Hold On To Your Hat
While this Newsletter will focus on the near term economic and financial prospects, readers should remember that there are still in place strong longer term trends that will influence near term prospects. As was described in an earlier Newsletter “The Great Deleveraging” the Western World has accumulated significant debt that must be substantially reduced before new strong growth cycles can begin again. How these debt problems are handled will have an ongoing influence on economic growth and financial markets. It is important to recognize that this is no ordinary debt cycle. Economic slowdowns typically are caused by individuals and/or corporations overspending by borrowing and not being able to service the debt they have taken on. In this particular cycle it is governments as well as individuals that are burdened with too much debt. The corporate sector as a whole is in much better shape than normal in a period of slow growth. The general excellent health of the cash laden corporate sector is a fact generally ignored by the doomsayers. The low interest environment created by central banks and government policies is a major positive for corporations.
Turning to recent events and progress being made in handling the debt crises, Europe stands out as a work in progress. The Greek refinancing, after spending weeks at the brink of failure was accomplished. Greek debt holders took substantial losses while the Greek government was strong-armed into adopting severe cost cutting measures. As part of this process, the European Central Bank pumped new liquidity into the European banking system, so for the moment there is relative calm in Europe. While there are signs of economic weakness in some members of the union, Germany, the power house of Europe, has recently been generating positive economic numbers. Predictions of a European recession have become more muted, but it is still a strong possibility. Is the debt overhang problem solved? Not by any means. Portugal, The Irish Republic, Spain and even Italy are far from fully solvent. While the European banking system is in better shape than it has been for some time it is far from robust. Greece is also just treading water, still running large deficits and very likely in need of another future bailout. An upcoming Greek election will probably bring in an anti-austerity government that will opt for default rather than payment. While the EU is now well enough buttressed to withstand such a default, the problems of Spain pose a much greater challenge. Spain’s unemployment level is 23%, and amongst younger Spaniards is 51%. Spain experienced the most excessive real estate boom, and foreclosures are rising. Regional banks are weighted down with real estate loans and many may not survive despite efforts by the central government to consolidate the Regional banks into stronger entities. While Spain is no Greece, its problems will take years to solve and this will be the same for other weaker members of the European Union. The stronger members such as Germany, France, and the Scandinavian countries will strive to keep the Union together. They may well be successful but the uncertainty of their survival will continue to impact world financial markets for the foreseeable future.
In North America the economic outlook is much less uncertain. The U.S. has put together a string of quite good economic numbers. Car sales are up, consumer confidence has improved and employment numbers are edging upwards. The housing market is firming in some localities and appears to be bottoming, but is still far from robust. Interest rates remain very low which is good for borrowers but bad for savers. U.S. banks are still contending with the overhang of bad mortgage loans in their investment portfolios, but are in much better shape than a year ago. U.S. politics continues to be negative with the protracted Republican primaries focusing on all that has gone wrong in the U.S. in the last four years. Long term debt issues remain, and must be dealt with in the next several years, whether by additional taxes or spending cuts, or both. The political divides on these issues will continue to dominate U. S. politics.
In Canada the economic environment is lackluster, with GDP growth trailing that of the U.S., but still on the positive side. In other comparisons against the U.S., Canada is in much better condition. Our unemployment is lower, our banking system is considered the best in the world, and our stable majority Federal Government has set in place a Federal Budget designed to balance the Budget in several years. The Canadian housing market has held together extremely well, but could be vulnerable to rising interest rates. Under some pressure from the regulatory authorities lending institutions have been tightening mortgage borrowing requirements. Canada is dependent on its resource sectors as a national growth generator in a world where manufacturing continues to shift to lower cost emerging economies. China, the source of a majority of world demand growth for commodities, continues to expand. While Chinese growth has recently slowed to 8% to 9% level, in absolute terms 8% growth on an already large demand base produces big increases - enough to keep supplies of many commodities tight. Recent Chinese monetary tightening to combat a real-estate bubble appears to be ending. This could well signal easier fiscal and monetary conditions and a return to double digit growth and higher demand for commodities in 2013 - a positive development for Canada.
Given the foregoing views, what predictions can be made as to the future course of events and their impact on the performance of financial markets?
Europe – The struggle to keep the European Union together will continue, accompanied by screaming headlines at every missed step. Financial markets will swing between hope and despair in both Europe and North America - in other words markets similar to what we have experienced in the last year. While Greece has managed to obtain recent rescue financing, it is unlikely to be able to meet the stringent conditions of that financing and will not remain in the European Union. Enough progress has been made in shoring up the European banking system in anticipation of such an event as Greece leaving, that the EU will survive the Greek departure. Ireland helped by UK support will make it through. Portugal will definitely be a problem - how large will be determined by the success of its recent austerity programs, but Portugal is a relatively minor player. Spain is a larger problem and again only time will tell if the Spanish population will accept the belt tightening required to reach a balanced budget. Italy is potentially in financial trouble, but with a new government and its austerity plans, coupled with the high personal wealth in the country it should soldier through. The road ahead for the EU is thus a perilous one full of potential crises.
North America – The US and Canada will continue to experience slow growth aided by low interest rates and recovering domestic demand as employment improves. The US will continue to struggle with its debt problems and its housing markets. The US banking system however is now recovered to the point that it can be a positive economic force. Canada will continue to suffer the fallout of US slow growth and depend on commodity demand for its growth stimulus, but there will be growth.
Despite positive trends in corporate earnings and fundamentals, the financial market environment in North America will continue to be driven more by psychology than fundamentals on a day to day basis. In the longer term however, fundamentals – corporate earnings, dividends paid and P/E multiples - do count. The market crash of 2008 remains very much in the minds of many investors including many professional money managers. The fear of being caught in a falling market, or the desire to profit from market declines by shorting, has become a central element in many investment strategies. This leads to wide swings in day-to-day markets, exaggerated by computer driven trading, even when there has been no new fundamental news. If there is real negative news, such as problems in Europe, market moves can be even more violent. While these market fluctuations are unnerving for investors they do present an opportunity to acquire good quality stocks at lower prices. The focus of investors in this type of environment should continue to be on bottom line cash flow and not capital gains. While capital gains are to be welcomed, investing in securities that pay little or no dividends as a dominant part of an investment strategy to achieve capital gains, is too aggressive in a market place that has shown itself reluctant to reward risk takers. As your investment manager, Northland Wealth will continue to strive to increase bottom line portfolio cash flow, by using high quality, financially sound, dividend paying corporate securities as core investments. We also continue to research and acquire for clients alternative asset classes that demonstrate strong cash flows such as private real estate investment trusts (REITs) and mortgages not normally available to individuals. These types of investments work to stabilize and improve portfolio returns.