Fear gripped the markets through April and May, driving global stocks downward. The European debt crisis unexpectedly reignited when the incumbent and “pro-bailout” New Democracy party failed to win the early election it called. The result increased the odds Greece would exit the euro and led investors to scrutinize all sovereign debt holdings. Government bond yields in Italy and Spain quickly spiked and pressure mounted against Spanish banks.
But consistent with the pattern of mid-year corrections in 2010 and 2011, hope of bolder government intervention sparked a rally in June. It received a boost when New Democracy proved victorious in a second Greek election, mitigating the risk of a disorderly Greek exit from the Euro. The market recovery gained speed in the final days of June as a summit of Eurozone leaders in Brussels produced an agreement to relax conditions for emergency bank loans.
Overall, the S&P 500 lost roughly 3% in the quarter. International stocks fared worse. US Treasuries gained, benefitting from their perception of safety, a flight to dollar-based assets (at the expense of the Euro), and buying from the Fed. Ten and thirty year Treasuries hit record low yields during the quarter. Gold, oil and most commodities declined as the global economy showed signs of weakness.
Just a few months after providing an upbeat assessment of the US economy, Fed Chairman Ben Bernanke extended “Operation Twist”, citing high unemployment. Designed to hold down long-term interest rates, the Fed will sell an additional $267 billion of shorter maturity securities and use the proceeds to buy those with a longer maturity. The program should successfully keep borrowing costs low, but the full impact on the economy is unclear.
Capital Markets Outlook
Last quarter we predicted the European debt crisis would fade from the headlines only to reemerge in 2013. The Greek election surprise and subsequent pressure on Spanish and Italian debt quickly forced the issue back to the forefront. At this point, it appears Europe should remain the dominant driver of market performance for the balance of the year.
The most likely outcomes are:
- Extremely Difficult to Predict
As a whole, the euro-zone is in dismal fiscal shape. The same is true of the US, UK and Japan. All have balance sheets ranging from concerning to scary. But the US, UK and Japan are viewed as safe-havens. Why? Because unlike the Eurozone, they have a single currency and a central bank that can print money if necessary. This gives creditors confidence they will be repaid, even if those payments lose purchasing power. The European Central Bank does not currently have the power to print money to buy debt. This power, or at least a similar ability to fund or guarantee banks, may be necessary to restore confidence and facilitate resolution.
You can run a large deficit as long as someone is willing to continue to lend you enough money to support it. It’s the same for countries. Eventually, there is a tipping point where creditors believe they are less likely to be repaid and demand higher interest rates to compensate for risk. This exacerbates the problem. A negative feedback loop begins and can very quickly spiral out of control.
Greece passed the point of no return in this game a long time ago. Despite a major debt restructuring, it appears there is no way Greece can pay its bills without help from other governments. If Greece had its own currency, it would have been forced to devalue it long ago to reduce its debt burden. Spain is in somewhat better shape and may ultimately prove solvent, but bad bank loans made during the 2003 – 2007 property bubble leave the country reliant on outside assistance, for now. Italy remains a question mark. Ireland, Cyprus and Portugal have already required bailouts.
Bailouts have worked so far in this crisis, and capital markets continue to act as if they are the solution. But there may be a flaw with this. The largest four countries in the euro-zone (Germany, France, Italy and Spain), make up about 75% of the region’s GDP. Two of these have already been identified as high risk. Troubled countries can’t bail themselves out. A third, France, is running a deficit of about 4.5% of GDP and has outstanding debt of over 90% of GDP. Finally, there is Germany, thrust into the unwanted role of savior. Germany is running a deficit of around 1% of GDP and has outstanding debt of about 80% of GDP.
A common perception is that Germany could solve everyone’s problems if only they were willing to play along. Market movements reflect this, spiking on any indication Germany may play a bigger rescue role, and declining whenever Germany acts more isolationist. But Germany simply doesn’t have enough money to solve the problem. Europe’s two “firewall” funds (the EFSF and ESM) are comprised of commitments from member countries. The key word is commitments, as neither fund is yet fully funded with cash. Some of the commitments come from countries clearly not in a position to help. Germany could easily make its contributions, but then its own financial health would be impacted. It can’t fully fund both vehicles.
Common Eurozone issued bonds are another oft-cited solution. Even if Germany agreed to common Euro-bonds (which it so far adamantly opposes), it would remain challenging to find enough buyers of such debt to finance the current mess.
