John Apruzzese on the Investment Outlook
November 8, 2011
The best analogy I've come across for investing in the current market environment is whitewater rafting. Investors survived Class V rapids — the equivalent of riding a waterfall — in 2008, albeit with the help of a large rescue team. The waters continued to churn until the summer of 2010 when investors started to relax. But we hit Class IV rapids this past August and there has been no let up since.
The obstacles ahead are starkly visible: the European debt crisis; the U.S. budget crisis; and early signs of a slowdown in China. Individually, they look daunting enough. Together, they make us question the prospects for global economic growth.
Consider just one aspect of the European sovereign debt crisis: Italy's 1.9 trillion Euro debt, or about $2.6 trillion. Only the United States and Japan have more debt and their economies are 8.2 and 2.4 times the size of Italy's, respectively. Over 300 billion Euro of Italy's debt will mature over next year and the yield is over 7%, making the prospects of orderly repayments increasingly remote.
For all the drama surrounding the Greek debt, the potential ramifications of a default there pale in significance to the damage that Italy could wreck. Investors in the United States cannot ignore the possibility of a European sovereign debt crash that would be as bad or even worse for the markets than the Lehman bankruptcy. While the possibility seems to us less than 50%, it is certainly more than 10% and the likely consequences are startling. Mario Draghi, the MIT-educated Italian central banker now taking over the chairmanship of the European Central Bank, could single-handedly change the end game by reversing recent ECB policy.
Over the next few months, however, the markets are likely to turn their attention from Super Mario to the Super Committee in the United States to see if there is even an outside chance that it can live up to its name before the presidential elections. But early indications of the committee's effectiveness are not encouraging, and we are running out of maneuvers to stimulate our economy.
The overarching issue both here and in Europe is too much debt. The most positive resolution to over-indebtedness is to grow our way out. The alternatives are a long, grinding period of debt reduction through default and reduced consumption leading to deflation; or rapid inflation that would relieve the debt burden by devaluing it, but in the process destroy middle class savings and standard of living. Unfortunately, historic levels of fiscal stimulus and loose monetary policy have not been able to generate sufficient economic growth.
Revisiting our analogy, the waters down the river are murkier still. China's government is determined to stop accelerating inflation by tightening monetary policy. Beijing is even attacking the shadowy banking system which has grown enormously, quite outside of formal loan growth restrictions. The transition in China's top leadership scheduled to culminate in 2013 only adds to the prevailing uncertainty. Leading China experts have no visibility beyond the top two new leaders, making it impossible to predict the true nature of the future ruling group.
Despite all the macro uncertainty, U.S. corporations are generating impressive financial results, thanks to a laser-like focus on costs and an increasing orientation to growth in the emerging markets. With the bulk of the third quarter earnings reports in, the S&P 500 looks to have increased earnings at close to 24% over last year on revenues that are up about 12%. Profit margins are close to historic highs and balance sheets are strong.
In these conditions, we at Evercore Wealth Management remain focused on risk control and the preservation of our clients' capital in real terms. We continue to actively rebalance portfolios so that equity exposure is no more than the midpoint of the range, and we are identifying the companies best positioned to grow in this environment. And we recently increased our clients' allocation to our Diversified Markets Hedges strategy, our lifejacket as it were, to help mitigate what we see as very real economic and political risks. The rapids aren't letting up any time soon, but we are confident in our crew and remain firmly on course.
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