November 10, 2011
Global Investment Markets Await Resolution of Euro-Deficit and Sovereign Debt Crisis
Most close observers agree that Greek private and sovereign debt is in virtual default. Ireland is in financial rehab. Portugal is dangerously near the default precipice. Spain’s balance sheet and banking system financial accounts are in a precarious state. Bond market vigilantes have now put Italy in play, pushing it to the political brink with a change of government underway. Too big to fail, too big to bail, Italy becomes the poster nation as the developed country deleveraging process continues.
Taken as a group, these five countries account for a mere 5.2% of the world’s GDP (Gross Domestic Product, or sum total of all global goods and services produced annually), and roughly 2.5% of the world’s stock market capitalization. At the moment, the so-called “Southern Tier” of the Eurozone holds the world’s financial markets hostage, forcing investors everywhere to assess the attraction of owning risk assets.
Meanwhile, in early October, a funny thing happened on the way to the financial market forum. Just short of a U.S. stock market bear signal (i.e., a 20% decline in share prices since the April, 2011 S&P market high), on October 3rd American equity markets bottomed and are now (despite yesterday’s swoon) up over 12%. After almost three months of overblown media-generated negative spin during the summer, investors in the U.S. (20% of global GDP, 44% of world stock market capitalization) appear to have realized the double-dip recession scenario isn’t going to materialize, and that economic growth in the rest of the world will be better than most talking heads had opined.
As the expert-generated doom-and-gloom noise and conventional wisdom lost credence, the markets began to focus on third quarter corporate earnings reports which continue to surprise on the positive side. To date, more than 80% of third quarter U.S. company earnings (up 17% year-over-year vs. 2010) have come in ahead of consensus expectation. In the end, stock prices correlate with the trend in corporate earnings. Stock valuations today, as measured by such metrics as price-to-earnings ratios (11x 2012 estimated earnings per share), equity earnings yields (at roughly 8%) vs. U.S. Treasury yields of 2-3%, and stock dividend yields of 2.1%, have tilted the playing field decidedly in favor of stocks.
Some “analysts” (media-speak for a reporter’s inability to find anyone to say for the record what the writer is going to go ahead and print anyway) are even beginning to voice the possibility of the beginnings of a new bull market in equities! Such an assertion is a bit premature to be sure, but investor market psychology in the U.S. today is so pessimistic that in the times ahead the very absence of bleak news might be enough to turn current investors’ depressing mindset into a more positive outlook. If so, price-to-earnings ratios in an under 3% inflation environment could be expected to improve with a change in psychology.
Another Side to Europe’s Malaise?
The U.S. financial market storm of 2008-2009 has certainly arrived in the developed countries of Europe. The reckoning for Europe’s entitlement-welfare culture is at hand. U.S. politicians and voters ignore Europe’s financial market and political turmoil at their own peril. The authorities in Brussels can hope at best to buy time with fiscal and monetary palliatives while the markets sort through the private and sovereign debt mess that has surfaced. Global financial markets are fully aware of what is occurring and are discounting the probable outcomes. As the news continues uncertain, amplified investment market price volatility is/will be the result. The essential question remains whether the global deleveraging and inevitable entitlement system reform can be realized in an orderly fashion.
The dilemma for investors today is whether to own risk assets in a world where possible erosion by administered inflation (i.e., central banks printing money) could result in negative REAL returns, or whether to take advantage of today’s price opportunities and current values offered in the global equity markets. The reaction on the part of all at a time like this is to overreact to good or bad news. The tendency is to allow our investment decisions to be dominated by short-term concerns. Our disciplines suggest for investors with the longer view, rebalancing toward the more out-of-favor equity sectors (e.g., natural resources, emerging markets and global real estate) is the more sensible course.
Should you have any questions or comments, please let me know.
Best,
James L. Joslin
Chairman & CEO