The World Turned Upside Down (Article)


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Geopolitical and socioeconomic challenges remain at the forefront of daily headlines. These issues have taken a heavy toll on investor sentiment the past several years. While markets are usually driven by a mix of expectations and current conditions, we’ve never encountered such an influence of investor sentiment upon economic expectations. In today’s complex world, distinguishing coincidence from causality is becoming more challenging. Learn more at:$

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The World Turned Upside Down (Article)

  1. 1. INVESTMENT HIGHLIGHTS June 2012 The World Turned Upside Down (1646) To the Tune of, When the King Enjoys His Own Again. “Listen to me and you shall hear, news hath not been this thousand year: Since Herod, Caesar, and many more, you never heard the like before. Holy-dayes are despisd, new fashions are devisd. Old Christmas is kickt out of Town. Yet lets be content, and the times lament, you see the world turnd upside down”THE WORLD TURNED UPSIDE DOWN Ireland offers hope for others as its economy is turning the corner with positive growth in 2011, and is expectedGeopolitical and socioeconomic challenges remain at to continue through 2012, while yields have tightenedthe forefront of daily headlines. These issues have taken -1.9% versus six months ago. Improving one’s fiscala heavy toll on investor sentiment the past several years. deficit, encourages foreign investment, reduces interestWhile markets are usually driven by a mix of rate risk premiums, and restores business confidence.expectations and current conditions, we’ve neverencountered such an influence of investor sentiment Unexpected political turnover during the last two years,upon economic expectations. In today’s complex world, suggests voters are losing patience with failure. In a U.S.distinguishing coincidence from causality is becoming presidential election year, that points to political gridlock.more challenging. To attract attention, forecasters must In France, President Hollande is the first Socialistprovide uniquely compelling insights, have an president in nearly two decades, after narrowly defeatingexceptional reputation, or be very provocative. The a very unpopular Nicolas Sarkozy. We believe his planconvergence of cheap access to information combined will do little to bolster 0% growth, while furtherwith sophisticated data mining tools and increased jeopardizing France’s credit rating. His election platformcomputing power has increased reliance on empirically- called for increasing taxes on higher incomes, whilederived conclusions. These tools are very effective used stimulating growth with more government spending,in the right way, but intuitive fundamental relationships despite France’s already high 5.2% fiscal deficit andare now being contested more often by potentially debt/GDP of 89%. In contrast, Spain’s conservativespurious correlations. The leveraging of empirical Popular Party, headed by Mariano Rajoy, overwhelmedanalysis can more easily and convincingly reinforce the ruling Socialist Party last November, asmisguided beliefs in this unprecedented age of contrived unemployment soared to 22%. We dont believe Spain isreason, swayed by behavioral biases. This isn’t the first headed down the same path as Greece, given its muchtime The World Turned Upside Down, and it won’t be the lower debt and policies of its new government. Spainslast. Thus, we are hesitant to embrace the notion that problems begin with stabilizing real estate and end withthis time is different. bolstering bank capital ratios, as regulators raise the bar. Greece is an extreme case, so drawing similarities toBelow, we discuss the European Sovereign Debt Crisis other countries should be done with forethought.and the U.S. Fiscal Cliff, specifically, how both are likelyto impact our outlook in The World Turned Upside Down. European debt markets were calmed when MarioMany countries within the Eurozone have tipped into Draghi, President of the European Central Bank (ECB),recession again as the European Debt Crisis continues facilitated security purchases of over €1 trillion throughinto its third year. Countries most at risk, including the Long Term Refinancing Operations (LTRO). ThisPortugal, Italy, Ireland, Greece, and Spain (that spells program exceeds the Fed’s quantitative easing in QE-1PIIGS), have witnessed the cost of debt financing soar & QE-2 combined. The Eurozone’s fiscal deficit isagain, with Italian bond yields over 5.7%, notably 4.4% expected to persist due to failing competitiveness andgreater than Germany. Spanish 10-year yields have adverse demographics, resulting from low birth rates thatwidened +0.4% over the last six months to 6.6%, while continue to decline, and adverse immigration trends.Italy has actually tightened -1.1%, suggesting improved European Monetary Union (EMU) members agreed inconfidence in Italy, but not Spain. Austerity measures the Maastricht Treaty to not exceed 60% debt/GDP andhave been effective in reducing projected fiscal deficits a fiscal deficit/GDP of less than 3%. These are assumedby cutting government spending and raising tax rates. to be prudent levels of fiscal discipline. The Eurozone’s 1
