Two and a half years ago, before the U.S. subprime crisis went viral, many economists and market strategists were hopeful that the rest of the world would be sufficiently strong to withstand U.S. credit woes. Now that the shoe is on the other foot, with Europe's sovereign credit problems rattling markets around the globe, today's talk of the "decoupling" of world economies may prove just as foolish.
The U.S. stock market has been under severe pressure since late April, when doubts about the efficacy of a European rescue for Greece's sovereign debt crisis surfaced, but on June 4, the Standard & Poor's 500-stock index dropped 3.4 percent in response to a dismal May jobs report and words from a Hungarian government official that talk of a debt default for that nation "was not an exaggeration." A second-straight month of improvement in German factory orders, thanks to a greatly weakened euro, was reported on June 7, briefly sparking optimism in European and U.S. markets. By the close of trading, U.S. stock indices had all turned negative again: The S&P 500 suffered its worst two-day loss since March 2009.
Bruce McCain, chief market strategist at Key Private Bank (KEY) in Cleveland, views the elevated volatility and 167-point loss in the S&P 500 index over the past six weeks as a short-term correction, a process that may yet inspire further conviction among investors that the bull market is sustainable.
"We haven't seen market or economic evidence to [confirm] that the global expansion or global rallies are over and we're headed into a new bear market," he says. "If we solve some of the longer-term problems, there could be a continuation of the rally that began last year".
If some of the problems develop to the point where they pose a threat to global growth, "we could get a failed rally that isn't very strong and [takes the market] lower and perhaps breaches [prior] lows," McCain says.
markets now face U.S. growth problem
That's precisely the scenario that Gerry Jordan, manager of the $90 million Jordan Opportunity Fund (JORDX), anticipates. Earlier this year there was a lot of optimism about growth in U.S. gross domestic product returning to levels above 4 percent. With the strength of exports in doubt, amid a 7.8 percent gain in the U.S. Dollar Index and news of slowing growth in Europe and China, the forecast for the second half of 2010 is much less rosy, he says.
Earlier this year, "people had been talking about how strong the [U.S.] economy is. That's over. It ended with [the debt crisis in] Greece in January or February, but everyone ignored it," says Jordan. "What's finally started to leach into people's [consciousness]—and the May jobs number cemented it because it was godawful—is that it's no longer just a European problem or a China-slowing-down problem. Now it's a U.S.-wasn't-as-good-as-we-thought-it-was problem." He says he thinks "economic growth rates for this year and next year have to be taken down meaningfully."
Jordan predicts that Europe will be back in recession by the second half of this year, or the first part of 2011 at the latest, as austerity programs implemented by governments in the euro zone impose a drag on those economies. He says he's stunned by arguments that the U.S. can decouple from economic ills in the rest of the world, given how intertwined the world's economies are at a fundamental level. "Europe is 30 [percent] to 40 percent of global GDP. If Europe goes into recession, you have to take a haircut to your global GDP estimates, and if European sales account for 30 [percent] to 40 percent of U.S. companies' revenue, you have to take a haircut to U.S. earnings estimates."
Jordan says he's eliminated small-caps from his portfolio and has pared his midcap exposure to from 10 percent to 15 percent, from the portfolio's prior 20 percent to 30 percent. Megacaps such as Coca Cola (KO), General Mills (GIS), and Microsoft (MSFT) are by far the biggest part of his portfolio because they are generating so much revenue that it will be hard to derail their earnings, he says.
"With the local economies slowing down, smaller companies will have a harder time making their way through," says Jordan. To attract investors, companies "have to have [low-leverage] or debt-free balance sheets." High-quality stocks, which trailed smaller, more speculative issues in the 2009 stock market advance, will regain favor, he says.
where's the drop in European orders?
Jordan sees the negative currency-translation effect that is expected to result from a dramatically weakened euro as "a bookkeeping problem" that ultimately will be less important than a sharp decline in sales volumes resulting from decreased purchasing power in Europe.
So far, however, there's scant evidence that orders from, and shipments to, Europe are down, says Hank Herrmann, chief executive officer of investment firm Waddell & Reed in Overlook Park, Kan.
