Experiential Wealth

Quarterly Market Commentary – Q1 2010

Apr 16, 2010 | Individuals, Institutions, Plan Sponsors, Quarterly Commentary

The US economy continues to recover from the Great Recession which began in December 2007.  Every economic indicator either has turned positive or at least shows stability. A V shape recovery seems unlikely.  Residential real estate values remain under pressure as the second and maybe third wave of foreclosures are waiting on the horizon which will add a significant amount of inventory to the market.  Under the current economic conditions, one of the biggest challenges is the mortgage interest reset expected later this year and through 2011.  The Alt-A (no documentation) and Option-ARM (negative amortization) loans reset dates are 5 years into the loan terms. A vast majority of these loans were taken out 4 to 5 years ago and approaching their reset dates. Although the interest rates at reset may not be significantly higher under today’s low interest rate environment, new payments must begin to include principal repayment.  This will add more financial burdens on homeowners and most likely support mortgages that are greater than the value of their homes.

According to the Bureau of Labor Statistics, the nonfarm payroll employment increased by 162,000 in March, while the unemployment rate remains at 9.7%.  The unemployment rate is expected to remain at historical highs for an extended period of time.  Although the massive layoffs in 2008 and early 2009 are over, finding a job for many remains elusive.  In March, about 44.1% of the 15 million unemployed were out of work 27 weeks or more (the long-term unemployed), up from 40.9% in February.  Even at an extraordinary growth rate of 500,000 new jobs per month, it would take 18 months just to bring the unemployment rate down to 4%.   If the labor force is growing at the same rate as the population (about 1% per year), employment would have to rise 110,000 a month just to keep the unemployment rate stable at the current 9.7% level.  After the last severe recession in the early 1980s, GDP grew at an annual rate of 7% to 9% for five straight quarters, and the unemployment rate plunged from 10.8% to 7.2% in 18 months.  Nobody is expecting a repeat of this type of robust recovery this time.  Case in point, the first quarter GDP growth of 3.2% was weaker than the prior quarter at a 5.6% annualized rate.  Many economists are expecting the unemployment rate to increase by the end of this year.

Borrowing and spending are not confined to the US consumers.  The Greek debt crisis is the latest casualty from the over-leverage and over spent era of easy credit.  The Greek debt issue by itself is not significant – in terms of the value of debt or as a country among its trading partners.  It represents 2.5% of Europe’s GDP. However, being a member country of the European Union and one of the 16 that use the common currency, the financial collapse of Greece will have a significant rippling effect on its neighbors and the European Union.  Greece has the largest budget deficit among its EU countries at 12.7% which is significantly higher than the 3% limit set by the European Commission.  Moreover, the current crisis shines a bright light on all other countries that are heavily leveraged and brings into question their abilities to perform on their sovereign debts.  The trick is to contain the Greek crisis before it becomes a contagion.  The New York Times prepared a good summary of the web of debt among the 5 EU countries with the highest debt levels.  The following illustrates the creditor-debtor relationships among the EU nations and how a collapse of the Greek public debt sector can easily be the first domino to fall.

Image Credit: New York Times http://www.nytimes.com/interactive/2010/05/02/weekinreview/02marsh.html?ref=weekinreview

Over the next 5 years, €240 billion must be raised to pay the maturing bonds and meet ongoing interest payments.  This is approximately Greece’s current GDP. At the current annual budget deficit of 12.7% of GDP instead of the 3% limit set by the European Commission, the Greek government will not be able to meet its obligations going forward through borrowing alone. An immediate and necessary spending cut will result in a severe recession which further constrains the country’s GDP and will likely expand its outlay.  Thus a modification of the current loan terms and maybe a write down of a portion of the sovereign debt is necessary.  S&P downgraded the Greek debt to junk status and also downgraded Spain’s long-term credit rating by a notch last week.

This weekend, Greece has accepted a bailout arrangement, negotiated with the European Central Bank, European Commission and the International Monetary Fund.  The package, worth €110 billion over three years, has a number of conditions which require painful restructuring by Greece.  This package should be treated as a down payment and it temporarily prevents the crisis from expanding out of control.  Now the focus is on Spain and Portugal.  Could it be Italy and United Kingdom thereafter?

Much of the debt crisis is also a crisis of confidence.  With investors just beginning to recover from the US led toxic asset contagion that led to a synchronized worldwide recession and market collapse, if the sovereign debt crisis is not controlled; this may cause investors to re-price risky assets which could increase borrowing costs among all borrower types.  The sovereign debt problem is very serious, and at current levels, many countries will not be able to grow their way out of it.  The slow economic recovery in developed economies is adding more pressure.  The Greeks’ public outcries against the severe and necessary austerity program are just one example of more unrest to come throughout the EU.

Economic recovery has been uneven globally with developed economies recovering at a tepid pace and the developing economies returning to pre-crisis normality.  This disparate and uneven recovery will persist.  Most of the developed economies have been negatively impacted by sub-prime mortgages and general over-leveraging over many years.  Most emerging economies are not burdened by either factors and are in a much better position to grow their economy.  In fact, inflation trend is beginning to show in some of the emerging economies.  In the US and other developed economies, the concern is regarding growth and not inflation.  As long as the unemployment rates remain high, consumer demands remains weak, and income growth is flat, inflation will continue to remain dormant.  Some economists suggest that there remains a possibility of a W shape recovery where the US will re-enter a recession before fully recovering.  Barring any unforeseen conditions, interest rates will remain at current levels for an extended period.  The danger of this scenario is the investor will pursue higher returns (in a low return environment) without a good understanding of the accompanying escalation of risk.