|
July 15, 2011
In this newsletter, we will address important issues influencing the markets, review the second quarter performance of Vega programs, and tell you how we plan to position our portfolios for the third quarter.
MACRO PICTURE
There are five major macroeconomic issues leading to extreme unpredictability in market behavior. To give some perspective, we would like to point out that the volatility index of S&P 500 (^VIX) has increased by over 25% over the last five months.
- US Debt Ceiling Negotiation Fiasco
- European Crisis and Possible Default of PIIGS (Portugal, Ireland, Italy, Greece, Spain)
- Recovery, Non-Recovery, Gradual Recovery, Anemic Recovery, Slow Recovery, or Subdued Recovery of the US economy (depending on whom you ask)
- The Unemployment Picture
- The Housing Crisis
We feel it is vital to address these potentially worrisome issues separately and express our views on the possible implications of each for the markets and the world economy.
- US Debt Ceiling
The debt ceiling debate is likely to continue up until, if not past the current deadline of August 2nd. Let us note that the statutory debt limit has been in place since 1917, and has been increased multiple times to keep pace with rising government expenditures. The current battle between Republicans and Democrats can be explained rather simply. Republicans require measures cutting discretionary spending and entitlements before agreeing to sign off on any debt ceiling legislation. Democrats are currently proposing a $1 revenue increase (read new taxes) for every $3 in spending cuts. It seems that this country has finally realized that it cannot spend more than it collects (in the words of economist Joseph Stiglitz, "an unsustainable lifestyle cannot be sustained").
There is no question that every member of Congress fully comprehends that a failure to reach such an agreement before the August 2nd deadline would lead to cataclysmic consequences in the highly fragile US and world economies. We might find ourselves watching congress vote repeatedly for small, incremental increases in the debt ceiling to avoid making a groundbreaking decision, but we expect the total package to be somewhere between $2.5-4 trillion. As soon as a default is avoided, market attention could immediately turn to the size and composition of the deficit reduction package. The impact of the budget standoff will depend on how long the negotiations last, but the ever-increasing pressure on the elected representatives to meet the deadline will force them to compromise.
The only objective estimates of the market's perception of default risk come from so called CDS (Credit Default Swaps). Regretfully, CDSs on treasuries have seen a 10 bps increase recently, reflecting the mounting anxiety of market participants. If two months ago, most people considered a default scenario unimaginable, now it is certainly not the case. Recent findings suggest that most market participants agree that there is at least a 10% probability of a short-term default. We do not think that this default scenario is priced into the market - please see our comments regarding our portfolio positioning below. As everybody else, we strongly believe that the market implications of a default would be instantaneous and extremely pervasive. Investors would no longer consider treasury securities as "risk-free" assets, and would immediately demand a credit-risk premium increase (the extent of which is impossible to estimate). Such an increase would snowball into elevated interest rates on all real estate and consumer loans, causing catastrophic effects given the extreme fragility of US consumerism and the miserable state of real estate markets. According to UBS analysts using the standard single-stage dividend discount model, an estimated 25-50 bps increase in the perceived risk-free rate (meaning 0.25% increase in the Federal Reserve Discount Rate) might reduce the intrinsic value of the S&P 500 by 9-16%. Leading indicators to such a scenario are often measured by the behavior of other "stable" currencies and commodities. We are already witnessing rallies of the Swiss Franc, the Yen, and Gold.
Our conclusion is simple: we do expect Congress to reach an agreement on the debt ceiling and reduction of the deficit. Default is extremely unlikely, and we do not advise our clients to position portfolios for this scenario. However, some prophylactic measures should be taken.
- European Crisis
While the Greek situation seemed to be old news, as we found out, it has not been resolved by any means. It is obvious to everybody that the debt virus is in the air, but nobody knew who would be the next victim. It is logical to assume that the fiscally weak are most vulnerable (PIGS), but nobody could have guessed that the reality of Italy's real financial health fell far short of Prime Minister Silvio Berlusconi's rosy pronouncements. Suddenly, Italy has been admitted to the Fiscal Hospital in critical condition. The main difference between Greece and Italy is that Italy's government is more likely to undertake decisive austerity measures. Frequently violent demonstrations in Athens have exposed profound divisions within Greek society. At the end of 2010, total Italian government debt stood at 119% of GDP, the second highest level in the Eurozone among Greece (142.8%), Ireland (96.2%), Portugal (93%), and Spain (60.1%). However, it is important to understand that it is not the nominal level of debt that is critical. What matters is how the debt relates to the size and growth of the economy. Thus, an economy can cope with any level of debt as long as country's income (GDP) grows at about the same pace (it's not much different from your personal fiscal situation), meaning that the ratio of debt to GDP remains constant.
A country finds itself in great problems only when the burden of servicing its debt is increasing faster than its income (which is exactly what has happened all over the world); the consumption rate of western countries has finally caught up with us.
