Troubles in the Eurozone
By Mark Dixon, Chief Investment Officer and Jim Baird, Chief Investment Strategist
Plante Moran Financial Advisors
The U.S. economy has recently shown signs of strength, growing at the end of 2011 at a solid 3% rate. U.S. companies are making record profits. Corporate balance sheets are exceptionally strong, with record cash holdings, by some estimates, exceeding $2 trillion. The U.S. stock market is currently selling near 14 times trailing 12-month earnings, below the long-term historical average, and profit margins are near historical highs. Despite operating in a period of below average economic growth in recent years, Corporate America has done a fantastic job of rebuilding itself and creating, once again, a profit machine. Profit growth has not just come from one sector of the market, but has been widespread across a broad swathe of sectors and industries. Among the more notable developments is that, for the first time in decades, manufacturing in the U.S. has been a leading benefactor of the return to growth. With so many positive things happening, it is frustrating that the investment markets continue to react violently in the short run to macroeconomic developments, proving once again that while many investors TALK about investing for the long term, when risks increase, many act as if they INVEST for the short term.
As has been the case so many times in the past few years, the most recent round of turmoil once again centers on Europe. We have written in the past about the ongoing cycle of private sector deleveraging (paying down debt), and the slow growth "new normal" environment that will likely persist for some time. In order to give this deleveraging process time to play out, policymakers have continued to "kick the can down the road," through the implementation of a myriad of policies. On the domestic front, the Federal Reserve has employed a series of unconventional monetary policy measures, including increasing its balance sheet in order to purchase long-term bonds (treasuries, government agencies, and mortgages) to artificially bring down long-term interest rates, while also holding short-term rates at historically low target levels. At the same time, certain stimulative fiscal policies, originally enacted in the heart of the Great Recession, have yet to be reversed. The result has been a multi-year period of high federal deficits, with no immediate end in sight.
In Europe, the policy response has been equally as unprecedented. Late last year, the European Central Bank (ECB) announced its Long-Term Refinancing Operation (LTRO) program that was geared toward reducing the risk of a bank panic by providing an expanded source of funding to the fragile European banking system. In addition, lifelines have been granted to troubled peripheral countries within the region on a recurring basis. Despite these efforts, the severity of the problems has again taken center stage in recent days. As concerns of a failure of the austerity pact and bailout package for Greece have re-emerged, so have discussions about a Greek exit from the Eurozone. Global stock markets have reacted violently (though the U.S. market is still in positive territory year-to-date at the time of this writing), over concerns that a Greek exit could cause further contagion that would put stress on the global financial system, creating disruptions similar to those that occurred when Lehman Brothers failed in 2008.
Many investors remember that there was a time before 2008 when sub-prime mortgages were considered to be too small to influence the global financial system. That belief was ultimately shown to be not only optimistic, but patently false. It would appear that very few are making the same mistake about the potential effects of a comparatively small country like Greece defaulting on its debts. This is one key difference between the environments of today vs. that leading up to the fall of 2008. In 2008, it seemed as though policymakers were largely unconcerned about the ability of the financial system to withstand a shock. Having perhaps learned a lesson the hard way, policymakers today appear to be acutely aware of the potential negative outcomes of a major event and are committed to deploying whatever resources may be needed in an effort to ensure that doesn’t happen again. That said, with many economies in Europe already in the grip of a recession, growth in the Eurozone as a whole is basically flat. Meanwhile, with the risk of recession in the United States increasing, further slowdown in the global economy could make the next wave of "can kicking" more expensive than is anticipated currently. In the short run, there is no doubt that there are many issues to be concerned about.
In light of concerns about the potential exit of Greece or even more countries from the European Union, news flow out of the region has once again become the dominant driver of market sentiment both globally and here in the U.S. Austerity fatigue appears to be setting in across Greece, as the country’s populace is feeling the effects of the mandated tax hikes and income cuts that were key conditions of the bailout agreement. However, at the same time, an overwhelming majority of Greek citizens want to remain a member of the European Union. Given the dichotomy between these two desires, the Greek political scene is likely to continue to be a focal point in the coming weeks and a source of market volatility as voters work through these seemingly mutually exclusive positions. And if the Greece issue is resolved by policymakers, there are some who feel that Spain, Portugal, and Ireland may not be far behind. Ultimately, the best outcome would be for Greece to reach a conclusion on these issues that will allow them to chart their course and commit to and implement policies that will allow them to pursue that outcome. That will not be an easy task.
When it was created, the Euro currency was hypothesized to create trading efficiencies among adopting countries by reducing exchange rate uncertainties and transaction costs. In theory, the idea of a common currency would seem to be a viable solution if the group of adopting countries were homogenous. Unfortunately, there are stark differences in the fundamentals and fiscal policies among the various European countries, making a common monetary policy a difficult proposition. In the near term, the consequences of a Eurozone exit would seem to be unambiguously painful for Greece, and potentially the global financial system. It may be the only practical way for Greece to address these fiscal issues, however, short of becoming long-term serial beneficiaries of bailouts, which would not only be costly, but would also fail to address the core issues. In short, it is not a feasible solution.
In addition, there is a rising concern among some that the U.S. could enter a recession this year, either due to a shock of the global financial system, or simply as part of the natural course of the business cycle. Obviously, the former would be much more problematic than the latter, though both would likely cause temporary turmoil in financial markets. It can certainly be argued that with the ten-year U.S. Treasury yield close to 1.70%, the bond market is calling for recession. So, does this mean that a meltdown similar to that which occurred in later 2008 and early 2009 is imminent or inevitable? No one knows for sure, but we believe the likelihood of that outcome is lower this time for the following reasons:
- Corporate balance sheets are in much better shape and operations have been very lean.
- American businesses have been very prudent in hiring and investment decisions since the recession ended, and it appears that the typical excesses that typically need to be purged at the end of an economic expansion simply haven’t built up to the degree that would typically be the case.
- The U.S. banking system has improved its capital ratios, has reduced leverage, and doesn’t appear to hold as many "bad assets" as was the case at the time.
- The real estate markets, both residential and commercial, have not recovered but have seemingly stopped bleeding.
- Policymakers appear willing to address problems head on, and many, including the Federal Reserve, have continued to say they will do whatever is necessary to avoid the spread of contagion.
Of course, just because the environment is different does not mean the result will be. For months now, we have cautioned that the key to getting through this type of investment environment is to have the right investment policy that balances the short-term risks with the long-term potential. We assist all of our clients in arriving at a conclusion regarding this policy that we believe to be appropriate in helping them meet their long-term goals. In addition, we have taken measures over the last few years that we believe help to protect client portfolios on the downside, while also allowing for upside potential. A global crisis may ultimately occur, or even a mild recession that causes a backup in risk asset prices, but the key to long-term investment success is having an investment policy that is focused on the investor’s investment time horizon, long-term goals, and tolerance for risk. We have been underweight in international equities within our client portfolios for some time now. While it might seem as though, given the current conditions and risks, international stocks are positioned to indefinitely provide less value than the U.S. stock market, we know that this is untrue. Even as international stocks underperform relative to the U.S. stocks in the short run, long-term relative value may very well be created. A disciplined investment approach allows investors to look past the short-term noise to take advantage of these long-term opportunities.
We continue to monitor these developments and will keep our friends and clients apprised of our opinions as events unfold. At this point, we are very satisfied with the highly diversified portfolios we maintain for clients, and the outstanding firms that manage our client’s assets. As always, we will continue to look for additional opportunities as they present themselves.