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Decoupling
By: John Petrides, Growth Portfolio Manager
Date: 6/7/2010
The investment community is fixated on the fiscal and monetary tangled web within the European Union and losing sight of the recovery underway in the US economy. One might say the US and Asian economies are decoupling from the European economy. In 2007 and 2008,decoupling was the sound bite du jour, referring to how the global economy was growing, lead by the BRIC (Brazil, Russia, India, and China) nations, without the US. Now, it appears that the European economy has decoupled and is mired in its own recession without the participation of the rest of the world.
Western Europe is certainly in a bind, as the EU tries to unravel a culture fostered on generous government support programs incompletely funded by taxes. That gap has been filled with borrowing and the markets are no longer willing to underwrite the fiscal profligacy of Europe. So, the European governments must now implement significant spending cuts and/or tax increases to reduce their bond market dependency.
On the other side of the pond, the US economy continues to turn in a positive direction. The housing market is rebounding led by a rise in starts and new home sales, and stabilization (slight increase) in average selling prices (even Florida saw an uptick recently). Even commercial real estate markets are stabilizing and billions of dollars have been raised to buy into distressed properties, seemingly far more than are available. Durable goods orders have increased more than expected, and estimates for seasonally adjusted car sales continues to rise. Although the latest employment report was below expectations in terms of job growth, the report did show an increase in average hourly wages and the average hourly work week, which translates into very strong nominal wage growth. The stock market has weakened sharply out of concern that the problems in Europe might spillover into the domestic market, but the economic and profits recovery here has the potential to win over this adverse shock.
Speaking of stocks, the recent fears of a credit lockup in Europe have brought valuations back to late 2008 levels when the global financial system was brought to its knees. Now, corporations and consumers are better prepared to handle adversity. Corporations have repaid/refinanced debt and are sitting on about $1 trillion in cash, a record amount, even as profit margins and cash flow have increased sharply. Large banks are heavily reserved for losses and are also quite liquid. Interest rates remain exceptionally low and policy remains focused on making sure that a full fledged economic recovery becomes well established. Confidence and visibility among management teams is growing. This spells good things for stocks.
The market is a discounting mechanism. It attempts to forecast economic growth and corporate profitability six to nine months before it happens. If this is true, given current trading levels, the market is forecasting significant fall out in growth due to the actions/inactions of the EU and a sluggish US recovery. The experience of 2008 demonstrated that anything is possible. Therefore, some probability needs to be assigned to a credit lockup in Europe and contagion to foreign markets, including the US. Even so, in our opinion, the market is pricing in too high of a probability that such a situation can and will happen. Although cash levels have been raised recently, we remained positioned for a cyclical recovery.
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