of the largest issuers of sovereign debt in the world, with over $2 trillion outstanding). Also, and of critical importance, banks based in the core of the eurozone – Germany, Holland, Belgium, and France – would be forced to write off sovereign bonds worth tens of billions of euros (maybe hundreds of billions as the dominos fell in Spain and Italy), forcing recapitalization and government bailouts and nationalization. Finally, if peripheral countries left the eurozone the euro would immediately appreciate, thereby hurting exports in Germany and the rest of the core. In other words, a country leaving the eurozone would be painful for all of Europe and is much easier said than done.
German, Dutch, and Finnish politicians are understandably loath to be seen as financing profligate and irresponsible governments in southern Europe. At the same time, if countries in the south collapse their own banking systems might be ruined. It would also mark a dramatic end to the project of European integration begun after World War II. Few in Europe’s core – and none of its leaders – want to see that. Can they prevent it? The EFSF (European Financial Stability Facility), designed to aid eurozone countries in financial difficulty, was passed last year, and its expansion (possibly to the trillions or euros) is currently being negotiated. In the last week of September Germany’s parliament passed a bill expanding the size and powers of the bailout fund, and increased to €211 billion the amount of the EFSF guaranteed by Germany. This has not been enough to assuage the financial markets, but it’s an important step on the road to a broad restructuring of debt in the periphery of the eurozone and greater fiscal union.
The European Central Bank also has an important role to play in the solution to the crisis. In addition to providing unlimited liquidity to eurozone banks, the ECB has already bought close to €150 billion of eurozone government debt, ramping up purchases in recent weeks. The ECB has been extremely hesitant to take these actions – especially the buying of eurozone sovereign debt – but is boxed in by events. These purchases are not ideal but the alternatives are far worse.
German Chancellor Angela Merkel has consistently maintained her support for the euro and both she and French president Nicolas Sarkozy say they support Greece staying in the eurozone. George Papandreou, Greece’s prime minister, has pushed austerity measures through the Greek parliament and has pledged that Greece will stay within the eurozone and will remain a member of the European Union. Merkel is dragging the German public along slowly, as she knows German voters are heavily resistant to bailouts, but also knows that debt restructuring in the south is probably better than the alternatives. The most likely scenario is for the eurozone’s core to organize a restructuring of debt in Greece and possibly other peripheral countries, with further money (this time in the trillions of euros) pledged to backstop Spain and Italy. This will prevent financial contagion. The price for this will be deep and painful austerity measures enacted in the eurozone’s periphery and increased central control of all eurozone members’ finances. No one, in the end, will be happy with this result, but it’s the least costly route forward and the eurozone is likely to swallow hard and accept it.
Emerging Markets
Data released in the third quarter showed that the Chinese economy is slowing down. Annual inflation in China slowed to 6.2% in August from a three-year high of 6.5% in July, which shows that higher interest rates and increased bank reserve requirements are having their desired effect. The country’s manufacturing sector contracted for a third consecutive month in September, raising concern that the Chinese economy is slowing down more than expected, and more than is healthy for the global economy. Chinese policymakers have a difficult job, as inflation is still too high and needs to be brought down further to prevent its economy from overheating. At the same time, they need GDP growth to remain high and sustainable, as they have staked much of their government’s legitimacy on a strong economy.
With Europe in turmoil and lethargy in the U.S. economy, China is critical to global growth. It’s by far the most important BRIC country (BRIC refers to the emerging economies of Brazil, Russia, India, and China), as increasing demand for commodities in China is driving growth in other BRIC countries and elsewhere. Russia, for example, is heavily dependent on oil exports, and the global price of oil is largely driven by Chinese demand. Chinese demand is also a big determinant of the price of iron ore and soybeans, whose production is driving the Brazilian economy. The price of copper, critical to Chile’s economy, is influenced heavily by Chinese demand. The same is true of silver and tin, whose high prices have helped Peru record some of the fastest growth rates in the world in recent years. The list of countries benefiting from high commodity prices and Chinese demand is long.
This is why evidence of slower economic growth in China helped to spark a broad selloff in emerging market stocks and currencies in August and September. Just last month Dilma Rousseff, president of Brazil, wrote an editorial in the Financial Times complaining of currency manipulation in the United States and China, which had hurt Brazil’s competitiveness by inflating the real. Things have changed significantly since this was published, with the real down 18% against the dollar in September, consistent with other emerging market currencies.
