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2012 Q3 NIFCU$ Market Commentary (Article for Credit Unions)


Economies worldwide have rebounded since the 2008 …

Economies worldwide have rebounded since the 2008
Financial Crisis, along with rising global equity and
tightening credit markets. Even the rebound in earnings
growth and profit margins has been remarkable. Yet, the
U.S. economic growth hasn’t broken out as hoped, after
significant global fiscal and monetary stimulus, including
slashing interest rates. Unemployment remains high and
volatility has been unnerving for investors. Learn more at:

Published in Economy & Finance , Business
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  • 1. QUARTERLY INVESTMENT OUTLOOK THIRD QUARTER 2012RATIONALIZING UNCOMFORTABLE CHOICES than usual, because the credit squeeze was addressed so aggressively by policy makers. Central banksEconomies worldwide have rebounded since the 2008 provided almost unlimited liquidity and direct purchase ofFinancial Crisis, along with rising global equity and distressed securities, which thawed credit market tradingtightening credit markets. Even the rebound in earnings and caused issuance to recover quickly. A headwind forgrowth and profit margins has been remarkable. Yet, the banks still remains trying to improve their capital ratiosU.S. economic growth hasn’t broken out as hoped, after and divesting certain businesses, as required bysignificant global fiscal and monetary stimulus, including legislative and regulatory changes. Lending is expandingslashing interest rates. Unemployment remains high and again, but more slowly than otherwise strong earningsvolatility has been unnerving for investors. The key and deposit growth might allow. Strong cash flows andquestion is: What is holding us back and will it continue? increasing household net worth have minimized demandWe observe that sentiment has played an increasingly for credit. Would-be borrowers are holding significantlycritical role in economic trends, trumping fundamentals. more cash, exceeding $2 trillion for U.S. business. Research, investment, and increasing dividends areEconomic recoveries following deep financial crises increasingly self-financed, but some companies havehave historically struggled for an extended period due to financed significant share buybacks to take advantage ofthe drag of deleveraging that limits consumer spending exceptionally low interest rates. The economy hasand investment, thus growth and earnings. Yet, profit struggled through this difficult adjustment phase, butmargins rebounded more quickly than usual since 2009, now most U.S. banks exceed their future capitalas strong cash flows bolstered balance sheets with rising requirement. Unfortunately, European banks are stillcash levels, and strong investment levered productivity lagging in this regard.gains. Foreclosures now account for most of thehousehold deleveraging observed. Consumption Current threats to global growth include the continuingremains resilient, as household net worth of $62.9 trillion Eurozone debt crisis, pending U.S. fiscal cliff (i.e., taxrebounded faster than prior cycles, as significant rate increases and spending cuts expected in 2013),retirement savings (i.e., 401k, 403b, 457, IRA, profit China’s slowing growth, and Iran’s nuclear enrichmentsharing) increased in value. Household financial assets effort. Implementation uncertainty and high complianceof $52.5 trillion now comprise 69% of total household costs of Dodd-Frank financial reform of 2010, as well asassets, exceeding $76.3 trillion. Consider that combined the increasing cost of health care reform, are additionalhousehold and corporate sector net worth far exceeds reasons for sluggish U.S. growth and weak employment,U.S. Treasury debt outstanding of $15.9 trillion. in our opinion. Government agencies have struggled to finalize more than 200 new financial rules andGovernment spending still exceeds tax revenues by over procedures required, in a timely way. It is daunting for$1 trillion, but private fixed investment has accelerated to even the most sophisticated financial service firms toalmost 14%, construction has increased 10%, understand the complexity of this law. Yet, the sum ofcommercial lending is expanding again, and the savings these threats is still less than in 2010 and 2011.rate has settled under 4.0%. The data indicate U.S.deleveraging has moderated more quickly than Investors may have hoped for a quiet summer to enjoyexpected, and may be reversing with increasing their vacations, but capital markets seem to have nocorporate and household credit demand. A theorized respect for the calendar. Forecasting sentiment and itsperiod of extended deflation hasn’t materialized, impact on markets is a challenge, but our fundamentallysurveying global inflation rates. Thus, we have to global tactical asset allocation models still suggest theconclude policy and legislative headwinds probably outlook for global equities is compelling, favoring theoffset aggressive stimulus, limiting economic recovery United States in particular. Relative valuation betweenmore than deleveraging. The government sector is a stocks and bonds plus record low interest rates favorslong way from deleveraging, in spite of higher tax rates equities. Additional factors driving our tactical models,and budget sequestration expected in 2013. including economic growth, low inflation, and earnings growth, remain key drivers of our preference for equity.Historical comparisons suggest the recent financial crisis Anomalies of low price/earnings and price/book ratios,(post-Lehman bankruptcy) has transitioned more quickly negative real bond yields, and dividend yields exceeding 1
