“May you live in interesting times” goes the ancient Chinese saying – whether a blessing or a curse is presumably up to the individual. 2011 has been a most interesting year so far from the standpoint of financial markets. It has been a good year for many asset classes from US and European equities to real estate and, of course, the seemingly irrepressible energy, agriculture and precious metals commodities. Even the bond market – where one could logically suppose that higher inflation and a weaker dollar would conspire to pull US Treasury rates out of their low single-digits – has been rallying in recent weeks.
Two things make this performance particularly remarkable – and paradoxical. The first is that there really has not been a lot of great economic news to go around. First quarter growth in the US has been underwhelming, while spiraling commodities prices have been pushing headline inflation into uncomfortable territory. Corporate earnings are up but unemployment remains stuck around 9%. Meanwhile the major growth engines among emerging economies appear to be taking a bit of a pause – China, India and Brazil have all been more ponderous lately – and Europe has bifurcated into a small coterie of stable paymasters trying to keep the basket cases on their periphery from coming apart at the seams. The economic news is not terrible by any means, but there are reasonable concerns that the tepid pace at this stage of the recovery does not bode well for the kind of sustained growth cycle that investors have become used to during previous post-recessionary periods.
The second remarkable thing about year-to-date market performance is the relentless number of potentially destructive X-factors that have been popping into existence since the year began – the ongoing unrest all across the Middle East, humanitarian and economic devastation in Japan, flooding along the Mississippi River and year-long droughts in states just to the west of the deluge. It would seem that the combination of sudden market shocks and a generally fragile economic undertone would threaten to lead markets lower. But no – the Russell 3000 index sits above 9% (as of the 5/10 market close). True, there has been volatility aplenty, but investor sentiment (for now at least) appears to be determined to keep the good times rolling. Whether that lasts for much longer is another question. We think there is a decidedly odd tenor to the market currently. Here are a handful of things that we find strange about the current state of play:
Europe: To Default or Not to Default?
The debt problems in second-tier Eurozone nations have not gone away. Credit spreads of Greek sovereign debt to US Treasuries are over 12% currently, and spreads on Portuguese issues have nearly doubled since the beginning of the year. Just about six weeks ago the Greek stock market was the Continental high-flyer. The MSCI Greece index was at 23% year-to-date on March 25, and Portugal was up by just under 10%. As of May 6 the Greek index had plummeted and was up just 1.5% YTD. As for Portugal? It was actually 3.4% higher, closing at 13.1% on May 6. So far this year the rally in European equities has been largely thanks to the strong performance of the shakiest economies (Ireland, Spain and Italy have also been strongly outperforming the region). This does not seem like a recipe for stability – and Greece’s entry into bear market territory may be a harbinger of things to come for the region. Would that the Delphic oracle were still around…
Emerging Markets: Two Cheers for Hungary.
Likewise in emerging markets, the distribution of returns among countries and regions has been curious to say the least. Among the MSCI emerging markets countries Hungary has been leading the parade with a 30% return for the year to date. Hungary, you may recall, was another nation seemingly one step away from the poorhouse last year during Europe’s summer of woes. Meanwhile the BRIC index representing the world’s growth engine economies is flat for the year to date – and the only reason it is not deeper in negative territory is due to the least growth engine-y of that quartet – Russia, which is up just under 11%. Again – not the kind of thing that leaves us swimming in confidence.
US Debt Markets
Anyone? Of all the space oddities in this market environment perhaps nothing is quite so confounding as the US bond market. Safe haven for risk-averse portfolios? Puh-leese. Stratospheric commodities prices, a chronically weak US dollar and steadily increasing inflation are not supposed to be ingredients for bond market strength, especially when government bond yields have hovered around historical all-time lows for much of the past eighteen months. And yet – over the past two weeks yields on the 10-year note have plunged from 3.61% to 3.14% (remember that when bond yields fall, bond prices rise).
What makes bonds look so attractive that the scarlet letters of inflation and currency weakness can’t keep investors away? The CW, for what it is worth, seems to be pointing the finger at the expected end of QE2 in June. Really? If QE2 does in fact end then (which is probable but not at all certain given the Bernanke doctrine of asset price support at all costs) then all that happens is that the Fed stops buying bonds. But not buying bonds would, all else being equal, increase yields – which would be bad news for someone buying a 3.14% coupon bond today. The rationale seems to be that going off QE2 would put an end to the current rally in stocks and other risk assets (which, to be fair, really got its full head of steam during the run-up to the QE2 announcement last summer) – and that would bring money out of other securities back into bonds. We find this unconvincing and do not see anything compelling about government bonds at current market levels.