There are numerous short term solutions, but none solve the problem. We believe for the Euro to hold together, the ECB must be allowed to print money to buy debt. However, it is strongly engrained in the German culture to avoid this type of inflationary behavior due to horrible past experiences.
Something has to give. We believe one of two scenarios is likely within the next two years:
- The ECB is granted more power.
- Germany agrees to give the ECB sweeping authority to buy unlimited government debt or inject unlimited capital into struggling banks.
- The ECB moves forward with one or both, instilling confidence in the private markets.
- The Euro declines modestly, but the global economy moves back onto a solid growth path. Stocks rise. Bonds fall. Inflation may or may not become a large problem a few years down the road.
- The Eurozone splits.
- Major countries like Spain and Italy become unable to issue new debt at manageable interest rates.
- Germany is unable or unwilling to provide further bailout money and refuses to change the rules for the ECB.
- The euro-zone breaks apart and several of the old currencies come back.
- The cost is staggering. The global economy contracts sharply. Markets initially fall, but most likely recover within a few years.
We strive to avoid being overconfident in our expectations for capital markets. In the current situation, this is easier than usual. The reason this particular environment is so hard to predict is because it is reliant on politicians beholden to increasingly disenchanted voter bases, not just markets and economics.
Economics has a degree of science to it. People, on the other hand, are impossible to predict. So far, ECB President Mario Draghi has resisted expanding the bank’s mandate. Likewise, Germany has been averse to major policy changes. But all of this could change if the alternative becomes imminent and its outcome appears awful enough.
In our view, investors should maintain a blended asset allocation that fits their long-term objectives. Volatility is likely to increase, but despite all the doom and gloom stocks remain attractively priced and have significant upside potential if the crisis can be resolved.
With interest rates at record lows and deficits at or near record highs, the long term risk of holding too much cash and bonds is underrated by most.
The Bullish Case for Stocks
- With the June agreements, European leaders took another step toward integration. Shared liabilities and commitments to the banking system mean all countries have increased incentive to avoid a messy breakup of the Euro, even at high cost or the sacrifice of some sovereign powers.
- Stocks are cheap globally. The S&P 500 is trading at about 13 times expected 12 month forward earnings, below its historical average. The Euro Stoxx 50 Index has fallen to 0.9 times book value (sources: Birinyi Associates, The Wall Street Journal, and Bloomberg).
- Interest rates are extremely low. Historically, valuations of stocks are inversely correlated with rates, implying stocks should move higher. The earnings yield on equities is around 8%, and the dividend yield is 2.2%, compared to just 1.6% in ten year Treasuries. This is massively bullish if you believe earnings will continue growing.
- The Fed remains accommodative, promising to keep interest rates low through late 2014. Inflation remains in check, opening the door for further stimulus.
- Almost no one expects large gains in stocks.
- Corporate balance sheets are strong.
- The fourth year of a President’s term has historically been good for stocks.
- The US housing market is showing signs of stabilization and, in some areas, growth.
The Bearish Case
- The European debt crisis appears to be spiraling out of control and politicians have produced little in the way of permanent solutions.
- Europe is on the brink of recession and faces increased austerity measures.
- Most leading indicators of the US economy softened in Q2.
- Risk of geopolitical tension stemming from Iran remains elevated.
- Analyst estimates for Q3 corporate earnings continue to be revised downward.
- China’s property market could be a bubble about to burst, unleashing a wave of bad debt issues which could slow global growth.
For a time the US seemed resistant to Europe’s woes, but cracks began to emerge in the second quarter. GDP growth slowed, corporate profits fell, and unemployment slightly increased. But not all was doom and gloom. While slower, economic growth remained positive, and the US housing market continued to show signs of improvement.
- Estimates for first quarter US GDP growth were lowered to 1.9%, down from previous estimates of 2.2% and below fourth quarter 2011 growth of 3.0%.
- Despite strongly positive domestic growth, US corporate profits from abroad fell $48.1 billion in Q1 2012, marking the first decline from the preceding quarter since 2008.
- Job growth slowed as the unemployment rate ticked up from 8.1% to 8.2% in May, and remained elevated at 8.2% in June.
- Sales of new and existing homes repeatedly surpassed expectations, and are up strongly over prior year levels. Home price declines continued to slow.
Conditions in Europe deteriorated. New austerity measures and the increasing threat of Greece leaving the Euro led to a broad-based slowdown over much of the region. Economic growth remained weak, bond yields increased, and unemployment worsened, among other things.