The markets have overreacted to the recent data coming out of China. After all, Chinese policymakers have been actively trying to slow down the country’s economy to rein in inflation, so somewhat slower growth should be expected. It should be remembered that China’s leadership has had great success in managing its economy during the last two decades. The country almost completely avoided the Asian financial crisis of 1997, which decimated most of its neighbors. China has continued to grow robustly during the last 4 years in the face of decreased demand from a slumping United States and western Europe. Somewhat slower growth in China is probably a good thing over the longer term, as it decreases the chance of a hard landing, which really could devastate growth in many other emerging economies, and could even lead to social unrest in China itself. Given that China is still growing very quickly – it’s set to grow 9% this year and 7-8% next year – the recent selloff in emerging market securities and currencies is overdone.
The United States
Data from the United States released early in the third quarter disappointed equity markets, and showed that the economic recovery is weaker than many had expected. The housing crisis continues to depress demand and remains a major drag on economic growth. Consumers find it difficult to increase consumption when they are living with underwater mortgages and a very uncertain employment outlook. Mortgage rates are at record lows, but that is of limited help to the housing sector since most borrowers must have superb credit and the ability to put down 20% of the value of a new house in cash. The policymakers in Washington don’t seem to grasp that lowering interest rates fails to add much stimulus in such an environment. Mortgage standards were obviously too loose in the run-up to the housing bust which began in 2007. But just as obvious is the fact that standards are far too tight now. Fiscal and monetary stimulus have been tried by the trillions of dollars, but the housing crisis – the ultimate cause of the economic slump in the U.S. – lumbers on as too few people can access mortgages.
Fed chair Ben Bernanke announced in September that the Fed would begin “Operation Twist”, in which it will sell short-term Treasuries and buy longer term Treasuries. The goal of this project is to lower long term interest rates, which should provide at least some stimulus for the economy (how much is very much in doubt). “Operation Twist” gives a green light to Congress and President Obama to take advantage of very low rates to enact more fiscal stimulus, but given the political climate in Washington further significant fiscal stimulus is out of the question. The Fed is using the tool it has – monetary policy – but is essentially pushing on a string, as high rates are not what ails the U.S. economy. In Bernanke’s defense, he doesn’t have many arrows left in the quiver, apart from more active and public encouragement of politicians to engage in additional fiscal stimulus. He could also advocate more radical changes to the mortgage market, such as loosening borrowing requirements and writing off the value of underwater mortgages. These policies would be far more helpful for the economy than lower interest rates, but Bernanke probably understands that they would be dead on arrival in Congress.
Fiscal stimulus might be the only hope left to boost growth and increase employment in the near term, but this, even if enacted, might be limited in its effect. President Obama was forced to admit that many of the “shovel-ready” projects promised when the stimulus bill was passed in 2009 were actually far from ready, and their slow implementation significantly muted the effect of that spending. It’s difficult to see how things would be any different if big fiscal stimulus was tried again. Policymakers simply have little remaining they can or will do that would be effective in increasing demand and helping the U.S. economy in the short term. The housing market will have to work itself out over time, as will the broken credit markets, the damaged banking sector, and lethargic labor market.
However, there are reasons to be hopeful about the U.S. economy, in spite of all the gloom. Manufacturing data released at the end of September, though not great, were better than expected. Construction spending increased by 1.4% in August, even as the market expected a decline. Jobless claims fell to 391,000 at the end of September, which indicates that the labor market, though still depressed, is at least not getting worse. The data are consistent with a slowly growing economy, and do not suggest that the U.S. will fall back into recession. We expect the U.S. to grow 1.5%-2.0% for all of 2011, and 2.0%-2.5% in 2012.
Reasons for Optimism
The mood in the financial markets is undoubtedly pessimistic, but there are reasons to maintain optimism about the future. One is that Europe, one way or another, is going to find its way through the current euro and sovereign debt mess. We believe the most likely route will be further fiscal union and tightly controlled bailouts, as the alternative would be unacceptably disruptive and painful for all European economies. History suggests European leaders will step in to avoid outright sovereign default and a banking crisis, though they will probably resist until the financial markets force their hand. It is likely that there will by some shaky moments in the weeks ahead, but things look brighter over the longer term.
Slowing economic growth in China is not as bad as the financial markets are predicting. Inflation in China was high and outside the range of Chinese policymakers earlier this year. It is coming down as Chinese policymakers hoped, which makes robust growth more sustainable in the long run. This is good, not just for China, but also for other emerging economies supplying it with commodities. China will continue to grow at fast rates during the next few years.
The situation in the U.S. appears somewhat bleak, but here too there is reason to be hopeful. The economy is still growing, after all, in spite of all of the current headwinds. The housing market, though still depressed, is very likely to bounce back in the years ahead as prices are very cheap compared to rental rates. The credit markets will eventually heal and bank lending will pick up. The timing is not certain, of course, but long-term investors will be richly rewarded by maintaining their position in risky assets.
