Will Europe Derail the Economic Recovery

July 10, 2010

Summary

In our First Quarter Review, we addressed why we believe the economic recovery is sustainable and would not be derailed by the new health care regulations.  Since then, health care has fallen out of the spotlight as fiscal problems in Europe have risen to a head (further explanation below).  While many economic indicators have maintained their improving trend, others have lost some momentum.  In our opinion, this is largely a result of the wearing off of the “sugar rush” provided by the stimulus bills last year, but Europe is likely a factor as well.

With a growing list of reasons to be concerned, the markets finally responded with the pullback we have been expecting.  So the question looming over us at this point is, “Will the problems in Europe have a significant impact on our economic recovery?” 

 2nd Quarter Review

The S&P 500¹ gave back around 11% in the second quarter, leaving us with “only” about 50% gains from the lows of 2009.  As we have mentioned in previous letters, it is normal and healthy for the market to have a pullback of at least 10% after the significant gains from last year – and it finally happened.  We believed the market would pull back enough to re-induce some level of panic, which we are starting to see at this point.  Naturally, we don’t know when the market will resume its’ gains, but we will take advantage of this opportunity to “reload”, just as we always try to do.

 With corporate earnings & balance sheets very strong, we believe this pullback is creating some great opportunities for us as the media continues to focus on the list of concerns we already know exist.    

 Let’s take a quick look at some recent news updates and then address the question mentioned above.   

• Manufacturing – Factory orders continue to grow, as the ISM Manufacturing Index indicates manufacturing is now up eleven straight months through June.  “We are now 11 months into the manufacturing recovery, and given the robust nature of recent growth, it is not surprising that we would see a slower rate of growth at this time.”     *Institute for Supply Management
• Inventories – After plunging through 2009, inventories started to grow in January and have grown 4 straight months through April.  However, sales have been rising for 13 months through April, creating considerable demand for continued growth in manufacturing and jobs.  Inventory/Sales Ratio = 1.23   * U.S. Commerce Department
• Unemployment – Job growth continued in May for the sixth out of the last seven months.  But most of the jobs added in May were government census jobs, leaving the market disappointed in the low private sector growth.  June produced much better private sector job growth of 83,000 jobs, with the unemployment rate dropping to 9.5%.     *Based on data from US Bureau of Labor & Statistics
• Leading Indicators – The Leading Economic Index rose .4% in May after no change in April, rising steadily since March 2009.  "The index points to continued, though slower, U.S. growth for the rest of this year," says Bart van Ark, chief economist of The Conference Board.     *The Conference Board
• Economy – GDP growth for the first quarter was revised to growth of 2.7%, lower than initial estimates.  Initial estimates for the second quarter will be released July 30.  *U.S. Commerce Department – Bureau of Economic Analysis 
• Healing in the Financial System – Healing has continued as many banks are reporting strong earnings, despite the continued high level of foreclosures.  Many have also been writing-up the value of assets that were written-down last year, just as we expected.  Full healing will still take several years, so we expect the Fed to keep short-term rates low for the next year or two.  Our expectation for increases to start this summer will likely be delayed as a result of the European crisis.*Sources include the Bureau of Economic Analysis- www.bea.gov, www.economy.com
• Inflation – Inflation continues to be tame, as we expected, with the Consumer Price Index falling in both April and May.  Deflation is much more of a concern than inflation in the short term in our opinion.    *U.S. Bureau of Labor Statistics
• Housing – With foreclosures still near record highs (RealtyTrac Inc.) and home construction still abysmally low (U.S. Commerce Department), many are still pessimistic on housing.  However, according to Case-Shiller, home prices nationwide have stabilized and are rising, although there are still pockets of extreme weakness.  Home sales have also increased more than expected (National Association of Realtors), probably due to government incentives.  Altogether, we expect continued stabilization and recovery in housing, but at a very slow rate. 

Will the European crisis derail our recovery?

For those of you who are smart enough to avoid the news, this may be the first you are hearing of the European crisis.  In a nutshell, European socialistic economic policies are finally doing what many of us expected – sinking.  Their high tax rates and government spending have stifled private sector economic growth, leaving them in an unsustainable fiscal position.  In May, Greece’s issues came to the forefront and a European Union bailout package was needed to keep them from defaulting on their debt, which may still happen.  In addition, Portugal, Italy, Ireland, Spain, and Belgium are all in trouble, facing the same issues.  As part of the European Union, these countries do not have the ability to pull the fiscal tricks heavily utilized by the U.S., limiting their flexibility.  In addition, England is in the same boat financially, but since they are not part of the EU, they have greater flexibility in how they respond.

So how will this affect us?  According to Bart van Ark, chief economist of The Conference Board, “Public debt and deficits weigh heavily on growth prospects on both sides of the Atlantic. We project a serious slowdown in European growth in 2011, which could further weaken the U.S. outlook.” 

We are essentially experiencing a worldwide deleveraging process triggered by the popping of our housing bubble and the near collapse of our financial system.  It took several decades for consumers and governments to leverage up to this point, so we still expect it will take three to five more years to get through the drag on the economy of this deleveraging.  We believe this means worldwide economic growth will experience growth 1-2% below its’ potential until debts are back to more reasonable levels. 

This information is provided for informational purposes only and is not a solicitation or recommendation that any particular investor should purchase or sell any security. The information contained herein is obtained from sources believed to be reliable but its accuracy or completeness is not guaranteed. Any opinions expressed herein are subject to change without notice. Past performance is not a guarantee of future results.

 ¹The S&P 500 Index is an unmanaged index used as a general measure of market performance.  You cannot invest directly in an index.

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