  • 2. Treasury yields, are all consequences of continued high most during the quarter with the consequences of theinvestor risk aversion. Our tactical asset allocation continuing European debt crisis still a threat to globaldiscipline seeks to be pragmatic and objective, but many growth. China’s growth also slowed to a still remarkableyears of volatile equity markets makes Rationalizing 7.6% y/y, but the Chinese government expects growth toUncomfortable Choices as difficult as it has ever been. re-accelerate toward 8% this year, with easing monetary policy. The trade weighted U.S. dollar (+1.4%) alsoInvestment Review firmed in the second quarter.After another good start through April of this year, equity Since the March 2009 lows, the S&P 500 has returnedmarkets tumbled in May, but the S&P 500 rebounded in 119% vs. 25% for bonds and 5% for cash. Even theJune to finish the quarter only slightly lower (-2.8%) vs. CRB Index of commodities, benefiting from ETF flows,+2.1% return to the Barclays Capital Aggregate Bond has risen 45%. We have recommended overweightingIndex. The S&P 500 index has returned a respectable equities for this entire period, although heightened9.5% this year, and at 22.4% over the last nine months volatility of equities, including three corrections, hasis outperforming bonds by 19%, although volatility has been difficult to withstand for some investors. This isbeen high. During the quarter, value stocks exceeded likely why we observe the lowest allocations to stocks ingrowth by 1.8%, while large-cap stocks trumped small- a generation from individual and institutional investors,cap by 0.7%. Higher dividend yielding stocks surged most notably in pension funds.ahead with Telecom (14.1%), Utility (6.5%), and HealthCare (1.7%) sectors leading the S&P 500 for the quarter. Economic and Capital Market OutlookBonds outperformed during the quarter, but continue tolag equities this year by more than 8.5%. U.S. equity The U.S. economy has managed to remain relativelyperformance has been driven by the continuing strong immune to slowing growth and geopolitical challenges inrecovery in earnings and high profit margins. other developed economies. Yet, growth uncertainty and volatility have taken a heavy toll on investor sentiment,Earnings growth exceeded 14.7% in 2011 and pre-tax most recently reflected in underperforming internationalprofit margins are still hovering near 13%. Earnings equity markets, offshore accumulation of U.S.continue to surprise positively for the twelfth quarter in a Treasuries, and a stronger U.S. dollar. Addressing therow. In Q1/2012, 67% of companies beat estimates by Fiscal Cliff’s economic impact is now most likely to be5% on average. For 80% of S&P 500 companies deferred until after the election, although agreement hasreporting to date, 68% of companies beat estimates by been reached on a continuing budget resolution. That4% on average compared to March 30, 2012 estimates. neutralizes the risk of another debt ceiling debacle untilEstimate revisions for 2012 turned negative recently after March 2013, providing the next Congress time toafter the May 2012 jolt, but U.S. companies continue to develop a possible solution.beat estimates. We believe S&P 500 earnings willincrease 6.3% in 2012 and 7.7% in 2013, providing an Recall in The World Turned Upside Down (Investmentopportunity for equities to generate a compelling return Highlights, June 2012) that we believe the effect of therelative to bonds. The upward progression of 2013 and Fiscal Cliff should knock about 1.5% off U.S. growth or2014 keeps forward estimates trending higher, even if about half the sum of tax rate changes and spendingcurrent estimate revisions have been modestly negative. cuts, adding up to $500 billion or 3.2% of GDP. While characterized as a “cliff”, the effect may be more of a S&P 500 IBES Earnings Forecast (12 Mo) 140 “slope”. Increased tax payments won’t be due until April 2014 15, 2014. There are behavioral and practical reasons to 120 2013 expect permanent tax cuts are anticipated quicker than S&P Operating Earnings ($) 2008 2012 100 2007 2011 long expected expiring tax increases, whose effect is 2010 80 2000 2001 2006 2005 likely be spread out over a longer time period. 60 1999 200 2004 2009 Unemployment benefits have been declining. We should 1997 40 1992 1995 1996 1998 2002 assume behavioral responses to anticipated tax changes 20 1990 1991 1993 1994 S&P 500 annual estimate started some time ago, and will continue into 2013. traces by calendar year 0 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Economic Forecasts 2010 2011 2012e 2013e 2014e U.S. GDP (Y/Y Real) 3.2 1.6 2.3 2.3 2.5 Earnings 2013e 2013e 2012e 2011e 2010 2009 2008 Earnings Growth 40.3 13.2 6.3 7.7 7.1HighMark 8.2% 5.8% 6.3% 14.7% 40.3% -7.1% -23.1% CPI Inflation (Y/Y) 1.4 3.0 2.2 2.3 2.8Consensus 11.4% 11.8% 5.7% 14.7% 40.3% -7.1% -23.1% Unemployment 9.4 8.5 8.0 7.5 7.2HighMark $ 119.00 $ 110.00 $ 104.00 $ 97.82 $ 85.12 $ 60.80 $ 61.48 Fed Funds Target 0.25 0.25 0.25 0.50 1.75Consensus $ 128.76 $ 115.56 $ 103.38 $ 97.82 $ 85.12 $ 60.80 $ 61.48 Treasury Notes-10y 3.31 1.88 2.10 3.00 4.0Financi als 16.5% 13.4% 22.0% 4.1% 288.2% 106.9% -130.8% S&P 500 Target 1258. 1258. 1425. 1520. 1600.Non-Financials 9.4% 11.4% 4.7% 15.8% 28.1% -18.6% 7.2% Source: HighMark Capital estimates and Thomson DatastreamSource: HighMark Capital estimates and Thomson Datastream Fears of slowing U.S. economic growth have increased,International stocks (MSCI EAFE: -6.9%), including but there is still no evidence that a meaningful slowdownEmerging Market Equities (MSCI EEM: -8.8%) struggled 2
