Posted on November 2, 2012 by David Laidlaw
While the equity markets ended the quarter on a weak note, overall, the quarter produced strong gains in the stock market. The S&P 500 ended the quarter up 6.35% and is up a healthy 16.44% for the year. We believe that much of this gain has been driven by accommodative monetary policy throughout the world, rather than fundamental economic or earnings strength. In August, the European Central Bank’s (ECB) President, Mario Draghi, promised that the Euro would survive and its weaker sovereigns would be protected at all costs. The implication is that the ECB will buy the debt of Spain and Italy as necessary to prevent their interest rates from rising too high. However, Germany has not specifically agreed to backstop Europe’s debt. Spain’s rates are rising above 6% again and there have been extremely violent protests in Madrid recently.
A couple of weeks ago, the Federal Reserve launched QE 3. This program calls for the Fed to buy $40 billion of mortgage-backed securities per month until the rate of unemployment decreases. The basic thinking is that this bond-buying program will drive interest rates down further or at least prevent them from rising. These low rates will then spur higher borrowing and greater economic activity. Finally, this higher level of activity will bring about job creation.
We are skeptical that this policy will work to reduce unemployment in the long term. However, in the short term, it already has caused asset prices to rise. Stocks are up about 3% since Ben Bernanke hinted at this policy at an announcement in Jackson Hole this summer. More money is chasing a relatively stagnant supply of stocks which has caused the market to rise.
Even though the stock market is strong, the economy is quite weak (see chart, page 1). GDP growth for the 2nd Quarter of the year was revised down to 1.3% from the first estimate of 1.5%. Purchases of Durable Goods declined 13% in August. Much of this shortfall can be attributed to the lack of airplane purchases; however, even excluding transportation purchases, durable goods orders still declined 1.6%. Finally, manufacturing sentiment readings have indicated contraction for three of the last four months.
Corporate earnings are still growing, but the pace of growth is anemic. Core holdings in our portfolio such as Nike reported strong US sales, but very weak sales in Europe and China. Input costs are also rising as oil prices spiked higher over the summer.
Finally, Congress has not addressed the “fiscal cliff” we are scheduled to face on January 1st of 2013. Without any further legislation, tax rates will rise significantly as the “Bush cuts” expire. Top income tax rates will rise to 39.6% and dividends will be taxed at marginal rates due to the loss of the special 15% Federal tax rate they receive now. Additionally, capital gains taxes will increase 59% (from 15% to 23.8%). Government spending will also decline through across-the-board cuts agreed to in 2011. Without any new legislation, our slow recovery will morph into a recession.
Stock values may go higher as the Fed and the ECB continue to inject money into the system. However, the world’s economy is not growing fast enough to support a substantial increase in corporate profits. It also appears as though the threat of destabilization coming from Europe is still large regardless of optimism from those who follow the ECB closely. China’s growth has also slowed and the latest news from there is not encouraging concerning the political in-fighting associated with the change in governments. Viewed in sum, we are less enthusiastic about the prospects for a sustained expansion in the stock market.