Lawrence Fuller, Managing Director and Portfolio Manager

PDF version of the Market Outlook

It is full steam ahead for the U.S. economy, led by a surge in corporate profits and capital expenditures, a return to job growth and a rebound in consumer spending. Inflation remains well-contained, while interest rates hover near historic lows, and investor sentiment is improving as the public’s fear of losing has gradually morphed into a fear of missing out. This comes as no surprise, as peaks in investor sentiment almost always coincide with peaks in leading economic indicators. Similarly, sentiment reached its most bearish a year ago when leading economic indicators were bottoming along with market prices. The Dow Jones Industrials (+1.4%), Standard & Poor’s 500 (+1.5%) and Nasdaq Composite (+2.6%) all finished the month with respectable gains. Consumer discretionary led sector performance with a gain of 6%, while the healthcare sector was the worst performer, posting a loss of 3.9% (source:Bloomberg.com)

While still maintaining a bullish outlook for the U.S. stock market, we significantly pared back our exposure in recent weeks from a tactical standpoint in anticipation of a correction in prices and sentiment. As market participation broadens and asset prices rise, so do the risks. Before markets correct, investors either become too bullish or not bearish enough, and we surmised that investors were guilty on both counts. Our greatest concern has been the potential for a financial crisis in Europe, and the complacency with which investors and markets have addressed such a possibility. The storyline to date has been nearly identical to the one that played out in the United States in the spring of 2008. Although we have a much different cast of characters, debt and derivatives still hold leading roles.

In early March we vastly reduced our exposure to international equity markets, despite what we felt would be a continuation of robust economic growth in the developing world. We expected that tighter monetary policy in response to rising rates of inflation would serve as a headwind in emerging markets, but it was the casual manner in which the European Union (EU) was addressing the fiscal crises in several member nations that concerned us most. At that time, we stated that “the EU will bail out Greece, but any ad hoc intervention that does not also address the fiscal crisis facing the member nations of Portugal, Italy, Ireland (Greece) and Spain (PIIGS) will be reminiscent of the Federal Reserve sweeping Bear Stearns under the rug of JP Morgan in March 2008.” Investors are now catching on to the fact that the piecemeal approach currently underway is not addressing the systemic risk. European Central Bank (ECB) President John Claude Trichet said last week that the bailout of Greece will “help restore confidence and safeguard financial stability in the euro area.” This statement brought back memories of when Federal Reserve Chairman Ben Bernanke stated that the sub-prime mortgage crisis was well contained in 2007.

Greece concealed its budget deficits for more than a decade through the use of complex and unregulated financial instruments known as derivatives, which allowed them to defer interest payments on its debt. Now they must refinance more than $11 billion in coming weeks, which it cannot afford to do in the public market at today’s astronomical borrowing costs. Its debt carries a “junk” credit rating, and its deficit will likely surpass 13% of GDP this year. We believe the EU will soon approve a loan package of $144 billion to avoid a debt default, and that Greece will implement the austerity measures required to receive this loan, but such measures will only serve to deepen the recession underway and further depress economic growth. Furthermore, Greece is but the tip of the iceberg.

The budget deficits facing the remaining PIIGS are equally as ominous, and the refunding needs of Spain and Italy dwarf those of Greece. Rating agencies are lowering credit ratings based on their budget deficits, which is putting upward pressure on their borrowing costs. The contagion is spreading. It is estimated that the PIIGS require $600 billion in 2010 alone to fund their deficits and maturing debt. A default by one member nation could lead to a financial crisis similar to the one we experienced in the United States in 2008. Nearly every member of the EU owes or is owed varying amounts of, dare we say, toxic sovereign debt. French banks hold outstanding loans to PIIGS nations that total more than 30% of their GDP. Germany and the United Kingdom hold loans to these countries that total nearly 20% of their respective GDP. While the consensus may view this intricate web of sovereign debt as a significant risk, it is for this very reason that we believe a default to be an unlikely event.

The EU and the European Central Bank (ECB) must coordinate an effort that allows the PIIGS to feed from the trough of the central bank in order to lower their borrowing costs to levels consistent with the stronger member nations of Germany and France. They could do this by instituting a Troubled Sovereign Debt Program (TSDP) modeled after the Troubled Asset Relief Program (TARP) in the United States, whereby the ECB purchases debt in the secondary market, irrespective of credit ratings, in the same manner that the Fed purchased mortgage securities. The European Commission must also waive the constraints on budget deficits relative to GDP (currently 3%) to allow the stronger member nations to implement their own stimulus programs, either through tax cuts or spending initiatives that restore growth throughout the region. Austerity measures may reduce budget deficits, but they stifle economic growth, and if an economy does not grow in excess of the rate that it is accumulating debt, despite the interest rate, the end game is a default. We see no other solution to this evolving crisis.

Should these steps be taken, the euro would weaken significantly, but this would only serve to improve European exports and bolster desperately needed economic growth. Inflation is of no concern at this time, and the ECB would be wise to lower short-term interest rates from the current rate of 1%. Another positive to note is that this crisis is unfolding as the global economy is gaining strength, which is a polar opposite to the scenario we saw as the credit crisis ensued in the United States. We do not think these events will derail the bull market or economic expansion underway in the U.S. Our financial system as a whole has negligible exposure to the troubled sovereign debt in question, although JP Morgan and Morgan Stanley each have exposure of more than $30 billion. Our exports to the European continent are not substantial enough to slow our rate of growth either.
We expect the mainstream media to immerse itself in debate and analysis over these issues in the days and weeks ahead. As heightened levels of risk are brought to the forefront of investors’ minds, they will be factored into market prices very quickly, and lead to what we believe will be yet another opportunity to invest in domestic equities. We see the S&P 500 having strong support near the 200-day moving average, which approximates 1100, and a decline from the recent highs (1219) to that level would be a healthy 10% correction. We expect the market to find its footing in the 1100-1150 range, affording us the opportunity to increase our exposure to a near fully invested position again.

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