  2. 2. fiscal deficit averages 4.2% with debt/GDP of 89%, Most analysis of the Fiscal Cliff simply subtracts the totalwhich exceed the Treaty’s guidelines. Long gone is any aggregate impact, ranging from 0.5-3.5%, from currenthope of the Euro being an alternative reserve currency, real GDP forecasts. Such logic is flawed in many ways,supplanting the U.S. dollar. Most Eurozone politicians one of which is the confusion between real and nominalhave proven themselves incapable of weaning off effects. Increased taxes and spending cuts are nominalspending other people’s money, but a few countries set quantities, so the assumed impact on demand fails toan example by embracing a balanced fiscal approach. account for any offsetting impact on inflation. We believe transfer payments, such as unemployment insuranceInvestor concerns are rightly focused on global growth and payroll tax reduction, have a stimulus multiplier ofand earnings potential, but several concerns continue to less than 1.0 (i.e., growth resulting from increased fiscalhaunt the global economy. Asynchronous Global spending). Most economists agree that the multiplierExpansion, as a theme for 2012, has already begun to attributed to the American Recovery and Reinvestmentshow signs of economic decoupling and reduced global Act of 2009 was much lower than 1.0, so why wouldn’tcontagion. Meanwhile, transitory concerns of 2011 have multipliers of “negative” stimulus be reduced too?moderated, although some new concerns have Historically, permanent changes to tax policy haveemerged. Economic effects from the European Debt exhibited a higher multiplier than tax rebates andCrisis have remained limited in other regions, so we still temporary stimulus. Some studies have calculatedfavor U.S. and Emerging Market equities. It is hard to multipliers of less than 0.5.anticipate when capital markets will discount the impactof the Fiscal Cliff, although we believe it is still too early. The Budget Control Act imposed spending reductions ofA natural tendency is for investors to shorten their time $2.1 trillion over 10 years in exchange for raisinghorizons with heightened volatility, although the best Treasury’s debt limit by $2.1 trillion, including $1.2 trillionresponse may be to extend one’s time horizon and in across-the-board spending cuts over 10 years. Thisrebalance faithfully in The World Turned Upside Down. It sequestration has been in everyone’s forecast sincehas paid handsomely to be a contrarian investor, if one September 2011, so subtracting it again from currentcan stay the course, particularly since 2009. forecasts is double counting. The total net fiscal impact calculated by the CBO is just $65 billion (0.4% of GDP)The Fiscal Cliff Of 2013 in 2013, not 10% of $1.2 trillion or $120 billion. Lower program spending will force productivity gains in order toThe U.S. Congressional Budget Office (CBO) released a maintain most program objectives. Given dramaticreport in May 2012 summarizing the economic effects of private sector cost rationalization, government shouldlegislated policy changes under current law, taking effect have room to significantly improve productivity, limitingin 2013. The combined impact has been referred to as the blunt force of sequestration. Spending cuts are back-the Fiscal Cliff, and is expected to clip about $560 billion end loaded, and the CBO’s net impact accounts forfrom the U.S. fiscal deficit in 2012 - 2013. Without any interest expense savings. Thus, simple subtraction of thechanges, the CBO expects U.S. real growth in GDP will sum of all these changes overstates the net impact.average 0.5% in 2013. The fiscal deficit should narrowfrom $1.3 trillion (8.6% of GDP) in FY2011 to $612 billion By law, both houses of Congress are required to submit th(3.8% of GDP) in FY2013, representing meaningful and pass a budget resolution by April 15 , thus it shouldimprovement in our fiscal balance. The CBO estimates a be theoretically possible to pass tax reform or improve2% reduction in GDP due to the Fiscal Cliff, although upon sequestration. Unfortunately, it has proven difficultother estimates range as high as 3.5%. Obviously, the to pass legislation, so gridlock may continue throughoutissue is complex and contentious, based on many this election year. The House has passed a budgetassumptions. It is unclear how much of the Fiscal Cliff again this year, but the Senate has failed to pass its ownhas already been discounted in forecasts, but we must budget resolution for the third year, and apparently hasclose the gap between government spending exceeding no intention of doing so. This election year, it appears25% of GDP versus the 20% of GDP limit in tax revenue the only hope is a “grand compromise” that slows(Hauser’s Law) that has never been exceeded, spending, incorporates sequestration, and raises theirrespective of tax rates, since the Sixteenth Amendment debt ceiling enough to deal with it after mid-2013.introduced a permanent income tax in 1913. Pressure is increasing on Congress and the President toGDP headwinds from the Fiscal Cliff include expiring tax address the Fiscal Cliff. We are assuming capital gainscuts on income, dividends, capital gains, estate and dividend tax rates will both increase to 20%,transfers, and indexing of the alternative minimum tax. suggesting some relief on the dividend tax increase.The payroll tax reduction and extended unemployment Reducing repatriation taxes on foreign earnings hasbenefits (99 weeks) will expire at year-end. Health Care bipartisan support, but it is one of many negotiatingReform will boost payroll taxes, even as Medicare doctor pawns. Overall, we are assuming a net impact of 1.5%reimbursement rates decline. Our estimate of the reduction on U.S. GDP, which is embedded in our 2.5%nominal impact is 1.5%, given our assumptions about growth rate for 2012-2013. We assume U.S. real growthlikely adjustments, and is embedded in our 2.5% real would otherwise have the potential of a 3.5-4.0%growth forecast for 2012-2013. increase without these effects. 2