  • 3. is imminent. The ISM Purchasing Managers Survey has Falling energy and industrial commodity prices aredipped to 49.8 since May, but that still correlates with dampening inflationary concerns enough to allow other2.4% real growth over the next year. Monthly economic emerging countries to follow suit, although drought-data has been stronger than 3.9% nominal GDP growth stricken agricultural commodities are worth monitoring.suggests, including retail sales (5.1%), business sales India, Korea, Australia, and Brazil should be able to(5.7%), and construction (9.9%). Industrial production follow China’s lead in cutting interest rates, while the(4.4%) is actually accelerating again. Slack in capacity ECB recently cut interest rates to 0.75%.utilization has nearly normalized, and there are reasonsthat persistently high unemployment of 8.3% may be A significant drag on global growth has been higher oilmore structural, than cyclical. If so, monetary policy prices, triggered by the Arab Spring turmoil of 2010.targeting employment slack would be sadly misguided. Recently, oil prices fell from over $114 last April 2011 toGDP has lagged other growth measures since the July $85 in July. The 20% decline in oil prices since February2011 revision to the national accounts methodology. 2012 has the potential to fuel over $70 billion inClassic economic output gap and economic slack discretionary spending if lower prices can be maintained.analyses may lead astray interest rate “doves” that Falling commodity prices coincided with recedingdismiss traditional policy setting rules and inflation. speculative investment flows, particularly into ETFs. U.S. Real GDP 2Q/2012: 1.5% Y/Y: 2.2% 18 Housing has been one of HighMarks five key potential 15 growth drivers since 2011. New housing starts (+39%) 12 and permits (+21%) accelerated, benefiting from the 9 Real GDP % 6 jump in the household formation rate from 357K to 1.1 3 million in 2011, near record low inventory of new homes, 0 as well as improving affordability with lower mortgage -3 rates and home prices. The average historical household -6 formation rate of 1.2 million, plus replacement of 300K -9 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 homes every year, suggests normal demand for housing exceeds 1.5 million. That suggests housing starts could Real GDP (Qtr/Qtr A.R.) Real GDP (Year/Year %) double from the current 760K rate, so there is significantSource: HighMark Capital and Thomson Datastream upside to housing starts to satisfy demographic demand. New Home Sta rtsWe expect 2.3% U.S. real growth in 2012-2013, similar 3,0 00 Hous ing S t arts * Peak: 2.2M (12/ 2005)to the 2.2% observed over the last year. A shallow 2,5 00 P ermit s -- Demand = 1.5 M + Sec ond Homesrecession contracting -0.4% is expected in the Eurozone 2,0 00this year, while 6.8% growth is expected in Emerging 100 0s 1,5 00Markets. Global growth of 4.0% is expected in 2012, 760Kaccelerating in 2013. If these consensus estimates prove 1,0 00 800Koptimistic, investors could be disappointed, but it seems 5 00 Dem and = Hous eh ol d Format ion + Replac em ent + S ec ond Homesto us that markets have actually discounted a far worse 1. 65 mill ion = 1.2 m illion + 300,000 + 150,0 00 0economic scenario than consensus suggests. 1960 1965 1970 19 75 1980 1985 1990 1995 2000 2005 20 10 Indicators of US Economic Activity 20% Source: HighMark Capital and Thomson Datastream 15% 10% Global Industrial Renaissance 5% 0% In Are the Nightmares Behind Us? (Quarterly Investment -5% Outlook for Q1/2012), we introduced several new -10% Industrial Prod.: 4.4 themes, including an Era of Heightened Productivity. We Construction: 9.9% -15% continue to refine our thinking about this complex theme. -20% The more we look into emerging American innovation, 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 the greater our conviction that relative competitiveness To tal Construction Industrial Production can boost potential economic growth. It is exciting to observe so many new areas of research andSource: HighMark Capital and Thomson Datastream development seeking to improve living standards and operating efficiency. Yet, it is not surprising such themesChina’s risk of a hard landing is receding with aggressive are difficult to quantify in economic terms. Technologymonetary easing, including bank reserve requirement has become an enabler of new things that are cheaper,and interest rate cuts. China’s short-term interest rate or faster, smarter, more efficient, substitutable, or increaseSHIBOR has fallen from 6.5% to 3.35% in a year, but productivity. A strong financial system is also necessarymostly in the last two months, so investors should be to facilitate desired potential growth and productivitypatient about when changes will have an impact. The gains over the next decade. American banks aregovernment recently announced an 8% growth target, approaching their goal of meeting higher Basel III capitaland they have plenty of policy flexibility to get there. requirements, and are stronger today than anytime in the 3
