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2012 Quarter 1 Market Review
Recently, my family travels have reminded me how truly global our economy is. Our family (at least those who are still living at home) spent spring break in San Francisco, a wonderful city with a great deal of culture and diversity. We spent some time watching whales and sea lions, tasting wine in Sonoma, and exploring the former prison on Alcatraz Island. However, we also walked around Chinatown and were fascinated by the amount of commerce being done there every day. It made me think of the amazing growth in the country of China in the past decade, and the strides being taken there toward economic dominance.
The Chinese government, of course, closely monitors and controls economic activities, but they seem to have found a balance between their socialist views and a free-market economy. In any case, China has a rapidly growing middle-class which will create demand for a wide range of goods and services, some of which will be produced domestically and some of which will be imported, creating great opportunity for smart exporters from other countries.
 My daughter is currently studying in Rome, Italy, for the second semester of her junior year of college. When we speak with her (usually via Skype on my PC or via “Facetime” on my son’s iPod – amazing technology!), I am reminded of the other side of global economic activity prevalent in certain developed countries in Europe. She describes seeing many native Romans out of work and the laziness of government workers, such as their police force. While she is experiencing life in a wonderfully historic and beautiful part of the world, it strikes me that Italy has a long way to go to get out of its economic doldrums. Economic reforms will be difficult, but necessary, for Italy and a handful of other European countries, including Spain, where my daughter is visiting this weekend (Barcelona).
There are many smart environmentalists who embrace the theory of global warming. They reference dramatic statistics about how climate change affects our water supply, wildlife, wild lands, and human health in harmful ways. There is certainly an economic impact of global climate change, either by the need to fix immediate problems that it creates, or by developing solutions to improve our environment for the long-term. I don’t know whether global warming has been created by mankind or whether it is part of a super long-term cyclical climate pattern, but in any case the issue certainly needs to be studied and addressed, and new economic opportunities will be created in our attempt to solve the problem.
The other kind of “global warming” that we have witnessed in spades in the past few years is the fiscal and monetary policy actions of developed governments around the world, in an attempt to “heat up” world economies that were driven into the Great Recession by the financial crisis of 2007-2008. I have written previously that I believe the government stimulus enacted by both the Bush and Obama administrations was necessary and helped the U.S. avoid a catastrophic economic collapse. Similar stimulus that has been attempted in the European Economic Union is a bit less effective because of the diversity of economies among its constituent countries, and the fact that there is no common “central bank” to redistribute government resources. With that said, it seems that some of the fear of a European collapse is easing as their government leaders are working more closely together to develop creative ways to solve their economic problems.
So, given the recent improvements in most economic indicators of the U.S. and the continued growth (albeit a bit slower) in many emerging markets, can we expect a “cooling” from worldwide central banks anytime soon? Probably not for a while. There are two major concerns with the global economic outlook. First, the primary driver of the record high level of current corporate profits is the fiscal deficit created by government stimulus programs. Second, the developed world is in a long-term cycle of de-leveraging (paying down debt). These two situations are interconnected…we had an overload of consumer and business (private) debt during the go-go years of the 1990’s, and we now have an excess of government debt driven by the need to stimulate a weak economy. It is difficult to determine how this will play out over the next few years.
The best case scenario (and the one that developed governments are hoping for) is that today’s stimulating monetary policies will result in gradually improving private-sector growth, so that governments can begin to realize revenue growth, reduce stimulus, and ultimately return to some form of austerity (balancing their budgets). A bad outcome would be that developed economies simply will be unable to grow themselves out of this highly levered position, possibly due to deteriorating demographics, and we experience very stagnant economic development for another decade. It is a tricky situation for governmental leaders. I am hopeful that the growth of emerging markets countries, along with the ingenuity historically displayed by businesses (especially in the U.S.), will result in a gradual return to economic prosperity.
First Quarter 2012 Review
The equity markets continued to roll in the first quarter of 2012, with the best quarter overall since Q3 2009 and the best Q1 in fourteen years! The stock market advance was remarkably orderly and consistent through the quarter on both positive and negative days. There were only seven trading days that experienced price changes of greater than 1% (6 positive, 1 negative), which has not occurred since Q1 2007.
