by Jason Norris, CFA
Senior Vice President of Research
“Déjà Vu All Over Again?” –Yogi Berra
Monday marked the first day of trading for the third quarter of 2012 and the end of the first half of 2012. As we reflect on the first two quarters of 2012, they look eerily similar to the first two quarters of 2011.
Just as in 2011, domestic equities staged a strong rally in the face of mixed economic data while Europe continued to put band-aids on their debt woes. Given all the policy and economic uncertainty, it’s hard to believe that the S&P 500 posted a handsome 9.5 percent return for the first half of 2012.
Domestically, the U.S. economy is holding up, with GDP expected to grow at approximately 2 percent. However, the fiscal cliff and a European recession are wildcards for the sustainability of this growth. Despite the parallels between the first half of 2011 and 2012, we don’t believe we will see a repeat of the third quarter sell-off that we experienced last year. It seems the European Union is moving, albeit slowly, towards a solution to their debt problems. Additionally, gas prices, which were climbing last year, have fallen substantially, aiding the U.S. consumer.
“Gentlemen Prefer Bonds” – Andrew Mellon, U.S. Treasury Secretary in the 1920s While equities have staged a strong rally this year, U.S. Treasury yields fell to record lows in recent months. The yield on the 10-year Treasury fell 30 basis points to 1.6 percent the first six months of 2012, resulting in a 2 to 3 percent return for bonds. Though 10-year Treasury yields hovered around a modest 2 percent for the entire first half of the year, individual investors amazingly continued to favor bonds over stocks. So far this year, over $150 billion has flowed to bond mutual funds as $50 billion has left U.S. equity funds. While stocks have delivered healthy returns, economic and policy uncertainty continue to weigh on individuals’ perception of the attractiveness of U.S. equities.
The More Things Change, the More They Stay the Same While European leaders worked towards establishing a bailout fund this week, there was further evidence that troubled nations have yet to “bite the bullet.” If those troubled nations continue to max-out their credit cards, it remains to be seen whether Germany and the other fiscally responsible EU nations (e.g., Finland and the Netherlands) will contribute to a bailout fund.
Concerns over economic growth are not just a European issue. There is mounting evidence that China will continue to see a deceleration in their rate of GDP growth over the next few years. In fact, some economists have called for Chinese growth to slow alarmingly to 4 to 5 percent; down from the 7 to 8 percent pace they are now enjoying. This may or may not be a “hard landing,” but if China does slow to this degree, it will adversely effect growth in the U.S. However, the impact does not have the same magnitude of a European recession. Exports make up 13 percent of U.S. GDP. Twenty-two percent of our exports are destined for Europe while only 7 percent land in China.
A Diamond in the Rough Barclays CEO Robert Diamond resigned this week amid allegations that the bank understated its borrowing rates in 2008 in order to mask its problems during the financial crisis. There is now speculation that the Bank of England was nudging Barclays to understate its borrowing rate to alleviate a financial panic. Authorities are now looking at more than 10 other banks to assess if they manipulated their rates as well.
This is just another black eye for the already-stained financial services industry.
Our Takeaways from the Week
- While stocks showed strong returns similar to the gains seen in the first half of 2011, we do not anticipate 2011-like sell off in the third quarter. Equities remain underowned and attractively valued
- As Europe dips into recession and China slows, we will focus on U.S. equities that have greater exposure to the domestic economy.