Investment Strategies Newsletter
Since the start of the New Year, we have witnessed nothing short of a seemingly never-ending equity market rally. However, it seems to mostly reflect a level of investor confidence that we haven’t seen in a long time. The VIX, a measure of market volatility sometimes referred to as the fear gauge, has dropped to new lows. This is primarily due to short-term positive economic data combined with undervalued stock prices marking 2012 so far, both at home and abroad. This kind of encouraging data has bolstered the markets, at least in the short-term. We can’t deny that it has been a great way to ride out the year’s first quarter, although we do worry investor perception may have gotten a bit ahead of reality, as there is still a lot to worry about.
Springing Ahead
It has certainly been a relief to see good performance by the markets week after week. The last week of March marked the 26th consecutive week of stronger US economic data, led by ISI’s homebuilders survey, which broke above 50 as of March 28. Since the start of 2012, the S&P is up 11%, and over the past five months, the US stock market has rallied about 28%. It is possible that this extensive equity rally is here to stay for a while, if investors stay optimistic and comfortable with riskier assets and do not scramble to safety. Even looking abroad, the global composite Purchasing Managers Index (PMI), an accepted indicator and forecast of economic sentiment, as a summary of the manufacturing industry, increased over four months from 51% to 53.8% in February. However, the US manufacturing PMI is released April 2, and it will be very important to pay attention to, as manufacturing PMI, historically, has been a good double dip indicator, and we are dealing with a third straight year of legitimate worries of a double dip.
A Macroeconomic Look: The Good News and the Not-So-Good News
The recent surge in crude prices will mean much higher prices at the pump than Americans have been used to lately, which could negatively impact consumer confidence and discretionary spending. We are unsure of the effect this will have on the automotive industry and auto sales, in particular, but history unfortunately shows us that over the past 10 years, there has been a severe 50% negative correlation between gas prices and motor vehicle sales, where gas prices go up, and motor vehicle sales go down, according to economist David Rosenberg. However, this is just speculation at this point, because in January and February, auto sales were impressive. In other oil-related news, there is concern surrounding a possible Israel/Iran conflict over Iran’s nuclear program. If a military conflict did occur, it would have an enormous impact on the global oil supply, and in turn oil prices, since Iran is such a prominent supplier of crude.
The last week of March witnessed a four-year low for jobless claims, with the four-week moving average for new jobless claims dropping by 3,500 to 365,000. However, as could be concluded from Ben Bernanke’s speech at the end of Q1, improved employment and jobs data should not be cause for too much celebration. According to the Federal Reserve Chairman, levels are still not where they need to be to grow our economy, and could be more a reflection of fewer layoffs rather than increased hiring. Although he did not mention any plans for a third round of Quantitative Easing, it is probably safe to say that one could sense his caution about the state of our economy for the near future, and his willingness to step in if need be. This proactive stance by the Fed, as is often the case, acted as a catalyst for high investor confidence in the markets following the announcement.
While there has been a fairly significant improvement in housing in the US for the first time in a long time, it remains a very weak area of our domestic economy. Considering we’ve just witnessed the warmest February and March in decades, some economists seem cautious to applaud the housing sector’s performance too much, with new home sales down 1.6% in March, as cited by ISI. However, for the first time since 2005, homebuilding is expected to contribute to growth and recovery in the housing sector this year. We believe this weak link in the US economy is finally starting to turn around, albeit slowly.
Real consumer spending is contributing largely to poorer than would be expected real GDP for the first quarter at 2.0%, in comparison to an unrevised 3.0% in the fourth quarter of last year.
The Euro Zone and Elsewhere
Although it seemed to have faded into the global backdrop to some degree this quarter, perhaps due to a lack of many developments on the scene for the better or worse, the euro zone is still as worrisome as ever, and we’ve yet to see the full repercussions of its economic struggles. The European Central Bank continues to expand its balance sheet through its Long Term Refinancing Operations program of lending low cost liquidity, but without yet lending in full swing, it is difficult for the region’s banks to truly capitalize on the program.
European leaders have been debating how to approach a firewall, or pool of resources intended to stop the contagion spreading throughout Europe. There has been a lot of pressure on Germany’s Chancellor Angela Merkel to contribute to boosting resources, and on March 26 she announced her support for combining the EFSF bailout fund with the European Stability Mechanism (ESM). There has been disagreement among various countries on whether such a move is necessary, given that the crisis has quieted since the ECB’s LTRO program announced in December, while others believe the current time is appropriate for that very reason.
There are still many signs of recession from countries such as Italy and Spain, and that is what worries the countries who want a firewall in the event Italy or Spain needs a bailout like Greece. Some of the most debt-ridden countries are organizing plans and strategies for privatization, but many think that Greece is too far gone for such an initiative, after continued failures to meet stated targets, much to the EU and IMF’s chagrin. Looking out through the year, EU/IMF estimate that Greece’s debt reach 327 billion euros by the end of 2012.
In terms of emerging markets, we are also keeping a close watch on China. Although the country is down off of its highs, it still had a healthy start to the year. It has continued to reign in credit, in accordance with a lower growth rate target of 7.5%. We can imagine seeing exports hurt by weakness in Europe, and this is a likely possibility in the upcoming months. The country should work to increase internal consumption and reach higher quality growth, especially to avoid a bubble forming within China’s economy.
Cautious Optimism
The general trend of Q1 seems to be one of optimism, but also caution. There are reasons to be optimistic, but also reasons, we believe, to remain cautious, due to investor perception of the state of the economy that doesn’t quite match what, in reality, is still quite fragile. As we wrote in our last update, although the domestic economy is performing at a higher level so far in 2012, when you consider how bad things were in 2008, we are still just working to emerge from the deep hole known as recession. This is certainly not to undermine the hopeful improvement we’ve seen thus far, but it is to remind our clients that 2012 will likely be a rough year with low points and periods of slow growth, even though it has kicked off with quite a bang.