Second Quarter, 2012 Market Review & Outlook

15 january 2013

Fear gripped the markets through April and May, driving global stocks downward. The European debt crisis unexpectedly reignited when the incumbent and “pro-bailout” New Democracy party failed to win the early election it called. The result increased the odds Greece would exit the euro and led investors to scrutinize all sovereign debt holdings. Government bond yields in Italy and Spain quickly spiked and pressure mounted against Spanish banks.

But consistent with the pattern of mid-year corrections in 2010 and 2011, hope of bolder government intervention sparked a rally in June. It received a boost when New Democracy proved victorious in a second Greek election, mitigating the risk of a disorderly Greek exit from the Euro. The market recovery gained speed in the final days of June as a summit of Eurozone leaders in Brussels produced an agreement to relax conditions for emergency bank loans.

Overall, the S&P 500 lost roughly 3% in the quarter. International stocks fared worse. US Treasuries gained, benefitting from their perception of safety, a flight to dollar-based assets (at the expense of the Euro), and buying from the Fed. Ten and thirty year Treasuries hit record low yields during the quarter. Gold, oil and most commodities declined as the global economy showed signs of weakness.

Just a few months after providing an upbeat assessment of the US economy, Fed Chairman Ben Bernanke extended “Operation Twist”, citing high unemployment. Designed to hold down long-term interest rates, the Fed will sell an additional $267 billion of shorter maturity securities and use the proceeds to buy those with a longer maturity. The program should successfully keep borrowing costs low, but the full impact on the economy is unclear.

 

Capital Markets Outlook

Stocks

Last quarter we predicted the European debt crisis would fade from the headlines only to reemerge in 2013. The Greek election surprise and subsequent pressure on Spanish and Italian debt quickly forced the issue back to the forefront. At this point, it appears Europe should remain the dominant driver of market performance for the balance of the year.

The most likely outcomes are:

1. Binary
2. Extremely Difficult to Predict

As a whole, the euro-zone is in dismal fiscal shape. The same is true of the US, UK and Japan. All have balance sheets ranging from concerning to scary. But the US, UK and Japan are viewed as safe-havens. Why? Because unlike the Eurozone, they have a single currency and a central bank that can print money if necessary. This gives creditors confidence they will be repaid, even if those payments lose purchasing power. The European Central Bank does not currently have the power to print money to buy debt. This power, or at least a similar ability to fund or guarantee banks, may be necessary to restore confidence and facilitate resolution.

You can run a large deficit as long as someone is willing to continue to lend you enough money to support it. It’s the same for countries. Eventually, there is a tipping point where creditors believe they are less likely to be repaid and demand higher interest rates to compensate for risk. This exacerbates the problem. A negative feedback loop begins and can very quickly spiral out of control.