November 2011 - Investment Outlook and Market Commentary
Our Investment Committee recently discussed what one topic could influence the markets the most, either positively or negatively. It was nearly unanimous that the European debt crisis was the issue of most concern.
To understand what is happening in the euro-zone (the 17 member countries who make up this community and who all use the euro as their currency) you need to know several things:
- The countries of Ireland, Portugal, Greece and now Italy have for decades lived beyond their means by borrowing money to support the socialist lifestyle they have been accustomed to living. For instance, Greece’s total federal debt as a percent of GDP is now at 160%. To put that into perspective, the same ratio for Germany is 80% and for the USA it is 68%.
- Banks have financed this “spending binge” for years without regard to exactly how it was going to be paid back.
- Now banks are being asked to “take a haircut” on the bonds they own in an effort to help Greece repay its debts.
- The euro-zone countries have created a bailout fund European Financial Stability Facility (EFSF) for countries in trouble and funded it with $611 billion.
The purpose of the EFSF was to lend money to these countries in an effort to help them pay off some of their debts. The only problem is that it will probably take at least $1.5 trillion to do this and not the current $611 billion.
There are 3 main players in this drama that could rescue these ailing countries, if they so chose to do so: Germany, France and the European Central Bank (ECB; like our Federal Reserve Bank). However, the problem is that France is pressing for euro-zone governments to turn their joint bailout fund (the EFSF) into a bank that can borrow money from the ECB and use it to help these ailing economies.
Germany says no and is insisting that Greece’s private sector bondholders take a big hit to reduce Greece’s debt to a more sustainable level; a proposal that France and the ECB are resisting for fear that it could accelerate bond investors’ flight from the Southern European countries.
On the other hand the ECB says that their mandate is to ensure liquidity to its member countries and it should not have to be involved with solvency issues. Lending to governments either directly or through the bailout fund is unpalatable to the ECB, as they inherited a cautious approach to central banking from the German Bundesbank.
From the ECB’s point of view, intervening more actively in government debt markets, like other central banks do, would jeopardize the ECB’s political acceptance in Germany where there is fear that bond buying leads to money printing and high inflation. Sound familiar?
We keep hearing that the leaders of the euro-zone countries (led by Germany and France) have come to a first step solution, although the details are still being worked out. The devil is always in the details. We learned is that the bailout fund will be increased from $611 billion to $1.4 trillion. We don’t think this is enough, and feel the number should be $1.7-$2.0 trillion. No details have been given as to how this will be funded. We also just learned that private institutions can voluntarily accept up to a 50% discount on the bonds they own. In other words, if they bought Greek government bonds at par or 100 cents on the dollar then they can redeem them for 50 cents on the dollar. We don’t think this is enough and believe that a 60 or 70% discount is needed.
This is indeed good news that the governing heads of the euro-zone countries have at least come to a first step in potentially solving this crisis, which is Europe’s worst financial crisis since WW II. As we look ahead the question that stares us in the face is...can this 17 member bloc actually cobble together a longer term plan that will help these overleveraged countries pay back their debt, reduce their debt ratios and ultimately become a creditor nation as opposed to a debtor nation? Stay tuned.
While the Investment Committee invests the portfolios for the next 3 years, we do have some thoughts on the market for the rest of the year. Again, trying to predict what the market will do in such a short period of time is really a tricky game. Having said that we feel that there is a reasonable chance that the U.S. stock market, through the end of the year, can be marginally higher than where it is today. We fully expect the market to have some sell-offs, but due to the low current valuation we see any sell-offs as being modest with the S&P 500 potentially going into the low to mid 1300s (currently the S&P 500 is trading around 1280). However, there are still plenty of potential “mini land mines” out there such as disappointing 3rd quarter earnings, Europe’s leaders not being able to move to the next step, the debt issue here at home with no conclusive decisions from the super committee on what needs to be cut by Thanksgiving and continued slow economic growth due, in part, to the high unemployment rate that can stop this rally.
On the fixed income side we are starting to see the 10 year government bond move higher in yield (lower in price), which we have been predicting for months. The 10 year bond is in its own bubble and “coming back to earth” was only a question of when and not if. We currently see fair value on the 10 year bond in the mid 3% area. It recently closed at 2.40%, up from 1.75% only weeks ago.
In conclusion, while we have gotten a tad bit more positive on the market because of what the euro-zone leaders have cobbled together as a reasonable first step to a solution, we are not absolutely convinced that the global economy is out of the woods. For this to happen we will need to see more progress with the euro-zone countries in addressing its debt problems and some initial resolution with our debt reduction super committee and what its recommendations are to try and get our deficit under control.
Airlines Retirement Planning
Retirement Advisors of America (RAA) has an extensive history working with airline pilots. Our company has been serving pilots for more than twenty five years and we understand that every airline has unique guidelines when it comes to the process of retiring. We are here to help you navigate through these processes.
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Our company’s proprietary information has been gleaned from over twenty five years of professional experience. Just as we continually provide our clients with quality and accurate information through their retirement years, our Final Approach Program (FAP) serves as a pilot’s primary source of quality information prior to retirement. For more information contact one of our financial consultants at (800) 321-9123.
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