That is by no means the end of the litany of the strange. In US stocks we have the curious case of the Toxic 200. The Russell 1000 is an index of large cap stocks which is further divided into two additional benchmarks: the Top 200 is otherwise known as the mega-cap index, and the remaining 800 stocks of the Russell 1000 show up in the Mid Cap Index. The Mid Cap has outperformed the Top 200 (and therefore, logically, the 1000 Large Cap) in just about every way possible over the last ten years and continues its run this year – and this is also true in both the growth and the value style indexes as well as the blend. It is perhaps plausible that in certain industry sectors – Big Oil, Big Finance and Big Pharma come to mind – the leading names in the sector have become too closely associated with US government policy and its attendant political risk – hence the chronic underperformance. We will be digging into this more and it will likely be the subject of further commentaries this year.
All in all, paradoxes and conundrums abound. This is not a market for feeling safe or supremely confident in performance against a single benchmark. It is, in our belief, a market in which risk management is the paramount objective – because there are risks aplenty.
Twenty years ago I was a Tokyoite – a gaijin (expatriate) living in a delightful little neighborhood called Shimouma and working for an American investment bank in the buzzing financial district of Otemachi, where our 10th floor office had a view over the Imperial Palace and where on a clear winter morning you could see all the way out to Mount Fuji’s snow-covered elegance framed against a backdrop of deep azure. Having personally experienced life in Japan, with all its oddities, charms, and vividly-remembered moments of fleeting beauty, I have to say that the images and video clips that have flooded the media since last Friday are for me indescribably searing, haunting and painful. As the world frets about potential economic loss, one must remember that this is first and foremost a humanitarian crisis. Markets will recover, portfolios will move on, but tens of thousands of lives have been brutally impacted and that recovery will be a far longer, more emotionally devastating process.
Nonetheless, we do have to take stock of what these events mean for the larger picture of the world economy and global investment markets, and that is the purpose of this Market Comment.
The world was a volatile, nervous place before the events of last Friday. Since that first 8.9-magnitude earthquake struck off the northeastern coast of Japan, devastating miles upon miles of territory and claiming the lives of thousands, that nervousness has metastasized into something more like full-blown panic (though we do not think that extreme panic will be long-lived). On Monday Japanese securities markets bravely opened for business and, predictably, bore the brunt of a massive sell-off. The Nikkei 225 was down over 6% - dramatic to be sure, but nothing close to the 20% the Dow Jones Industrial Average lost on Black Monday in 1987. There was a discipline to Monday’s trading patterns in Japan – the collective market trying to discern opportunity in the fog of chaos. But Tuesday was a different story. After developments significantly worsened at the troubled Fukushima nuclear plant, about 170 miles north of Tokyo, the market went into a tailspin and added nearly 11% to Monday’s loss. The Nikkei has lost almost 20% since the disaster began. A stock index that just grazed 40,000 at the peak of the Japanese asset bubble in 1989 is now worth 8,605.
Japan is the world’s third largest economy (having just been eclipsed by China for the number two spot last year). It is also one of the richest economies on a per-capita basis (far more so, obviously, than up- and-coming powers like China or India), a major exporter of high-value added finished goods and one of the largest foreign holders of US Treasury securities. It is also the most indebted nation in the developed world, with a debt-to-GDP ratio just under 200% (that ratio in basket case Greece, by contrast, is less than 80%). In fact there has been very little good news to tell about Japan’s socio-economic story for quite some time. The population is the oldest in the developed world and in decline, chronic deflation has produced years of either recession or anemic growth, and the political system is dysfunctional even by the very low standards of national governments just about anywhere these days. If any country did not need the crippling body blow of a category-five natural disaster, that would be Japan.
Believers in the “January Effect” would be heartened by the first trading day of 2011, which saw equities indexes around the world jump by more than one percentage point. What ensued was actually a fairly lackluster week for most markets. The US and a handful of Asian markets ended the week higher while other Asian, as well as most Latin American and European markets, trended lower.
