Terrific piece from the always insightful Jeremy Grantham of GMO on the state of the financial markets and where things may be headed:
The second quarter of 2011 saw equity markets close down slightly over the last quarter – the S&P 500 began the quarter at 1,325.83 and ended at 1,320.64. Losses were on track to be far more substantial until the last week of June when the S&P 500 rallied over 50 points in the final 4 trading days after news of the Greek bailout and some encouraging US economic data.
Commodities, after experiencing an impressive two year long run-up, fell sharply in the second quarter. Crude oil, which touched $115.52 per barrel on May 2nd, sold off to $89.61 by June 27th as economic indicators pointed towards a slowing global economy. Mirroring the equity market rally, crude oil (and commodities as a whole) rebounded a bit in the last week of the quarter, closing at $95.08 on June 30th.
Perhaps the biggest news this quarter was the highly anticipated end of the Federal Reserve’s second quantitative easing program. QE2, as it has come to be known, saw the Fed invest $600 billion into US treasuries in an effort to keep interest rates low, promote economic growth and stave off any signs of deflation. It is debatable whether or not this program resulted in any long-term benefit for the US economy, but it certainly did provide monetary rocket-fuel for the rally in stocks and commodities.
When Ben Bernanke announced the QE2 plan on August 27th, 2010 the S&P 500 was trading at 1,064 (mired in a summer slump after peaking at 1,217 on April 23rd). Once the QE2 announcement was made, equity markets promptly rallied for the next 8 months, peaking at 1,370 in April 2011 on the belief that the Fed’s policies would provide the necessary support and impetus to boost economic growth.
Now that the second round has expired, and the possibility of a third round looks ever less likely, market participants may wonder whether equity markets can continue to move higher without that monetary stimulus. We are a bit skeptical that equity markets can rally further without this backstop and recommend clients remain defensive until it becomes clearer that the economy can stand on its own two feet absent the crutch of Federal Reserve support.
Greek Debt. Another summer and another quarterly letter with a section devoted to the debt problems in Europe. And despite the passage of the latest round of bailout/austerity measures in Greece, we don’t believe this problem is going away anytime soon. Most observers expect Greece to restructure its debt over the next few years. As with the Russian default of 1998, any restructuring or default, though widely anticipated, will shock the markets. We expect concern will move rapidly to other countries in peripheral Europe as Portugal, Ireland, Spain and Italy will likely be the next group to find themselves sitting in the debt crisis crosshairs. As with most crises of confidence, European authorities will have to decide where best to build a firewall. Tough decisions will be made and in its exhaustion, Europe will likely realize that not every troubled sovereign can or should be saved. We believe neither Spain nor Italy can be abandoned, and we do not believe Ireland deserves to be. But as with many things that spur strong emotions, these events may take on a life of their own and force elected representatives to act in a knowingly destructive manner, simply to deflect virulent public opinion.
Debt ceiling debate. Meanwhile back on our side of the pond, a similar dynamic is playing out. With their 2010 reclamation of the House still fresh, Republicans appear determined to use their voting power to force budget cuts before approving a raise in the debt ceiling. Democrats, meanwhile, strongly prefer reducing corporate tax breaks and other revenue raising measures as a solution. Both sides are still far apart, but we expect they will find a workable solution before the August 2nd deadline. In our view, a workable long-term solution must involve both revenue raising measures and cost-savings in major programs, especially Medicare/Medicaid. We agree with many market commentators that a default on US debt would be catastrophic and hope cooler heads will prevail ending this game of debt/budget chicken sooner rather than later.
Regards,
Louis Berger Subir Grewal
We held our first “webinar” earlier this month on the timely topic of municipal bonds. We have posted the narrated presentation at www.youtube.com/wsqcapital for the benefit of those who were unable to attend. We plan to host three webinars this quarter:
To register for any of these webinars, please visit blog.wsqcapital.com. We will continue to add recordings of future presentations to our page on youtube. Feel free to pass along an invitation to anyone in your circle interested in learning more about these topics.
IRA contributions, Roth IRA conversions
Most taxpayers can make IRA contributions for the 2010 tax year up until the individual tax-filing deadline, which is April 18, 2011 this year.
Roth IRA conversion rules have changed and virtually anyone can now convert a traditional IRA into a Roth IRA. Partial conversions of an IRA account are also permitted. Please contact us if you’d like to discuss specific issues surrounding your circumstances.
Interest Rates & QE2
In prior letters, we have discussed the extraordinary measures the Federal Reserve and other central banks around the world have taken to keep interest rates at historic lows. Short-term rates in the US remain below current inflation levels, which means savers are being penalized for holding cash. This is no doubt due to the actions of the Fed which continues to purchase the bulk of newly issued US Treasuries under its Quantitative Easing program. We estimate short and medium-term rates are 1.5% to 2.0% below where they would otherwise be.
Meanwhile, the flames of inflation have begun to flicker. A combination of increased demand and easy money policies has driven up food and commodity prices. If this trend continues, maneuvering through the obstacle course of rising inflation will take a toll on the global recovery. And as is usually the case, the burden will be heaviest for the world’s poorest who spend a higher percentage of their income on necessities. We are beginning to see some policy action and rate hikes in developing markets. Unless inflation levels stabilize quickly, this will begin to impact global trade. We caution bond investors that future returns are likely to be lower than those in recent years past. We continue to recommend high-quality bonds with 3-5 year maturities.
