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U.S. and global markets were dealt a body blow during the second quarter of 2010. The S&P 500 Index shed 11.9% of its value, notching its worst quarterly performance since the financial crisis in the final three months of 2008. Global markets were similarly rocked, with Japan‘s Nikkei down 15% for the quarter while Brazil’s Bovespa and the U.K.‘s FTSE 100 each gave up 13%. Greece, as one might have expected, led the suffering with a 39% plunge. Bonds held up well, however, as investors sought the shelter of high-grade dollar-denominated debt. The U.S. 10-year Treasury note benefited, as it did during the 2008 financial crisis, from this flight-to-quality. It ended the quarter yielding 2.96%, a very significant drop from the 3.84% yield where it started the quarter.
One thing the second quarter was very good at was packing a huge supply of bad news into a mere three monthsthe European debt crisis, the BP oil spill disaster, the May 6th “flash crash”just to mention a few items. Now add to this list the increasing evidence that the economic recovery in the U.S. is slowing. That we have hit a “soft patch” here in the U.S. is plain to see: home sales declined with the expiration of the home buyer tax credit, unemployment remains stubbornly high at 9.5% and GDP growth is slowing. (GDP grew 5.6% in the fourth quarter of 2009 but only 2.7% in the first quarter of 2010. The second quarter figures will be released on July 30th.)
Despite the laundry list of macro concerns, however, U.S. companiesparticularly large
multinationalsare back to generating solid profits. In the nearly two years since the Lehman Brothers debacle, companies have been trimming their payrolls, making themselves more efficient, and generating the piles of cash upon which they now sit. Specifically, non-financial companies in the U.S. held $1.84 trillion in their bank accounts at the end of March, a cash hoard that is 26% larger than at this time last year. They are not spending this money now, however, because as yet there are few signs of a strong recovery in aggregate demand.
There are peculiar cross currents in the markets. The corporate earnings now being reported are generally quite strong. Margins remain solid, but growth is tepid and companies are cautious about the future. The elephant in the room is the growing notion that aggregate demand may remain weak for an extended period, causing today’s whiff of deflation to become a stench. As this year has progressed, the markets have evolved from being concerned about runaway budget deficits sparking rampant inflation to the potential for a decent into a Japanese-style deflation cycle. The signposts for deflation are becoming more prominent: the weakening GDP numbers, companies’ meager revenue growth, and the ever-shrinking yields on U.S. government debt. (Bond investors afraid of inflation would not accept such paltry interest payments on U.S. debt if they thought inflation lay just ahead.)
Before the 2008 financial crisis, debt was viewed as something vaguely unpalatable but tolerable, assuming the underlying economy went on its merry way, maintaining its forward momentum. In the years since, however, debt has come to be seen as something toxic that must be contained. With the Euro crisis coming into full bloom during the past quarter, many people in developed but debt-laden countries such as the U.K. and the U.S. have made their desires known that they do not want to go the way of Greece. Getting oneself out of a debt hole, however, is challenging and requires lots of political will because the two standard remediesless government spending and/or higher taxesare not easy to implement. Now, with the changing perception of debt, austerity may be coming into vogue.
Austerity, however, is not by itself the solution to our economic problems. In fact, it may be precisely the wrong thing for this moment, as it would likely weaken our fragile and uneven recovery. To see how, just think back to the Gross Domestic Product identity from your economics class. The components of the identity are personal consumption (C) gross private domestic investment (I), government purchases (G) and net exports (X-M).
Here is the GDP identity: GDP= C + I + G + (X-M)
With about half of last year’s $787 billion stimulus package still to be spent, the “G” is, for the moment, the strongest and most consistent component of GDP. “C” has been weak (though improving slightly) and “I” remains very weak as companies big and small hold off on hiring and investing. Cutting back on the one strong part of our economy now would likely hurt us more than help.
Despite the economic softness in the U.S. and Europe, many positive global investment
trends remain in place. The mega-trend of this decaderapid economic growth and a rising standard of living in emerging economies such as Brazil, China, and Indiacontinues to power ahead at full steam. Given that roughly 80% of the world’s population lives in emerging countries, the growth and opportunity in these countries is a powerful long-term trend that will continue to help drive global growth forward even as the U.S. and Europe remain in their seats on the sideline. Emerging market demand for raw materials as well as for technology, consumer and healthcare products is on a steep upward trajectory that is unlikely to level out anytime soon, and there are many innovative companies from around the world participating in this growth.
Orion’s annual Form ADV update is complete. Please let us know if you would like to receive a copy. We appreciate your continued confidence and as usual we welcome your comments and feedback.
Peter Thoms & Seph Huber
Orion Capital Management LLC
1330 Orange Ave. Suite 302
Coronado, CA 92118
Email: [email protected]
Email: [email protected]