State of the Market
During the second quarter of 2011, equity markets around the world were whipsawed as investors' attention shifted between good news and bad. News of strong corporate profits and balance sheets was overshadowed by high unemployment, weak economic growth, and worldwide political drama.
A strong rally in late June erased earlier losses and essentially left most equity market indices little changed from the beginning of the quarter. The U.S. bond market eked out a small gain for the quarter – an improvement over the marginally positive performance in the first quarter of the year.
The total returns for major asset classes are below.
||MSCI Emerging Markets
While the second quarter ended on a relative high note, the rally of late June was short-lived. Investors have once again turned their attention to Europe’s debt issues, the relative strength of the U.S. economy, and a myriad of other potential “recovery killers.”
Headlines Scream, Markets Whisper
Investors are still feeling the sting of the last recession. Like a recent mugging victim who becomes overly cautious when parking on city streets, some investors today fear a Lehman-style contagion in every difficult fiscal, economic, and political issue.
News stories about budget battles in the U.S. and riots in Greece may make good headlines and fill the 24-hour news cycle, but the markets are seeing something quite different as evidenced by the chart below. This chart depicts the “TED Spread” over the last five years. The TED Spread is essentially a measure of how expensive it is for banks to borrow money from each other overnight. Throughout the crisis, it served as an accurate gauge of global banking “nervousness” and correspondingly global credit and liquidity.
[caption id="attachment_462" align="aligncenter" width="622" caption="TED Spread"][/caption]
At the peak of the crisis – immediately following the Lehman bankruptcy – the TED Spread spiked, the flows of capital stopped, and global credit markets collapsed in on themselves. This event was the catalyst that amplified the severity of the global recession and market decline.
The chart clearly shows an increase in the TED Spread throughout 2007 and 2008 as banks grew increasingly nervous about the stability of the system and the probability of contagion. In hindsight, we wished we had paid closer attention.
Compare that to today – a period of intense scrutiny of global events. The TED Spread is indicating no jitters among the banks and virtually no chance of another liquidity driven crisis of confidence. (This conclusion is supported by data and signals in other markets as well.)
A benign TED Spread does not imply all is well with the world. It instead conveys confidence that our global financial system is stable and capable of coping with current events without triggering another round of crisis as witnessed in 2008.
Default: Who, How and When
The finance Minister of Greece, the Treasury Secretary of the United States, and the Budget Director of Wisconsin are all facing the same reality – default is inevitable.
Default is a strong word. However, in the context of government finance, default simply means a broken promise. This can be a promise to bondholders, to taxpayers, to government employees and retirees, or combinations thereof. One thing upon which we can all agree is that, collectively, we have made promises which we cannot keep. So it is not a question of “if” we need to restructure, but one of “who, how and when.”
The restructuring will take the form of reduced pension benefits, means-tested entitlement programs, raised retirement ages, and higher taxes. The “who” is everyone.
As I write this, a debate is raging in Washington D.C. about “how and when.” Both parties agree that our deficit spending is out of control and our spiraling debt levels pose real systemic risk to our future prosperity. There is consensus that now is the time to act and that action should be a $2-$4 trillion reduction in deficits. That is the good news.
But neither side can agree on “how” to reduce the deficit. Democrats want tax increases; Republicans want spending cuts – no surprise there. Republicans say the recovery is too fragile to absorb tax increases. They may be right, but if so, then the recovery is too fragile to absorb spending cuts either. Ultimately, the pain of reduced spending and higher taxes will be shared. Don’t worry; there will be plenty of sacrifice for everyone.
Thoughts on the Debt Ceiling
The reason our fearless leaders are currently engaged in deficit reduction brinksmanship is that the government cannot issue any new debt beyond the current congressionally approved limit of $14.294 trillion. To borrow more, Congress must pass and the President must sign a law that raises the debt ceiling. Failing to do so by the beginning of August, will hinder the government's ability to finance its operations. Each side is using this deadline to strong-arm the other in the hope of advancing their political agenda.
If Republicans in Congress want to limit deficits and reduce the national debt, they have the power to do so every year in the budget process. The President and Democrats could have imposed fiscal discipline many times in the past two years but chose not to. All parties have chosen instead to run huge deficits. It is disingenuous for any elected politician to claim they are acting in the nation’s interest by tying the hands of the Treasury to finance the spending that Congress has already approved.
The debt ceiling will be raised. Everything else is political theatre.
Thankfully, a long-term, successful investing experience does not require accurate forecasting of economic activity or handicapping political outcomes. Instead, it requires patience and an acknowledgement that the economy and the markets move in cycles. We believe full participation in those cycles is key because 1) markets go up more than they go down, 2) the chances of calling the exit and re-entry points accurately is close to zero, and 3) the cost of missing out is ultimately more painful than the cost of holding firm.
It is worth pointing out that the markets “feel” worse than they are. Year to date, almost every asset class, fund, and strategy that we follow is in positive territory. Despite all the headline risk, the markets are holding up fairly well.
They say patience is a virtue. This is especially true for investors, and especially during a soft patch such as this.