The Global Economy – Maybe the Glass is Half Full

To say that Europe dominated the 2011 financial<br /> headlines would be an understatement. One word or comment from a<br /> European politician or central banker sent stock markets tumbling.<br /> Conversely, the smallest hint of a resolution to the debt problems of<br /> the other “PIIGS” nations (Portugal, Ireland, Italy, Greece, and Spain)<br /> sent the markets soaring.

Navigating a Sea of Opportunity

The Global Economy:
Maybe the Glass
is Half Full

2012Q1 – Quarterly Newsletter – Investment Compass

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say that Europe dominated the 2011 financial headlines would be an
understatement. One word or comment from a European politician or
central banker sent stock markets tumbling. Conversely, the smallest
hint of a resolution to the debt problems of the other “PIIGS” nations
(Portugal, Ireland, Italy, Greece, and Spain) sent the markets soaring.

In the history of the S&P 500, there have been only eleven days
where more than 98% of the stocks that comprise the index moved in the
same direction. Six of these eleven days occurred in 2011. In addition,
from August 5th to the 30th, the S&P 500 experienced an
extraordinary average daily move (up or down) of about 2.5%. This
average, to put it into perspective, is 3.5 times the daily volatility
for the previous nineteen years.

As a result, 2011 will be recalled as a year in which most everyone
“was waiting for the other shoe to drop”. Some of these “shoes”
included a potential” PIIGS nation debt default; which countries might
have to replace the Euro as their currency; whether or not the Chinese
economy could be slowed down without causing a ‘hard landing’;
inflation and its squeeze on the emerging markets; and a credit rating
downgrade of the US—potentially leading to a double dip recession.

The only one of these “shoes” that has dropped so far is the US debt
downgrade in August of last year. Not surprisingly, after the US debt
downgrade US bonds enjoyed a stunning rise of over 3% for the month.
The reason was that investors believed that US Treasury bonds and the
US dollar were still by far the best house in a bad neighborhood. It
was a reminder that once again – in tumultuous times, the safety of US
dollar assets becomes apparent to the global financial markets.

The Big Picture

One dominant theme of the last five years has been the macro-economic
backdrop. Macro refers to “the big picture” with respect to the economy
and the risks that are weighing on the global economy’s ability to
expand. The curious aspect of the macro picture is how it has morphed
at different stages, taking investors on a rollercoaster ride. What
began with the collapse of U.S. real estate changed into the Lehman
Brothers default which ushered in the liquidity crisis and the
subsequent recession.  

Steepness of the Yield Curve
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this chart

After a seemingly all too brief lull, it has now morphed into a
sovereign debt crisis engulfing Europe. Some observers are now casting
a wary eye on Japan which after over twenty years of economic malaise
is now possibly near the end of its Houdini-like ability to forego a
debt crisis of its own. Japan has defied just about everyone who has
ever tried to profit from such an event occurring over the last twenty

US Economy Looking Good

The economic data for the US has been better than expected for over two
quarters with the economy having generated over 2 million jobs since
summer 2011. Further, for twenty–three consecutive months, the economy
has been able to create new jobs while the real estate sector is
showing early signals that the bottoming process has begun. Key US real
estate markets such as Miami and Phoenix are showing encouraging data.
The surprise thus far is the resilience of the US economy despite
headwinds at home and abroad. Domestically, the biggest source of
headwinds likely comes from the lack of political resolve on both sides
of the aisle “to get something done”. Politics seems to trump economics
with the US Federal Reserve caught in the middle.

With the Fed having done all it
prudently can and Treasury fiscal measures to cut the budget deficit
ruled out until after the November 2012 Presidential elections, it has
fallen to the American economic machine to revert to form and pull the
global economy back on track.

