In
light of current stock market volatility and an elevated level
of client inquiries, we have chosen to accelerate publication
of BTR's second quarter Investment Strategy Update.
CORRECTION,
OR SOMETHING WORSE?
May
was a terrible month for stocks. And thus far, June has been
no better. Considering that U.S. shares had risen almost 70%
from the March 2009 bottom to the April 2010 high, some sort
of setback was certainly due. But the flow of news has been
quite disturbing and investor sentiment has rapidly grown more
negative. One can't help but wonder whether we are witnessing
a correction within an ongoing bull market, or the start of
something worse.
Every
stock market downturn is scary. This one seems particularly
so, given current events and investors' too-recent memories
of the 2008-09 bear market. What started out with the Greek
sovereign debt crisis has now spread to include the U.K., Ireland,
Hungary, and most of southern Europe. And in Asia, China's authorities
have instituted restrictive economic policies in order to slow
their overheating economy and stem an increasingly speculative
real estate market. These events, along with the huge environmental
disaster off the U.S. Gulf Coast, will surely serve to slow
the U.S. and global economies. And as if that weren't enough,
there are also the military situations in North Korea, Iraq,
Iran, and Afghanistan to worry about.
What
happens next? Will China be able to pull off an economic soft
landing? Can the European Union survive this crisis in its present
form? Will current events serve to push the nascent U.S. and
global economic recoveries back into recession? And are we,
indeed, witnessing the start of another global banking crisis?
We think not. While risks have undoubtedly grown, our expectations
are that the U.S. economic expansion will continue, albeit at
a slower rate, and that the current stock market decline is,
in fact, a correction within an ongoing, cyclical bull market.
This
Is Not "Lehman" Revisited
The
U.S economic and financial environment today is quite different
from that which preceded the collapse of Lehman Brothers. Back
then, our economy had moved into recession. World trade was
contracting, U.S. residential real estate was crashing, and
banking system leverage was wildly out of bounds. In addition,
oil prices and interest rates were quite a bit higher.
Today,
our economy is in the first year of a new expansion and there
are encouraging signs that the process of transitioning from
recovery to sustainable growth is proceeding normally. Consumers
are spending, U.S. corporations are flush with cash, and a capital
spending cycle has barely just begun. Credit, while not necessarily
abundant, is no longer frozen, and corporate profits have been
in a dynamic rising trend. Moreover, the global economy is expanding,
world trade has been growing, and U. S. manufacturing seems
poised to experience a meaningful revival as our costs of manufacturing
have become much more competitive internationally in recent
years. In addition, while last Friday's employment report was
certainly disappointing, the very high current level of corporate
productivity should soon lead to significantly improved job
creation. Evidence of increasing hours worked and rising wage
levels imply that businesses are still squeezing what they can
out of their current work force, and need only a shot of confidence
to start hiring again. Furthermore, while the financial deleveraging
process undoubtedly has further to go, U.S. banks seem to have
a handle on where their problems are and are taking advantage
of the extremely low Fed funds rate to generate profits and
rebuild their capital bases, which makes them far more sound
than they were before Lehman failed.
Could
events in China and Europe derail our economic recovery? We
don't think so. First, we believe that China is doing the right
thing by tapping on the brakes. Its policymakers are attacking
their real-estate speculation problem early enough, while it
is still concentrated in a relatively few coastal cities, and
not yet a broad-based bubble. China's centrally directed economy
has been well managed. Just as the government was successful
in stimulating the economy during the global credit freeze of
2008-09, we believe it will now be successful in engineering
a soft landing, thereby slowing China's growth to a more sustainable
8-9% rate.
Regarding
Europe, containment of the sovereign debt crisis is very important,
even though the direct effect on the U.S. economy is relatively
small. Greece's economy is roughly equivalent in size to that
of the San Francisco Bay Area. In fact, Europe as a whole currently
accounts for only 3% of global economic growth and 9% of U.S.
corporate profits (14% of S&P 500 company profits). Even
if the euro/dollar exchange rate were to decline 30% from top
to bottom, S&P 500 earnings would be shaved by only about
4%. Of course, the economic and financial risks will grow if
the debt crisis in Greece spreads to include other countries.
Can
the European Union Survive?
When
we first wrote about the European Union ("EU") in
July 1998, we had our doubts about its longevity. While a common
currency was going to be used by most EU members, with a centralized
monetary authority in control, it was impossible to unify and
centralize fiscal responsibility. Our opinion was that the individual
nations' productivity levels and cultural attitudes were just
too different from each other and, in the past, their populations
had shown little willingness to compromise. Time has proven
this view to be accurate. Despite rules intended to control
fiscal overindulgence, individual EU member states have consistently
failed to keep deficit spending and debt levels under control.
