Global Financial Market Turmoil

We are troubled by the recent turbulence in global stock, bond, commodity and currency markets. Especially disturbing is the plunge and heightened volatility in the U.S. stock market. Nevertheless, we believe the current storm will pass through without serious negative impact on the global economic recovery and we continue to recommend that investors maintain discipline with a positive outlook for global equities.

A consensus of financial market observers attributes the turbulence to the highly publicized debt problems of Greece, Portugal and Spain and the clumsy, unsynchronized response to the crisis by the Euro Area governments and European Central Bank (ECB).  Our view is that the policy makers cannot afford the risks of sovereign bond defaults, which could well lead to a freezing of the European banking system reminiscent of the credit crisis conditions in the U.S. in early 2009. Europe has an even larger “too big to fail” banking problem than the U.S. Although a bailout of Greece and possibly other countries in the Euro Area is repugnant to many taxpayers, especially in Germany, we expect the finance ministers and the ECB will soon hammer out a solution sufficient to calm jittery markets.

An additional important factor exacerbating market upheaval is the aggressive and speculative pursuit of profit by U.S. and international hedge funds. Their trading desks are armed with powerful computers programmed to react almost instantaneously, often with leverage, to the latest news release or to shifting trading patterns in financial markets. The result can be a barrage of buy or sell orders in a chain reaction impacting stock, bond, commodity and currency markets around the world. For example, a recent worker protest in Greece against government austerity measures triggered a jump in European bond yields and a plunge in the euro and European stock markets, an immediate increase in U.S Treasury bond prices and a sudden drop in U.S. stock prices, a rise in the U.S. dollar and a sharp decline in commodity prices, and a selloff of stocks in the leading emerging economies of China, India, and Brazil.

Whereas hedge funds embrace heightened volatility as an opportunity to increase profits, long term investors are frightened by the risk to their portfolios and governments are alarmed by the destabilizing effects on their economies. Something must be done to prevent the hedge funds from converting financial markets into casinos and in the process driving serious, long term investors out of the markets. By some estimates, “high frequency” trading by hedge funds already accounts for more than 50% of U.S. stock market volume. Coordinated government regulation is urgently needed. We think that governments and regulatory agencies around the globe are finally recognizing the severity of the problem and will take appropriate remedial action. In the U.S., we expect the Securities and Exchange Commission (SEC) to finally wake up from its decade long stupor and incompetence.

As we emphasized in our Review of the Fourth Quarter and Year 2009, we are convinced that equity strategies based on a 6-12 month horizon are more often correct and easier to implement successfully than short-term, market-timing strategies. We share the view of U.S. Treasury Secretary Geithner that a slowdown in Europe will not be great enough to derail the U.S. and global economic recovery. That is, we continue to forecast a multiyear global expansion similar to but not as strong as the 2003-07 expansion, and we continue to think this expansion will be accompanied by a bull market in equities and commodities.

The current European upheaval may have limited economic impact, but it will have important investment consequences. The most debt-burdened European countries will be forced to implement budget austerity programs, which will damage the euro and retard economic growth. Some countries may well sink into a double-dip recession, although the crippled euro will provide a partial offset by benefiting export-oriented companies. The upheaval diminishes the attractiveness of European stock markets, which to us had very limited appeal prior to the crisis. U.S. exporters to Europe will be impacted negatively by a shrinking market for their products and services and a strong dollar will hurt their competitive pricing capability. On the other hand, the American economy will benefit from reduced commodity prices (especially gasoline), lowered inflation expectations, and lower mortgage and corporate borrowing rates. A weakened European economy and currency will similarly slow exports from China, India, and Brazil to Europe (Europe is China’s largest export market), but we see this as a positive. As we pointed out in our May 12 blog on international stock markets, the major problem here is that these economies are overheating, and their governments are reacting to the increased fear of inflation and asset bubbles by adopting restrictive policies. The consequence has been a painful retreat in their stock markets. Slower exports to Europe will cool these economies, reduce inflation worries, and possibly lead policy makers to move to the sidelines. This, in turn, could provide a green light to the leading emerging economy stock markets even as the European markets are flashing yellow.