The U.S. stock market seems to be acting more negatively than the underlying business fundamentals, says Herrmann, which makes him think the current decline will turn out to be a near-term correction, rather than the start of a bear market. Still, the S&P 500 index now looks quite cheap, he says, trading at 12.5 times his adjusted view of the consensus estimate for 2011 earnings among Wall Street strategists, especially given how low interest rates are. The trend is still lower, with breaches of some significant support levels on technical charts a cause for concern, he adds. "At minimum, it looks like it's going to have to go through some stabilization phase that's not showing much evidence of being in place yet," Herrmann says.
Despite improved corporate earnings, stabilizing housing prices, and a stabilizing unemployment rate in the U.S., it's not surprising that investor confidence was shaken lately, given the absence of a clear upward path in the macroeconomic data, says Steven Wood, chief market strategist at Russell Investments. "It's been a concentrated economic recovery in terms of time, rather short and rather brisk. It's not like this tide is going to lift all boats," he says.
inventories still must rebuild
Herrmann is increasingly wary of the government's jobs data, citing discrepancies between the surprisingly weak May numbers and what top managers of U.S. companies are telling people at Waddell. Business activity at agencies that assign temporary workers also suggests that there's much more hiring going on than the data reflects. While Herrmann says he's careful not to put too much stock in anecdotal evidence, the reports ring true for him because he doesn't believe that the inventory-rebuilding cycle has played out yet.
"It looks like inventories would be contributing on a materially positive basis over the next couple of quarters," he says. "Our economy is doing just fine, thank you…. It's not strong enough to create 300,000 new jobs on a monthly basis, but it looks pretty good and self-sustaining."
Jack Bauer, managing director of fixed income at Manning & Napier, sees less reason to question how sustainable the recovery is and more of a need to reassess its pace. The outlook for three of the four main sources of economic growth isn't good, he says. Consumers will be constrained by their need to pay down debt and by the weak job market, decreased state and local government spending is offsetting greater federal spending, and U.S. exports are falling because the dollar strengthened. That leaves business spending as the only intact growth vehicle. Even with earnings up and companies needing to invest in new equipment after postponing spending in recent years, "when you only have one of four cylinders [firing], it's tough to see growth as being all that impressive," he says. Bauer predicts 2 percent to 3 percent real GDP growth in 2010, with no reason for concern over consumer price inflation of 1 percent.
The Chinese government's efforts to pull liquidity from the financial system since January may be putting the brakes on that country's economy faster than Beijing intended, says Key's McCain. China is so big that any sharp slowdown there could spread, weakening commodity prices as well as the economies of such Asian neighbors as Australia, which exports a lot of raw materials to China.
Time for active asset management?
McCain notes that nickel prices seem to be having difficulty putting in a bottom, which suggests lack of investor confidence in China's ability to control the pace of its slowdown. Herrmann at Waddell believes recognition of China's slower growth is simply scaring financial speculators away from commodities now that they realize how much more expensive the cost of carrying large inventories will be.
With equity valuations 10 percent to 15 percent lower than they were five weeks ago, Wood considers this a good time for investors to selectively reposition their investment portfolios, moving some money from cash and Treasury bonds into riskier assets such as stocks. He also thinks the current environment argues for active asset management because index funds will have a hard time doing well.
Equity-focused investors will need some help from a moderating U.S. dollar. For now, it remains possible to view the dollar's gains as a technical rebound extended by Europe's currency crisis, says McCain. Investors are still willing to take a bit of risk, and some of the money pouring out of Europe could be lending strength to small caps, he says. If the dollar maintains its strength for the rest of this year, however, it would be suggesting a weaker global economy—and a resultant flight to safer assets by investors. That would not be good news for small-cap stocks.
The contribution of consumer spending to this recovery has been only 60 percent of the average in previous recoveries, says McCain. If U.S. exports falter, "it's hard to imagine we wouldn't feel that effect with slowing growth here as well … [we're] all in the same kind of basic boat."
The market will maintain its laser-like focus on weekly jobless claims data, which haven't budged much from the 450,000 level, says Craig Peckham, equity product strategist at Jefferies & Co. (JEF). "If we see that number contract, it will make people feel more optimistic about the overall employment picture," he says. The fact that U.S. companies will start to report second-quarter results in a little over a month may limit the downside for equities, he says. Any improvement in attitude and overall tone from U.S. companies might be enough to buoy investor sentiment, which is "very poor," he adds.