News out of Europe yesterday included a proposed plan by France and Germany to solve the EU debt problems. This plan called for the creation of a “collective government” run by the EU President and a tax on every financial transaction. Both of these ideas are significant and, we believe, unworkable.
By setting up a “collective government,” Germany and its people will continue to transfer wealth to weaker countries in the EU. Part of setting up the collective government is that countries would no longer issue their own bonds, but would issue Eurobonds backed by the EU as a whole. In doing so, interest rates would fall in the PIIGS, but would rise in Germany. In other words, it would hurt Germany because it would pay higher interest rates and take on the risks of all the countries in the EU. Politically, German Chancellor Merkel is dead on this issue as her popularity has sunk to its lowest level in nearly five years. In December of 2010, a poll by ZDF television of 1,421 Germans found that 62% opposed greater aid to the PIIGS. That was eight months ago. Recent polls now show a majority of Germans now want to dump the Euro and go back to the Deutschmark. We don’t believe Germany wants to be the piggy bank for the rest of the EU countries and lose its sovereignty to the President of the EU.
A tax on every financial transaction makes no sense. European banks are in bad shape. This tax is the equivalent to the adage “kick‘em while they’re down.” When I was in Italy a month ago, many vendors did not accept credit cards. Our guide in Rome said they did this to get around having to pay taxes. This new tax will only serve to drive transactions further underground. We believe it will also drive deposits out of banks.
This is a last gasp effort to save the Euro. It might buy a little time, but Merkel cannot continue to act against the wishes of her people. Eventually, we believe the German people will win out and the EU will collapse under its own weight. The uncertainty surrounding the EU debt crisis will continue to weigh on stock markets around the world. We believe it is still prudent to play some “defense” at this time.
When we mentioned that the market would be volatile last week, we didn’t know that Standard and Poor’s would downgrade US Treasuries late Friday night. The downgrade is having a ripple effect across global equity markets today. What is interesting is the yield on US Treasury Bonds has fallen dramatically today. That is the complete opposite of what one would expect after a downgrade. What normally happens is that yields shoot up. The drop in yields is setting the stage for an economic recovery a few months down the road.
I received a call from a client today and was asked, “Do you see anything good out there?” My response was something along the lines of “right now, not much.” But, we are encouraged by the bond market rally, the drop in oil prices and the drop in commodities (except gold). This is exactly what happened in late 2008, early 2009. If oil prices and commodity prices fall, the price paid for goods and services will fall and consumers will have more money to spend. With interest rates dropping, the cost of borrowing will fall. Anyone with a mortgage should refinance now (if you need assistance, please call us). Refinancing will either lower payments or reduce the time to pay off your house, both good for the consumer.
Another silver lining from the downgrade is that it will force our government to confront the debt in a more meaningful way. However, we think that with the economy wavering, the government should take the opposite approach of the typical playbook and cut spending first, and then raise taxes. Even the most recent cuts occur years into the future with no assurances that a future Congress wouldn’t reinstate the spending. The government needs to cut spending in a more meaningful way including the level of compensation for federal workers. (See video below)
If you have facts or figures that dispute the video, please forward them on to us. We are only interested in the truth.
All those pundits that said we need to get a debt deal in order to “stabilize” the markets are certainly eating their words. The last few days have been horrendous for the stock market and today is no exception, with the market being down over 450 points so far. As we stated in our last update, the debt ceiling was a minor consideration compared to what is happening in Europe. As you might recall from our March newsletter, we detailed our concerns about Europe. The contagion from Greece has not been contained and is spreading faster than the flu. We expect more volatility in the days ahead.
Although some clients may be more nervous than others, a key point for all to keep in mind is that the time to prepare for winter is during the fall harvest, not during a winter blizzard. We did our harvesting a few months back by reducing your exposure to the stock market. At some point, the ice will start to melt away and it will be time to move money back into the stock market. Every stock market downturn has different causes, but one thing is constant – human emotion. That emotion is showing up in these current downswings in the market.
Most of your portfolios have what we believe is a substantial amount of “dry powder”. In the past couple of months, our decisions were based on the amount of risk and reward we saw in the market, with more risk than reward. Our decisions going forward will be based upon that same principal, and however hard, we are confident the right decisions will come through with our disciplined approach. Although we do not hope for a major fall in the equity markets, we will be sure to take advantage of our cash position and capitalize on unique opportunities when the time is right. A lesson we learned many years ago still remains intact: When the market is going up, any cash is too much cash. When the market is going down, you never have enough cash.
At times like this, we may be more accessible after work hours due to other client calls, investment meetings and conference calls with analysts on the street. Please don’t hesitate to call us here at THOR or on our cell phones at any time if you need to talk with us.
The next few days we are going to see political theatre that could be greater than Shakespeare’s plays. Some have asked us not to talk about politics, but at times like this, it is politics that is driving the market lower. We believe the market will be very volatile over the next few days with more risk on the downside than on the upside. Eventually the debt ceiling will be raised, as it has to be. The problem with this situation is twofold: 1) the drama in Washington is impacting the economy because of the uncertainty it is causing amongst investors and business owners, and 2) even though the short-term ramifications are important, long term structural changes to our entitlement programs are much more important for future growth.
Uncertainty: We have talked in previous market updates about why we believe many companies and individuals are holding cash. The main reason has been because of the uncertainty they have about the future. Items such as healthcare costs, taxes, regulations, and other issues are points of uncertainty we have previously addressed. Now we have the added uncertainty of the US going into default. With the economy growing at a snail’s pace, uncertainty like this can be the impetus that may cause the economy to pull back. A small downward adjustment in consumer spending will cause our economy to contract. Our economy did well under both Clinton and Reagan. Why? The rules of the game weren’t changing as rapidly or significantly as they are today and confidence was high. We believe our economy won’t truly take off until confidence is restored.
Structural Changes: This is not a red or blue issue, but a black and white one. If structural changes are not made to Medicare or Social Security, we will go bankrupt. There is a demographic tidal wave called the “baby boomer generation” that will be swamping these programs over the next 15+years. Any debt deal that does not adjust these programs may give a short-term reprieve, but will not help us in the long run. If these programs were reformed, some of the anxiety associated with our spending levels in this county would be resolved.
As you know, we have been concerned about the “risk” in the market place. Although the debt ceiling is one of the things we are worried about, there are other items that give us more concern, such as the problems in Europe, sluggish US economic growth, rising interest rates in BRIC countries, and several others. Even though the headlines are about the US debt ceiling, which may be the impetus for a market correction, the other factors we are watching are getting worse. Europe has tried twice to fix the Greek crises in the past 60 days and it is no longer in the headlines. However, the problem is not over and we contend it looks to be getting worse. Both Spain and Italy have seen their interest rates rocket in the past month and, while they did retreat temporarily, are back to their recent highs. Not only is this costly for those governments trying to fund their deficit, but rates for consumers have shot up as well. Interest rates usually go up in a strong economy, not a weak one. Italian 10-year interest rates have gone from slightly over 4.5% to almost 6% in the last two months. If that happened in the US today, that would mean that a current 30-year mortgage rate of 4.75% would jump to 6.25%. This would not be good for our economy and this type of interest rate movement isn’t good for the Italian economy. We don’t want to be pessimists but contagion has started to spread, and it is at the cost of world financial markets. Feel confident that we are watching all the concerns expressed in this update and will act appropriately.