We are not complacent regarding our positive outlook. Financial markets have been rocked by numerous unanticipated developments over the past 2 years and more may be coming. We remain vigilant and flexible.

Fed Watch

In recent Outlooks and blogs, we have emphasized the importance of Federal Reserve policy in influencing the direction of the U.S. stock market and the relative performance of industry sectors and investment styles. In particular, we have pointed out that in 1994 and again in 2004 the Fed reversed accommodative, anti-recession, low-rate policies and raised rates as economic recoveries gathered steam. In both cases, the Fed rate hikes abruptly halted powerful stock market rallies and led to rotational shifts in investor stock preference. We have also noted the negative impact thus far in 2010 on the prior stock market rallies in China, India, and Brazil as governments and central banks tightened credit in an effort to ward off potential inflation and asset bubbles.

To most Fed watchers, the question not whether the Fed will raise rates but when will they raise rates. For months the Fed has indicated its intention to keep rates low for “an extended period” even though the country has emerged from recession and the recovery has strengthened. At the end of 2009, we expected the Fed to raise rates late in the 2nd quarter or early in the 3rd quarter, by which time we anticipated that job growth would be the catalyst to trigger a change in Fed policy. In April, we subsequently pushed back our expectation to November when the Fed acknowledged economic growth, but stated its concern for the sustainability of the recovery and left in place its “extended period” language in statements regarding their interest rate deliberations. A Wall Street Journal survey of economists, disclosed in a May 12 article, finds that the consensus view in early April was for a hike in November, but now 42% expect the Fed to hold off on tightening until at least 2011. The WSJ attributes their shift in opinion to the European debt crisis, which “underscores the fragility of the global financial system and the risk, however small, of outside shocks derailing the recovery.” As a support to this view, on May 14 Chicago Federal Reserve President Charles Evans stated “I think the risks, obviously, with the global situation make things a little bit more uncertain than we were expecting…so, if anything, I am even more comfortable with my assessment that accommodation continues to be important.”

As the WSJ article points out, low inflation under 2% combines with the European turmoil to provide the Fed with room to keep policy on hold. We presume that the Fed prefers to avoid a rate increase in the politically sensitive months leading up to the national elections in November and thus welcomes this breathing space. On the other hand, the Fed is also painfully aware of the criticism of former Fed Chairman Greenspan and the Fed’s “too little, too late” rate raising policy coming out of the last recession, which permitted the creation of the housing bubble. We will monitor closely and comment on developments at the Fed in future blogs.

International Stock Markets: Searching for Goldilocks

Heading into 2010, we shared the view of a majority of international investors that the best performing stock markets this year would be China, India and Brazil. This expectation was based on the consensus forecast of economists polled in December by The Economist that these 3 countries would enjoy 2010 GDP growth of 8.6%, 6.3% and 3.8% respectively. In contrast, the major developed economies of the U.S., Europe and Japan were projected to experience anemic, subpar growth ranging from 0.6% to 2.4%. Since then, the economic performance of each of these leading emerging economies has exceeded expectations, and growth estimates in the latest poll of The Economist have been raised to 9.9%, 7.7% and 5.5% respectively. Nevertheless, the stock markets in these countries have been disappointing: for 2010 through May 10, the Shanghai Index (CSEX) has retreated -17.6%, the India Sensex (IBSI) is off -0.8% and the Brazil Bovespa (BSPI) has fallen -8.3%. In the much slower growth U.S., where 2010 GDP growth is currently pegged at 3.1%, the S&P 500 Index is down only -0.4%.

Why is this happening?

