The list of concerns unnerving investors seems to be expanding quickly. The degree to which this “recovery” is addicted to emergency policy stimulus has been the most important source of uncertainty since the beginning of this year. Now add to this the danger posed by a tightening in Chinese monetary policy, the growing sovereign debt risk problem in the periphery of Europe, most visible in Greece, but also in Portugal, Italy and Spain, and the trial balloon floated by the Obama Administration that reveals a desire to punish the banking sector with restrictions on proprietary trading. Obviously, a bearish scenario involving a Chinese boom/bust, U.S. housing relapse and/or euro meltdown cannot be ruled out. Nevertheless, there is a good chance that these sources of uncertainty will be resolved in the coming months and a sustainable recovery will fall into place for the rest of the year.
The Chinese authorities are moving in the right direction. China is withdrawing stimulus as the economy booms at an unsustainably rapid 12% pace. Policy announcements are issued on a near-daily basis. The removal of some monetary stimulus is appropriate in order to avoid an asset bubble. However, do not expect an aggressive shift toward tighter policy. Chinese officials likely will implement various measures to cool overheated sectors of the economy and temper credit growth, but will not risk undermining domestic demand, particularly since the export sector has yet to fully recover from the global downturn. As is the case in the U.S., China still has the advantage of a relatively benign inflation environment, which provides policymakers with the leeway to remove stimulus at a gradual pace. In sum, the Chinese growth outlook remains encouraging and will lend considerable support to the global and U.S. economic recoveries.
There is no doubt that Greece is in financial peril. The country’s debt burden has climbed well above 100% of GDP, and borrowing rates already exceed the country’s long-term growth rate. The bond markets signals not just an increasing probability of a technical default by Greece but also an increasing possibility of a cascade of sovereign debt defaults along the periphery of the euro area. Although an irrational act by either the Greek or European government is always possible, it is in neither party’s interest for Greece to miss a payment. In the end, Greece is simply too big to fail and a deal will eventually be struck to avoid the worst case scenario. Of course Greece will face a long and painful workout process, but its debt and that of the other PIGS (Portugal, Italy, Spain) should ultimately be redeemed at par.
President Obama’s proposal to reduce risk taking in the U.S. banking sector may be a larger threat. The administration’s motivation is simple to understand. It reflects a frustration over the housing boom and bust and its devastating effect on the economy. However, the proposal fails to encompass many of the factors that actually caused the crisis; e.g., lack of proper regulation and oversight, lack of enforcement of existing rules, lack of effective disincentives or punishment for rule-breakers and fraudsters, outright fraud and a blind eye to that fraud, inadequate accounting standards, and arguably, overly-lax monetary conditions. It would be unfortunate for a restriction on market efficiency to take precedence over sensible steps to rein in bad behavior and correct market distortions. Ultimately, a better articulated and thought-out reform plan will probably be crafted.
The U.S. is not in imminent danger of a crisis over the budget deficit, in part because interest payments on the debt are still low relative to GDP and to government revenue. Treasury yields will rise in the coming years even in the absence of a funding crisis, but this should be in the context of a sustained recovery in corporate profits and sales. Thus, while the fiscal situation is a headwind to growth and could cause serious problems down the road if not corrected, it will not derail the cyclical bull market in stocks, corporate bonds and commodities as long as inflation remains calm.
Closed-end funds (CEFs) remain seemingly attractive in this yield hungry environment, however many CEFs have underlying net asset values that seem to have temporarily plateaued. Several investment grade CEFs trade at a premium as investors seek quality whereas many equity related funds trade at deep -15% relative discounts. Investors are in a cautious mood and will be quick to recoil from risk at the slightest hint of financial trouble anywhere in the world.
Michael Ashley Schulman, CFA
Hollencrest Capital Management