Friday, June 4, 2010

The less-than-perfect storm has picked up momentum

In our last Sunday evening piece on May 9th, titled 'Is it Contagion or a Less-than-Perfect Storm?,' we attributed the current market turbulence to the confluence of several factors rather than to Greek contagion alone.

Our list of non-Greek factors included regulatory and fiscal reform, monetary tightening in China, U.S. mid-term elections, geopolitical concerns, and the Gulf of Mexico oil spill, which has become the largest U.S. spill in history with resulting long-term implications for oil companies and offshore drilling.

More recently, we have had to expand this list to include the still unexplained May 6th 'flash crash,' growing geopolitical tensions in Korea, Thailand, and the Middle East (all hot spots that we will discuss on our client call this Thursday1), and persistent signs of stress in the short-term funding market, exacerbated by the potential for bank credit rating downgrades with the passage of financial reform.'' In addition, newspaper headlines are touting the worst May since 1940 for the stock market.'' Clearly, the less-than-perfect storm has picked up momentum.

Not surprisingly, this combination of factors has continued to weigh on capital markets.'' Since their respective peaks in mid-April, the MSCI Europe Index is down 18%, the FTSE 100 is down 17%, the MSCI Emerging Markets Index is down 12% and the S&P 500 is down 11%.

What is particularly notable over the last few weeks is the increase in the 3-month London Interbank Overnight Rate (LIBOR) and the related LIBOR-OIS and TED spreads, which measure short-term credit and liquidity risk.2'' Today's market participants keenly focus on movements in these measures because they widened leading into the 2008 global credit crisis and did so well ahead of corporate bond or equity market distress.

The key question we and our clients face is if this current equity downdraft and widening of short-term credit spreads is the harbinger of either a further major drop in the financial markets and a double-dip recession or simply one of many corrections we are bound to have for the foreseeable future in the face of the uncertainties mentioned above. ''

To address this question, we review current economic fundamentals, which continue to signal recovery and growth in most corners of the world.

We also explore how today is very different than 2008, given where we are in the economic cycle, the liquidity of U.S. financial institutions and expanded Federal Reserve policy tools, the existence of non-fundamental factors that may be contributing to widening spreads, fair valuations in equities, high yield, and real estate, and, finally, pessimistic investor sentiment.

Taken together, these differences versus 2008 suggest that another huge decline in the equity markets or a double-dip recession is unlikely.'' That said, we recognize that investor sentiment can shift quickly and dramatically, and sustained negative sentiment can become self-fulfilling.

The Latest Economic Data

The latest economic data illustrate that on balance the global economic recovery continues, and in fact, the OECD raised its global growth forecasts this past week. ''

In the U.S., the economic recovery continues and leading indicators point to forward growth.'' On the positive front, May consumer confidence measures were stable or improving, with the Conference Board Consumer Confidence Index jumping to its highest level since March 2008 on an improved 6-month outlook for business and labor market conditions.

Less positive, however, were the new order numbers in several manufacturing surveys; they remained firmly in growth territory but did weaken from April.'' In addition, housing data remains mixed with existing and new home sales robust in April but home prices as measured by the Case Shiller Home Prices Index falling modestly in March.

In Euroland, economic activity data remained favorable but consumer sentiment deteriorated.'' On the positive front, initial estimates for Q1 2010 GDP showed modest 0.2% growth from Q4 2009, and both the May manufacturing and services PMIs point to continued economic growth in Q2.

Consistent with these readings, business confidence generally remained stable in Germany and improved modestly in both France and Italy as companies anticipate a weaker euro may benefit exports and fiscal reform may hold down labor costs.'' Neutral to negative, however, was the modest fall in consumer confidence in all three of these major European economies amidst the sovereign debt crisis and pending fiscal reforms.'' ''

Japan's economic data have generally reflected a solid recovery, benefiting from strong exports.'' Q1 2010 GDP increased at a 4.9% annualized pace and accelerated from growth in the prior quarter.'' The new offers/applicants jobs ratio, which is a leading indicator, improved modestly.'' ''

Data in China remained robust in April, with industrial production and retail sales growth stable at 18%-19% year over year.'' Broad money supply grew 21.5% year over year despite recent increases in bank reserve ratios to help moderate economic growth and inflationary pressures.