  3. 3. Greece: Fait Accompli or Not? membership has risen from 70% to 80% in the last three months. Following elections, we think that GreeceGreece is a country with 10 million residents producing should seek to exceed the Troika’s prescription:€229 billion of GDP and €235 billion of sovereign debt implementing tax reform and privatizing additional assets(haircut from €341 billion), but uncertainty about its to lower debt further and restore confidence in the future.future has been the most significant reason for wipingout nearly $4 trillion in global equity capitalization during We believe the likelihood of withdrawing from EMU doesMay. Rising odds speculating that Greece will exit EMU increase substantially if Greece defaults, but there is nohas had an exaggerated effect on financial markets. Yet, benefit to exiting from EMU or defaulting. Greece couldthe only way for Greece to legally exit EMU is through a default to force further debt restructuring, but thereferendum process. EMU membership is only for a consequences would be grim. Greece is a wealthysovereign country to decide. No one apparently country, and has agreed to privatize €87 billion (37% ofenvisioned a country might withdraw during the decade debt) in the austerity deal. Why would a country not selllong effort to form this monetary union. ECB President more assets if needed to avoid default? Default wouldMario Draghi has confirmed the “strong preference” for trigger higher interest rates in peripheral countries,Greece to share a common currency with the rest of the whereas capital flight is already accelerating with bankEurozone, but costs to other countries continues to rise. deposits plunging in Greece and soaring in Germany. It is in nobody’s interest to repeat Russia’s default in 1998. thGreek elections on May 6 resulted in significant loss ofsupport for the ruling Socialist PASOK government. If Greece withdrew from EMU, experts suggest aDuring Greece’s fifth year of recession, unemployment devaluation of 30-40% would restore competitiveness. Arose to 21.7%. Voters endorsed the conservative New currency board would likely manage the transition,Democracy party, led by Antonis Samaras, while a imposing capital controls for some period. Inflation wouldsignificant protest minority embraced fringe parties that rise significantly under this scenario, and borrowersopposed the Troika-imposed austerity. These voters would pay a high interest rate risk premium for years.hoped alternative leadership might negotiate a better Greece’s experiment with Socialism has failed, as it hasdeal for more time or increased debt forgiveness. in other countries. Excessive entitlements, diminishedPopulist opposition to the Greek bailout is at odds with incentives, an ineffective tax system, political corruption,support of EMU membership, so anti-austerity parties and inferior competitiveness has put Greece at a globalare also seen as Euro-skeptic, which is more unpopular. disadvantage, while mounting fiscal deficit spending has compounded into an unsustainable liability. We believe aUnable to form a government, new Greek elections were change in government is actually Greece’s best hope. thscheduled for June 17 . Recent polls suggest Mr. 1Samaras is leading again, supporting the Troika Tax collection rates and compliance are abysmal, whilenegotiated bailout agreement that kept Greece from tax avoidance schemes are expanding in countries withbankruptcy in exchange for promised fiscal austerity. Mr. high fiscal deficits. Those avoiding taxes will continue toSamaras graduated with a degree in economics from pay less than their fair share, no matter how high taxAmherst College and an MBA from Harvard University, rates are hiked. How bad is Greek tax collection? Theand is well qualified to lead Greece through this period. Ministry of Finance reported in June 2011 that tax arrears exceeded €41 billion, which would cover the €20Greece’s inability to form a government and implement billion debt refunding in 2012 and the €17 billion fiscalthe Troika-imposed fiscal discipline has driven up bond deficit. Clearly, there are decipherable policy differencesyields over 29%, although below the previous peak of between countries that distinguish fiscal success or36.6%. A caretaker government was appointed, but in failure, even at our state level. Membership in EMU hasthe interim, uncertainty has had an impact. Bank allowed Greece to enjoy lower interest rates than weredeposits plunged 30% in three weeks, straining capital justified, while failing to meet the Maastricht guidelines.ratios of impaired Greek banks. Large commercial banks Greece’s only way forward is to accept fiscal disciplinerequired an infusion of recapitalization funds. Sufficient and forfeit budget control to creditors and the Troika---aliquidity is available from the Troika to reinforce or lesson the developed world would best learn soon.nationalize the Greek banks, provided the Greeks don’tpursue an irrational course, giving