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Newsletter October 2011

October 2011

Download October Newsletter PDF

In the third quarter, volatility intensified again in global equities resulting in a broad decline in virtually all equity markets.  By quarter’s end, the Dow Jones Industrial Average had declined almost 15% from its April peak, while the S&P 500 was down 17% over the same period. Foreign equity markets fared even worse, as concerns over the potential contagion of the deepening sovereign debt crisis in Europe escalated.

On the fixed income front, S&P made the unprecedented move of lowering the credit rating of US debt, a shot across the bow to Congress to get its fiscal house in order. Meanwhile, following its August meeting, the Fed formally announced that it intended to keep interest rates low “at least through mid-2013.” In addition, they announced a new $400 billion program dubbed, “Operation Twist.” The Fed has already purchased over $1 trillion of primarily short-term US bonds over the past few years through QE1 and QE2. Under Operation Twist, the Fed will buy longer term US government bonds using sales or proceeds of maturing short-term bonds, theoretically driving down interest rates on long-term treasury debt in another attempt to stimulate the economy. 

Inside the European Debt Crisis
The headlines have been dominated by news emanating out of Europe regarding the reoccurring economic crises in the weaker members of the euro zone. In light of what appears to be a combination of dilemmas with respect to their present structure, the very essence of the 12-year-old experiment of a common currency, known as the euro, is being threatened.

Most Americans have a limited understanding of all the moving parts in European monetary and fiscal systems, which is unfortunate given the important role it is playing in the global economic landscape and the impact it may have on our futures. As such, we thought it would be helpful to provide a primer on the subject to give you a better understanding of the situation and any proposed solutions. A complete explanation of these entities and interrelationships is far beyond scope of this letter, but we will attempt to filter this in a fashion that will at least give you an adequate vantage point in understanding how this is playing out on the global stage.

Many refer to the European Union and the euro zone as the same thing, however, the euro zone (officially called the euro area) is a subset of the European Union specifically referring to those in the Union that have adopted the euro as their common currency and sole legal tender. Let’s begin with some background on how these alliances were formed.

The European Union is both a political and economic union that consists of 27 member states mostly from Europe. Its origin is rooted in the European Coal and Steel Community (ECSC) that was formed after WWII with the goal of promoting economic cooperation, eliminating conflict and maintaining lasting peace. The original six members were Belgium, France, Germany, Italy, Luxembourg, and the Netherlands. In 1957, the European Economic Community (EEC) was created by the six members of the ECSC as a ‘Common Market’ by the Treaty of Rome. As economic conditions improved in Europe during the 1960’s, the countries decided to stop charging duties on imported goods from other members and developed a plan of joint control over food production to assure that everyone had sufficient supplies of food.

The first new members were admitted to the EEC on January 1, 1973 as Denmark, Ireland and the United Kingdom raised the number of members to nine. Shortly thereafter, the Arab-Israeli war created economic and energy strife throughout Europe resulting in transfers of resources to help poorer countries. These difficulties also led to civil unrest that encouraged the fall of dictators in Portugal and Spain, opening the door to further expansion of the EEC. 

By the early Eighties, Greece, Portugal and Spain formally joined the EEC. In 1987, the Single European Act was signed creating the framework to eliminate problems with the free-flow of trade throughout Europe and the formation of a “Single Market.”  

As communism crumbled throughout Eastern Europe following the fall of the Berlin Wall, the implementation of the Single Market was fully launched with the guarantee of the four freedoms: movement of goods, services, people and money within the member states. The European Union was formally established in 1993 with the signing of the Maastricht Treaty laying out a timetable for the implementation of a single market economy across Europe.   The multi-stage implementation of the European Union led to the formation of the euro zone, which consists of members qualifying to operate under a single euro currency. Preparations for the conversion formally began in 1999 and were completed in 2002. Currently, 17 of the 27 European Union member states are operating under the euro zone. 

There is no common representation, governance or fiscal policy specifically for the euro zone, but there is some coordination with the European Union through the Euro Group, which makes political decisions regarding the euro zone and the euro. The Euro Group is composed of a president and the finance ministers of the various euro-zone states.  In emergencies, national leaders of other member states may also have a say in the Euro Group matters.

The 27-member European Union has multiple governing bodies that oversee different aspects of the union’s operations. The European Commission is the executive body of the European Union and is responsible for proposing legislation, implementing decisions, upholding the Union’s treaties and the general day-to-day running of the Union. The European Council enforces legislation for the Union and seeks to improve cooperation between governments. In addition to these governing bodies, there is the European Parliament, which serves as a public forum of the EU debating important issues and overseeing the activities of the Council and Commission.

Monetary policy for the 17-member euro zone is the responsibility of an independent European Central Bank (ECB), which is governed by a president, currently Jean Claude Trichet, and a board consisting of the heads of national central banks. In this respect, the ECB is similar to our Federal Reserve Bank; however, the ECB has a single mandate of keeping inflation under control, whereas the Fed had a dual mandate of price stability and full employment. 

Economic Trouble in the EU
Before the launch of the euro in 1999, world-renowned economist and Nobel laureate, Milton Friedman, encouraged the euro zone to abandon the idea of a single currency platform. If they chose to proceed, he predicted that the euro zone would not survive its first major economic crisis. Mr. Friedman recognized what may prove to be a fatal flaw of this currency union, which is, without flexible exchange rates of currency, imbalances will be created as individual member states have limited mechanisms to deal with their own economic cycles.

The problem arises because each member state has full control of fiscal decisions such as tax rates, entitlements, and government spending. In addition, they each have differing societal views on saving, consumption and work ethic. Collectively, these dynamics have consequences that create differing economic outcomes and cause imbalances between members with no monetary means to address them. For instance, low workplace productivity, unrealistic entitlements, and lax tax enforcement in Greece have resulted in skyrocketing deficits and stifling debt that has placed it on the brink of insolvency.   

