Vigilare Wealth Management Q1 Summary
The year has started with a bang. From Europe to the United States, global stock markets around the world rallied unabatedly. The S&P 500 was up 12%, posting the strongest debut to a year since 1998, with Technology and Financial stocks leading the way. Last year’s stock winners were this year’s losers, and vice versa.
In Europe, there were major government interventions to address the solvency concerns of the weaker European nations. Greece received a timely bailout weeks before a major bond payment was due. This was Greece’s second bailout in as many years. Also, the European Central Bank provided a lifeline in the form of over $1 trillion of loans to cash-deprived European banks. These banks presumably used this new capital to support the government bond markets in their home countries, thereby bringing most sovereign European bond yields down. The aggressive European policy actions appear to have temporarily reduced the likelihood of a “Lehman Brothers” financial panic and generally encouraged market participants to take on more risk.
Meanwhile, U.S economic data continued to show resiliency, especially notable in the employment and retail sales data. This spilled over into consumer confidence which rebounded from historic lows, and is now at a one year high. Americans are feeling much more confident about the economy today than last summer.
“Danger Will Robinson!”
Both 2010 and 2011 started strong and quickly turned negative in the summer months. Is 2012 going to be a replay of the prior two years? There are many reasons why these positive economic “green shoots” could quickly turn yellow.
Europe has done nothing to address the structural problems of their ongoing crisis. The struggling Eurozone countries have half-heartedly acquiesced to German demands of fiscal austerity and structural reform, only to see their economies deteriorate further. Germany is unwilling to go “all-in” and provide a firewall such as issuing Euro-bonds backed by all Eurozone members (i.e. Germany accepts the move to single bond market like U.S. treasuries). A European recession will only cause underlying problems currently masked by an abundance of liquidity to flare up, and yet again re-introduce more discussions of bailouts and capricious interventions, only the stakes will be even larger and the markets will be less patient and more skeptical.
China’s leadership in global economic growth is extremely important today considering the U.S economy is crawling, and Europe is in a recession. Higher inflation, tighter credit conditions, slower demand from the west, and falling real estate prices are starting to strain the Chinese economy. China’s prior success has been largely attributed to massive credit and loan expansion since 2009, which boosted investment in infrastructure and real estate. Chinese GDP was as high as 12% in Q1 of 2010 and has been steadily declining. The Shanghai composite was up 4.3% this quarter, but has fallen 8% from its peak on March 2nd. A further slowdown would put pressure on the U.S and European stock markets which are dependent on growth from that region.
The U.S. economic data has improved but its growth trajectory is well below the typical growth pattern following a recession, which is remarkable considering years of running trillion dollar deficits and zero percent interest rates. And now with the possibility of the U.S. Government throttling down spending in 2013 (probably not such a bad idea and in the spirit of tough love), we are concerned. The problem with below average growth is its fragility, and how easily positive momentum is lost.
According to the National Oceanic and Atmosphere Administration, this winter was the fourth warmest on record dating back to 1895 (those of us in California, Florida, and Arizona really didn’t notice the difference). The next few months of U.S economic data may reveal if the unusually balmy winter just pulled forward demand from the coming summer months, or if the mild winter really had a minimal impact on the recovery.
Never have gasoline prices been at this high a level so early in the year. As of the end of the quarter the U.S. Department of Energy reported gasoline prices at $3.996, not that far from the all-time high of $4.165 in July of 2008 (Europe is currently at record levels because the Euro was much higher in 2008). Gasoline prices usually peak in the summer. With personal income showing very tepid growth and the personal savings rate below 4% again, higher gasoline prices could have a profound effect on spending and confidence.
Earnings, Earnings, Earnings. The strongest argument for the bull market has been positive earnings. Low interest rates, high productivity, and strong overseas sales (China in particular) have contributed to double digit earnings growth going back to the beginning of 2009, but the momentum has slowed in the last couple quarters. Earnings estimates for the current quarter have been revised downward and are now expected to grow a meager 0.87% (source WSJ and S&P Capital IQ).
We will be looking for signs that we are indeed on that road to a sustainable recovery. Bank earnings were encouraging in the fourth quarter, as the banks reported slight expansions in their loan books (except for residential real estate). A follow through this quarter would be very bullish for the economy and the markets. We would see this as an opportunity to invest more aggressively in U.S. cyclical and small cap stocks.
There have been numerous false bottoms in residential real estate. The positive multiplier effect of a housing recovery would be enough to give the economy the buoyancy needed for sustainability.
Lastly, if we observe a follow through in jobs growth and other critical economic data into the summer months, this would debunk the argument that seasonality was responsible for the strong data this quarter. However, if the recent U.S. “green shoots” are temporary, a slowing China and problematic Europe will erode profit margins and earnings, and we will quickly find ourselves revisiting the volatile summer of last year.
The Vigilare Management Team