The Eurozone wasted no time in getting back to the limelight, with Portugal taking center stage as the region’s bad boy for now. However, a €1.25 billion Portuguese bond issue went off without hitch this week, and that has caused markets in Europe and elsewhere to regain their footing and move ahead to new highs for the (admittedly very short) year to date. The Eurozone is likely going to stay in focus, however, as debate continues to swirl around the prospects for Spain and Belgium, and broader concerns about the currency itself fail to dissipate. Having said that, at least one vote of confidence in the Euro comes from tiny Estonia, which joined the currency union this year.
Bond markets have been on the losing end versus equities since last fall, and so far activity in the New Year could best be described as “flat” – little movement in the broad market or Treasuries, with corporate high yields and emerging markets bonds trending upwards. Yields on the 10-year US Treasury note are up almost 100 basis points from their October 2010 lows. Even more ominously, the Bond Buyer Muni Bond Index has fallen by more than 11% in the past three months (by comparison, the Dow Jones Corporate Bond Index has declined by just over 2% for the same period). The municipal market is a large question mark for the year ahead, with state and local municipalities in many locations exhibiting severe economic weakness.
US corporate earnings are underway and the results so far appear encouraging across a variety of industry sectors from materials to energy, financials and retail. Investors will be watching earnings closely for signs of limited additional upside to the strong gains achieved in 2010. So far the evidence is not bearing out this concern: Alcoa produced its best quarterly results in two years while other companies from retailer Sears to homebuilder Lennar comfortably beat consensus estimates. We are starting to see some indications from the economist community that US growth could trend higher this year than expected, though 3.5%-plus growth is by no means a consensus at this time.
The unemployment figures released last Friday showed a drop in the benchmark rate to 9.4% but also revealed lower-than-expected private sector job creation. US jobs prospects will continue to be a primary focus of attention this year, as investors wonder whether consumer activity will continue its nascent growth trends. To the extent the all-important US consumer spending metric remains muted it will make US earnings much more dependent on events in other markets – and we can expect to see many eyes fixated on events in the large growth engines of China, India and Brazil. The delicate balancing of inflationary potential and currency rates – especially in China – presents a persistent source of concern and focus.
One way or another, we’re back in the thick of it, and no doubt interesting times await.
One way to visualize what is happening in this latest round of Euromarket jitters is to look at the present disparity in returns among European stock markets. Sweden and Denmark, both non-Eurozone countries (i.e. they continue to use the Swedish krona and Danish krone respectively), are at the top of the tables with year to date returns in the neighborhood of 25% as of November 12. Germany, the Eurozone’s putative anchor of stability, is up 8.2% YTD (also as of November 12) while other relatively stable markets like Belgium, Austria and the Netherlands are in low-single digit territory.
Then the bottom drops out with the Not-So-Fabulous-Five: Portugal, Italy, Spain, Ireland and Greece cover a spectrum of returns from -6.5% (Portugal) to -37.0% (Greece) as of 11/12 year to date. The EU, the world’s second-largest economy when aggregated, is bookended by countries whose national currencies are not directly affected by the fate of the Euro on one side, and the countries that actually could determine the currency’s fate on the other side.
This is the background context for the latest slings and arrows to rail at the ramparts of Fortress Europe: these being of a decidedly Emerald Isle flavor. As we write this the consensus appears to be forming around the conclusion that Ireland will require a financial bailout to the tune of $100 billion give or take. A “technical team” is in Dublin now to review the details, even as the Irish government continues to dissemble about not actually-really-totally needing the bailout just yet. As yields on Irish government debt rise to record levels this appears to be Act III of the Greek Tragicomedy of 2010, with Acts IV and V (Spain? Portugal? La bella Italia, cosi fan tutti?) plausibly waiting in the wings. You will recall that Greece’s woes catalyzed EU policymakers and central bank authorities to mobilize €750 billion earlier this year, and the Irish bailout, should it proceed, would be drawn from those funds.
