By Norman Levine
Throughout the world, the second quarter was not kind to equity investors. The number of major markets with positive returns could be counted on one hand, with a few fingers left over. As worries about government finances took stage front and centre, stock markets began to rethink their previous assumptions that economies in the developed world would have a ‘V-shaped’ recovery and that vigorous government stimulus programs would rescue their economies. Richard Nixon once said, “We are all Keynesians now”, and many governments have embraced his philosophy of applying large amounts of stimulus in an attempt to restart growth and reduce unemployment (They all have chosen, in the past, to ignore the second part of his philosophy which was to reduce spending when times were good).
It didn’t work for Nixon and it isn’t working now. Unfortunately, Lord Keynes’ philosophy makes for good headlines for populist politicians aiming to look like they are doing something in the eyes of their voters, but it makes for lousy economics. As we pointed out in our commentary last quarter, there is a cost to throwing huge amounts of money around and, after seeing that all that cash has yet to generate much economic activity, governments are now starting to realize that the piper must be paid. The United States is a major exception, as President Obama (very much a populist politician) is still extremely interested in renewing his massive stimulus program despite having little evidence that much in the way of long-term results were accomplished with the first round.
In a recent Forbes article, economist Michael Pento states that the cause of the Great Depression in the 1930s and the recent Great Recession, which began in 2007, was one and the same: an overleveraged economy. The private sector and individuals in the United States are going through a necessary and painful deleveraging, resulting in slower economic activity now in return for stronger economic activity once the process is complete. The U.S. government, however, is going in the opposite direction, with gross national debt to GDP of 90% for the first time since World War II. We hope this massive amount of public debt does not crowd-out the private sector, just when its growth is needed the most.
The problems in Greece have multiplied, even though the European Union is in the process of throwing hundreds of billions of euros at the country. Greek workers refuse to change their indolent behaviour and expectations and are resorting to general strikes and refusing to let cruise ships dock at their ports, thereby destroying its tourism industry and denying the country its main source of revenue. The government has responded by raising taxes ( a doubtful measure as few pay them and so more of nothing is still nothing).
Greece, however, is not alone anymore as the economic problems in the “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain) continue to deteriorate and spread to other countries. Spain, too, is experiencing general strikes. Fiscal prudence is now becoming the order of the day. European governments are all pledging (to various degrees) to cut spending in order to reign in their debt. The recent UK budget is a good start. Unfortunately, they are also mostly pledging to raise taxes (once again making for good headlines but lousy economics) when cutting taxes to put more money in the hands of consumers and businesses would be a wiser course to take if economic stimulation is their goal. Here, Canada stands out as a beacon, and the results speak for themselves. Keep in mind, though, that Canada is not an economic island and we cannot help but be somewhat affected by what other countries choose to do.
Where does this leave us from an investment prospective? As indicated above, we feel the financial crisis is far from over. This will keep pressure on governments (especially the European Central Bank and the Fed in the U.S.) not to raise interest rates. The shift from stimulation to debt reduction is deflationary. Falling energy prices, high unemployment and lower commodity prices due to a slowdown in China’s economy, will limit inflation.
By Norman Levine
Reactionary government policies will create uncertainty in all markets. In response, market volatility will remain high and equity markets will have no clear direction, resulting in a wide trading range. While the economic and political outlook remains uncertain, corporate balance sheets and earnings are strong. Companies are hoarding cash. This bodes well for dividend increases and share buybacks, which should limit downside risk in equity prices.
For now, we aim to generate stable income from high quality investments. Bonds look attractive, as interest rates are likely to remain low and the yield curve is expected to continue to flatten. Quality stocks will provide secure and increasing dividend income. It is our intention to remain defensive at this time and intend to become more aggressive as the economic outlook improves.
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