March 9th of this year marked the third anniversary of the post-financial crisis market rally (37 month bull market, and counting). From that market low, U.S. large cap stocks have risen 122% and the rally in riskier small cap and emerging markets stocks has been even more impressive. Large cap stocks are now near the market peak in October, 2007, and small and mid-cap stocks have surpassed that peak level. Patience is a virtue! International equity markets jumped on the bandwagon in Q1, especially in the emerging markets. Headline risk in Europe lessened during the quarter, which gave investors some confidence in the global recovery.
Commodities remained volatile during the quarter, with sharp increases in crude oil prices due to renewed concerns about Iraq, but an equally sharp decrease in natural gas prices. While metals performed well in Q1, livestock prices declined.
Bond returns were widely divergent during the first quarter, with yields spiking for a couple of months in U.S. Treasuries, and then backing off near the end of the quarter. Here are the returns for selected market indices for Q1 2012 (as stated in U.S. dollars):
Outlook
Even with the impressive rise in stock prices over the past three years, current Price/Earnings ratios are only 80-90% of their 20-year average, implying that stocks are still not expensive looking forward. The Earnings/Share growth that has resulted in record high corporate profits in the U.S. had been primarily driven by margin expansion (cost cutting)…until the 4th quarter of 2011, when nearly all the earnings growth was a result of revenue growth, which should be more sustainable over time.
Domestic auto manufacturers expect to export a record 1.7 million units in 2012 (more than 10% of domestic production). Light vehicle sales, retail capital goods orders, and even housing starts have all started trending upward. The household debt service ratio (debt payments as % of disposable personal income) is at 10.8%, which is the lowest level in thirty years. Tax rates on dividends, capital gains, and income are well below their 40-year averages. Homeowner affordability (mortgage payment as % of household personal income) is at the lowest level on record at 10.5%.
The U.S. unemployment rate has dropped to 8.3% and our country has gained 3.9 million private sector jobs in the past two years. [Interestingly, but not surprisingly, here are our current unemployment rates by educational level: College or Greater 4.2%; Some College 7.3%; High School with no College 8.3%; Less than High School Degree 12.9%.]
So, it appears that the U.S. economy is trending nicely upward. However, as mentioned, we live in a global economy so we need to consider factors outside our borders. Emerging markets now comprise 49% of global GDP, and currently show real GDP growth of about 5% (as compared to real GDP growth in developed markets of around 1%). Collectively, emerging markets consumption has now surpassed the U.S. Clearly, there are opportunities for businesses around the world to take advantage of these trends.
The global challenge, it seems, is the European crisis. As mentioned earlier, the European Union lacks a fiscal mechanism for the redistribution of resources among its members. Borrowing costs in Greece, Portugal, Ireland, Spain and Italy have increased dramatically, making growth very difficult in these countries. European economic leaders seem to be working in sync a bit more lately, creating a sense that a creative solution to their problems might be found.
Given the huge levels of government debt in the U.S. and Europe, growth could ultimately be restrained when the stimulus is reduced. Most economists believe that European austerity measures cannot be implemented too soon, or a severe recession will be imminent.
Many market analysts now believe that some of the greatest risks are found in U.S. government bonds, as yields are low and the economy is improving (which would imply higher interest rates in the future). Yet, money keeps pouring into bond mutual funds. One investment manager commented that “bond investors seeking risk-free returns are getting return-free risk.”
As the range of possible economic outcomes is still very wide, a well-diversified and balanced investment portfolio is the only way to counter some of the inherent market risks while providing an opportunity for adequate long-term returns. As our economies are global, so must be our investment portfolios. Opportunities are often found outside our domestic borders and investors should be positioned to take advantage of them. As I did in San Francisco, look around…signs of global diversity are everywhere!
Thank you for being a client of Falcons Rock.
Gregory D. Wait, President
Falcons Rock Investment Counsel, LLC
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