Weathering uncertainty in the global equity markets | submitted by Nathaniel Hedden

2011 saw an imperfect storm roil the global markets. Political unrest, natural disasters, man-made disasters, and the continuation of a three-year-long correction in equities ran both the developed and emerging global markets into the red at the end of the year. Fortunately, the first of half of 2012 has only seen the markets affected by a man-made disaster, namely the crisis of confidence in Europe.

SPY, EFA and EEM chart. Source:Bloomberg

The main source of our angst for the global equities markets is the uncertainty of how, or if, the Eurozone will resolve its current fiscal crisis. The problems in the Eurozone are long-term, systemic, and correctable.

When looking at the current state of the Eurozone, three main factors are readily apparent:

  1. There needs to be a defined link between politics, policies, and economics.
  2. The expectations of the individual Eurozone countries are not realistic or sustainable.
  3. The construction of the Eurozone is fundamentally flawed.

The points listed above are not a death knell for the Eurozone. There are corrective actions that can be taken to get the peripheral European nations out of their individual, and collective, economic morasses. A connection of fiscal policy to the monetary union may eventually guide Europe back to solvency. A restatement of the laws and rules that bind the Eurozone countries together needs to be amended to allow members to not only enter, but to exit, or be removed from, the union. Countries within the Eurozone need to modify labor, tax, and benefit laws to more adequately reflect the realities of the economies that support them.

Unfortunately, the actions of the member states of the Eurozone have not addressed these issues quickly or thoroughly enough. Politicians who have tried to address these issues are facing stiff challenges at home. To date, most of Europe has narrowly escaped a recession, but these countries may soon be declared to be in one. First and second quarter GDP is down or flat across the majority of the union. The consensus has this trend continuing for the rest of 2012 and into 2013.

The European Central Bank is adjusting interest rates and assisting sovereigns and banks to provide the liquidity required to work their way out of the current economic problems. This operation is currently using a scalpel. It remains to be seen whether or not an amputation is required and if the operation would be completed by a Northern European surgeon or by one of the PIGS (Portugal, Italy, Ireland, Greece, Spain) acting themselves.

The chart above shows both the Emerging Markets (EEM) and the Developed Global Markets (EFA) underperforming the U.S. markets (SPY) through the first half of 2012. The reasons for this are directly related to the uncertainty of the situation in Europe in general, and specifically in Greece. Emerging Markets are export economies, and with weak demand or limited output, they do not flourish. U.S. fiscal policy is now placing a premium on job creation, especially jobs in manufacturing.

China and the rest of the developing world will need to calm their internal inflation threats and continue developing internal demand for their products. The ability to fund internal growth and demand will mitigate some of the pressure placed on Emerging Market economies by the lack of demand for their goods and the re-shoring of U.S. manufacturing jobs. Export growth for the Emerging Markets won’t improve until the U.S. and Eurozone have worked through their own problems and there is more stability in international currency markets.

There are risks currently and potentially affecting the Global Markets in the second half of 2012: political, currency, headlines, natural disasters, inflationary, and market risk to name a few. To mitigate these risks, we are maintaining our recommendation to our clients for very selective entry into the Global Markets. To be sure, there are regional plays, such as Switzerland, or possibly China and Brazil, that may weather the near term less than favorable market conditions. We have elected to access exposure to the Global Markets through selected large cap S&P 500 holdings. The S&P 500 has earned nearly 50% of profits from global markets in the last five years.

By selecting well-established large cap U.S. equities with a strong global presence, we can access the global markets while maintaining our stance that the U.S. markets are the most prudent place for investments for the rest of 2012. In late 2010, we started moving out of Global Markets and aligning our portfolios with this uncertainty in mind. The Global Markets, and especially the Emerging Markets, will certainly rebound at some point in the future, but it is our intention to maintain our flight to quality with a U.S.-centric global strategy for the foreseeable future.

Disclaimer: Implied and expressed opinions in this piece are to be considered “General Advice” and subject to change. The information contained in this report was not presented with specific regard to any particular person’s financial or investment objectives, or financial situation. Any person using the advice should consider its appropriateness to their financial situation and perform their own diligence prior to investing.

Nathaniel Hedden is a director and senior portfolio manager at Musser Capital Advisors, Madison.

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