Economic data broadly remains supportive of a continuation of the global recovery.'' Moreover, we believe it is important as well to distinguish between a deceleration in the rate of growth, which is evident in some measures above, and a decline in economic growth, which is not evident.

Is Today Developing into Another 2008?

The economic, policy, and financial market backdrops are very different today than in 2008, suggesting this market downdraft is more likely a correction than the start of a major market decline and a double-dip recession.

First, the economy is in the early-to-mid stages of a cyclical recovery as opposed to the end of a long period of economic expansion, as was the case in 2008. Underlying data demonstrate that the U.S. and other major economies are in the nascent phases of economic recovery, the OECD estimates that all of its member countries are in fact producing output below their capacity, and leading indicators point to continued growth in the quarters ahead.

In addition, monetary policy remains lax, which is traditionally supportive of equity appreciation and economic growth.'' By comparison, in late 2007 and early 2008, almost all OECD countries were generating GDP above their potential, monetary policy was much tighter, and leading indicators were signaling future economic contraction.

Second, U.S. financial institutions are better capitalized and major central banks such as the Federal Reserve already have a playbook to enhance liquidity if necessary.

To-date, it appears that U.S. banks have not experienced significant funding issues, in part because of several changes in the past two years:'' U.S. financial institutions have cut their reliance on short-term commercial paper by approximately half; they have raised capital such that their Tier one ratios (which measure their ability to absorb losses) have increased to 11% from 8-9%; and they have cleared up the uncertainty around asset values on their balance sheets.

In addition, the Federal Reserve has shown its propensity to act swiftly, re-instating its program to loan U.S. dollars to the European Central Bank (ECB) to enhance liquidity for European financials.'' Interestingly, only $6.4 billion has been drawn from the facility, compared with $430 billion at the peak of the crisis, suggesting it still remains less expensive for European banks to borrow U.S. dollars in the open market than through the ECB and Fed swap lines. ''

Third, the recent widening of funding spreads no doubt reflects renewed concerns about liquidity and credit risk.'' That said, spreads remain well below peak levels and often not discussed is the impact that new SEC regulations and potential financial reforms may be having on spreads.'' More specifically, new SEC regulations require money market funds to hold at least 30% of their portfolio in assets that can be converted to cash within 5 days and to shorten the weighted average maturity of their portfolio from 90 to 60 days.

As a result, money market funds' desire for shorter duration assets has likely pushed longer-term funding spreads higher.'' In addition, money market funds may be more hesitant to lend to banks given speculation that ratings agencies, including S&P, may downgrade bank credit upon the passage of financial reform if government support of the institutions is perceived to be reduced or eliminated.

Fourth, the major developed equity markets are less expensive today on an absolute basis than they have been historically.'' Heading into 2008, the picture was starkly different, with most equity markets trading above their historical averages.'' As a result, there is a greater margin of safety built into valuations today than in late 2007, when the market peaked.'' That said, it is important to be aware of both relative and absolute valuations when considering the attractiveness of any given market, as well as what is driving the cheapness.

For example, while Euroland equities are attractively valued on an absolute basis, they are at best fairly valued relative to the U.S.'' In addition, Spain and Italy are the main drivers of Euroland equities' attractive absolute valuations, as are European financial stocks broadly.'' As such, an investor would have to be comfortable with these sources of dislocation to buy Euroland at the index level.