The problem with the stock markets of China, India and Brazil is that their economies are too hot. That is, accelerating growth is giving rise to fears of excessive inflation and asset bubbles. In China, for example, the government recently announced that April year-over-year consumer prices rose a more-than-expected 2.8%, producer prices jumped 6.8%, and property prices soared 12.8%. Consumer prices in Brazil are projected to rise 5.2% in 2010, and India inflation could top 12%. In response, the central banks in these countries have initiated policies designed to cool their economies. Some observers think the steps taken by the policy makers are too little and too late, and the result will be the dreaded inflation and asset bubbles. A contrary opinion is that the central bankers will be excessively restrictive and cripple economic growth. It is normal in the economic cycle for governments and central banks to reverse stimulative polices in the aftermath of recessions as recoveries gain strength. It is also normal for investors to question the outcome of a change in policy, and there is ample historical precedent in the U.S. and abroad of investors pulling back to wait and see if the policy makers are able to pilot a soft landing.

At the opposite extreme are the economies of Europe and Japan, which are too cold. Growth outlooks for these countries were weak at the beginning of the year, and the future now appears to be even bleaker. The highly publicized debt problems of Greece, Portugal and Spain will surely lead to austerity measures that will further retard growth, and quite possibly push the countries back into recession. Italy, Ireland and even Great Britain also have severe deficits that will require government action. The massive holdings of these countries sovereign bonds held by the leading banks of Germany, France, and Switzerland could spark a further crisis if the debt laden countries are unsuccessful in implementing adequate austerity programs. The consensus foresees 2010 Euro and GDP growth of only 1.1%, and we suspect that this gloomy assessment may be revised downward. It thus comes as no surprise that for 2010 through May 5 the Euro Area (FTSE Euro 100) stock index suffered a -9.6% decline. As for Japan, we expect another year of very modest growth (2.0%) and debilitating deflation (-1.0%).

Positioned comfortably between the too-hot Asian economies and the too-cold Euro Area and Japan, the U.S. economy is providing a propitious environment for common stocks. Favorable employment, consumer spending and manufacturing data indicates that the recovery is picking up steam, and the 2010 GDP growth outlook is now above 3%. Corporate profits have been above Wall Street expectations, and research analysts are raising significantly their 2010 earning estimates. On the other hand, growth has not been so strong that inflation forecasts have become ominous and, of great importance to investors, the Federal Reserve has repeatedly expressed its intention to keep interest rates at a historically low level “for an extended period.” To be sure, the major headwinds buffeting the U.S. stock markets thus far in 2010 have emanated from Asia, South America and Europe.

What lies ahead? Can investors anticipate a change?

We think the policy makers in China, India and Brazil will successfully guide their economies to a soft landing, and will then halt their restrictive measures in order to usher in long-term sustainable economic growth with controlled inflation. The Economist’s latest poll supports this view: consensus 2011 GDP forecasts for China, India and Brazil are 8.1%, 8.0% and 4.5% respectively. We expect the governments and central banks to complete their braking activities some time in the next 6 months, and investors will likely anticipate this green light and restore bull markets for the duration of a multiyear expansion. It makes sense that investors will migrate back to these geographic areas where growth is greatest once government and central bank policies are no longer threatening.

We are less positive regarding the stock market prospects of the developed countries over the next year. Japan and the Euro area will simply not have sufficient growth to attract investors. On the other hand, some of Europe’s leading export-oriented companies, aided by the weak euro, deserve investors’ attention. We expect the U.S. stock market, which has rallied for 14 months without a 10% correction, to stall, or possibly retreat, when the Federal Reserve signals its decision to gradually restore long-term norm interest rates from the current recession lows. There is much debate as to when this might occur, but most Fed watchers believe it will be within the next 9 months. We think the Fed may wait until after the November election, by which time job growth and a stabilized housing market will put the recovery on firmer footing. We further expect the Fed to alert investors of a new tightening policy several months in advance by eliminating the “extended period” language in statements regarding their interest-rate deliberations. Worth noting is that 1-2 years into the past 2 recoveries from recession, in 1994 and again in 2004, the Fed commenced to hike rates, and on each occasion stock market rallies abruptly halted as investors turned more cautious.

We remain convinced that investors who take a global perspective will be amply rewarded.