After several days of slow decline, major stock indexes sold off dramatically yesterday afternoon. The downward move was unusually swift and steep, suggesting that program trading (computerized sales triggered by pre-determined stop loss orders) drove the sharp decline shortly before 3 PM. Buyers, again likely supported by computerized trades, stepped in shortly thereafter, sparking a sharp reversal with the Dow Jones Industrials Index moving higher off of its nearly 1000 point nosedive.

The plunge represented the largest intraday point drop in history, although much of that loss was recovered before the close, leaving the Dow down 3.2% on the session. We would also note that the decline, as a percentage, pales in comparison to the nearly 23% collapse that occurred on October 19, 1987. While yesterday’s intraday volatility was historically significant, the actual decline for the day was much less noteworthy.

While the press was quick to point to the deteriorating fiscal situation in Greece and the mounting concerns about widening sovereign debt risks in Europe, accounts began to surface that a technology glitch may have exacerbated the selling. Later, news reports suggested that a single trader may have simply entered a trade incorrectly, although reports have been conflicting on that account as well. It may be some time before a full explanation is apparent, but it seems clear from the rapidity of the plunge that it wasn’t just about Greece or Europe or a sovereign debt contagion.

Yesterday’s brief but severe volatility notwithstanding, investors have been increasingly concerned about developments in Europe. In recent weeks, the ongoing efforts to arrive at an aid package for Greece that would be politically palatable elsewhere in the European Union, yet sufficient to provide meaningful aid, have intensified. At the same time, recent economic news in the U.S. has been generally favorable, providing fundamental support for improving consumer confidence in the cyclical recovery.

In the balance of this piece, we will briefly discuss the conflicting forces that we see that are driving the markets – from positive cyclical developments in the domestic economy to the intensifying fiscal crisis in Europe.
 

Conflicting Forces: Domestic Recovery Checked by Fears of European Contagion

The U.S. Economy has an uphill battle in the years ahead; we have shared our thoughts on this matter with you over time and in many forms. Our most detailed outlook for the economy and capital markets was outlined in 2010: The Road Ahead published in February. In short, we believe that the U.S. economy and capital markets have entered a secular period that will look very different than that of the preceding two and 1/2 decades. “The New Normal” – as this expected environment has been dubbed by PIMCO’s Dr. Mohamed El-Erian – may well be characterized by deleveraging, re-regulation, higher taxes, resurgent inflation and rising interest rates. We believe that the culmination of these headwinds, whether they are in concert or independent from one another, will be a slower pace of growth over an extended period. Further, we anticipate that capital market returns may be below average in such an environment.

At the same time, the near-term outlook for the U.S. economy actually continues to improve. The Commerce department announced last Friday that first quarter growth came in at a respectable 3.2 percent annual rate. Earlier this morning, we learned that the U.S. economy created 290,000 new jobs in April, which was stronger than expected and higher than the March number of approximately 230,000. Contrast that with the same two-month period last year, during which an estimated 1.281 million jobs were lost. Without question, the U.S. labor markets are not yet as robust as we’d like to see, but they have clearly improved.

While the manufacturing sector has continued to show steady improvement, gains in construction continue to be elusive, as the overhang of excess housing inventory and expected further challenges in commercial real estate create a cloud over a sector that otherwise typically experiences a more pronounced bounce when the economy emerges from recession.

Again, while our long-term (or secular) view of the economy remains unchanged from that which we outlined in 2010: The Road Ahead, our cyclical economic outlook remains comparatively upbeat. The cyclical bottom appears to have been reached last summer, and an expansion is underway. While the pace may not be as brisk as would be ideal, and we can’t definitively say that a double dip recession is improbable, current economic data points to more positive than negative momentum.

Conversely, outside the U.S., the situation is not universally rosy. While China and the emerging world has largely returned to strong growth, the same cannot be said for many developed economies. The epicenter of perceived risk is in Greece, where a sovereign debt crisis prompted Standard & Poor’s to downgrade Greece’s debt to junk status just over a week ago. Moreover, Portugal and Spain have seen their debt ratings downgraded as well. While the fiscal situations in these countries have been deteriorating for some time, the negative sentiment in credit markets has intensified, driving borrowing costs sharply higher.

The result is that the dire circumstances have forced the European Union’s hand, ultimately leading to agreement on a bailout package (in the face of intense opposition in Germany, the EU’s largest single economy) to Greece amounting to an estimated $145 billion. Meanwhile, Greece has experienced a building civil unrest in recent weeks; on Thursday, the Greek parliament took the politically unpopular but seemingly necessary step of instituting a package of austere spending cuts that appears certain to send the Greek economy into a deeper recession (or a depression). At this point, however, they are left with very few options.

In recent weeks, concern about a potential contagion – a spreading of the Greek debt crisis to other countries in Europe – has also been building. The prospects for further downgrades in Portugal and/or Spain are real and the risk in those economies also appears to be rising. Some have even suggested that fiscal imbalances in other European economies, perhaps most notably the United Kingdom, could impair their sovereign credit ratings, drive their borrowing costs higher, and weaken the European economy further.

As we have repeatedly noted, we continue to believe that the recovery in both the U.S. and global economies, while certainly on track, remains quite fragile (look no further than the major stock indices for evidence of this). The continued crisis in Europe, if allowed to expand into a full blown contagion that affects additional Eurozone economies, and ultimately the global banking system, could jeopardize this recovery. Risk assets are under pressure as a result, and we will only know with hindsight whether or not this particular episode was the end of a cyclical bull market or just another correction within a continued cyclical recovery.

Whatever the result, there is little doubt that risk aversion will continue to ebb and flow with the data. As we have mentioned in past writings, our secular view is one of lower economic growth, likely to be accompanied by increased volatility due to the current conditions of extremely low inflation, private sector deleveraging and re-regulation. We believe that such an environment is supportive for the use of alternative investments within a portfolio. While we believe that positive stock returns over the next decade are more likely than not, and that stock returns could easily outdistance those provided by U.S. Treasuries and cash, we also believe it will be a very bumpy ride. Volatility will be ever present, and investors must balance the long term need for return with the short term tolerance to accept risk.

In the meantime, we will continue to look for opportunities that may present themselves as a result of this volatility.

If you have any questions regarding your portfolio, or would like to discuss these issues further, please contact your relationship manager.