- First quarter GDP grew 0.1% in the EU, as reported in May. Better than expected growth in Germany helped the region avoid recession and improve from the -0.3% rate in Q4 2011.
- Spanish and Italian 10 year bond yields increased to 6.4% and 5.8% at the end of June, respectively. These figures are up from 5.4% and 5.1% at the beginning of the second quarter.
- EU unemployment rate increases to 10.3% in May, up from 10.2% in April and 9.5% in May 2011.
- While Europe captured most of the headlines, China is experiencing a slowdown of its own. The government grew more accommodative, but is unlikely to provide the same level of stimulus as before. The nation is placing greater focus on sustainable long-term growth fueled by domestic consumption.
- First quarter GDP growth slowed to 8.1% year over year, down from 8.9% in the fourth quarter and 9.7% in Q1 2011.
- Year over year growth in home prices turned negative in March, and worsened to -1.2% in May.
- Growth in retail sales continued their downward trend, coming in at 13.8% in May, down from 15.2% in March.
- While dipping slightly in April, export growth rebounded in May to 15.3%.
Understanding the Coming Tax Changes
As we approach 2013, investors should be mindful of potential tax code changes in the US. Of course, all of this is hypothetical—much will depend on the November elections. But it’s worth understanding the possible outcomes as they could have a material impact on investment portfolios.
Bush Tax Cuts
First and foremost are the so-called “Bush tax cuts”. Put into effect in 2001 and 2003, these cuts reduced tax rates on income, capital gains, and dividends. The cuts are set to expire in January. While most believe an extension is likely, particularly given weakening economic growth and persistently high unemployment, nothing is certain. Obama has publicly proposed an extension, but only for one year and for families earning less than $250,000.
Should the cuts expire, income tax rates will increase almost across the board with the top two rates rising to 36% and 39.6%. Additionally, the capital gains tax will increase from 15% to 20%. Perhaps the most dramatic change will be the treatment of qualified dividends. Currently, these are taxed at 15%, the same as capital gains. If the “Bush tax cuts” expire, they will be treated as ordinary income. So if you’re in the top income tax bracket, your rate will increase by almost threefold to 39.6%. There will likely be a compromise to a lower rate, but the change poses a potential risk for higher yielding “dividend” stocks.
Regardless of the reason, those with income-heavy portfolios could be in for a shock. One way to mitigate the impact is to place higher yielding securities in tax-deferred accounts like IRAs. Withdrawals are already treated as ordinary income. You could then create “home-grown” dividends and income by selling securities in taxable accounts. Doing this provides greater control over your final tax bill as you can harvest losses to offset any realized gains.
New Investment Income Tax
On Thursday, June 28th the US Supreme Court upheld most of Obama’s health-care overhaul. That means barring any legislative action, a new 3.8% tax will be levied on investment income starting in 2013. It applies to capital gains, dividends and interest income, among other things, and would impact individuals making more than $200,000 and married couples jointly earning more than $250,000. So even if the “Bush tax cuts” are extended, those affected will have to pay 18.8% on capital gains and dividends. If the cuts are not extended, the top rate on capital gains will increase to 23.8% and the top rate on dividends will jump to 43.4%.
Payroll Tax Cuts
In February of this year, Congress extended the payroll tax cut originally put into effect during 2011. The cut, which reduces the social security tax withholding rate to 4.2% from 6.2%, is set to expire in January if no extension is applied. While the impact on investment portfolios will be minimal, it will reduce the amount of discretionary income paid to workers. The result is less money being saved and spent, which could ultimately slow the pace of recovery.
Alternative Minimum Tax (AMT) Patch
The alternative minimum tax was created in the 1960s to help prevent high income earners from circumventing their fair share of taxes. However, the policy never accounted for inflation, so over time AMT has hit a larger share of the middle class. Congress has repeatedly enacted “patches” to help the tax keep pace with inflation, but there is still no patch for 2012. This means come April of next year, the number of taxpayers subject to AMT could rise from 4 million to 30 million, according to the Congressional Budget Office. So unless a patch is put in place, AMT is likely to pull a significant amount of discretionary income out of the economy.
Bill Harris, Craig Birk, and Kyle Ryan
The Personal Capital Advisors Investment Committee
This article is distributed for informational purposes only. The author’s statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. Diversification strategies do not ensure a profit and cannot protect against losses in a broadly declining market. All investments involve risk including the loss of the principal amount invested. Data and statistics contained in this report are obtained from what Personal Capital considers to be reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.
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