Financial Update

Financial Market Update

The latest newsletter from Grant Cleary Wealth Management - full newsletter on their website:
www.cleary.co.nz

Market Summary

Sept Quarter

The quarter ending September 2011 continued the story of the year where remarkable events continue to happen on what seemed like a daily basis. Indeed, during the quarter we had four successive days where the Dow Jones moved by more than 400 points, which was unprecedented. For the quarter, the S&P 500 was down 14.3% in US$ terms bringing back memories of the worst of the GFC. The sell-down gained pace as the quarter went on as volatility became the norm.

The market was down 2.15% in July, 5.68% in August and 7.18% in September. The sell-off, on the back of declines in the market in the second quarter was driven by three specific story-lines although their impact was cumulative. The market swoon essentially started when Standard & Poors (S&P), one of the three main rating agencies, downgraded the United States Government debt on August 6th. S&P cut the rating from AAA (the highest rating) to AA+ after warning the US a number of times about their unsustainable fiscal path.

While the other ratings agencies, Moodys and Fitch, chose not to follow S&P, the downgrade set off a stampede out of all risk assets and a bout of quite remarkable volatility. What was particularly strange to non-market participants was that the only asset which rose in price during this period of volatility was US Treasuries, the very asset that S&P said was now worth less! The downgrade is largely symbolic. S&P are not incorrect in saying that the fiscal outlook for the United States is bleak. The budget deficit this year is still in excess of US$1 trillion dollars and there has been little serious debate about tax or entitlement reform in order to close the yawning gap now and into the future. In fact, the US is the only country that has no plan to reduce its debt. Even Greece has a plan to reduce its debt. However a US default is basically an impossibility.

The United States borrows money in its own currency and can print as much of that currency as it pleases. A credit rating agency is not supposed to make a judgement about whether the dollars it repays the debt with will be worth less in the future because there are more of them (commonly known as inflation). A credit rating is meant to assess the chance of default. As one commentator memorably described, the United States can no more run out of dollars than a bowling alley run out of strikes! The bond market is the only arbiter of US budget position. If they believe that the US will start running the printing press, they will start to demand a higher interest rate to compensate for the diminished value of their principal when the bonds mature. At the moment however, with all the market turmoil of late, bond buyers are stampeding towards US Treasury bonds in effect saying that they are comfortable with little or no return in order to avoid the losses they may suffer on Euro debt, equities and commodities.

The next rationale for the market swoon was the increasingly weak US economy which has triggered fears of a double dip recession. Unemployment remains stubbornly high at an official 9.1% (and in the teens unofficially if you add those who have dropped out of the workforce because they cannot find work). Economic growth is weakening and fiscal stimulus is starting to be retracted. A slower economy usually implies lower profits for companies and therefore lower share prices.


Finally, as Americans wrestled with their own intractable economic problems, they gazed across the Atlantic to see that Europe is doing even worse. The situation in Greece continues to deteriorate and there is no chance that they will be able to meet the terms of the bailout package struck in June this year. Without further aid, Greece will have to default. The impact of that is severe as it will firstly imperil all the European banks who have held Greek debt as part of their regulatory capital.

Secondly, it will turn attention to the other southern countries who have debt positions not unlike Greece. Portugal is similarly weak, Ireland has a large debt from bailing out its banks, Spain has massive unemployment and Italy (with the third largest Govt debt in the world) is the rather large elephant in the room.

Unfortunately, the people responsible for trying to sort this out are politicians. These well-meaning people are possibly the worst set of individuals in the world to try and sort this out. First they are responsible to their own parties / countries and so all have different self-interested objectives and goals. Secondly, politicians, at all times and all places, are infamous for failing to take hard decisions unless they have to. No politician takes a course of action that will upset people unless they really have to. Kicking the can down the road is always the preferred option.

Ultimately, in situations like they are currently faced with, the best alternative of action sometimes is simply to take your losses. This will cause short-term pain, but everyone will be better off in the long run. The longer you forestall dealing with an issue, the worse the outcome will be. At some point, the Europeans are going to have to deal with their debt issues by forcing losses onto holders of the debt. The solution is actually remarkably easy even if the politics are not.

The politicians need to ring-fence the countries which are likely solvent (Italy, Spain, Belgium) from those which are effectively insolvent with unmanageable debt burdens (definitely Greece, probably Ireland and Portugal). The insolvent countries are put into a form of sovereign bankruptcy with bond holders taking a loss. The EU with support from the IMF assists with bank recapitalisation plan to ensure that banks are able to survive the debt defaults. This is likely funded by some sort of Eurobond with enough firepower to support the illiquid but solvent countries of Italy and Spain.

Greece can actually stay in the Euro in the interim but then must decide as a nation whether they want to be part of the Euro over the long term. Greece will be locked out of the debt markets which will force them to either balance their budget or move out of the Euro and back into the drachma.

The economics of the current situation is certainly hurting markets and asset prices but politics is making it worse. The intransigence of the US political system (with the Republicans odious „no new taxes‟ mantra stifling any rational debate) has the same negative impact as the political uncertainly of Europe which requires 17 nations to unanimously agree on any decision. Politicians really do need to stop making this mess worse.

Another aspect of the debate currently is the tension between austerity now and additional fiscal stimulus. There are many who argue that the focus on balancing budgets is counter-productive. Withdrawing Government spending from an anemic economy will only exacerbate the weakness and bring on a recession. With recessions having a negative impact on Government fiscal balances (due to lower taxes), the austerity simply worsens the fiscal position. Greece is living proof of this. As they cut their deficit aggressively, they have simply magnified the problem because the economy has shrunk.

The best solution, as is being employed by the UK, is a slow withdrawing of stimulus coupled with a responsible long term plan for budget prudence. New Zealand is also trumpeting this gradualist approach although this has been partially forced through the circumstance of the massive spending required to fund the Christchurch earthquake recovery. But the government has made plain that they wish to return the fiscal budget to a surplus by 2015 although the projections for the dissolution of the fiscal deficit is somewhat optimistic in our view.

Australia has a different problem. Julia Gillard has been unable to get any reforms through Parliament due to her razor thin majority. The country is doing ok economically but has a major problem due to the mining boom. Mining will boom next year with upgrades to Olympic Dam and new mining activity in Pillbara coming on-stream. Unfortunately, the economy is already running at full capacity which means inflation is a credible threat. The problem with mining is that it is very capital intensive and it appropriates a lot of the investment capital of the nation. While capital hungry, mining does not however employ a great number of people. This leaves the nation starved of capital for investment into other activities which might generate jobs and incomes.

Gold was on a tear during the quarter breaching US$1900 in late August (appropriately given its chemical symbol) before settling back down in the US$1600‟s by the end of the quarter. In fact, the performance of gold became rather perplexing in terms of the rationale for holding it. While it was going up, gold bulls said this was because it was the only true money given the threats to the fiat currencies posed by huge debts. As Governments printed more money, so the argument went, these currencies would become devalued against tangible assets like gold which cannot be manufactured by Central Banks. But towards the end of the quarter, gold started reacting like other commodities surging or falling based simply on expectations for global growth. Indeed, the market became extremely binary in nature.

Trading days were simply either “risk on” or “risk off” depending on the progress of the European bailout. „Risk off‟ days saw US treasuries rise, US$ rise, equity and commodity markets fall. „Risk on‟ days saw NZ$ climb, equities rebound, bonds fall and commodities gain.

These sorts of markets are extremely dangerous because standard diversification between bonds and equities does not provide any correlation benefit. It is essential to have other uncorrelated assets including global macro hedge funds, infrastructure and private equity assets.