Greece was one of the more egregious violators, which inevitably
led to the current situation.
Historically, sovereign debt problems have been resolved by
a combination of currency devaluation and the partial write-down
or repudiation of the affected nation's debt. In the case of
Greece, or any EU nation that also uses the euro, unilateral
currency devaluation is not an option. Without a separate currency
to debase, thereby stimulating exports and other economic activity,
we doubt that Greece will be able to get its financial situation
in order, even if its politicians and populace have the will
to do so. As such, we expect that Greece will eventually leave
the Eurozone and the EU, voluntarily or otherwise. Regarding
other European nations, there is no quick fix, but we are hopeful
that they will get the message and work to reduce their debt
and spending levels. If they cannot, the EU may have to abandon
the euro and eventually consolidate into a smaller, sounder
group of nations, or perhaps even disband altogether.
Some
Expected and Unexpected Positives
Strange
as it may seem, there are some long-term positives that will
be derived from the current sovereign debt crisis, just as there
were from the bursting of the U.S. real estate bubble. What's
happening in Europe is fundamentally deflationary. That fact,
along with the related dampening effects on U.S. economic growth,
will serve to keep Federal Reserve Board policy on hold for
longer than we had been expecting, thereby maintaining a highly
stimulative low-interest rate environment. Thus, mortgage rates
and other borrowing costs will remain at very affordable levels.
It is fortuitous that China is simultaneously acting to slow
its economic growth rate. By doing so, it may help to maintain
the global economic advance at a lower, but ultimately more
sustainable rate with, we hope, less volatility.
More
importantly, the crisis in Greece may serve as a shot across
the bow to much of the rest of the developed world where, in
many cases, debt-to-GDP levels have become unsustainable. Undeniably,
those countries were, and may still be, headed towards their
own debt crises. The European social welfare experiment had
grown out of control and was destined to come to a difficult
end. We hope the Greek debt crisis will be sufficiently revelatory
to spur other nations into undertaking corrective action. Ireland
is already doing so. Spain and Portugal have recently announced
severe fiscal cutbacks, and the governments of France, Germany,
and the U.K. have stated their intentions of doing the same.
So,
what about the United States? While this country may be "the
best looking horse in the glue factory," there can be no
doubt that we are headed down the same path. We wonder whether
the events in Europe can also serve to foster the beginnings
of fiscal responsibility on our own shores. It is difficult
to be optimistic, in light of overall spending trends at the
federal, state, and local levels. But the aftermath of the real
estate and financial bubbles proved a few things. First, when
faced with overwhelming evidence of the need to act decisively
and effectively, American politicians can do so. Second, in
the face of what they perceive to be ineffective government,
American voters can also act decisively. The question is whether
or not we have gained a sufficient collective understanding
of the fact that whether you are an individual, a family, or
a nation, you cannot continually spend more than you bring in.
Furthermore, beyond a certain level, raising taxes will not
maximize a nation's revenues. Fiscal restraint and a vibrant,
healthy economy, driven by the private sector, will be absolute
necessities if we want to ensure this nation's future prosperity.
Conclusion
The
U.S. economy is transitioning from the faster growth of recession
recovery to a slower, steadier, and more sustainable rate of
expansion. In the past, such transitions were often accompanied
by stock market corrections, but once growth expectations were
readjusted, the stock market advance usually resumed. We expect
much the same in this environment. Growth will be slowed by
current events, but our economy is basically in good health
and the U.S. is well positioned to participate in what we expect
will be a continuing global economic expansion.
Nonetheless,
there is little doubt that risk has increased, and we recognize
that now is not the time to be inflexible. We are well aware
of the danger of financial contagion associated with this particular
pullback, and we are carefully monitoring events as they evolve.
We may choose to lighten exposure to equities somewhat on the
next advance, but we continue to believe that there will be
a next advance.
How
will this correction end? We consider it unlikely that the stock
market will just turn around and go right back up. Alternatively,
it is possible that news events and crowd psychology will become
sufficiently negative to bring about a selling climax - short,
sharp, and then over. However, we think it most likely that
the markets will undergo a bottoming process that will take
a couple of months or more to evolve, probably with some scary
moments along the way.
What
to do now depends on one's time horizon. While many stocks have
fallen to what we consider to be highly attractive levels of
valuation, it is always difficult to know how the next few months
will evolve. Yet we are confident that, from these levels, our
current portfolio holdings will be quite rewarding to clients
over the next two to three years. 
