Insight & Commentaries
Equity markets have enjoyed a spirited rally since late August when the Federal Reserve announced further actions to stimulate growth via a new round of asset purchases euphemistically dubbed Quantitative Easing II (QE II). By our math, it seems that markets have already discounted more asset purchases than are likely, especially given some of the discord that seems to be following the announcement. In this commentary, we explore some of the potential pitfalls that may follow from QE II, and why this round of easing is not the same as the first round of easing during the heat of the…
Where we last left off in our August commentary, the Dow was at 10,644. Since then, the index fell to 10,000 and has bounced back to nearly 10,600. In other words, the equity market continues to churn and mark time as it contends with the challenges at hand – namely the ongoing liquidation of private sector debt, periodic concerns about sovereign finances, and large amounts of excess slack in the global economy. Especially hard hit has been America’s private sector workforce. All of this has conspired to produce a sub-par recovery that, in some ways, seems a lot like purgatory.
Despite the hoopla about the summer market rally, we continue to see a market that is basically without a trend. Bonds have generally outperformed stocks over the past six to nine months, and the momentum has come out of a broad array of indicators that we rely on for managing portfolios. In fact, our interpretation of the array of data we review has become more bullish for bond investors and less bullish for stock investors since our latest quarterly report.
Many who watch markets today draw comparisons to the early 1930s and conclude that the end of robust, global, Keynesian-style stimulus might drive today’s economy right back into the ditch. For those of us who have been concerned about the potential for a rapidly growing government to dampen the “animal spirits” of private enterprise, we are not entirely convinced that some restraint doesn’t come without its benefits as well.
What do troubles in the Euro-zone mean to U.S. investors? The answer is relatively simple. Growth rate expectations will likely be cut, dollar translation will have a negative impact on U.S. company profits, and dollar strength will make U.S. exports more expensive to Europeans. While there are near-term challenges for the European community, and the global growth story, there may be a silver lining in this for the United States, vis-à-vis the dollar and the U.S. recovery story.
There is concern that after a stimulus-induced recovery in GDP and corporate profits, the domestic economy is slipping into a sub-par growth rate that provides neither job creation nor further material gains in profitability. How can this be, given the fact that nearly $11 trillion in government commitments (guarantees, loans, and investments) have been put in place? Could it be that too much of the monetary and fiscal pump-priming was squandered?
Global equity markets have recovered about half their losses since 2007 amid signs of slowdown in layoffs and improvement in earnings, as forecast by most analysts. However, most ordinary people have a different assessment of the economic environment. So while we welcomed improvement in financial markets in 2009, we do not see the economy as out of the woods.
Deflation has long been a concern of central bankers. After a period of falling prices, markets are pricing in a return to inflation. Our observations on credit and the economy confirm this expectation. However, quarterly data from the Federal Reserve shows that U.S. private sector borrowing is contracting at a $2.3 trillion rate. This trend is a significant risk to the outlook that needs to be monitored.
We believe that S&P 500 earnings have reached a trough and that recovery in earnings, led by cost reductions, is real and underway. Our most likely scenario calls for earnings to return to $65 by 2011 from the $40-45 in trailing-12 month earnings that are likely to be posted by the S&P 500 companies this quarter. We are marking this quarter as the trough point in that data series. Tactical asset allocations have been returned to “neutral” positions in response to improvements in our various indicators on credit, the domestic economy, and trade.
Since our last commentary, we have seen signs of improvement in a variety of economic indicators. We still have concerns about what the quality of the recovery will ultimately be, but believe it is appropriate to add some exposure to equities and broaden out portfolios to include foreign assets and corporate bonds, given recent improvement in our indices.
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