Budgets and Bluster
The issues facing most developed-market governments are remarkably similar whether we are talking about Greece, Ireland and Spain, or the US, California and Illinois. The long-term challenge involves tackling unfavorable demographics and enacting the painful policy reforms required to tackle the cost of social programs. In the short term, the double-whammy of a real-estate/financial crisis requiring an immense expenditure of government support, followed by a great recession driving down tax revenues have created huge deficits. The exact mix differs: in Ireland the cost of a bank bail-out has supercharged the national debt, whereas in Greece the crisis is compounded by a culture of tax-evasion and protectionism. In the US, the core problem is reforming Medicare and a health-care system that takes in more revenue per person and results in lower levels of health than those in other developed countries.
The imminent congressional debates over the federal budget and the national debt ceiling will bring fiscal issues front and center in the US. As the 2012 election campaign kicks off over this summer, we expect fiscal issues will be key in every race. In Europe, meanwhile, the moment of reckoning for Greece, Ireland and Portugal fast approaches. European institutions will either have to come up with a plan for debt-restructuring or direct support to assist struggling governments in the short-term. Meaningful progress towards the longer term demographic and policy challenges will also need to be made.
Nature, Energy and Politics
The March 11 earthquake and tsunami took a terrible toll on the people of Japan. The economic damage is also enormous as a significant percentage of the area’s power generation and distribution capacity has been offline for weeks, impacting businesses and residences across the main island of Honshu. Rolling blackouts have affected many areas, including Tokyo. Two nuclear power generation facilities (Fukushima I and II), with a total of ten operational reactors between them, suffered severe damage. It is now clear that all the reactors at Fukushima I will need to be scrapped. A large amount of fuel from the operating reactors and spent fuel stored at the facility has been damaged and released into the environment. The situation remains critical and the full extent of the crisis is still unknown.
Nuclear power generation requires operational and design expertise far more specialized than other forms of energy production. In general, the industry has recognized this and a great deal of thought and effort has been put into improving design and procedures. We should also not forget that most other forms of energy generation carry their own risks, and often a higher carbon footprint. For instance, the production and burning of coal costs numerous miners their lives every year, and damages the respiratory systems of populations globally. Hydro-electric dams have failed due to design faults or natural disasters causing a large number of casualties. We firmly believe renewable energy must be at the core of any long-term solution to global energy needs. Nevertheless, replacing our current energy infrastructure is a multi-decade project and represents an enormous investment. One step towards that process would be to accurately account for the true health and environmental costs of all forms of energy production. As things currently stand, the conventional energy industry derives numerous economic benefits from tax-breaks, favorable industrial policy and political gridlock in assessing the true environmental cost of greenhouse gas emissions.
With all this in mind, we believe certain modern nuclear plant designs can play a role as a crucial bridge technology. In many fast-growing economies, nuclear power is the only viable alternative to coal and gas for large scale power generation. It is clear though, that the nuclear industry will face tough public scrutiny and a risk re-assessment is underway. We are particularly concerned about the operational safety of nuclear power in countries without a strong tradition of accountability, independent oversight and open public discourse (see China). Some of these concerns are acute for certain developed nations such as Japan, which has few energy resources of its own and relies on nuclear power for 24% of its electricity needs. As a result, we continue to view long-term investments in renewable energy favorably.
Upheaval in the Middle East
Mass protests in the Arab world have captured the world’s imagination since the sudden, largely peaceful overthrow of Ben-Ali in Tunisia. We certainly do not believe every group engaged in protest has benign intentions and recognize that in some countries one repressive regime may be replaced by another. That said, we are hopeful the power of public protest and increasing civic engagement by ordinary citizens will transform the moribund political and economic regimes in the region. For the time being, we expect this part of the world will continue to experience upheaval over the next decade or more. In many of these societies, oil wealth has distorted economies and politics. A demographic bulge is now bringing about rapid change. Investors should remain aware that demographic and political change may cause certain markets to be disrupted over the next decade.
We are positive on emerging markets in the long-term, but advise caution for the present since asset prices have risen very rapidly. Further rises in oil prices could accelerate inflation and lead to a slow-down in global growth, which would impact emerging markets negatively.
Regards,
Louis Berger Subir Grewal
We held a webinar earlier this month on municipal bonds. We provided a basic overview of the municipal bond market and discussed recent events. We’ve now posted a replay on youtube, the links are below:
We always recommend national portfolios when managing a substantial allocation to municipal bonds. Clients often ask about losing the state tax income benefits by buying out of state municipal bonds. Our answer has always been that we believe it is crucial to control geographic risk and concentration, particularly since these can be idiosyncratic, tail-event type risks.
In past discussions with clients, we’ve focused on how certain states and municipalities can have an over-reliance on one or two industries and be impacted by a cyclical or secular downturn. We’ve also pointed out that certain natural disasters can impact a geographic area so severely that a short-term recovery becomes difficult or even impractical. Many disasters can erode the tax base and asset values to such an extent that creditors may suffer substantial losses in default.
For instance, environmental devastation during the dust-bowl era wreaked immense damage on agricultural production in many states and this impacted state and local finances significantly. The tragic events unfolding at present in Japan should remind investors that natural and environment disasters can devastate communities for extended periods of time. When these disasters come in the form of a dam failure or nuclear accident, they can make a large area inhabitable.
Such events are inherently unpredictable, and highlight the need for geographic diversification in investment portfolios of all types. Humans are fallible creatures, in investing as in many other things. Geographic diversification is a way to limit the impact of that fallibility.
