October 19, 2011
If investors feel that global stock markets have been unusually volatile of late, evidence supports their views. Trading in the Dow Jones Industrial Average during the last 11 years (2000–2011) has been more volatile than any time during the last 100 years — with the exception of the 1930s. The S&P 500 recently joined global markets, even if only briefly, in bear market territory when its intra-day declines from the recent peak exceeded 20%. As if on cue, reports emerged from the European Union about bank recapitalizations, and market volatility turned to the upside. Importantly, we also enjoyed a turn in the tide of U.S. economic reports, which further supported the rally.
European leaders have been criticized for playing "small ball" at a time when much bolder action is required. Market pressures on major French banks may have been the final straw. Current planning appears focused on the required "haircut" of Greek debt, recapitalization of European banks and increasing the size of the European Financial Stability Fund (EFSF). Intermediate term, the European Union needs to improve its competitiveness and governance to assure investors that Spain and Italy won't lose market confidence. We stand by our view that Europe will take the necessary actions, likely at the last moment possible, to stave off a greater financial crisis.
While European growth has suffered of late, and the European Union may enter a shallow recession, recent data on U.S. growth has been better than expected. Consumer spending has held up well through the third quarter, we have seen solid Purchasing Managers Index reports and the labor markets have modestly improved (with a long way still to go). So while the U.S. economy may be set to avoid recession, stock market volatility likely will not recede until the worst of Europe's problems are in the rear view mirror.
- Low-quality stocks are historically inexpensive compared to the market
- Low-quality stock discounting may continue until investors increase risk-seeking behavior
- Central banks have plenty of room to loosen monetary policy
- Easier monetary policy should help cushion slower global growth
Europe & Asia Pacific Equity
- Markets are focused on recapitalization of European banks
- Uncertain political policy action is weighing on investor sentiment
U.S. Fixed Income
- U.S. Treasury yields have showed noticeable volatility of late
- Concerns over economic growth and European sovereign debt persist
U.S. High Yield
- High yield market credit spreads should compensate investors for expected default losses
- Spreads in excess of expected defaults one year out are at 30-year highs
Global Real Estate
- Global real estate is significantly underperforming during the market downturn
- Valuations reflect underperformance but fail as a timing device
- Chinese commodity demand is heavily driven by infrastructure investment
- Government stimulus may be required to jumpstart commodity demand
Even though European developments were at the front of our recent investment policy discussions, we also spent considerable time on the outlook for U.S. economic growth and emerging-market monetary policy. We continue to expect that European leaders will avoid pushing their economies and financial markets off a cliff. We received economic data this month that supports our view that the United States is avoiding recession, but current tax cuts will need to be extended next year to reduce fiscal drag. Emerging-market economies, with strong fiscal positions and higher interest rates, can now start to ease monetary policy to stimulate growth. A concrete plan from European leaders, dealing with both short-term liquidity and long-term solvency issues, is necessary to sustain a positive outlook for both global growth and investment risk-taking.