July 2011

Dear Clients and Friends,

The stock market gave back some first quarter gains however it remains in positive territory for the first half of the year. Worries over the European sovereign debt crisis, extensions of the US debt ceiling, the ending of the Federal Reserves quantitative easing (QE), political unrest in Egypt and Libya, and the aftermath of the Japanese tsunami all contributed to investor concerns.  The good news was that the quarter ended on a very strong note, with the week ending July 1 being the best in two years.

During the Federal Reserve’s quantitative easing, which ended in June, the Fed was the largest purchaser of US Treasury bonds which kept their yield low.  The ten year US Treasury bond declined slightly from 3.5% to 3.2% during the quarter, providing a small boost for bond markets and the Barclay’s Aggregate Bond Index (a broad bond market index with a high allocation to government bonds) had a small gain. 

Returns for key indexes (including dividends) were:

Economic and Market Outlook    Although economies around the globe are strengthening and corporate profits are rising, market uncertainties continue.   As of July 1 the Fed is no longer engaged in quantitative easing, resulting in uncertainty on long term interest rates. Although some progress has been made, the sovereign debt crisis in Europe continues.  A Congressional showdown over the US debt ceiling is likely and a partial shutdown of the US government is possible.  Although there are considerable risks in both the European debt situation and the US debt ceiling discussion, there are substantial reasons to view both of these issues from the “glass is half-full” perspective.

Although Greece represents only about 2.5% of the Eurozone economy a sovereign debt default by Greece could significantly affect investor confidence, even develop into panic and severely disrupt global financial markets.  The probability of this occurring appears low since the key Eurozone economic powers of Germany and France have shown flexibility and the commitment to minimize the possibility of a default over the near term and / or to ensure that if a default does occur it will occur in a controlled manner with intervention by the European Central Bank (ECB).  In addition to Greece, the risks of other European countries defaulting on their debt is elevated, but the more time that elapses, the more time the ECB and other nations have to develop contingency plans and mitigate the possibility that this could develop into a Lehman-like financial crisis.   Due to these concerns, European stocks are inexpensive compared to other sectors of the world and should benefit if investors become confident that a default by Greece will not create havoc in the European financial markets.

Another investor concern is a possible congressional stalemate over raising the US debt ceiling. Contrary to mis-leading comments from some media and politicians, this would not lead to a default on debt since there is more than sufficient revenue to pay interest on the debt.   However it could lead to a partial shutdown of the US government and this could slow the economic recovery.    In addition, as Federal Reserve Chairman Bernanke has noted, if the US does not address the high federal deficit, it will likely lead to higher interest rates, higher inflation, a decline in the US dollar, slower economic growth and higher taxes.

On the positive side, if Congressional debate results in meaningfully lower government spending (a reduction of at least 0.5% to 1% of GDP), that should benefit the economy in the long-run and could be a catalyst for a further stock market rally.

We do not expect that the massive deficits in the entitlement programs of Medicare, Medicaid and Social Security will be addressed until after the 2012 elections and perhaps not until a  Republican wins the White House again (whenever that might be).  However it will be difficult for Congress to ignore these deficits and eventually will have to deal with them.  If they do that in a meaningful way in the near future, it should benefit the financial markets.

We are certainly aware of the risks posed by the sovereign debt crisis in Europe as well as the debt ceiling debate in the US, and are prepared to take steps to reduce risk in investment portfolios if necessary.  We also recognize that these uncertainties may also create buying opportunities and are prepared to take steps to attempt to capitalize on them as well.  At the moment we view this as a “glass half full” environment.

In June the Federal Reserve ended its program of buying US Treasury and mortgage backed bonds (called quantitative easing or “QE”) begun in the aftermath of the 2008 credit crisis to provide liquidity to the financial markets and keep long term interest rates low, making it attractive to individuals and companies to make purchases of items such as real estate, vehicles, computers and business equipment.  QE dramatically increased the money supply and lowered long term interest rates.  Over time we are likely to see higher interest rates and rising inflationary pressures resulting from a larger money supply.  Quantitative easing of this magnitude is unprecedented and it is not known how high or quickly interest rates or inflation will climb.  In this environment it will be important for investors to remain nimble and seek out investments which should do well in a period of rising inflation such as TIPS (inflation protected bonds), precious metals, commodities, natural resources, foreign currencies and high yield bonds.

Developed vs. emerging market investing   Historically investing in emerging market countries has been much riskier than in developed countries.  In the past, potential risks included less government oversight and enforcement of laws, thinner markets, and irresponsible government financial policies.  This has been changing as the governments in many of the developing countries have adopted and enforce improved laws, the markets have developed and matured, and the countries have adopted prudent financial policies (arguably some are following more prudent financial policies than some developed economies).  As a result the risks posed by investing in the emerging markets have been reduced.  Further, their younger populations, strong economic growth, strengthening currencies and higher interest rates have made many of their stocks and bonds markets more attractive.

The “Bond King” disdains US Treasury Bonds           Bill Gross, manger of Pimco Total Return, the largest US bond fund, and who has sometimes been dubbed the “bond king”, now refuses to buy US Treasury bonds.  He feels that the US government is “picking the pocket” of investors by keeping interest rates low and encouraging inflation through deficit spending and quantitative easing.  Instead he prefers investing in foreign bonds and US blue-chip dividend paying stocks.

John W. Eckel CFP®, CFA