In the absence of a common currency, a country in these circumstances could lower their interest rates to stimulate domestic demand which would lower the value of their currency, thus making their exports more competitive. For example, since Greece depends heavily on tourism, a weakened currency would lower the cost of travel to Greece, thereby attracting more tourists which boosts the country’s revenues. Since these mechanisms were not available by virtue of their common currency, Greece was forced to deficit spend and accumulate debt to run their economy to the point that they simply cannot make the payments on this debt. As a result, foreign holders of Greek debt are now demanding interest rates in excess of 25% on ten-year bonds and 74% on two-year bonds, making it impossible for Greece to finance further debt or refinance existing debt that is maturing. In the open market, Greek debt is now priced under $ .50 on the dollar. Without the ability to borrow additional money, bankruptcy is inevitable.

In light of these circumstances, the other members of the euro zone are facing a true dilemma. Either they let Greece fail and destabilize the euro, or they can attempt to create structures to allow Greece to survive at great cost to their respective countries. So far, they have chosen to postpone bankruptcy by first creating a $100 billion bailout package in 2010 and eventually increasing it to $157 billion in 2011 allowing Greece to borrow through the ECB subject to the implementation of strict fiscal measures including austerity, tax increases and asset sales. The borrowing was set up in tranches that would be released based on achievement of specified benchmarks. In return, Greek leaders have pushed forward with draconian cuts to pension benefits, health care, and other public services while raising taxes and heightening enforcement of existing taxes.

So far, this has proven to be ineffective because the austerity measures have shrunk spending thereby reducing revenues which puts Greece right back where they started with even more debt. Meanwhile, the severity of the austerity measures has fueled bouts of civil unrest, as most Greek citizens feel the measures are far too harsh.  Leaders of the member nations that are funding these programs are finding it progressively more difficult to sell taxpayer-funded bailouts of other countries to their citizens.   

Another complication in this crisis is the fact that Greece’s debt is primarily owned by member nations’ banks, pension plans, insurance companies and the ECB. It is estimated that 60 percent of Greece’s $300 billion debt is owned by a combination of these entities and the IMF.  If Greece is allowed to default on its debts, it will ripple through the entire European financial system. Euro-zone leaders are feverishly working to create a mechanism to stabilize their financial institutions in the face of a possible orchestrated Greek default, as well as, a template to deal with other weak members of the Union in the future. The sheer magnitude of the complexities of the governing bodies surrounding this Union with their individual sovereign interests is making it extremely difficult for it to act in a timely manner in response to this recent set of crises. Many of the actions require unanimous consent of all member states.

The primary criticism of euro-zone leaders has been their unwillingness to acknowledge the depth and breadth of the crisis and their inability to develop a solution. This failure to adequately address these problems has significantly raised both the stakes and cost of a solution, as fears of contagion to other weakened members such as Portugal, Italy, and Spain continually rattle the markets. For instance, their initial bank stress tests deemed Irish banks to be sufficiently capitalized only to enter into bailouts within six months. This week, Dexia, one of Europe’s largest municipal lenders who passed the European Banking Authority’s more rigorous bank tests in July, announced they were breaking up—forcing Belgium and France to backstop their losses.

Thankfully, there has been some movement, as member states agreed to the establishment of the $660 billion European Financial Stability Facility (EFSF), a special purpose vehicle financed by members of the euro zone to combat the sovereign debt crisis. The facility can raise the funds to provide loans to euro-zone countries in financial trouble, recapitalize banks or buy sovereign debt. The Facility may be combined with loans from another vehicle, the European Financial Stabilization Mechanism, and the International Monetary Fund (formerly run by the infamous Dominique Strauss-Kahn) to create a financial safety net in excess of $1 trillion. However, despite its size, it has been judged to be woefully inadequate and efforts are already underway to approve a substantially larger facility.  

Impact on the World Economy
This ongoing European crisis has been a major factor fueling the recent exaggerated volatility in the equity markets both here and abroad. Couple this with the tepid global recovery, the Japanese earthquake, the Arab spring, and the political dysfunction in Washington, and it is no wonder that consumer confidence is waning. The markets have reflected this combination of circumstances and sentiment, not only with the recent sharp downturn, but also in the fact that equity asset class diversification has not provided its long-term dampening in volatility because virtually all equity asset classes have been affected with fixed income serving as the only safe haven in the short run. 

The fact is the economy is recovering albeit slowly, unemployment is elevated but stable, and corporate earnings and balance sheets are in the best shape they have been in recent history. However, the anxiety caused by the unresolved issues, both here and in Europe, has the potential to become a self-fulfilling prophecy and derail the recovery. On the contrary, if our political parties begin working together on domestic issues and the European countries get their collective act together by implementing substantial structural reforms, confidence and energy will return to the global economy and the recovery will gain momentum.

The set of circumstances we face today, like many we have overcome in the past, will be resolved, one way or another.  As such, we remain committed to our disciplined approach of prudent asset class diversification, adjusted to an individual’s personal circumstances and tolerance for risk. We are equally confident that, in the long run, tried and true tenets of prudent investing will prevail.

Investment indices are represented by the S&P 500 and Dow Jones Industrial Average. Performance of these indices is not indicative of any particular investment. The indices are unmanaged and individuals cannot invest directly in any index. The Barclays U.S. Aggregate Bond Index is comprised of a variety of taxable bonds, and is used as a measure, or benchmark, of the US bond market. No strategy including diversification can guarantee a profit in a down market. Past performance does not guarantee future results.