  • 4. last decade. They are better positioned geographically innovation in the article: “Comeback Kid: America’sand financially than rivals anywhere in the world. Product economy is once again reinventing itself.” It may requiredevelopment cycles have shortened with the advent of a little faith to believe American businesses will developcomputer aided design and simulation. Innovations such competitive products that can drive our economy to newas additive manufacturing (aka: 3-D printing) and heights, but it has never paid to sell America short.adaptive robotics, for example, are part of an emergingindustrial renaissance with the convergence of evolving Tax Debate in the Bull’s Eye This Electioncompetitive advantages in manufacturing. The debate over tax policy in America has becomeWe highlighted in Q1 how the global revolution in highly polarized over fairness and morality, measured ininformation technology has democratized education and any number of ways. Simply adjusting tax rates is thetransformed innovation, inspiring a renewal of simplest method of changing tax policy; yet someentrepreneurialism. Ubiquitous computing and big data suggest that our tax code is unfair because companiesin the cloud feed our thirst for information, providing and individuals are not treated equally, even withininstantaneous access anywhere and anytime. How can income brackets. Targeted tax credits, exemptions andwe measure such contributions in productivity? The rise deductions leveraged for political advantage introducedof productivity, highlighted in HighMark’s 2012 themes, over many decades have increased the complexity ofhas become immeasurable. We can’t define output our tax code, and singled out constituencies forconsistently if many services are now offered for free or favorable exceptions. Our increasingly progressive taxnegligibly cheap. code has resulted in the top 10% paying more than 50% of the federal tax revenues, while more than 50% ofEmerging Market labor cost advantages have begun to households pay no income tax at all, according to dataerode with an industrial renaissance. A repetitive task from the Congressional Budget Office. Tax revenues arethat used to be cheaper to outsource, will eventually be very cyclical as a result. A significant divergence inreplaced by a machine that doesn’t get tired and makes statutory rates and effective tax rates also raisesfewer mistakes. It can be housed in the U.S., as easily questions of fairness, but will those who benefit mostas in Shanghai. Since 2000, Chinese wages increased exploiting tax exceptions actually pay more simply byfrom $0.50 to $3.50/hr. on average. Studies of raising tax rates? We believe that only broad-based taxpersistently high unemployment suggest several causes, reform can improve fairness across all income brackets,including the structural consequence of rapidly evolving in an already highly progressive tax code.job skill requirements, and the mismatch with employers’needs. The decline in manufacturing has been caused Legislation and regulatory rulemaking has increased theas much by an economic transition in the application of complexity and inefficiency of tax policy at the federaltechnology to a wider range of industries. An increase in and state level. “The Economic Burden Caused by Taxon-shoring reflects accelerating automation, as the labor Code Complexity”, by Dr. Arthur Laffer et al, estimatedcost advantage narrows, minus rising transportation that administrative, filing, and compliance costs havecosts. Consider one technician managing six adaptive increased dramatically since tax reform legislation inrobots, running 24 hours a day that displace 20 jobs in 1986, and exceeded $431 billion in 2010, equivalent toShanghai. The math is compelling, as it is startling. 30% of total income tax revenues collected. No businessIndustries yet to be reformed are in the bull’s eye now, could survive such inefficiency. Tax code complexity isincluding heath care, education, government services, further compounded with other goals to promote specifictransportation, and utilities. behavior and outcomes, unrelated to tax revenue needs. Simplifying corporate and individual tax reform couldLeveraging productivity gains require cheap power on produce material savings for taxpayers and government.demand, and America has been at the forefront of Since taxpayers bear over 70% of this cost, discretionaryharnessing meaningful natural gas reserves by hydraulic income would increase. The challenge remains vestedfracturing. Power utilization efficiency gains combined special interests fought for each incentive, exemption,with cheap natural gas, generating 23% of U.S. electric and deduction. The greatest loss of tax revenue is due topower, has driven the lowest electricity prices globally. behavioral changes exploiting tax avoidance strategies.China’s Resources Ministry recently announced that Simplifying tax reform can recapture tax revenue and stillpreliminary surveys suggest shale-gas reserves exceed improve discretionary income.25.1 trillion cubic meters, which could be the largest inthe world, and enough to meet Chinas natural gas Wide differences exist between average effective taxneeds for the next two centuries. Finding a practical way rates