Current Market Valuations, What Global Deleveraging Looks Like

European Financial/Debt/Economic Crisis

The crisis that has developed over the past three years was a natural side-effect of the medicine of the financial crisis. Efforts by governments to intervene and slow the economic decline, combined with previously high debt levels spelled trouble for nations without an autonomous central bank and reserve-currency status.

Once a government attempts to intervene through deficit-financed stimulus, it must have a sufficient multiplier effect, along with low enough debt levels and a strong tax-collection policy for such a deficit stimulus to be effective. Unfortunately, most Euro-zone nations did not meet one or more of these requirements, and the financial markets have responded negatively. The impact on us? Despite economic slowdown, aggregate U.S. exports to Europe have held steady, and it is estimated that less than 10% of S&P 500 companies’ profits are earned in Europe. So it is not an economic concern for us today, instead it is the risk that a financial crisis, originated in Europe, that would turn into another global economic recession. Meanwhile, stock and bond prices in Europe and much of the developed world reflect expectations for recession.

Secular Global Deleveraging

Deleveraging is closely related to the low interest rates and low growth rates mentioned. But the cause and effect relationship is cloudier, and this is where the economists start to divide.

Leverage problems can originate from two sources in a financial system. Leading up to and during the financial crisis, leverage issues related to both the quantity (using the same amount of capital to create more loans) and quality (modifying underwriting standards) of leverage in the financial system. Much of this damage later spread to the non-financial economy, as is expected following a financial crisis.

The resulting excess capacity, significant influence from central bankers and cumulative deflationary expectations can create a negative economic cycle. A catalyst event must occur to break the negative cycle and help reverse the trend.

Until then, countries will be faced with a dilemma- where they draw the line between the stimulus benefits of running a deficit and maintaining the faith of their creditors by not exceeding some debt-to-GDP level drawn in the sand by the marketplace. This is difficult, because once you remove the deficit stimulus to attempt to balance a budget, it continues moving further away due to reduced tax receipts (a problem most European policy makers are well aware of at this point). This will, over time, have a great influence on our investments,  stocks, bonds and their related derivatives.

Summary

The markets today are indicating a likelihood of a global recession (or near recession), as are economic trend lines. Bond prices are implying, today, years of economic malaise, and stock prices imply the same, or at least distrust in the feasibility of corporate profits to continue growing at the same rate. If this expectation does not prove to be true, the most probable outcome is an increase in the value of stocks and higher interest rates on bonds.

Because we do not pretend to know any more about our economic future than the aggregate marketplace, we instead invest based on a variety of potential outcomes and their relationship to our economic analysis. By assigning probabilities, and what is most likely to occur in each scenario, we can build guidelines for overall portfolio decisions. An economic slowdown will undoubtedly be negative for investor returns, but such an outcome is not guaranteed. However, when it comes to investing, “you can chase a butterfly all over the field and never catch it. But if you sit quietly in the grass it will come and sit on your shoulder.”

William A. Callahan, CFP®

President and Chief Investment Officer