Despite a nice relief rally in the first quarter, investors were once again overwhelmed with renewed fears of a Euro Zone collapse which contributed to the increased volatility sending the S&P 500 down 3.28% in the second quarter of 2012, but still up 8.31% year-to-date. Other issues causing increased volatility included concerns surrounding the fiscal path of the United States and fears of a Chinese slowdown.
Similar to 2010 and 2011 mild improvements in the global macro-economic landscape have been overshadowed by the threat of a disorderly Greek default and broader fears of the solvency and viability of the entire European Union.
The latest developments in the European debt saga have instilled pockets of confidence in the broader market as EU leaders agreed to increase bailout funds for Spanish banks further demonstrating their commitment to preserving the European Union. The essential issue at the core of this crisis is that Europe has a currency union but not a fiscal union. Subsequently, if one of the EU countries encounters severe difficulties (as seen with Greece) there is no automatic transfer of resources from the rest of Europe (as would be the case in the United States). Therefore, a troubled country also has no ability to devalue its currency to stimulate growth and so it languishes in recession. The result has been budget deficits and growing government debt in many of the troubled countries.
Meanwhile, fundamental disconnects between EU leaders still exist. Germany coupled with their northern counterparts, remains reluctant to approve monetary support for their recession ridden southern neighbors without more fiscal control and austerity measures implemented. However, the political climate is putting increased pressure on Germany to accept some plan to issue a common European debt instrument. Any developments to entertain pooling at least some of Europe’s debt obligations would be a positive catalyst for the markets.
Consistent with the “risk-off” mentality that accompanied much of the second quarter of 2012, the overall bond market provided strong returns even as interest rates hit record lows. U.S. equities outperformed their global counterparts for the 3rd consecutive quarter, further demonstrating the strength and resiliency of U.S. corporations in this uncertain environment.
As has been well reported over the past several months, the United States is potentially facing the largest fiscal drag in decades. At the end of 2012, several tax hikes and spending cuts are currently scheduled to hit simultaneously, sparking fear that the U.S. will plunge over the “fiscal cliff”. The cumulative impact will be more than $600 billion in fiscal drag, or roughly 4% of U.S. GDP.
Unfortunately, the impending November election is likely to be highly bitter, and may very well increase partisanship in both the House and Senate. It is likely that Congress will produce an eleventh-hour compromise that is likely to delay part or all of the fiscal drag.
Meanwhile, domestic housing and manufacturing data suggest that the U.S. economy is trudging forward. The momentum on the employment front seems to have tapered off in the second quarter as seasonal weather shifts most likely accounted for the better than expected first quarter results. As we mentioned in a recent weekly update, just 2.1% of U.S. GDP was derived from exports to Europe in 2011, which illustrates that a recession in Europe resulting in a net decline in exports to the Euro Zone would have minimal effects on our economy. Despite all the gyrations in sentiment most analyst predict the U.S. economy to grow at 2% – 2.5% through the remainder of 2012, while global growth is expected to grow at roughly 3%-3.5%.
Although the unemployment rate has declined to 8.2% from its peak of 10% in October 2009, it remains well above historical averages and the Federal Reserve’s comfort level of 5.2%-6%. Assuming GDP remains below trend and inflationary pressures are subdued, the Fed can be expected to maintain an accommodative monetary policy stance in order to promote higher economic growth and stable job growth. The Fed recently supported their accommodative stance by extending operation twist through the end of the year and many analysts predict additional stimulus in the form of QE3.
Throughout the remainder of 2012, we expect volatility to remain elevated, due to Europe and U.S. political uncertainty. In this type of uncertain environment equity markets could move higher if we get more clarity on these issues. Valuations remain compellingly in favor of equities and a disciplined diversified portfolio remains the most prudent strategy to navigate this environment.