We think that Italy's fiscal conditions are not beyond repair, since its deficit did not explode during the economic crisis (as Greece's did). Therefore, we strongly believe that the implications of the European crisis are ephemeral and the situation will resolve itself in due course.
While we do not want to underestimate the severity of this crisis, we think it will have only limited impact on the markets and on the Euro currency, and that the Eurozone will remain politically and fiscally intact in the foreseeable future.
- Recovery
We expect the second quarter earnings reports to be neither exceptionally good nor particularly bad, and anticipate the current anemic growth of the US economy to continue in the foreseeable future. Nobody expects miracles from or forecasts disaster for any of the large companies in the United States. Therefore, we do not think that the earnings reports will influence the markets significantly. It remains unclear whether the improvement of the bottom line should be attributed to the revenue growth or to the reduction of expenses. The increased attention to earnings should help shift investors' focus back to fundamentals and bring some respite from the negative headlines that have been recently plaguing investor sentiment. The good news is that the malaise in the macro environment might not necessarily lead to weaker financial results. We saw this trend take place during last year's so-called "softer patch," and we believe that this trend will reappear.
- Unemployment Picture
To put it bluntly, the unemployment picture in the United States remains nothing short of disastrous. More specifically, according to the Labor Department, there are 4.6 unemployed workers for every opening, on average (in Arizona, there are 10 job seekers for every position). About 7.5 million people are collecting unemployment benefits, but the national 99-week unemployment benefit legislation has been terminated, and jobless workers are quickly moving towards the expiration of state unemployment aid. Nearly $2 out of every $10 in the wallets of American consumers has been received in the form of jobless benefits, food stamps, social security, and disability payments according to a recent study by Moody's Analytics. With the headlines regarding unemployment as gloomy as they are, there is no question that consumer spending is not going to be robust.
Since consumer spending accounts for an estimated 60-70% of the country's economy activity, it is very unlikely to expect a vigorous growth of the US economy.
- Housing
Unfortunately, we have not overcome many economic and structural issues which greatly inhibit any kind of structured recovery, and the US housing situation remains an extremely painful blister. While there are several islands of positive real estate news in the country (home prices in San Francisco, Manhattan, and Boston are on the rise), most housing prices continue to drop. Recent data continues to herald a decline of the disproportionately high housing prices of the early 2000's, and most economists estimate that it would take at least six to eight years for these imaginary prices to return to reasonable levels. Foreclosures continue to be widespread (to put it lightly). Banks are reluctant to show the inventory of non performing loans on their books. In addition, the situation is exacerbated by a new phenomenon: homeowners whose mortgages are underwater stop making payments - not because they cannot afford them, but because it makes perfect economic sense to walk away rather than continue throwing money into the wind! It seems that the only optimism regarding the housing market is coming from real estate agents. The ominous drop of Standard and Poor's Case-Shiller index (a key measure closely watched by economists) casts significant doubts on a quick housing market recovery. Moreover, the seemingly perpetual, unresolved mess with Fannie Mae and Freddie Mac does not reflect favorably on real estate's already-bleak recovery prospects.
Review of Q2 Performance
Together with this newsletter, you are receiving your Q2-2011 report. You will see that most of the equity accounts have performed on par with the S&P 500, and fixed income accounts continue to yield a constant stream of income. We are exercising considerable caution in our equity accounts: keeping some cash available for further purchases, significantly diversifying the portfolio, carefully considering equity position allocations, and taking protective measures in the form of options, commodities, etc.
Q3 Portfolio Positioning
So, how do we position our portfolio for the third quarter? Until at least some clarity on all of the abovementioned issues has been attained, we will continue to position our portfolios with utmost caution. In our Safety portfolios, we remain heavily weighted on the shorter end of the yield curve (i.e. buying shorter term fixed income instruments rather than chasing an additional percentage point of interest), and carefully evaluate every single issuer of debt. In our Equity portfolios, we maintain a reasonably high exposure to oil and oil-related stocks, while diversifying to various types of commodities such as Gold and Silver in more aggressive portfolios. We have also shifted our emphasis to large-cap, deep value, dividend-paying stocks while moving away from most aggressive positions. Individual stock selection has become as important as ever, and you should expect to see more frequent trading in your accounts.
Three main sectors which attract our attention for the second half of 2011 are energy, healthcare, and financials. We strongly believe that the insatiable appetite of the so-called "emerging" economies (China, India, Brazil, and Eastern Europe) and the continuing turmoil in the Arab Peninsula and Northern Africa will prevent a significant decline in oil prices. The aging US population, increasing cost of healthcare, and the complete mess with healthcare reform define the second theme. All of you know the infinitesimal interest rate you are getting on your savings accounts, so it's hard to imagine that financial institutions will not show a significant profit in the foreseeable future.
As always, we appreciate your business. Do not hesitate to call us with any questions you might have, and refer us to your friends.
Vega Capital Group Team.
|