and statutory tax rates. Thus, by simplifying the taxto utilize natural gas for transportation could reduce oil’s code, tax revenues can increase even if tax rates wereestimated $20/bbl geopolitical risk premium, given the reduced or at least held steady. Broad-based tax reformspread between natural gas and oil prices (natural gas = offers the best chance of rebalancing fiscal policy and$18/bbl equivalent vs. $85 WTI). Proximity to cheap eliminating costly inefficiencies. The collective benefit ofpower provides a competitive advantage to various tax reform can only be realized by addressing all specialstrategic industries, including manufacturing chemicals tax considerations at once, instead of incrementally. Theand other basic materials. The Economist recently Simpson-Bowles Commission recognized the need forhighlighted our economy’s underlying strength through comprehensive reform. By reducing spending as much 4
  • 5. as $200 billion per year, they recognized the need to debt ceiling debate, a continuing resolution has fundedlimit spending to 20% of GDP (maximum federal tax the government through March 2013.revenues), empirically derived in Hauser’s Law. TheCommission also recommended increasing tax revenue, Let’s (Operation) Twist -- Yet Again!while accommodating lower tax rates by eliminatingdeductions. In this way, they close the gap between We would like to believe the music has stopped, even iflower statutory and effective tax rates, with the goal of the Federal Reserve is still dancing The Twist. Thegreater fairness and consistency. Solutions that benefit challenge of unwinding current monetary policy, withouttaxpayers and increase revenues improve the likelihood damaging the economy, has become more difficult. Eachof comprehensive tax reform. Doing so might eliminate subsequent monetary initiative has provided diminishingpatching the Alternative Minimum Tax every year to benefit, which is why we think the hurdle is high for andaccount for inflation, and avoid uncertainty of temporary additional quantitative easing, as long as the economy istax changes that make tax planning so difficult. expanding. While bond yields tumbled over the last year, it is difficult to unravel the influence of monetary easingThe individual tax code is highly progressive, meaning from recurring global growth threats in July-Septemberthat higher income tax brackets pay a higher tax rate. 2011 and May 2012. Pledging another $267 billion toCongressional Budget Office data published for 2007 maturity extension on June 20th committed all that is left(latest available) shows 20.1% was the effective tax rate to "twist". Monetary stimulus can ease financial concernsof the top 20%, which was 58% greater than the tax rate such as liquidity, credit demand, and the cost of money,of the middle 20% of taxpayers paying 12.7% on but geopolitical concerns and structurally highaverage. Tax avoidance is a strong incentive for those unemployment are best addressed in other ways.subject to the highest rates. Warren Buffett penned aWSJ op-ed last August stating that his 2010 effective Since 2010, each successive monetary policy easingindividual tax rate was 17.4%. His annual salary is just initiative has been less effective. There is little$100,000, so most of his individual income comes from justification for further quantitative easing (QE-3), or aninvestments, including dividends taxed at 15%. extension of interest rate guidance beyond 2014 at thisHowever, Warren Buffett also owns 31% of Berkshire time, in our opinion. The only other option is to reduceHathaway, whose recent corporate tax rate was 29%. the interest rate paid on excess bank reserves (IOER),Mr. Buffett’s tax liability is dominated by his corporate currently 0.25%. Why should taxpayers pay interest toholdings, thus his individual income tax rate is banks on capital reserves held at the Federal Reserve,economically irrelevant versus his corporate tax rate. earning a higher rate of return than bank deposits? The Federal Reserve never paid interest on reserves prior toThe United States has the highest combined statutory the Financial Crisis, and ending this practice would likelyfederal and state average tax rate of 39.2%1 after Japan encourage banks to lend this money.cut its corporate tax rate from 39.5% to 38% in June. US Interest RatesOther countries also have slashed their corporate tax 15rates. While statutory rates remain high, average U.S.corporate taxes paid fell to a 40-year low of 12.1%. 12Since 1950, corporate tax rates as a share of federal tax 9revenue fell from 30% in 1950 to 6.6% in 2009. Larger 6companies have an advantage leveraging sophisticated 3tax avoidance and deferral strategies, making it moredifficult for smaller companies to compete. General 0 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009Electric, one of America’s premier companies, paid anaverage tax rate of 2.3% over the last decade, including USTB10Y USTBILLno income taxes in 2002 or 2008-2010. Last year the Source: HighMark Capital and Thomson Datastreamcompany paid 11.3%. With accumulated tax losses andoverseas earnings, General Electric will continue to Unprecedented interest rates will eventually rise, and webenefit from a lower tax rate, while most competitors pay expect 10-year Treasury yields to increase from 1.5% tohigher effective corporate tax rates. Increased regulation 2.1% by the end of 2012. We have suggested that a Fedand tax code complexity reduce global competitiveness Funds target of 1.0% would be very accommodative,raise barriers to entry, exacerbate inefficiencies, and and still no higher than previous cycle lows through Maythereby promotes “too big to fail”. 