There was no shortage of activity in the second quarter. Europe remained a focal point but the poor employment numbers in the US and slowing growth in China made for even greater market turmoil. Additionally, markets witnessed both French and Greek elections, a London Whale, a near overturning of Obamacare, and an emergency EU summit. Central banks in India, Brazil, China, and Australia lowered interest rates during the quarter in response to slowing growth. Much of this turmoil was evident in the declining equity indices discussed below.
While corporate balance sheets in the US remain strong, the US consumer continues to struggle. Payroll data has been weak and savings rates are at all time highs. Second quarter employment growth averaged 75,000 new non-farm jobs a month, a sharp decline from the average monthly gain of 226,000 in the first quarter of 2012. This dampened much of the optimism for domestic economic growth. Below is a sampling of US GDP estimates and revisions from some of the larger Wall Street forecasters:
In an effort to quiet the concerns, the FOMC extended Operation Twist through year-end and the Fed announced that they are prepared to take further action if necessary.
The Republic of Cyprus joined Greece, Ireland, and Portugal in requesting a bailout from European authorities. As fear spread throughout the region, EU politicians remained divided over austerity or tax increases. French President Nicolas Sarkozy finished second to Francois Hollande as the French elected their first socialist president in seventeen years; meanwhile, the Greeks needed two elections to determine their president. While some feared the Coalition of the Radical Left (Syriza) would pull off the upset and derail austerity measures across the country, the New Democracy was victorious in the end saving the country from an EU exit (for now). Both the UK and Spain entered double dip recessions during the quarter and real estate debt nearly drove Spain to a default. The country was forced to nationalize its 4th largest bank, Bankia, and EU officials have discussed various measures to deal with the spiraling 1.4 trillion dollar Spanish economy.
The 19th EU summit was scheduled for the last weekend in June but German officials agreed to certain concessions on the eve of the summit that allowed for an announcement of a €120B growth pact. These funds were coupled with an announced imperative to break the negative feedback loop between banks and sovereigns and an affirmation of the need to ensure the financial stability of the Eurozone. A European banking committee will be formed, rescue funds could be used for sovereign debt purchases without forcing additional austerity measures, and funds could be lent directly to banks without penalizing existing debt holders. While this is progress for the region, the efficacy of these announcements will only be known once the details have been worked out and implemented.
The big story for the quarter was the news out of London on the evening of May 10th that a JPMorgan trader had taken excessive risk with proprietary capital that would cost the firm $2 billion. JPMorgan lost nearly $14 billion in market capitalization on the following day. Despite a recent earnings announcement, some estimates still indicate the losses could be as high as $9 billion; the loss of confidence in the banking industry due to the apparent oversight of Jamie Dimon and his top lieutenants is even more costly.
The following chart summarizes various equity market indices in the second quarter:
While all equity markets experienced declines for the quarter, the US market fared much better as the risk market of choice. Emerging markets were down 10% while the MSCI EAFE was down 8.37%. At their troughs, the S&P was down 9.93%, the MSCI EM Index was down 15.77% and the MSCI EAFE Index was down 16.41% from quarterly highs. Fortunately, the announcements by European leaders on the eve of June 28th caused most equity markets to rally between 2-4% as investors believed that the EU, specifically Germany, was making progress towards fixing the banking crisis that plagued the region. Bottom Line: While some exposure to all equity sub-asset classes is warranted, we remain underweight European equities and overweight high dividend paying large cap multinationals. The larger cap corporations will distribute dividends and buyback stock as free cash flow yields remain high. The dividend stream will dampen near term volatility while strong fundamentals will drive long term price appreciation.
Fixed Income Markets
The following table illustrates the state of fixed income markets during the second quarter:
The stronger economies experienced additional declines in their ten year yields while the weaker economies witnessed massive expansion as capital flowed from riskier assets to safer assets. Europe remained a focus as threats of Greek and Spanish exits drove Ten Year yields to 30.82% and 7.16% respectively during the quarter. As the US addresses the upcoming fiscal cliff, markets will remain cautious. If nothing is done between now and the end of the year, the fiscal cliff could reduce GDP by 1-2%; some estimate this could force us into a double dip recession. Bottom Line: Investors with conservative portfolio construction with short duration and high quality will be rewarded over time.
Alternative Managers remained cautious about the world. Net exposures were relatively low and many felt the affects of LTRO were waning. The following chart summarizes various hedge fund indices in the second quarter:
The credit managers were the best performing group within the universe as risk assets were under pressure and undervalued credit names witnessed some price appreciation. As housing expectations improved and investors’ hunger for yield remained high, the MBS market experienced +1.09% appreciation which contributed to performance in the credit space. Unfortunately, most managers were relatively conservatively positioned heading in to the EU summit on June 30th and July 1st with the expectation that the outcome could be binary. Any hope of adjusting risk levels after the weekend when more details were available was quickly eliminated as news broke early on June 29th that European leaders had begun to make progress on addressing the region’s problems. Markets rallied and alternative managers couldn’t adjust exposures in time to benefit from the one-day rally.
The Alternative space remains nimble and will adjust exposures when risks abate. In the interim, investment teams will build positions in favorable risk/reward opportunities that will outperform when Mr. Market aligns prices with valuations. Bottom Line: The uncorrelated risk managed asset class remains a core allocation across client portfolios.
Private equity and real estate are becoming increasingly attractive asset classes. The Volcker rule has provided a unique opportunity to participate in the secondary private equity market as financial institutions look to exit the private equity space at very compelling prices before regulation goes in to affect. Attractive real estate opportunities are surfacing frequently for investors to generate returns from both income and principal appreciation. We continue to look for the best way for investors to capitalize on each opportunity.
Conclusion and Outlook
The three biggest risks facing investors today are concerns around the European sovereign debt crisis, a slowdown in China, and the fiscal cliff in the US. We continue to believe that with interest rates this low and macro concerns this high, volatility will remain and return expectations should be muted. Therefore, a patient long term focus with disciplined asset allocation remains paramount.
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