The US economic recovery is being led by exports, while car sales and
consumer spending are starting to regain a more solid footing. One
caveat on consumer data recently is that the savings rate has started
to decline once again. Whether this is because of increased confidence
returning to US households or simply because wages have been stagnant
is open to question. Consumers are having to loosen their purse strings
after several quarters of belt tightening in which the focus was more
on debt repayment.

Another key barometer of the US economy is provided by credit and
banking data. As the chart on the prior page shows, in the last six
months bank credit (i.e. lending) has begun increasing. This is a
positive indicator for cyclical sectors such as retail, automotive
sales and construction. The rise of credit creation from the banking
sector has been a missing ingredient for the economy’s ability to gain
traction. Despite all of the positive North American data, the economic
momentum is still early in its acceleration and not yet felt widely on
Main Street. It seems that the US mood is less “happy days are here
again” and more “will it hold?”

Steepness of the Yield Curve
Click Here to view a larger version of
this chart

European Headwinds

While exports have been a source of strength for the US economy,
Europe’s problems will provide headwinds to US exporters for the
remainder of the year. As many are expecting Europe to either enter a
recession or to already be in one, European demand for foreign goods
should suffer. Europe remains a key global market for both US and Asian
Perhaps one key piece of data from Europe is interest rates on European
government bonds. In response to the measures taken by the European
Central Bank (ECB) in December of last year, bond yields have eased
lower. This is a sign of investor confidence and provides stability on
interest costs while European leaders get their house in order.
The measures taken by the ECB included a $640 billion USD cash
injection into the banking system. In doing so, the ECB parted with its
traditional measured response to economic challenges because it feared
that a liquidity crisis similar to that of 2008 was starting to
entrench itself. In the 2008 financial crisis, banks around the world
became afraid to lend to one another. Thus the global economy ground to
a halt in relatively short order.

Where is the money going?

So far, the ECB’s measures seem to be helping as about half of this
money has found its way into government debt markets. In other words,
the liquidity that has been provided has been used to purchase
government bonds. This has helped to rein in interest rates and made it
easier for governments in Europe to borrow and roll over debt
The remainder of the ECB’s cash infusion was largely re-deposited back
at the ECB – even though the ECB is only paying 0.25% on these deposits
while charging the banks a borrowing rate of 1%. This is being done by
financial institutions because they are not fully confident that they
can avert a liquidity crunch and require access to funds for possible
future use despite the borrowing costs.

The one drawback is that very little of this money has
made its way into the banking system to allow consumers and businesses
to borrow with easier credit terms. It could be said that governments
are crowding out the private sector.

This experience is not all that different than that of the US over the
last two or three years. If events follow a similar script to that of
the thawing of the US liquidity freeze, credit should begin to ease for
European borrowers very gradually.
Markets will be watching whether or not European governments make
continued progress in getting firm commitments from the European Union
member nations with respect to fiscal tightening measures. In short,
spending must be reduced sharply and a new treaty that will require
European nations’ ratification in April of this year will impose steep
austerity measures. These spending cuts will curtail European GDP.
This is where the European plan differs from the US. In the US, fiscal
policy remained largely accommodative – partly because the political
process would not allow tax increases. In Europe, there is really no
political constituency that argues for tax cuts as consistently as that
in the US. Right or wrong, this has perhaps helped the US economy
sidestep an even more gradual economic rebound – regardless of what the
long term implications of more debt might be.

Partners – Capital Management

a Sea of Opportunity


This report is for information purposes only and is neither a
solicitation for the purchase of securities nor an offer of securities.
The information contained in this report has been compiled from sources
we believe to be reliable, however, we make no guarantee,
representation or warranty, expressed or implied, as to such
information’s accuracy or completeness. All opinions and estimates
contained in this report, whether or not our own, are based on
assumptions we believe to be reasonable as of the date of the report
and are subject to change without notice. Past performance is not
indicative of future performance. Please
note that, as at the date of this report, our firm may hold positions
in some of the companies mentioned.

Copyright (C) 2012 Pacifica Partners Inc. All rights reserved.

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