Same Europe, Different Crisis

January 31, 2013

While fourth quarter 2012 earnings results will continue to garner attention, investors may also be looking overseas to gauge market direction, especially with the recent, first meeting of the year for European finance ministers. It is worth remembering that each spring for the past three years, the S&P 500 has started a slide of about 10% during the second quarter, led by events in Europe.

However, this year may be different. In 2012, the European Union finally took two important steps to halt the financial aspect of its ongoing crisis.
One of those steps was the creation of the European Stability Mechanism (ESM), a permanent rescue fund for countries in need of credit and unable to borrow in the market. Another important measure was the authorization of Outright Monetary Transactions (OMT), granting the European Central Bank (ECB) more power to intervene in the bond markets to assist countries in distress.

With these programs able to lend with few limits to banks and willing to buy bonds of any country that will accept the conditions, we do not expect market participants to fear a European financial crisis this spring and drive a 10% decline for U.S. stocks as they have in recent years. But Europe’s crisis is far from over, and market participants may drive stocks lower later this year.

Europe has traded a financial crisis for an economic one. The ECB is able and willing to only fight one crisis. The price Europe has paid to avoid a financial crisis is in the form of recession and unemployment rising above 10% — including France at 10.7%, Italy at 11.1%, Ireland at 14.7%, Portugal at 16.3%, and Spain at 26.2%. The Eurozone is mired in a recession that the ECB has little ability to mitigate. Inflation is still over the 2% target.

This is not just a shift in the crisis facing Europe’s southern countries. It has now started to infect the core. In 2012, the economies of northern Europe, such as Germany, France, and Finland, were less negatively affected with economic growth and lower levels of unemployment more similar to that of the United States than the countries of southern Europe, including Italy, Spain, and Portugal. However, in 2013, the two largest economies of the Eurozone, Germany and France, will face low growth or even stagnation and rising unemployment.

The slowdown in northern Europe can make conditions in southern Europe worse by returning some risk of financial crisis. The economic slowdown in northern Europe may make these countries more reluctant to approve the release of aid packages to the southern countries. This is noteworthy, since if the Italian elections in February 2013 fail to produce a government that achieves political stability and applies economic reforms, the increased market pressure on Italy will likely require financial aid. Germany, the de facto decision maker as a result of making up the lion’s share of any aid package, may already be averse to approve any more unpopular aid packages ahead of the German elections coming this fall. With the elections slowing the decision-making process in Germany, no fundamental changes in policy will likely be made before the elections that may avert the growing economic crisis.
In early 2012, the European fear gauge was the bond yield of southern European countries rising as the financial crisis worsened. But now that a financial crisis has been allayed, the decline in northern European bond yields is a sign of a worsening economic crisis. In a remarkable sign of how the European financial crisis has eased, Portugal’s 10-year bond yield fell from 16% last summer to 6% [Figure 2], and Italian bond yields fell from 7.5% to under 5%. But at the same time, Germany’s 10-year bond yield fell below 1.5% [Figure 3]. This is not a sign of crisis averted, but of a different one brewing. Economists’ estimates for Germany’s gross domestic product (GDP) in 2013 are still coming down. Europe’s 2012 auto sales fell -8.2% from the prior year, the biggest drop in 19 years.
The investment consequences are that the bond yields of southern European countries may once again begin to rise, fall elections highlight the challenges putting pressure on stocks, and recession continues and ensnares more of the core nations of Europe. We may again see a stock market slide related to Europe’s evolving crisis, but it may not be until the summer or fall that it appears this year rather than in the spring. After the powerful rise in European stocks since the financial crisis was averted last summer, investors may be increasingly better off focusing on U.S. and emerging market stocks as the year matures and the European economic crisis deepens.


January 24, 2013

Technically, the United States went over the fiscal cliff on January 1, and for those of you paying attention, the S&P 500 rallied 4.57% from 12/28/2012 to 1/4/2013.* What? Not what the financial media was predicting? The good news is that Congress was able to pass the American Taxpayer Relief Act before markets opened in 2013, thereby making permanent the Bush-era tax cuts for most Americans. The bad news is that Congress kicked the can down the road two months on $109 billion in painful spending cuts. While we wait, and endure two more months of headlines about partisan bickering, we’ll get some real news about how companies are doing with the fourth quarter 2012 corporate earnings.

Corporate earnings seasons provide a report card for how companies around the world are doing. Not only do we get a backward view at business activity and profitability, but corporate managers provide forecasts about how they expect their business to perform in the future. Wall Street plays a bit of a silly game with earnings. Wall Street analysts try to guess how much companies will earn. If the analysts guess too high, stocks tend to fall; if they guess too low, stocks tend to rise. Then, there is guessing about the guessing. Money managers we are talking to think that Wall Street analysts have set the bar for corporate earnings a bit low for the fourth quarter. So while economic activity may have been hampered by the uncertainty around the fiscal cliff and a mediocre holiday selling season, Wall Street may be too pessimistic relative to how companies performed, relative to the previous quarter. In fact, we have seen many analysts significantly reduce their estimates since last October. According to Thomson Reuters data, earnings were expected to grow by 2.7%. Now, those guessing about the guessers say that these lowered expectations leave room for companies to surprise investors, even if their results aren’t particularly strong.

While corporate earnings are interesting and can sometimes provide insights into important economic trends, we don’t care all that much about any one earnings season as we are long-term investors; in general, we don’t get too caught up in the events of any three-month period. While we don’t focus that much on a single earnings season, you can expect the financial press to be buzzing. Headlines from the financial media about which companies beat and which ones missed their projected earnings make great news; but, remember, the financial press isn’t in business to give you advice. They are in business to sell advertising and generate ratings. So while the news swirls about earnings, about the budget deficit, and just about anything else, the key is to stay focused on your financial goals and maintain a consistent strategy.