2004. Yet, it would stabilize money market funds, which buy securities needed to finance liquidity needs ofDoing something substantive and permanent is a strong companies, financing operations, government, andmotivation to extend current tax rates into 2013 in order banks. Treasury purchases and date certain policyto attempt tax reform and pass the first federal budget in indication only seems to exacerbate market volatility.three years. In so doing, we could enhance thepredictability of tax revenues, while improving operating The Federal Reserve’s bloated balance sheet mustefficiency and global competitiveness. To avoid another eventually contract when securities are sold, unless the FOMC learns to dance the "Reverse Twist" to accelerate1 Federal corporate tax rate of 35%, plus 4.2% state average. 5
  • 6. maturity or Treasury cancels securities held by the on dividends could trigger underperformance of highFederal Reserve. The Federal Reserve bought the dividend yielding stocks before year-end, particularly inequivalent of 77% of Treasury issuance in 2011, which utility and telecommunication sectors with stretchedartificially suppressed interest rates. Such depressed valuations. Higher dividend yielding stocks also tend tointerest rates are unsustainable with real GDP growth of underperform when interest rates rise. Long-term capital2.2%, core CPI inflation exceeding 2%, and housing gains will be taxed at 23.8% (up from 15%), much lowerrecovering. Cyclical indicators such as industrial than unearned income from interest and dividends.production, business sales, construction, housing starts, Compelling global equity valuations versus bonds makesand even earnings contradict fears of a likely recession. it attractive to harvest income from equity capital gains, as an alternative to higher fixed income allocations.As the Federal Reserve has sought to keep the recoveryon track, they unwittingly perpetuated moral hazard, in Evolving Eurozone Crisisour opinion. Never before has the Federal Reserveoffered specific economic and interest rate guidance. Policymakers have struggled since early 2010 toCompanies, individuals, and investors are making long- stabilize the sovereign debt crisis that has driven up theterm decisions based on interest rate expectations. The cost of government bond issuance as credit agenciesdate certain horizon for holding interest rates low downgraded ratings. Fiscal deficits have soared, even inthrough 2014 compels investors to buy Treasuries, even countries with already high debt levels of 100% or morewith negative real yields, extinguishing inflation and debt/GDP. The viability of European Monetary Unioninterest rate risk premiums. When interest rates begin to (EMU) hinges upon whether greater integration willnormalize, possibly well before the end of 2014, promote fiscal discipline, while reversing decliningexpectations will be shattered. Fixed income returns will competitiveness that is undermining potential growth.turn negative, and volatility should increase, we believe. Failing tax compliance and collection doesn’t help either, Treasury Yield Curve when entitlement spending is growing so much faster 8.0 than the economy. Causes of fiscal deficit problems in 7.0 Average Europe will need to be addressed in Japan, where debt 6.0 ratios are even more concerning, although for now they 2004 5.0 can finance most debt issuance internally. Yield (% ) 2007 4.0 3.0 2008 With increasingly globalization, China is likely to be more 2.0 sensitive to slowing European growth than the United 1.0 Current Dec 2008 Dec 2007 May 2004 Avg:1962-2010 States. It is noteworthy that U.S. exports are just 13% of 0.0 0 5 10 15 20 25 30 GDP, with total European Union exports of goods to the Matur ity (year s) European Union in 2011 totaling $440 billion or 2.8% of U.S. GDP. If European growth is -4% below potential,Source: HighMark Capital and Thomson Datastream how significant is 2.8% x 4% = 0.1% of GDP? The benefits of shifting market share toward U.S. businessesEventually, interest rate and inflation risk premiums will may more than offset lost export demand. About half ofbe re-priced into yield curves. An inevitable bond market our exports stay in North America, and the rest is splitcorrection from artificially extended prices is likely to be between Europe and Asia + Latin America—both Mexicothat much more cathartic and destructive in convergence and Canada are growing reasonably well. About 30% ofto equilibrium. The chart above suggests normalizing the China’s GDP is dependent on exports, in comparison.Treasury risk premium would boost the 10-year Treasury While S&P 500 earnings sensitivity is higher than theyield from 1.5% to over 6.0%, resulting in a principal loss share of GDP suggests, perceived trade concerns withof about 30%. Higher U.S. Treasury yields will likely struggling EU economies are causing more U.S. equitycoincide with higher bond yields in other counties. We volatility, than the economic dependency suggests.expect the Federal Reserve to tighten monetary policywell before similar action by the Bank of Japan and the Greece, Portugal, Ireland, Spain and Italy have enjoyedEuropean