By comparison, Germany'an economy that stands to benefit from global growth and a weaker euro, has a relatively healthy fiscal position and seems to be a favorite among investors recently'is only modestly undervalued on an absolute basis. And, in fact, Germany is expensive on some metrics relative to the U.S. and is also one of the few equity markets that is up YTD on a local currency basis.'' These nuances lead us to prefer U.S. and Japanese equities to Euroland equities. ''

A similar valuation story is found in the U.S. high yield market and real estate.'' The 9.7% default rate that is currently implied by high yield spreads is comfortably above the 6-7% range suggested by historical precedent at this point in the cycle, as well as the 2-5% estimates of Moody's and S&P.'' With respect to real estate, public REITs today trade modestly below their historical average using normalized cash flow.'' In 2007, this sector traded close to all-time highs.

Lastly, while investor sentiment is pessimistic today, this can be an important contrary barometer to the likely direction of the market.'' Unlike the relatively bullish sentiment and investor flows that prevailed throughout much of 2007, today's investors remain highly skeptical.

To wit, the recent American Association of Individual Investors survey revealed almost 2 bears for every bull, a reading in the 92nd'' percentile historically. Moreover, according to Lipper FMI, investors pulled $5.3 billion from equity mutual funds during the past week (the largest outflow since March 2009) and withdrew $16.7 billion including ETFs (the largest outflow since at least the summer of 2002).'' Because major market tops typically occur when investors are bullish and fully invested, the prevailing negative sentiment is a positive contrarian factor.

Potentially adding to investors' pessimistic inclination lately is the often-cited Wall Street adage 'Sell in May and Go Away.' This saying originated in England as 'Sell in May and go away.'' Go away till St. Leger's Day.''' St. Leger's Day marks the last leg of the English Triple Crown and typically takes place in mid-September.

It was viewed as the end of summer vacations and the resumption of trading in the markets; however, over time investors have interpreted the saying as 'stay away' through October.3

While there does seem to be some historical credence to this idiom, given that the average monthly returns from May through October are only 0.26% vs. 1.05% from November through April, much of the difference results from weakness in the month of September, not the early summer months.

Moreover, the economy's position in the business cycle is a far more important determinant of equity performance than any seasonal pattern per se.'' On the back of last year's cyclical recovery, the S&P 500 was up 18.8% between May and October, 2009. As such, we don't lend much credence to this Wall Street proverb.

In short, there are enough material differences between today and 2008 to make a repeat of that crisis unlikely.'' Of course, we recognize that market sentiment remains fragile and that negative perceptions can quickly become reality.'' Market sentiment does, however, work both ways, as a more optimistic shift can also lead to a sharp rally, as we have seen at times in recent weeks.

What are the Investment Implications?

On the positive front, the global economic recovery continues, policy is largely accommodative, the Fed has tools to help ease short-term liquidity constraints, and valuations are undemanding relative to history.

On the negative side, structural challenges will likely persist with high sovereign debt levels requiring fiscal consolidation and/or higher taxes, not to mention the confluence of factors adding to the uncertain backdrop.

Whether or not these longer-term structural issues actually undermine the current cyclical recovery will depend critically on investor confidence, which as we mentioned earlier, is the hardest factor to predict.

Therefore, our hurdle rate to add risk to the portfolio has increased, and we have reduced our risk exposure since early April.'' Our base case remains that ultimately policy responses globally will be sufficient to remove extreme tail risk and that global growth will remain intact.'' As such, we recommend that clients who can weather the volatility build toward or maintain their long-term strategic weights as absolute valuations are undemanding and economic data remains supportive.

For those clients who are underweight, we suggest using recent weakness to first average into U.S. equities and real estate.'' For the non-U.S. portion of the portfolio, we advise clients to fund Japanese equities first in light of attractive absolute and relative valuations.

With respect to European equities, which offer attractive absolute valuations but neutral relative valuations and significant uncertainty, clients should wait to allocate assets if they do not want interim volatility but may choose to slowly build positions if they have a long time horizon and prefer to be opportunistic.

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