creditors reason to We expect the Euro to weaken toward 1.15 US$/€withdraw financing. U.S. investors have already versus a trading range around 1.33. Germany stands towithdrawn from funding Eurozone banks. benefit most as the Euro weakens, but growth in Greece, Portugal, Spain, and Italy is impaired by rising capitalGreece can only legally withdraw from EMU membership costs. Eurobonds and political union of EMU are a longby referendum, therefore Greek exit is unlikely in the way off, but that may be the final solution. Our attentionforeseeable future, and would require protracted efforts is still focused on the Eurozone, but we believe a moreto accomplish. We believe an exit would be disastrous difficult challenge lies ahead for Japan. A “Lost Decade”for living standards in Greece, while setting a damaging may limit Europe’s growth, but Japan’s fiscal deficit hasprecedent for EMU. Greek popularity of EMU pushed its debt over 230% of GDP. Japan’s credit rating has been falling, and Fitch lowered their rating again in1 includes European Union, European Central Bank, and IMF May to A+, one notch below Moody’s (AA3) and S&P 3
  4. 4. (AA-). Only 16% of Japan’s debt is foreign held, but we We believe any indirect effect from the Europeanrecommend hedging Yen exposure and avoiding Sovereign Debt Crisis on the U.S economy should begovernment bonds (JGBs), now the largest benchmark limited, since there are no signs of any liquidity strainexposure in global bond indices. Owners of international outside the Eurozone. U.S. banks enjoy their strongestbond funds should be attentive to their Japan exposure. capital position in over a decade, after efforts to raise capital, increase earnings retention, limit dividends,Conclusion constrain share repurchases, and divest riskier holdings, despite strong cash flow. Increasing loan demandWe observe that many of the economic threats evident coupled with easing credit conditions, have causedin 2011 have since moderated or been extinguished, commercial and industrial lending to accelerate to a highexcept for the European Debt Crisis. Expanding fiscal of 15.8% annual growth since the Financial Crisis.deficits across developed countries, including the UnitedStates, Japan, and Europe pose long-term risks to the Never have such perplexing investor behaviors beenglobal economy. So far, economic effects have remained observed over such an extended period. Increasedlimited to Europe. The other worrisome emerging threat uncertainty combined with market volatility can yieldis the Fiscal Cliff, which threatens to undermine U.S. exploitable market inefficiencies in The World Turnedeconomic growth. Estimates of its adverse impact could Upside Down. Investment discipline and unwaveringreduce growth by 0.5-3.5%, depending on the legislative faith to endure being uncomfortable and contrarian canresponse. We expect an impact of 1.5% to limit real help investors seize upon profitable opportunities.growth in GDP to 2.5% in 2013. Confidence in the ability Alternating between virtuous and malicious self-to address tax reform and other issues is discouraging reinforcing cycles undermines investor confidence, butand at a record low. According to Gallup’s most recent we suggest has little relevance to fundamental equitypoll, only 24% think our nation is on the right track. attractiveness, although risk tolerance may decline.The World Turned Upside Down is an uncomfortable Contrarian investors can benefit most from an “upsidesituation for investors. Ongoing concerns about the down” world when they stay focused on compellingEurozone’s stability are reflected in volatility of U.S. fundamental value that eventually attracts the empiricalequity and bond markets. Heightened risk aversion has “correctness” of greed. We don’t dismiss any of thecompressed compelling equity valuation multiples further many enumerated global threats, although we believeand driven real Treasury yields negative across the yield they are overwhelmed by a rising number of improvingcurve. The increased equity risk premium suggests global economic trends, strong earnings, compellingintense geopolitical pessimism about the Eurozone Debt valuations, low interest rates, and an anticipated Era ofCrisis and global fiscal austerity, yet global economic Exceptional Productivity. Asynchronous Globalgrowth and earnings remain resilient and are showing Expansion is the new paradigm, as we’ve highlighted,evidence of improving. Resilience in North America will that reinforces decoupling and reduces global contagion.likely reverse recent sentiment yet again. We believerelative asset valuations have diverged from equilibrium David Goerz, SVP - Chief Investment Officermore than anytime since 2001, exposing opportunities. http://commentary.highmarkfunds.comInvestment 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. Some information provided hereinwas obtained from third party sources deemed to be reliable. HighMark Capital Management, Inc. and its affiliatesmake no representations or warranties with respect to the timeliness, accuracy, or completeness of this publicationand bear no liability for any loss arising from its use. All forward looking information and forecasts contained in thispublication, unless otherwise noted, are the opinion of HighMark Capital Management, Inc. and future marketmovements may differ significantly from our expectations. 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