*Source: Bloomberg

2013 Outlook

January 14, 2013

After a quick start to 2013 for economic data and events in recent week, the coming weeks are relatively quiet. The key domestic economic report due out this week is likely to be the latest weekly reading on initial claims, as markets focus on the unofficial start of the fourth quarter earnings reporting season. Five Federal Open Market Committee (FOMC) members are scheduled to speak this week, and almost all of them have spoken out against quantitative easing. Overseas, a full slate of Chinese economic data for December 2012 are due out, as well as key central bank meetings in the Eurozone, the United Kingdom, and South Korea. In addition, both Spain and Italy will auction debt.

On balance, last week’s U.S. economic data on manufacturing, employment, vehicle sales, consumer sentiment, and the service sector for December 2012 exceeded expectations, and kept real gross domestic product (GDP) on track to post a gain of between 1.5% and 2.0% for the fourth quarter of 2012. Any increase in GDP in the fourth quarter of 2012 would mark the fourteenth consecutive quarter of economic growth since the end of the Great Recession in the second quarter of 2009.

Looking ahead into the current quarter (first quarter of 2013), growth may get a boost from a rebound from Superstorm Sandy, but the payroll tax increase that occurred as a result of the fiscal cliff deal signed into law by President Obama will put a dent into consumers’ disposable income in the
quarter, and leave real GDP growth around 2.0%. Looking ahead, failure failure to address the debt ceiling (and lingering sequestration issue) may lead to a recession in early 2013, while a quick resolution to the looming debt ceiling debate along with a “Grand Bargain” to address the nation’s longer term fiscal issues could lift real GDP growth into the 3.0% range for the year.

On balance, the first quarter, and indeed 2013 in general, is shaping up as follows: On the positive side:

  • Rebuilding of infrastructure and housing stock damaged by Sandy;
  • A continuation of recovery in the housing market;
  • A reacceleration in growth in China and emerging markets, which will help boost exports; and
  • A rebound in business spending after fiscal cliff and election-related uncertainty hurt business capital spending in the fourth quarter of 2012; should help offset the following negatives;
  • Tepid consumer spending;
  • Weak federal and state and local government spending; and
  • Muted contribution from net exports with Europe still in recession.

Overall, from an economic standpoint, 2013 may look and feel a lot like 2012.

Fiscal Cliff Details

January 4, 2013

It is a moderately Happy New Year. Congress has passed, and the President has signed, the new revenue half of a solution to the fiscal cliff. The new bill, passed 257-167 by the House and 89-8 by the Senate, provides clarity on tax rates for most U.S. households, but delays major decisions on fiscal spending until the end of February.

It makes Bush tax cuts permanent for households with income below $450,000 (couples) and $400,000 (individuals), and on income above that amount, raises marginal rates from 35% to 39.6%. It creates a permanent fix to the Alternative Minimum Tax (AMT) for the next 10 years. It increases estate tax rates from 35% to 40% for estates larger than $5 million. It helps the long-term unemployed by extending expiring jobless benefits. And, the major impact to working people, it allowed the temporary 2% reduction in Social Security payroll tax to expire, returning to the previous rate of 6.2%.

There are certain things we’d like to make you aware of from a financial planning perspective:

•   This first one is time-sensitive. The IRA direct transfer to charities deadline has been extended to the end of December 2013 for those who are 70½ years old and older. For those that took an IRA distribution between December 1, 2012, and December 31, 2012, and wish to transfer all or a portion of your distribution to a Charity (up to $100,000), you may do so by February 1, 2013. Also, for the month on January 2013 you may make a rollover and have it count as a 2012 rollover. There are several dates to be aware of and a transition rule in case you forgot to take your Required Minimum Distribution last year.

•   The rise in income tax rates on the highest earners and on dividends may influence your ratio of taxable to tax-deferred accounts and the types of investment vehicles in your portfolio.

•   The increase in the estate tax rate adds certainty that was missing in estate planning because of the pending expiration of the old rates. Estates that are affected should consider gifting and wealth transfer strategies. Minnesota estates are still taxed at the $1M level; make sure your estate planning documents are up-to-date.

•   The fix to the AMT makes certain investments in middle- and upper-middle-income taxable portfolios more desirable and others less so.

•   There will be increased opportunities for investors to do Roth conversions. This may or may not be a good idea for you and you should consult with your advisory team before acting.

•   The bill includes extensions for some tax credits and deductions, and limitations on others.

•   While the bill extends jobless benefits for the long-term unemployed, we recommend setting aside a cash reserve. Even if your job is secure, it’s a smart place to get money when you need it.

That’s the mostly-good news. While, technically, the United States went over the fiscal cliff on January 1, by passing the bill before markets opened for the first time in 2013 on Wednesday, Congress was able to avoid further damage to investor sentiment. Needless to say, market reaction has been very positive due to the avoidance of the near-term recession risk.

But what didn’t happen is a fix to the other half of the fiscal cliff. Congress and the White House failed to address deficit reduction; the bill delays for two months $109 billion in automatic, across-the-board spending cuts.

The failure to act keeps Washington on a potentially risky fiscal-policy path. By postponing difficult decisions on the debt ceiling, benefit programs, government spending and a tax overhaul, the deal all but guarantees that Democrats and Republicans will continue to clash on major fiscal issues throughout 2013.

We believe that the political machinations will continue to create noise in the market and we caution clients about being too consumed by headline news. We are advising clients to review with their advisor team how they might potentially benefit from the tax changes, and then to remain disciplined by adhering to a well-considered strategic allocation that fits their values and long-term financial goals.

Our financial planning department, our investment team and our financial advisory teams are all available to answer your questions.  You may also ask questions via our website: