The Eurozone Crisis Drags On

August 28, 2012

Europe is nearly through its August holiday and the only evidence of progress in the debt crisis has been press releases and sound bites from vacationing heads of state. Recently, however, the German weekly newsmagazine Der Spiegel reported that the European Central Bank (ECB) is once again debating a plan to cap interest rates in countries like Spain and Italy by buying unlimited amounts of their bonds.

The ECB, of course, immediately denied the report, as the plan’s potential to saddle German taxpayers with huge debt makes it a political non-starter for the EU’s most powerful member. Just to underline how Germany doesn’t (at least publically) approve, both the German Finance Ministry and the Bundesbank made it clear that any such plan is unacceptable, which didn’t stop the Spanish and Italian bond markets from rising on the news, thereby lowering interest rates.

Meanwhile, the Eurozone economy, as expected, contracted in the second quarter, with Germany positive, France flat, and most of the remaining countries negative. Less government spending, lack of hiring and worsening consumer sentiment led to a consensus estimate from economists of further contraction in the third quarter followed by weak growth in the fourth.

None of that is good news for the American economy or American investors. Europe as a whole is our largest trading partner, so slack demand across the Atlantic means lowered demand here, slower job growth, and lower profits for many American companies, particularly those with a large percentage of their business overseas. (Think Coca-Cola, Microsoft and General Motors, just to name a few.)

Compounding the problem is the continuing uncertainty as the Euro crisis drags on, month after month, with stalemate, and often economic impotence, built into the structure of the European Union itself. Don’t look for a resolution any time soon.

As always, the best defense is a diversified portfolio and the advice of a smart, experienced financial advisor.


Feeling bad, but still prosperous

August 16, 2012

The U.S. stock market, as measured by the S&P 500, has had an outstanding year so far, posting gains of 12.8 percent through August 10. Yet, there are plenty of reasons to feel pessimistic about the future: unemployment is at 8.3 percent, Europe continues to fumble for an answer to its debt crisis, and growth in emerging economies is slowing. How can stocks, which are supposed to trade on future earnings, be doing so well when the financial press is full of caution? We believe the answers to the apparent disconnect lie in the financial reports of U.S. companies for second quarter 2012.

For those watching closely, there has been a lot of good news for stocks. Of the companies in the S&P 500 that have reported second quarter earnings, more than 70 percent have beat Wall Street’s earnings estimates. That means that companies are making more money than analysts expected. As analysts adjust their future estimates to include the recent good news, prices of stocks rise. While earnings are surprising to the upside, revenue—or how much companies sell—has been surprising to the downside. Almost 60 percent of S&P 500 companies missed their Wall Street revenue targets. Companies are making more money than expected, but with fewer sales.

Companies are able to generate more profit per sale by controlling costs. Another way of putting this is that companies are squeezing more and more out of their employees; in economics parlance we call this productivity gains. Productivity gains are good, because it means that each employee produces more, which generally leads to higher wages and more disposable income. Higher disposable income in turn leads to more spending, which leads to higher revenue for companies. You get it—a virtuous cycle of growth. Yet while productivity is rising among those employed, we have a large pool of unemployed workers and that means that wages aren’t rising; try negotiating a raise when there are 3.5 job-seekers for every 1 job opening. Without rising wages, disposable income is stagnant, which means people aren’t buying more things, and that largely explains the missed revenue numbers.

The fact that we haven’t been able to enter the cycle of virtuous growth is part of the reason why the recovery has felt uninspiring. That said, even in this weak environment, companies continue to increase profitability as they squeeze workers for more output without increasing their wages. But, the current state can’t go on forever. Companies will eventually start hiring and that will result in higher wages. Either there will be virtuous growth OR companies will start to put up disappointing earnings. We don’t know which scenario will play out, but we are hoping, along with the rest of the country, for the former.


Europe: The Rollercoaster that Doesn’t Seem to End

August 7, 2012

The jump in volatility recently has caught the interest of many investors and prompted thoughtful questions about the economy.  We have been tracking three primary subject areas on a daily basis through these unusual global financial events:  (1) the health of the U.S. financial recovery; (2) the European debt crisis; and, to a lesser degree, (3) the health of China and other Asian economies.  These first two issues are at the heart of the recent market volatility.

The European Union is in an unfortunate position of slow to declining growth combined with unmanageable levels of debt.  In most economic downturns, the cycle to reverse the decline is a decrease in interest rates by the Central Bank, which puts more cash into the system and creates a declining currency value.  As a result of low borrowing rates and attractive currency exchange rates, domestic and international spending slowly improves.  The 17-member Euro zone does not have this luxury because, while they share a Central Bank lending rate and currency exchange rate, they pay their own sovereign debt at a borrowing rate set by the market.  Countries that have very high levels of debt—like Greece, Spain, Ireland, Portugal and Italy—cannot muster the growth needed to raise revenue to pay their existing debt and cannot issue more debt at a cheap enough rate to make it financially viable for the long term.  It is a vicious cycle that has been a decade in the making.  While it seems to have been a slow-moving train wreck, we appear to be nearing the climax.  Ultimately, that should be good news because it would create some clarity in an uncertain world.  The hope is that the Euro zone will solve the current problems without an undue level of bank failures and defaulting loans, while also fixing the deficiencies in the system.  There have finally been some meaningful ideas offered, such as a rescue fund that can borrow from the European Central Bank, thus ensuring enough resources to bail out even a large participant like Spain.

In addition to news from Europe, every day we see some chart that compares the current financial recovery in the United States to recoveries in the past.  More often than not, the current recovery is shown to be very weak and fallible compared to others.  A strong recovery creates jobs, increases our standard of living, and ultimately increases personal net worth.  We want a strong recovery because we want all of the above, so it is disappointing when jobs growth or retail sales or home sales are reported to be unexpectedly weak.  Although it has been frustratingly slow, and may continue to be for awhile, the good news is that our economy is making progress.  The even better news is that when the rest of the world gets its act together, the United States seems poised for solid growth and a recovery.  Recent earnings reports show a very lean corporate America with little fat to trim.  A pickup in global sales should have a pronounced and immediate impact on the American economy.

The outcome of the European debt situation and the recovery path of the U.S. economic recovery will influence the financial models and the psyche of investors worldwide.  While the volatility causes us to pay extra close attention to world events, our outlook for a slow and steady recovery in the United States has not changed.  We have lived through many of these market “blips” over the past few years and will probably experience many more over time.