Second Quarter 2010
ByQuarterly Review & Outlook
The equity markets for the second quarter were an exaggerated mirror image of the first quarter. Equity markets across the board were down rather sharply, more than erasing the gains of the first quarter and generating losses in every segment of the equity markets. Fortunately, our defensive approach worked well and helped mitigate the losses in the second quarter, also, a mirror image of the first quarter. The equity markets have essentially gone nowhere but with a lot of volatility. Environments like this are challenging and call for an abundance of caution with an eye toward capital preservation. As a further update, the equity markets have rebounded rather sharply during July and client portfolios are responding similar to our results in the first quarter (i.e. our equity holdings are doing well and total portfolio returns are being held back by our defensive issues).
The major focus of the markets during the 2nd quarter was the crises in European sovereign debt, most notably Greece and the rest of the PIIGS (Portugal, Ireland, Italy, Greece and Spain). The PIIGS are the weakest members of the European Union that are tied to the Eurodollar. Over the past decade, they have taken advantage of the low cost of borrowing and embarked on speculation in Real Estate and social programs, neither of which were sustainable. Their debt levels have risen well beyond their annual level of GDP and their deficits are far beyond the EU limits. Potential lenders became very reluctant (at best) to lend Greece any more capital and it took a concerted effort on the part of Germany and France to agree to bail out Greece (for the time being). Many market observers commented that the crises in Greece was a harbinger of what may happen in the U.S. should we continue to go down the road of Trillion dollar deficits. The EU countries, to their credit, have embarked on austerity measures geared to reduce their structural deficits over a period of time. Since the temporary bailout of Greece the sovereign debt problem has faded off the radar screen but we suspect that it will show up as a bright “blip” again within the not too distant future.
We have talked in the past ad-nauseam about the structural problems with the U.S. and developed world economies (e.g. too much debt, the increasing burdensome and costly regulation of the private sector, deleveraging, etc). In a sense, the equity markets are reflective of the push and pull of the short term positives in the economy (improving GDP and corporate earnings) and the negative effects of deleveraging and recent policy initiatives. The U.S. (and the developed world) are at a crossroads and are walking a tightrope trying to balance between reversing excessive debt levels while trying to encourage reasonable economic growth. The fragile worldwide recovery is not unlike the patient who is recently been moved out of the ICU into a regular hospital room. The patient fortunately avoided death (economic depression) yet is quite fragile and not well enough to be released.
The government stimulus likely averted a worsening decline but much of the stimulus is wearing off. This is reflected in recent economic statistics which indicate that while the economy is still growing, the rate of growth is diminishing and is at sub optimal rates. The rate of economic growth for the 2nd quarter was just 1.9% (below the 2% necessary to maintain current employment). The consensus of most economists is for a rate of economic growth for the 2nd half of 2010 to fall in the 2% to 2.5% range. While positive, this is barely enough to make a dent in the in unemployment levels. We have a great deal of concern that, should there be no action on the expiring tax cuts in 2011, we may slip back into a recessionary mode. The scheduled tax increases amount to a bit over 1% of the GDP. Historically, tax increases have had a multiplier effect of between 1.5X and 3.5X. Mathematically, it does not take much of a tax increase to “tip over” a slow growing economy. Needless to say, another recession would not be good for equities or unemployment.
To quote the current Fed Chairman, Ben Bernanke in his speech to congress last week, we are in “unusually uncertain times”. Our job during these “unusually uncertain times” is to navigate client portfolios through uncertain waters keeping a close eye toward the risks while striving to make forward progress. In other words, we plan to continue to place an emphasis on capital preservation while continuing to seek pockets of opportunity. Again, we hate to cast such a negative light on our view of the future. We believe it is our responsibility to think independently and honestly communicate our outlook to you even when the “news” is not uplifting. Our current outlook is little changed from last quarter. The combined effects of greater government deficits, higher taxes and a lengthy deleveraging process indicate that we will have an extended period of below normal growth and greater risk of “surprises”.
As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.
Sincerely,
James A. Martin, III