There was a lot of economic news last week which continued to confirm that the US is still growing at a slower (and anemic) rate, Europe could be entering another recession (if not already in it) and that Asia and India are also decelerating. While there will be good and bad economic news on any given day, due to multiple sputtering economies there were many more negative data points than positive. I also believe this will be the case going forward as we are probably in for multiple years of slow worldwide economic growth.
I believe this translates to overall so-so performance returns in the stock market, meaning declines in some years and at best mid-single digit to low double-digit returns in others. While this level of positive performance on a compounded basis is good and there will be timeframes and sectors with even greater returns, I believe that there is a greater than normal chance to see another significant decline of 20% or more in the overall market. Also, correlations will merge so that diversification will not protect as much as models project. To generate outsized returns it will become a stock picker's market even more than typical and taking a defensive position, such as raising cash when markets are doing well, would be warranted.
The stock and bond markets had short-lived bounces after the latest European politicians' meeting but that was largely due to such low expectations going into it. The sovereign debt crisis may not end until investors believe Euro-zone government bonds are safe. That will probably require a true Euro-bond where the healthier countries become liable for the weaker countries debt. I believe that this will be extremely difficult if not impossible to pull off so expect many down days in the market the remainder of this year and next as traders react to the news flow.
Note that debt laden governments are lending to weak banks in their own countries and the banks are then buying their government's debt. The governments are also lowering the collateral requirements so that lower grade assets can be used to receive loans. This circular system of recycling money could lead to a meltdown of major European banks and/or countries.
Also keep in mind that providing easier access to debt only deals with the symptoms of the crisis and not the underlying causes, which is too much debt which continues to grow. Multiple European countries have major labor and market constraints that need to be addressed. The changes that need to be made have not just economic but social implications and if there were easy solutions they would have already been done.
I have compiled many of the major statistics below and grouped them into "The Good", "The Bad" and "The Wildcards". While I would like to be more positive and that people (largely politicians in this case) can make changes to improve the outlook (maybe kicking the can down the road will allow enough time to avoid major problems), I believe a good level of caution is warranted given the economic and political headwinds (including the US elections in November).
Going into the June quarter earnings "season" over the next three to four weeks expectations are low. In fact, net income is forecast to decline almost 2% year over year for the June quarter. While expectations are low this is small comfort to lower earnings which typically is not positive for stocks.
The Good (note that it seems to all be in the US)
- US home construction, new-home sales and pending sales of previously owned homes results topped estimates.
- US Auto sales increased strongly year over year with an annualized rate of almost 14.1 million.
- The non-seasonally adjusted employment growth rate of about 2.2% year over year equals the rate of late 2006/early 2007 when the economy was expanding at a strong pace.
The Bad (spread throughout the world)
- US employment increase was only 80,000 in June
- US ISM Manufacturing index dropped from 53.5 in May to 49.7 in June (below 50 signals contraction)
- The first time below 50 since July 2009
- Business Activity dropped from 55.6 to 51.0
- New orders dropped from 60.1 to 47.8
- US ISM Non-manufacturing index dropped from 53.7 to 52.1
- While still positive it and many of its sub-sectors declined
- Business Activity fell from 55.6 to 51.7 (and was 58.9 in March)
- New Orders fell from 55.5 to 53.3 (and was 58.8 in March)
- US Retail sales in June grew at the slowest pace since November 2009
- High-end retailers remained resilient while mid-tier department stores fared poorly
- China's ISM Manufacturing index fell from 50.4 in May to 50.2 in June
- New-orders fell from 49.8 to 49.2
- New export orders fell from 50.4 to 47.5
- United Kingdom's output has barely grown over the past 18 months
- Spain's 10 year Treasury yield increased to 6.97%, almost hitting an all-time high
- Italy's 10 year Treasury yield rose to 5.99%
- The People's Bank of China (for the second time in a month), the European Central Bank and the National Bank of Denmark all cut their interest rates on Thursday last week
- Germany's and Denmark's 2 year bonds have negative interest rates
- If economies were strong they would be paying positive interest rates
- The US "Fiscal Cliff" of increased taxes and forced spending cuts set to take effect on January 1, 2013, will at least make many businesses freeze spending and will have a substantial negative effect on the economy if they occur as planned.
- And given that it will take Congress and the President to change the laws don't expect anything to occur until after the election and maybe not until new members and potentially a new President take office in January.
- IMF Managing Director Christine Lagarde said that its growth forecasts are likely to be lowered
- Higher risk collateral is being accepted by central banks to lend to their country banks.
- Can European countries (especially Greece, Spain, Italy and Portugal) make the necessary labor and market changes they need to become more competitive
- Example: Fiat's car production
- Italian plants produced 650,000 cars with 22,000 workers in 2009
- A single Polish plan produced 600,000 cars with 6,100 workers
- Example: Fiat's car production
- European Financial Integration
- The creation of a central Euro-area bank supervisor will probably not occur before the second half of 2013 vs. the proposed end of this year.
- This means that Spain's bailout will require that all Euro countries will have to agree to the bailout (watch out for Germany, Finland and The Netherlands).
- Euro-zone countries will probably still have to guarantee Euro-zone loans to their country banks.
- This increases the debt burden of the country
- While debt being proposed to bailout Spain is not senior to current debt there is always the potential that could change as it did when Greece's debt was restructured.
- Changes to this will make future investors shy away from buying government debt.
- Portugal's austerity program (two months bonus for public-sector workers) has been struck down by its Supreme Court.
- The government will have to find cuts in other areas to make its financial commitments to the EU.
- Drought in India
- Crop plantings have been delayed. A drop in farm income could further destabilize India's economy which only grew at 5.3% in the March quarter.
- Hydroelectric plants provide 20% of India's power.
- One power company has cut output by 7% in the past ten days
- The heat in the US Midwest could negative affect corn and wheat yields leading to higher prices in the US and abroad.
- Since corn and wheat are also used for feedstock to animals higher prices would affect a wide range of prices.