Equities
Stocks declined sharply in August and September as investors feared continued turmoil in Europe, further sluggishness in the U.S. economy, and the possibility that a slowing Chinese economy would hurt commodity prices and growth in other emerging economies. The MSCI All Country World index fell 17.3% in the third quarter and is down 13.2% year to date. The S&P 500 was off 13.9% in the third quarter, while the MSCI EAFE index declined 18.9%, and the MSCI Emerging Market index was down 22.4%. Emerging market currencies fell significantly in September, along with equity prices: the Brazilian real fell 18% against the dollar, the Chilean peso was down 13%, and the Turkish lira was off 8%. Investors rushed to “safe haven” investments and, for now at least, that includes U.S. Treasuries and the U.S. dollar.
We believe the financial markets have overreacted to fears of slowing growth in China, and we’re maintaining our long-term forecast that emerging market stocks will outperform. China is unlikely to grow at 9-10% every year, but 6-8% is possible, and that is far faster growth than will be seen in the U.S. or western Europe. Growth of 6-8% in China will support high commodity prices and robust growth rates in many other emerging economies in the medium and long term. We favor stocks from countries with low corruption levels and stable governments.
We hold Embraer, the Brazilian plane maker, whose stock held up well in September. A lower Brazilian real is beneficial for the company, since it sells its planes in U.S. dollars but much of its production costs are in reais. We also own engine maker Cummins and truck maker Paccar, both of which are extremely undervalued and have great long term growth prospects. The price of crude oil has fallen since the start of August and has brought down domestic oil companies Berry Petroleum, Rosetta Resources, and Newfield Exploration. All three of these stocks have been unfairly beaten down and are extremely cheap. Sociedad Quimica y Minera de Chile was down significantly in September, though it’s an excellent company with very good prospects for earnings growth. Its lithium reserves will prove to be a valuable resource in the coming years. Australian stocks were down in August and September, as much of Australia’s growth is linked to the sale of raw materials to China. We expect Australian stocks to outperform stocks from the U.S. and Europe in the years ahead. We hold Australian Westpac Banking, whose dividend yield alone is near 8%.
The correlation of stock returns increases when markets fall. This means that in equity bear markets there are very few places to hide, apart from fixed income and cash. Bear markets also create opportunities, however, as the stocks of good companies can be picked up at significant discounts. “Risky assets” were out of favor in the third quarter, as investors looked for safety above all else. This is unlikely to persist, however, as bond yields offer paltry returns. A 10-year Treasury bought today and held to maturity will yield 1.9%, while a 30-year Treasury will yield 2.88% (these yields do not include the effects of inflation, so the real rates on Treasuries will probably be negative). With this in mind equities are compelling.
Fixed Income
The swings in the stock market, along with the continued uncertainty surrounding the European debt crisis, led investors to the relative safety of U.S. Treasuries during the third quarter. This drove yields down into record low territory. The two-year U.S. Treasury yield dropped 21 basis points during the quarter to 0.24%, while the 10-year yield fell 124 basis points to 1.92%. The 30-year fell by 1.46% basis points to finish the third quarter at 2.91%.
In addition to the “flight to safety” trade, the strong rally in long-term U.S. bonds was partly due to the recent announcement by the Federal Reserve that it would sell some of its short-term Treasury notes and invest the proceeds in long-term Treasuries. This has been dubbed “Operation Twist” by the pundits since it resembles a similar Fed action by that name undertaken during the Kennedy administration in an effort to reduce long-term interest rates. While it may have a small effect on the level of long-term rates, we believe the overall economic effect of “Operation Twist” will be negligible. There are bigger issues plaguing the U.S. economy besides the level of long-term interest rates.
As mentioned above, Treasuries had an excellent quarter returning 6.48%. Long-term Treasuries (over 20 years in maturity) returned a spectacular 29.21%! Corporate bonds and mortgage-backed securities underperformed, returning 2.85% and 2.36% respectively. Higher-rated corporate issues outperformed lower-rated paper significantly, which is typical during periods of economic uncertainty. Yield spreads on corporate bonds have widened out to levels not seen since late 2009.
We don’t expect a dramatic increase in U.S. Treasury yields as long as the U.S. economy remains sluggish. However, we expect slow improvement in the economy over the next 12 months and a slow rise in yields from current levels. High volatility is likely to persist so long as the issues surrounding Europe remain unsolved and U.S. economic data remain subdued. With commodities down sharply over the last few weeks along with the prospect of slowing economies overseas, we don’t view inflation as being as much of a near term threat as we did 6 months ago. Therefore we have reduced the allocation to TIPS (Treasury Inflation Protected Securities) in client portfolios, although we still maintain a significant weighting to the sector as a hedge against increases in inflation expectations.
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