This time around there is less genuine fretting among observers that the Eurozone is teetering on the edge of the abyss – the stability of the currency does not appear to be in doubt. Actually, the fiscal house of Europe is in better order than those of either the US or Japan, and from our standpoint there appears to be a greater level of seriousness among EU policymakers in addressing the crisis than could be said of their colleagues in Tokyo or Washington. Having said that, there are sharply defined tensions among Eurozone countries, with most of the ill will being directed at Germany. The Germans have been constant critics of the bailout from its early days, and recent days this criticism has sharpened around the notion that public funds from the bailout should ensure the return of 100 cents on every euro held by private bondholders. The sharp rise in Irish bond yields reflects in part a concern by would-be investors that a bailout might fully compensate them in the event of a default. From their side the Germans argue that private investors need to wean themselves from those warm and fuzzy guarantees of full compensation they have become so used to hearing. Sound familiar? Debates over the Greenspan/Bernanke put are an ongoing feature of discourse on this side of the jet stream.
All of this matters greatly from an asset allocation perspective. We have been used to a world defined by two flavors of non-domestic investments: “developed international” and “emerging markets”. The topography of the real world is considerably more complex than that. You can’t really look at the EU as one “asset”, for example, when you have such fundamental disparity between the economic strengths and weaknesses of its member countries. EAFE – Europe, Australasia and Far East – is hardly an adequate benchmark for international equities when it includes nearly-insolvent European states alongside the high-growth markets of Pacific ex-Japan. The job of making intelligent portfolio allocation decisions becomes ever more challenging – and we believe there are opportunities amidst the chaos.
Two events of considerable and related importance took place last week. The 2010 US midterm elections produced a seismic shift in the balance of power of the legislative branch, from Democrats to Republicans. And the Federal Reserve announced its long-anticipated plan to embark on a new program of quantitative easing. These two events give us considerable insight into how US economic policy is to be approached for at least the next twelve months and possibly longer.
The markets took a day to digest all the news as it unfolded over Tuesday and Wednesday, and then erupted for major across-the-board gains on Thursday. In fact, as it stands now 2010 is shaping up with potential to be another strong year in US equities following the performance in 2009. Years like 2009 and 2003 are rebound years – they come off the trough of a major bear market and often register calendar year gains over 30%. But sustaining that kind of strength into a follow-on year of double-digit growth is somewhat rarer (2004, for example, produced rather anemic returns for US equities in the mid-single digits). As of the Friday 11/5 close the Russell 3000 was up 12.9% year-to-date, and the market’s firm undertone suggests that a year-end “window dressing” momentum rally could conceivably take the indexes higher still.
Is it all justified? Let’s take a closer look at last week’s news events. We start with the Fed’s action because, quite simply, the Fed is where it’s at for just about any economic policy is likely to be enacted for the next year or more.
QE2, the new round of quantitative easing announced last Wednesday, will pump $600 billion of new money into the markets to purchase long-dated Treasury bonds. The Fed will do this to the tune of about $75 billion per month up through the end of the 2nd quarter in 2011. In addition the Fed will reinvest proceeds from existing securities (from the 2009 QE program) as they come due, meaning that in total its national balance sheet goes up by that $600 billion. Now, bear in mind that the Fed’s charter has a double mandate: promote policies that maintain healthy levels of employment in the economy and stable prices. The desired outcome, in this regard, would be for QE2 to stimulate new credit creation, spurring businesses to expand and hire new workers, while at the same time not triggering inflation beyond where it currently sits – about 1-2% per year.
That second goal – 1-2% inflation, is probably more likely than the first. Inflation may be a problem again one day, but for now the conditions needed for it to happen – either organic growth in household incomes leading to increased spending; or some kind of indexation between wages and prices like the catalyst that sparked the inflation of the early 1970s – is unlikely. On the other hand, for QE2 to make a meaningful dent in that sticky unemployment number will require a bit more heavy lifting. Not only will the eased credit conditions have to really induce companies to expand – but they will actually have to make proactive decisions to hire more US workers rather than, say, some combination of outsourcing and investing in more business automation to achieve productivity gains. It’s possible – but the case is awfully shaky.
As for that other event of last week – it is hard to say much else other than that we are likely to be in for a long period of legislative gridlock. Depending on your political point of view you may find that dismaying or comforting – but to the extent that any bold policymaking actions are going to have an impact on the economy next year those actions are much more likely to be originating from Ben Bernanke and his team than from Capitol Hill or the White House.