We are troubled by the recent turbulence in global stock, bond, commodity and currency markets. Especially disturbing is the plunge and heightened volatility in the U.S. stock market. Nevertheless, we believe the current storm will pass through without serious negative impact on the global economic recovery and we continue to recommend that investors maintain discipline with a positive outlook for global equities.
A consensus of financial market observers attributes the turbulence to the highly publicized debt problems of Greece, Portugal and Spain and the clumsy, unsynchronized response to the crisis by the Euro Area governments and European Central Bank (ECB). Our view is that the policy makers cannot afford the risks of sovereign bond defaults, which could well lead to a freezing of the European banking system reminiscent of the credit crisis conditions in the U.S. in early 2009. Europe has an even larger “too big to fail” banking problem than the U.S. Although a bailout of Greece and possibly other countries in the Euro Area is repugnant to many taxpayers, especially in Germany, we expect the finance ministers and the ECB will soon hammer out a solution sufficient to calm jittery markets.
An additional important factor exacerbating market upheaval is the aggressive and speculative pursuit of profit by U.S. and international hedge funds. Their trading desks are armed with powerful computers programmed to react almost instantaneously, often with leverage, to the latest news release or to shifting trading patterns in financial markets. The result can be a barrage of buy or sell orders in a chain reaction impacting stock, bond, commodity and currency markets around the world. For example, a recent worker protest in Greece against government austerity measures triggered a jump in European bond yields and a plunge in the euro and European stock markets, an immediate increase in U.S Treasury bond prices and a sudden drop in U.S. stock prices, a rise in the U.S. dollar and a sharp decline in commodity prices, and a selloff of stocks in the leading emerging economies of China, India, and Brazil.
Whereas hedge funds embrace heightened volatility as an opportunity to increase profits, long term investors are frightened by the risk to their portfolios and governments are alarmed by the destabilizing effects on their economies. Something must be done to prevent the hedge funds from converting financial markets into casinos and in the process driving serious, long term investors out of the markets. By some estimates, “high frequency” trading by hedge funds already accounts for more than 50% of U.S. stock market volume. Coordinated government regulation is urgently needed. We think that governments and regulatory agencies around the globe are finally recognizing the severity of the problem and will take appropriate remedial action. In the U.S., we expect the Securities and Exchange Commission (SEC) to finally wake up from its decade long stupor and incompetence.
As we emphasized in our Review of the Fourth Quarter and Year 2009, we are convinced that equity strategies based on a 6-12 month horizon are more often correct and easier to implement successfully than short-term, market-timing strategies. We share the view of U.S. Treasury Secretary Geithner that a slowdown in Europe will not be great enough to derail the U.S. and global economic recovery. That is, we continue to forecast a multiyear global expansion similar to but not as strong as the 2003-07 expansion, and we continue to think this expansion will be accompanied by a bull market in equities and commodities.
The current European upheaval may have limited economic impact, but it will have important investment consequences. The most debt-burdened European countries will be forced to implement budget austerity programs, which will damage the euro and retard economic growth. Some countries may well sink into a double-dip recession, although the crippled euro will provide a partial offset by benefiting export-oriented companies. The upheaval diminishes the attractiveness of European stock markets, which to us had very limited appeal prior to the crisis. U.S. exporters to Europe will be impacted negatively by a shrinking market for their products and services and a strong dollar will hurt their competitive pricing capability. On the other hand, the American economy will benefit from reduced commodity prices (especially gasoline), lowered inflation expectations, and lower mortgage and corporate borrowing rates. A weakened European economy and currency will similarly slow exports from China, India, and Brazil to Europe (Europe is China’s largest export market), but we see this as a positive. As we pointed out in our May 12 blog on international stock markets, the major problem here is that these economies are overheating, and their governments are reacting to the increased fear of inflation and asset bubbles by adopting restrictive policies. The consequence has been a painful retreat in their stock markets. Slower exports to Europe will cool these economies, reduce inflation worries, and possibly lead policy makers to move to the sidelines. This, in turn, could provide a green light to the leading emerging economy stock markets even as the European markets are flashing yellow.
We are not complacent regarding our positive outlook. Financial markets have been rocked by numerous unanticipated developments over the past 2 years and more may be coming. We remain vigilant and flexible.