We started publishing market commentaries in early August 2011 as we saw three large concerns we thought were driving U.S. equity market prices: concerns over a renewed U.S. recession, concerns that a planned slowdown in China would weaken the strongest area of growth in the world, and concerns that a default by a European country would trigger another global financial crisis similar in scope to the one we experienced in the U.S. in 2008-09. We’ve published updates to our thinking as events occurred that we felt meaningfully impacted our assessment. Here’s our latest:

Concerns over a U.S. recession peaked in September and began fading by early October. Today, we think the markets are no longer concerned about a U.S. recession—that fear has dissipated largely because the economic data has gradually improved. 

In late October we wrote that China had stopped squeezing its money supply and that concerns in the public media of a property bubble bursting weren’t heard much anymore. Last week, China announced it was reducing the amount of money it required its banks to hold in reserve by one-half of one percent, allowing the banks to increase the amount of money they lend. This is the first step towards a looser monetary policy and we think a sign that China is beginning to shift from fighting inflation to promoting economic growth.  We believe this is meaningful as it presages increased economic activity, and hence demand, out of China.

Europe has gotten worse, not better, since we last wrote in October. The write-down of Greek debt that was a part of the August–September plan has gotten bogged down in discussions of which debt holders would and would not participate in the write-down. The European Financial Stability Fund (EFSF), which gained the authority to buy sovereign debt and inject capital directly into European Banks, has become nearly irrelevant as efforts to borrow money have failed and the entire facility has been discredited.  Italy and Greece have both replaced their prime ministers with “Technocrats” after their parliaments lost confidence in the former ministers’ ability to lead those countries to a solution.  (Technocrats are technical experts placed in authority by the ruling party in Parliament without an election being held.) Italian 10-year bond yields broke 8% in mid-November in spite of ongoing purchases of Italian bonds by the European Central Bank (ECB) now led by Mario Draghi. (Jean-Claude Trichet’s eight-year term as ECB President ended in October). Those yields have pulled back a bit in the last week or so, but remain worryingly high. 

The biggest news recently is the reduction in interest rates on dollar swaps to other central banks—this makes dollars available to European banks (through their central bank) at cheaper rates and helps relieve some of the near-term dollar funding pressure they had been experiencing. Announcement of this coordinated central bank action on November 30, 2011 prompted the S&P 500 to jump over 3% that day. While helpful in reducing near-term stress on European banks, this action doesn’t resolve the underlying issues. Probably more important was Mario Draghi’s address to the European Parliament on December 1, 2011 in which he suggested additional ECB assistance might be forthcoming if greater fiscal union (and enforceability of budgets) were rapidly achieved in the Eurozone. 

This is the crux of the matter. Germany and the ECB do not want to lend money to Italy, Spain, Greece, etc. in perpetuity—they want those governments to get their spending under control so any loans made now don’t have to be repeated in the future. Their negotiating tactic is to withhold further assistance until market pressure (unaffordable borrowing costs) forces governments to agree to enforceable fiscal discipline. This is a high stakes negotiation that will probably continue for a while. 

It remains possible that events may force the participants’ hands: European banks continue to struggle to access short-term funding; they remain undercapitalized and are reducing lending and selling assets to correct the problem. Overt default by a sovereign state would force them to mark their bonds to market and some banks would be shown to be insolvent. Finally, the Eurozone is heading into a recession which will stress government budgets further. While a European recession wouldn’t reduce demand for U.S. products very much a banking crisis would affect our banks and global financial markets:  the magnitude of the effect is difficult to estimate but is the reason for our continued interest in Europe.  Europe’s drama will continue to induce volatility in the markets and could still turn out very badly.

The reduction in the likelihood of a U.S. recession and the shift in stance of the Chinese Central Bank give us more confidence in buying companies we believe will do well going forward. Ongoing events in Europe continue to keep us a bit cautious. We continue to try to strike a reasonable balance between taking advantage of the investment opportunities we see and avoiding losses if events in Europe get worse.

The comments made by Ron Muhlenkamp in this commentary are opinions and are not intended to be investment advice or a forecast of future events.

 

 

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