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Contagion (Not to be confused with the recent movie)

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Contagion (Not to be confused with the recent movie)

Submitted by Foundation Private Wealth Management on September 28th, 2011

A couple of months ago we published a blog titled “Spring Fever”, which drew the analogy of the economic issues of early 2011 having a sort contagious effect in the markets similar to what we faced the previous year.  Now, as we have rounded out the summer, some of the contagious elements that were breaking out in the spring have turned into full blown viruses. 

This is very apparent in our financial thermometers throughout the world, the stock markets.  Since the spring of this year, all of the world’s major stock markets have continued to slide.  Thus the question becomes, what has or hasn't happened in 2011 that has caused the markets to continue lose ground, as opposed to rebound as they did in 2010?

To find my answer, I looked to the first place one would consider when dealing with a contagion, the CDC (Centre for Disease Control).  Their prescription for dealing with an infectious disease is to “prevent and control”.  Unfortunately, the “prevent and control” policy has not be adopted by world politicians, which is the primary reason that we are facing the current issues in the stock markets today.

To recap, the major issues that have continued to weigh on investors minds are:

  1. European sovereign debt crisis (Greece and the Mediterranean neighbours)
  2. Economic slow down in the United States (recently exacerbated by debt ceiling concerns)
  3. Overheating in the Emerging Economies (China being the most widely used example)

With respect to the US, politicians seem to have turned an inevitable long term issue into an overblown term short issue.  Essentially, the financial health of an entire country is being exploited for short term political gain by using self-imposed mechanisms like the debt ceiling.   The goal, of course, is to build momentum through 2012 and win the votes necessary to gain the power to form policy for the following 4 years.  Specifically, US politicians are actually jeopardizing the meagre recovery of their country's economy and instead of trying to prevent a crisis, they are actually creating one. 

On the other hand, in 2010 Ben Bernanke (the Chairman of the Federal Reserve Bank) launched the second round of quantitative easing (see Fixed Income Gains in 2010), which is partly responsible for the stock markets rallying in autumn of 2010.  This year, Mr. Bernanke has put the ball in the court of the politicians, leaving them the responsibility of implementing measures to stimulate the fiscal side of the equation as opposed to monetary side.  At this point, he believes that further monetary stimulus would not have as significant of result as fiscal stimulus would and he is likely correct.  Sadly, the politicians aren't holding up their end of the bargain.

In Europe, the strategy of its politicians is similar to that of an ostrich - stick your head in the sand and the problems will... well, there is no problem right?  To highlight this, the Economist in its Leaders section, on September 17th, 2011 put it like this:

“Europe’s leaders have repeatedly denied that Greece is insolvent (when everyone knows it is), failing to draw a line between it and the likes of Spain and Italy, which are solvent but of liquidity.  The excuse is that a Greek restructuring may cause contagion.  In fact denying the inevitable has undermined pledges about solvent governments.”

As we have been discussing with clients in our meetings, and please forgive me if I am repeating myself, there is a strong likelihood that Greece could be forced to separate from the union.  As Greece is part of the European common currency, they are currently not able to use the typical mechanisms that a “normal” bankrupt country would and thus could be forced to leave in order to “recuperate”. 

Initially, the idea of Greece leaving the EU sounds ominous.  However, European politicians need to take their collective heads out of the sand and either:

  1. Backstop the debt of Greece for now. This could be done through the issuance of Euro bonds or, more likely, expanding the European Financial Stability Fund (EFSF) that allows Greece and the other troubled countries to access funds and recapitalize their banks.  This would be similar to the Troubled Asset Relief Program (TARP) that was used to in the US.  This could then be followed by number 3 below, when time is right, to separate the troubled countries in the efforts to achieve a longer term solution.
  2. Enter into a system whereby the wealthy productive countries transfer funds to the poorer, less productive ones (very similar to the system we have in Canada between the 'have and have-not' provinces)
  3. Face the music, admit Greece is bankrupt and separate the infectious country out of the currency in a manageable organized fashion.  This could be done by recapitalizing the balance sheets of the Northern European banks that hold Greek debt.  I would equate this to battlefield triage, where medics may cut off the foot to save the leg.

Overall, the Europeans inability to control the contagious country, allowing its issues to spread throughout the union, maintains the increased uncertainty in the markets which is something that investors obviously do not like.

The final issue that has continued to spill over from the spring is the over-heating emerging economies, which is epitomized by China.  In direct contrast to the lack of action in Europe, political officials in most emerging nations have taken the steps necessary to curb off inflationary growth.  It is our opinion that they are proceeding in the right direction, looking to slow inflationary growth before it becomes a bubble ready to burst. 

I can only imagine that the politicians of the West wished that they were dealing with the problems of the emerging countries, where there is a young, able and growing middle class setting off to work, incomes are growing, national debt is non-existent or shrinking and the banking system looks to be in good shape. 

Unfortunately, there is concern that the emerging economies, though growing at a strong rate, may not be able to support the growth of the rest of the world.  As a result, the great companies that are growing revenues are being sold off with the rest.

Now that we've addressed where we were and where we are, this leads me to where things are going.  It is certain that the world economy, especially the Western World, continues to face a number of headwinds moving forward.  Furthermore, these issues are being magnified by too many politicians for far too many reasons.  It is also certain that the world will continue to face these types of issues - it always has and it always will.  However, barring a calamitous event, we can also be certain that good companies will continue to generate profits and markets will go up and down as a reflection of both the outlook for the companies or, as I have highlighted above, the various macroeconomic factors affecting them. 

So, where does this leave us today?  With the negative market reaction to what has happened over the course of this year, we firmly believe that markets are oversold and that there is a strong possibility that this will turn out to be a great time to invest (or remain invested). 

To highlight this, I have included two charts below of the 60 day percentage change in the S&P 500 and MSCI Emerging Markets Index, both of which we feel present good value.  In the chart of the S&P 500, the 60 day percentage change is just below 2 standard deviations from the mean. The MSCI Emerging Markets Index is similar over the same time period, just greater than 2 standard deviations from the mean.  Historically, percentage changes to the downside of this magnitude for the S&P 500 have only happened 5.4% of time and 4.8% of the time for the MSCI Emerging Markets index and, in both cases, this indicator has lead to great buying opportunities.

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