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.
Things to Watch
Existing home sales on Mon 10/25 (update: up 10%; higher than expected)
Case-Shiller home prices on Tues 10/26 (update: down 0.2%; lower than expected)
Consumer confidence index on Tues 10/26 (update: increase to 50.2%; close to expectations)
Durable goods orders on Wed 10/27
New home sales on Wed 10/27
3Q GDP initial estimate on Fri 10/29
Earnings: du Pont, Ford, Kimberly-Clark, Comcast, P&G, Exxon Mobil, Met Life, Microsoft, Merck
On the Menu: This Week in the Public Discourse
US government issues $10 billion of TIPS at a negative interest rate (-0.55%). TIPS provide natural hedge against inflation (i.e. hedge against QE run wild) but also benefits from deflation because the principal amount is only adjusted upwards against inflation (value not eroded if prices decline).
Dollar continues downward trend against most currencies (UK pound is one notable exception). Dollar and equities continue to move in near-perfect negative correlation (bear in mind that for foreign investors in US stocks, with non-dollar base currencies, a 5% increase in US stock prices and a 5% decrease in the value of the US dollar nets out to a 0% return).
UK budget direction announced on October 20 – moves to make significant cuts to government spending generally applauded as bold (as opposed to certain other Anglo-Saxon economies…) but market responses (in UK debt, pound sterling & equities) reflect an ambivalence about prospects for success.
Overall the earnings season is a bit more muted than 2Q: bright spots this week include strong rebound numbers from Ford, but Kimberly-Clark highlights weakness in staple consumer goods.
Housing remains stuck in the mud: higher sales of existing homes reflects availability and high volume of foreclosure sales, but prices remain mired around 2003 levels. No immediate recovery seen.
Market tenure remains generally upbeat – strong week in US last week with gains largely holding this week in somewhat more muted trading. October can be the cruelest month but this year it looks like we may escape the fright nights and head into window-dressing season with plenty of momentum.