vaughnwoods

Haven’t we been here before? In 2010, the market rallied from January to April, peaked, and then fell precipitously on fears over European instability. In 2011, the market rallied from January to April, peaked, and then fell precipitously on fears over European instability. In 2012, the market rallied from January to April, peaked, and has thus far fallen nearly 10% on fears over European instability. It is like we are living in a real-life version of Bill Murray’s 1993 hit, Groundhog Day.

For the third year in a row, the big question on everyone’s mind is “Will Greece leave the Euro?”. Outside of radical Greek political elements, there seems to be no political or fiscal will for Greece to leave the Euro. Credit Suisse analysts estimate the direct costs to core Europe of a break-up of the Euro-area (€698bn) are higher than the costs of bailing out the periphery (€627bn). When accounting for the indirect costs of a break-up, such as currency volatility, trade wars and inflation, bailing out troubled European countries looks like a bargain.

Fortunately, global economies are much better equipped to handle European instability today then they have been the last two years. The European Central Bank (ECB) has more than doubled the liquidity provided to Euro area banks. Current account balances have improved in Greece, Portugal, Italy and Spain. The housing market is improving, employment is improving and US households have finally reduced leverage back to trend levels. Food and commodity prices are falling whereas in 2011 they were rising. Private sector year-over-year loan growth is positive where as last year it was negative. Commercial & Industrial loans are growing 13% year-over-year and even consumer loan growth has turned positive. After the steep declines in 2010 and 2011, global central banks are much more dovish, including the Bank of Japan, the ECB, the Federal Reserve, the Bank of England, the Swiss National Bank, and nearly all the central banks from major emerging markets.

Meanwhile, Credit Suisse Analysts say that a global synchronized course of interest rate cuts across developed markets is vital for continuing to stimulate growth in Greece, Europe and the US, even while debt levels expand. This Reagan-esque strategy seeks to increase growth faster than debt, thereby shrinking debt levels as a percentage of GDP. The reason behind this strategy is very simple: there still exists $8trn of excess global leverage. To make US debt funding mathematically sustainable, the real 10yr bond yield would have to be -1% to -2%. If it was higher, then growth would simply slow below trend, requiring more unconventional monetary policy or central bank stimulus (i.e. quantitative easing) to drive down bond yields.

For this reason, US economists see a 60%-70% chance of additional stimulus action by central bankers by the end of the third quarter (September). The Bank of Japan is also engaged in stimulus. Analysts think the Bank of Japan will likely buy ¥32trn of Japanese government bonds (approximately 7 ½% of Japan’s GDP) in an effort to raise annual inflation from 0.50% to a goal level of 1.0%. The UK is also engaged in plans to increase quantitative easing. Moreover, analysts now believe the ECB will eventually be forced into more quantitative easing to fund peripheral deposit shortfalls and to stop the Euro from strengthening.

There are many implications here, more than anyone can identify. Nevertheless, let me highlight a few key issues:

1.) Even though global economies are better prepared to handle European uncertainty, we may still experience additional volatility into the summer. Every year the market’s trading range has a high-end and a low-end. Since we have just come off of a strong first quarter, it makes sense for the market to pause and move the other direction.

2.) Federal Reserve Chairman Ben Bernanke has recently expressed his reluctance to engage in more stimulus. Only more economic uncertainty will cause Mr. Bernanke to do what he is reluctant to do. Analysts are predicting continued economic uncertainty through September, which may pressure Mr. Bernanke to take action. An extension of Operation Twist, or an outright bond-buying program à la Quantitative Easing may be in the works if the market does not pick up soon.

3.) During the 1992 Presidential elections, Bill Clinton famously quipped, “It’s the economy, stupid.” The implications for growing uncertainty do not bode well for incumbents at any level of politics running for reelection. Unfortunately, this may mean more political gridlock during a time when we need consensus building.

Best Regards,

Vaughn L. Woods, CFP®, M.B.A.

*Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. Past performance is not a guarantee of future results. Asset allocation cannot assure a profit nor protect against loss. Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Views expressed in this newsletter are those of Vaughn Woods Financial Group. The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. VW1/VWA0154

**Marketedge.com, Pershing NetExchange Pro, Bloomberg, Credit Suisse, Briefing.com, Standard & Poors, WSJ.com

- Garthwaite, A., et al, 2012: not déjà vu, Credit Suisse Global Equity Strategy, 04-27-12