Central Bank, which should strengthen the the benefits of lower interest rates since the euro wasU.S. dollar. This should result in underperformance of introduced in 1999, but their government leaders ignorednon-U.S. bonds, and possibly drag commodity and gold mandated fiscal guidelines in the Maastricht Treaty.prices even lower. Given already negative real Treasury Most EMU countries are outside the guidelines today toyields, why must bond yields be subdued any further? varying degrees. The Treaty has been amended to introduce real penalties for countries exceeding fiscalInvestor desire for yield has increased further in the last guidelines. Recent proposals call for greater integrationyear, but bonds are risky at current valuations. Fixed of Eurozone banks under a single regulator, provisionsincome is a convenient way to generate income, but for deposit insurance, and severe penalties on violatingincome is taxed at a high rate of up to 35%. In 2013, fiscal guidelines. Such proposals will provide the abilityinterest and dividend income will be taxed up to 43.4% to recapitalize or manage failing banks. While these arefor the top income bracket, including a new 3.8% constructive changes, without political union, sovereignMedicare tax on unearned income due to health care countries must address competitiveness and otherreform. The significant increase expected in the tax rate structural issues that will take years to resolve. Only 6
  • 7. then will risk premiums normalize. The European ruinous policies are likely to increase its competitivenessFinancial Stability Facility has provided some relief, but gap with other members of the European Union. Policiesexpires soon, and will be superseded by a permanent advocated by President Hollande will reduce potentialprogram called the European Stability Mechanism, which growth and productivity in France, driving away many ofwill provide greater ECB flexibility. Creating universal its wealthiest citizens and successful businesses toEurobonds is strongly opposed by Germany, at least Switzerland or elsewhere. U.K. Prime Minister Daviduntil there is greater centralized fiscal policy controls. Cameron recently welcomed French business and individual tax exiles to the U.K., and “will roll out the redNo quick resolution is expected to Europe’s Debt Crisis, carpet” for them. It is insidious that French voters arebut it is noteworthy there are several overlapping issues, willing to experiment again with Socialism, whose moralyet unique concerns in each country. Spain and Ireland premise institutionalizes envy and self-sacrifice. Francehave been impacted most by declining real estate prices will face tough choices given President Hollande’saffecting the banking sector, more so than Greece, Italy promises conflict with the fiscal needs of the nation.and Portugal, which are grappling with high governmentdebt levels, ineffective tax collection, and excessive Economists suggest France has lost 500,000 industrialloopholes. The countries impacted do share similarly jobs over the last decade due to increasinghigh unemployment across uncompetitive workforces. protectionism and an uncompetitive workforce. France’sExports have declined significantly, as have growth rates shrinking export sector drove its current account deficitthat otherwise might allow these countries to grow their to record levels. France’s competitive position alsoway to better fiscal balance. Fiscal deficits are spiraling eroded, so any recovery will be fleeting, without of control due to unsustainable public sector wages unemployment already rising above 10%. Entrepreneursand pension commitments. Government spending must will not be incentivized to start new businesses, whilebe brought back in-line with tax revenue. German labor foreign direct investment will likely recede, seeking outmarket reform, which took effect in 2005, explains their other countries with more favorable business conditions.enviable 6.8% unemployment rate and export growth are We have observed the consequences of capital flight insuch outliers, in contrast with other EMU countries. Greece, Spain, and Italy. Beleaguered nations, including France, will continue to be market share donors if theyTaxing authority of most developed nations to service are unable to compete with their higher cost structuredebt was considered nearly limitless before the and unfriendly business environment. Debt/GDP isEurozone debt crisis. Sovereign debt is no longer approaching 90% with a fiscal deficit exceeding 7% ofassumed risk-free, after European debt ratings were GDP, so fiscal stimulus is not an option.downgraded and investors fled to safer havens.Unchecked government spending has brought debt The debt crisis within the European Monetary Union haslevels to a tipping point that ignited the current fiscal caused dramatic capital flight into Germany, as well asdeficit crisis. Capital flight from riskier nations is other safe havens, including the United States andshrinking their respective bank deposits. Long term Switzerland. Last fall, the Swiss National Bank imposedsolutions take time, but in the short-run we tend to a floor on the Swiss franc/euro exchange rate of CHFoverlook the asset side of a nation’s balance sheet. As 1.20. The weak Euro increased German competitivenessilliquid and impossible to value as it might be, thereby boosting export. It should not be surprising thatprivatization