Challenging Times

We live in challenging times, but when has anything ever been smooth sailing?  The financial markets are aware of outstanding issues in the world, and collectively price them in accordingly.  That’s why the surprises (both good and bad) have the tendency to result in overshoots of market reaction.  For example, despite Tuesday’s “crisis,” markets were already up again Wednesday.  In October, the S&P gained 11%, which helped reverse a good bulk of August and September’s losses.  Despite the high degree of volatility, however, we are not as far away from late July’s level as it might appear.

Few people had heard of MF Global until last week, when the financial derivatives broker filed for bankruptcy.  As has been in the news during the last week, the firm, led by former CEO and former NJ Governor John Corzine, made highly leveraged bets on European government bonds that are now going bad—and allegedly co-mingled these bets with customer accounts.  Fortunately, MF Global is not considered a “systematically important” financial institution in terms of the workings of the U.S. and global financial systems.  What differs from Lehman Brothers in 2008 essentially was Lehman’s key role as an investment bank and issuer of credit default swap contracts.

We’ve received a few questions about how this latest episode is different from 2008.  At that time, the breakdown was due to several unique factors, many of which acted as surprise to markets.  No one (including the rating agencies) felt that mortgage-backed securities had the potential to lose value as quickly as they did.  That was the “surprise” part, and, long-story short, led to repercussions the markets reacted to.  It was intensified by how almost everyone underestimated the importance of homebuilding and the real estate market on the economy.

The European situation is not a new event.  This has been developing quietly over recent years and started becoming a crisis months (really, years) ago.  The accord reached October 27 was an important moment for two main reasons.  First, the EU essentially provided the underpinning for a backstop in the event banks/insurers/other bondholders are not able to raise sufficient capital of their own.  Second, it came to an agreement with these banks to strengthen themselves.  Getting them all to agree on anything at all considering all of their different interests is an important milestone.

So now, the European debt issue is no longer a surprise (which again implies it is priced in to the market.).  Now, we’re down to specifics and where we go from here after the clean-up. That will still take time.  But, like in the U.S., taking a large backstop in the form of debt has its own repercussions, such as potential currency depreciation and inflation down the road. This is not new to us; in fact, we’ve been positioned for this in advance (probably a bit early, in fact).

Greece has been somewhat contentious politically (as have many countries), so this “theater” is not surprising or unexpected.  They are being asked to make big sacrifices and give up a way of life and entitlements that many Americans and other Europeans don’t enjoy.  The politicians there have to save face, and no one wants “austerity.”  However, the reality is that being part of or at least tied into the Eurozone is crucial to their economic growth, and recent polls have shown that that ¾ of Greeks want to remain in the currency union.

These are challenging times, no doubt, and we realize that many clients are concerned about both the economy and the world.  However, in the most dramatic cases for clients ready to cash it all in (for now), it comes down to the classic question… if an investor moves out of the markets now when he/she’s feeling most uncertain, when do they move back in?  When they feel more certain?  Unfortunately, that usually doesn’t happen until the market has rallied by a significant amount.  With a diversified portfolio, we are better braced for a variety of possible external events, making the “in” or “out” decision less relevant.

Economic Notes

First, a word about recoveries.  Recoveries can often be momentum events, and although surveys of “confidence” seem a little imprecise to include in an analysis of the economy, it’s these intangible factors that can lead to a self-fulfilling prophecy (in both directions).  We are not contrarian by nature, so when conditions “feel” better to people, they begin to spend more, much in the same way many individual investors put more at stake after markets have already begun to improve.

The European Central Bank cut interest rates from 1.50% to 1.25%, which was, surprisingly, somewhat of a surprise, in a response to downward revisions to economic forecasts.  Why not cut rates further?  Europe has a more conservative view than we do about monetary growth, mostly as a result of a legacy of inflation episodes in their history.  Therefore, they may be a bit more reluctant to floor the gas pedal as we are.

The Fed statement following the FOMC meeting showed very few surprises, as we mentioned in a special note earlier in the week.  While the “significant downside risks” remain (mostly due to European debt crisis uncertainty), the FOMC’s assessment of current U.S. economic conditions was more upbeat than in previous recent meetings as growth has “strengthened somewhat.”  That said, they feel keeping rates low for the foreseeable future and keeping asset purchase programs in place is prudent considering the tenuous environment for growth.  Additionally, they actually lowered longer-term forecasts for GDP growth in coming years down to 1.5-2.0%, and raised levels for expected unemployment from the low 7’s to about 8% for 2013.  Accordingly—with this slower expected growth—inflation expectations were somewhat contained.

The Chicago Purchasing Managers Index declined a bit, from 60.4 to 58.4—which was largely expected.  It is still high in relative terms, in keeping with decent manufacturing strength in the region.  While new orders fell, employment increased.

The ISM Manufacturing report was weaker in a headline sense at 50.8 versus 51.6 last month, but fairly consistent with expectations.  The composition of the report itself was positive, though, as new orders rose.  Prices paid fell fairly dramatically, which represents a lessened headwind to company inputs and potential inflation, and inventories fell—the majority of the negative number, but not necessarily a bad thing.  Construction spending picked up slightly, but barely enough to notice at 0.2%.  The ISM Non-Manufacturing index published a few days later was weaker by only 0.1, but lower than expected.  On that side, new orders were down but employment rose to the highest levels in months, and factory orders rose.

The ADP Employment Report showed job growth of 110,000 in the private sector, which was a bit above consensus estimates of 100k.  Manufacturing employment fell, while service jobs were up, as was hiring by small- and mid-sized firms, which has been an area of particular stagnation and negative media focus during this most recently recovery.  A day later, Initial Jobless Claims were also lower than expected, at 397k, down from 406k last week.  This number has been trending downward in recent months, but looks to be at least partially due to jobseekers falling off the benefit rolls.

The Non-Farm Payroll Employment number was slightly below expectations (and less than outstanding), at 80,000, but some upward revisions to prior months were a positive thing.  Much of the job losses continued to be on the state/local government end, in continuation of the ongoing trend of the last two years.  The unemployment rate fell from 9.1% to 9.0%, which captures of mainstream headline news, especially in this most recent recovery where jobs have not been added at a brisk pace.  This is somewhat intuitive, but these two numbers go hand-in-hand to a large extent:  the smaller the monthly job gain, the longer it takes for the unemployment level to drop…


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Markets had a mixed week but equities ended largely down as sentiment was “risk-off,” the opposite of the prior week.  As noted above, the uncertainty surrounding the implementation and Greek acceptance of the Euro accord added to investor selling (foreign stocks fared the worst last week), as did mixed employment data on the U.S. side.  Bonds were largely up, as was the U.S. Dollar, so foreign debt suffered.  Commodities were roughly flat.

It is interesting to note that now that over 400 companies in the S&P have reported earnings, roughly ¾ have topped estimates.  Corporate entities are in strong fundamental shape, and seem to be the opposite of their corresponding governments.

Enjoy the week.

Karl Schroeder, RFC, CSA, CEP

Investment Advisor Representative

Schroeder Financial Services, Inc.