But first a word from our sponsor, or more precisely, about our sponsor. During the Fed’s Quantitative Easing II (QE2) program over the last year, financial conditions eased and real interest rates fell for Treasuries, government sponsored enterprises, investment grade credit and high yield issuers. The Fed can therefore claim praise for helping high yield companies restructure their balance sheets, lowering the risk of deflation, and helping the U.S. trade imbalance. However, QE2 had little direct impact on employment. Thus, based on a mixed report card with substantive doubts, the hurdle for the Fed restarting large-scale asset purchases (i.e., a QE3) is quite high. None-the-less, the absence of a QE3 should not trouble investors. The best case scenario would be for the recovery to reach a level of self-sustainability (allowing the Fed to begin its exit strategy process). This is still possible. The question is whether the impact on inflation will stick when the Fed begins shrinking its balance sheet.
The global economy is poised for reacceleration in the second half of 2011, led by a rebound in the Japanese economy, inventory restocking in the U.S., and a strengthening capital spending cycle around the world. Structurally, however, many legacies of the 2008 Great recession remain. Debt deflation in the euro zone, investment and consumer deleveraging in the U.S., a broken banking system within the G7, ineffective European bank stress tests, and soaring public debt levels and deficits will continue to constrain the pace of economic expansion and threaten global financial stability.
For emerging markets, conditions are the opposite of the G7. Over the last decade, they have been in a broad economic ascendance, buoyed by a vibrant middle class as well as robust commodity markets. But recently, they have retrenched as authorities rein in excess credit growth and temporary inflation. None-the-less, the strong fundamental underpinnings of emerging markets will prevail and more capital will rotate back into the emerging markets as their economies cool and inflation peaks.
For the fixed-income markets, most investors are bearish on government bonds and advocate a below-benchmark (i.e., short-term) duration. The thought is that better growth and rising stock prices will push bond yields higher; however, many people may be surprised by how long yields remain low. Junk bonds are still attractive and the short-term European distressed debt markets offer interesting opportunities. Most investors believe the U.S. dollar will continue its decline against commodity and emerging market currencies, but may strengthen against the Euro.
For equities, the current bull market remains intact, but the multi-year outlook is problematic. For the remainder of the year, reflation trades will likely dominate the financial markets, favoring U.S. stocks and the Japanese Nikkei. A mini technology mania is also unfolding; thus, the NASDAQ could outperform. In addition, precious metals should crawl higher on low interest rates, a weaker dollar, and periodic flare ups in financial instability.
This thesis, however, wilts if there is a major financial crisis and flight to quality. Even as markets have reflated over the last few years, many ‘safety’ investments have appreciated: e.g., Swiss franc, U.S. Treasuries, and gold. If another wave of panic were to hit, the value of these would appreciate further. Very importantly, however, the avalanches of mass selling that were witnessed in 2008 will not be repeated because a huge amount of leverage (risk) has been removed from the system.
June was an interesting month as the Fed’s QE2 program ended; stocks, gold and bonds were negative. As some of this summer’s fears settle behind us – debt ceiling, Chinese growth, Japanese recovery, Europe’s debt quagmire – we should see a continued recovery, albeit volatile, painfully slow, and weak.
Michael Ashley Schulman, CFA
Hollencrest Capital Management