is only considered under extreme situations. German unemployment declined, while it soared in Italy (10.1%), Spain (24.6%), and France (10.1%).Default of a sovereign government, such as Greece,should follow only when privatization has been It is easier to envision Germany leaving the Eurozone,exhausted, like a company in liquidation. Of course, than weaker countries exiting EMU. A referendum couldthere is one asset that is always marketable. go either way with only 43% of Germans supporting theInterestingly, central bank gold reserves have Euro versus 41% that prefer a return to theappreciated significantly. This has boosted the ratio of Deutschemark, according to a recent YouGov holdings as a share of total reserves up to 90% in For Germany, it has been costly to back multiplesome countries. Eurozone countries hold gold reserves bailouts, but their growth should outpace the rest of EMUtotaling 10,792 metric tons or 64% of worldwide gold by a wide margin with a weak currency and such lowreserves, worth $610 billion. Greece’s gold holdings interest rates. Economic power is shifting further inaren’t significant enough to help them, but Italy holds Germany’s favor. The United Kingdom is a member of2,452 metric tons, and about the same as France. We the EU, but opted-out of the EMU. It hasn’t seemed tosuggest that Spain, Italy and Portugal could back debt impact its competitive position. However, will Germanyissuance with their gold holdings, or even sell gold to become so dominate that it further destabilizes EMU?refund maturing debt for an interim period.Geopolitically, how the newly elected socialist Frenchgovernment, stripped of its AAA-credit rating,cohabitates effectively within the European Union is animportant question. Socialism is incompatible incompetition with capitalism. France’s new agenda of 7
  • 8. Conclusion inflation rates (1.7% CPI, 2.4% core CPI) suggest bonds are overvalued given a normal inflation risk premium of“We forget that Mr. Market is an ingenious sadist, and 2.5-3.0%. Bonds typically include an interest rate andthat he delights in torturing us in different ways.” inflation risk premium, but the Federal Reserve has said---Barton Biggs, Value Investor (1932-2012). they will keep rates low for the foreseeable future, thereby promoting moral hazard. The level of investorInvestor concerns are rightly focused on global growth risk aversion belies the significant outperformance ofand earnings potential, but something much worse than equities versus bonds and commodities since Marchconsensus forecasts has been discounted in equity 2009. Economic activity and earnings have reboundedmarkets. As a result, there is a healthy margin of safety above 2007 highs, although fears of a “double-dip” orreflected in attractive equity valuations and low interest extended period of deflation and depression persist.rates with resilient moderate growth expected. Wecontinue to balance compelling global equity valuations, Asynchronous Global Expansion, as a theme for 2012,particularly for the U.S. and Emerging Markets, with the has begun to support signs of economic decoupling andongoing threats to global growth. These threats include: reduced global economic contagion. Asset valuationsU.S. Fiscal Cliff, Eurozone Debt Crisis, slowing have diverged from equilibrium more than anytime sinceEmerging Market growth, and Iran’s nuclear aspirations. 2001, exposing significant tactical opportunities. Low interest rates remain globally stimulative, promotingSince December 2008, investors have observed equities investment and housing affordability. Earnings also haveunderperforming bonds over the prior decade, but this benefited, while profit margins ratcheted well abovedifferential finally reversed in July 2012. Strategic equity normal. Such compelling equity valuations and negativeallocation policy exposures have generally fallen, as real yields are consistent with relentless risk aversioninvestors wonder whether equities will ever make sense and uncomfortable choices for uncertain investors.again. Heightened risk aversion has compressed equityvaluation multiples, and driven real Treasury yields Longer-term, our investment outlook strongly favorsnegative across the yield curve. The increased equity equities over bonds, cash, and commodities, with arisk premium suggests intense geopolitical pessimism remarkable 6.5% equity risk premium. While uncertaintyover the Eurozone Debt Crisis and an increase in fiscal and heightened volatility persist, current threats haveausterity globally, as if economies can’t grow without been discounted. So, the only variables that should begovernment spending. Investor discomfort with equities relevant for markets are a function of fundamentals.versus unsustainably low bond yields, quantify the Capital markets tend to discount improving prospectsuncertainty about asset allocation in portfolios. well before changing conditions are visible, so investors must consider Rationalizing Uncomfortable Choices.Investor preference for bonds is irrationally complacentas the 30-year bull market in bonds drove 10-year David Goerz, SVP - Chief Investment OfficerTreasury yields to a record low, below 1.5%. Current Highlights is a publication of HighMark Capital Management, Inc. This publication is for generalinformation only and is not intended to provide specific advice to any individual. 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