August 2011
European Uncertainty
Turmoil in the markets has begun to seem the new normal this month. As the economic picture for some of the southern European countries has darkened, many investors have become understandably nervous. Germany and France are the main drivers of the euro zone economy. As other weaker countries increasingly rely on Germany and France to shore up their finances, German and French taxpayers have become more disgruntled over the need to divert resources to other countries. The uncertainty over how far taxpayers in more economically sound nations are willing to go in order to prop up other nations in the euro zone is at the heart of the current market instability.
A proposal has been put forth for the euro zone to create and release a Euro bond in order to meet the debt obligations of the region as a whole. However, this would require German willingness to back the repayment of these bonds. Since a number of countries in the euro zone may not be able to contribute their fair share to the repayment of such bonds, a disproportionate amount of repayment would likely land upon German shoulders. So far they are unwilling to take on this type of obligation. This situation has led to an increased likelihood of European recession. A number of economists now put this figure at 50%, meaning there is an even chance Europe is facing a renewed recession.
How does this affect us in the United States? European Union statistics show Europe accounting for about one-fifth of U.S export totals.1 While this is clearly a minority stake; it is still a large portion of U.S. exports. If Europe does enter a recessionary period, a large number of corporations here will see some effects on their business.
U.S. Outlook
U.S. corporations continue to show good profits. In fact, they are earning record profits. A July 29th article by Market Watch notes that profits are the highest they have been in 60 years. Profits for 2008, 2009, and 2010 were actually $343 billion higher than previously estimated.2
Europe is not the only region that affects U.S. companies. Japan has seen better than expected GDP figures as their economy has fared better than forecasted in the aftermath of the March earthquake. Emerging markets are seeing average growth of about 6% annually.3 U.S. corporations are affected by the growth we see in these areas.
GDP forecasts are educated guesses that are constantly revised. Most economists upwardly revised their 2011 growth forecasts at the beginning of this year. They are now generally revising those numbers downward. GDP estimates for the rest of the year are still in positive territory though. Goldman Sachs recently revised their figures to 2% through early 2012, rising to 2.5% thereafter.4 The estimates do still show an expectation of further growth rather than contraction, albeit at most modest levels. Morgan Stanley went on to note that although recession is quite possible for Europe, and even possibly for the U.S., over the next 6 to 12 months it would not be of the sort seen in 2008-2009 for either region. If we do see recession in either economic zone it is likely to be shallow.
I would note that while the chance of U.S. recession has recently increased, most analysts still think recession is not the likely scenario. A one in three chance of recession – the most widely agreed upon current figure – means that the quoted economist believes it more likely that we will not see recession. They believe we are twice as likely not to see another recession as to actually see one. Additionally, this is the same chance given to the economy of entering into recession during 2010.5,6 So, while the likelihood of U.S. recession has grown it is still not the expected path of the U.S. economy. Slow growth is more likely than recession.
Debt Downgrade
The recent downgrade of U.S. debt by the S&P (but not Fitch or Moody’s) does deserve a mention. This downgrade was expected. S&P put the U.S. on Credit Watch negative by mid July. On July 21st they said a downgrade would be likely unless budget cuts of $4 trillion were part of the debt ceiling deal.7 The cuts were not part of the deal, S&P followed through with their downgrade. There was much media speculation this would lead to increased borrowing costs for consumers. Such ideas have been proven wrong. In fact, mortgage rates have fallen from about 4 1/2% to just over 4%.8 We have not seen credit card rates rise as some pundits had stated would occur. Most significantly, the downgrade is likely to lower gas prices as it triggered lower crude oil futures prices. This was yet another economic incident blown out of proportion by media hyperbole.
I recently read an interesting piece outlining the effects of the current low in interest rates. Some companies with AAA credit ratings can issue debt for such low yields that they theoretically could use bond proceeds to buy their own stock back and net a profit from the difference between the interest they would pay on the bonds and the dividends they would receive from the stock! In reality, all that has really risen with this downgrade by 1 of the 3 major ratings agencies is fear levels.
Summary
There are plenty of reasons to be pessimistic right now. U.S. unemployment remains relatively high. While the situation has improved, it is doing so at a very slow rate that is not likely to increase. Bipartisan efforts to address the deficit over the next decade have largely failed. Consumer uncertainty is negatively affecting retailers; although there are preliminary signs of a bottoming out here.3 Productivity gains are placing more pressure on workers who are not seeing pay growth. Housing remains a weak area of the U.S. economy. However, second quarter earnings for the S&P 500 are up 12% over the previous year. Analysts have estimates of the third quarter showing an increase of 16% over the third quarter of 2010.3 Corporate profits are the prime motivator of stock market activity and they are up significantly.
It is quite understandable that investors would be nervous right now. The decline in the market seen during the recent recession was of a scale not seen since the technology based bear market 10 years earlier. For many investors this downturn was either the first they had seen or the first that significantly affected them. An investor accustomed to seeing an ever increasing portfolio value is going to experience quite a shock when that balance begins to decline if they have never been through a previous down market. Combine this with worries over unemployment, governmental gridlock at the federal level, and local government cutbacks and it’s enough to make anyone jumpy. However, it is important not to allow emotion to override better judgment and keep focused on long-term strategies during such times.
The Price-Earnings (P/E) ratio of all stocks with earnings has fallen to 13.8 from 17.2 over the past 6 months.9 This decline has attractively priced a number of stocks and we have seen quite a bit of insider buying within the market over the past few weeks as a consequence. The research firm TrimTabs calculated $861 million in insider buying from August 1st through August 12th alone. To put this in perspective, this is the most insider buying in a single month since March 2009 (a month at the low point of the most recent major market decline).10 These insiders are not trading on information unavailable to the general public, but rather on the balance sheet figures they see rather than the fear they may feel. Insiders can certainly be wrong, but this is a strong indicator that professionals familiar with many companies feel strongly enough that their company is currently undervalued that they are willing to invest heavily.
We are likely to see more negative news over the coming weeks as the governments of Greece, Spain, Portugal, Ireland, and other European nations continue to struggle to shore up their balance sheets. Uncertainty over how far Germany and France will be willing to go to help these governments will likely continue to roil world markets. Dysfunction within our own government is likely to continue to make U.S. investors nervous. We are not on the brink of world economic collapse though. In 10 years time it is likely August 2011 will be just another fluctuation on a long-term chart that no one remembers any better than they remember September 2001 or February 2003 today.
1) http://trade.ec.europa.eu/doclib/docs/2006/september/tradoc_113465.pdf, pg.4
2) http://www.marketwatch.com/story/corporate-profits-share-of-pie-most-in-60-years-2011-07-29
3) Barron’s, August 20, 2011 The Economy is Slowing, Not Stalling
4) http://finance.fortune.cnn.com/2011/08/15/three-headwinds-to-corporate-profit-growth/
5) http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aluoqvsvAwO8
6) http://money.cnn.com/2010/07/08/news/economy/double_dip_recession.fortune/index.htm
9) ValueLine Investment Survey August 19, 2011
10) http://money.cnn.com/2011/08/11/markets/insider_trading_bulls/
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