On Strategy

Déjà Vu? Eurozone Crisis Today vs. 2008 Subprime Crisis

November 28, 2011

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• News flow on the eurozone debt crisis is speedy, and the latest news of a fiscal pact brings cheers by stock investors… for now.
• There are many similarities between the 2011 and 2008 crises—but even more differences.
• The end of the "Debt Supercycle" has ushered in a period of heightened risk and shortened economic/market cycles.

Before we get to a compare-and-contrast between the eurozone debt crisis of today versus the subprime crisis of 2008, let's first summarize (no easy feat) where we are today with the former.

Single currency experiment goes awry

At its most basic, the problems in the eurozone are nothing new: too much debt, from eurozone member countries to over-leveraged European financial institutions. Adding to the woes is the lack of global competitiveness among many of the zone's members, thanks to the tying of 17 vastly different economies and policies to one (too-strong) currency. The lack of a single fiscal authority within the eurozone that's capable of enforcement or supervision has allowed the problems to fester and the can to be continually kicked down the road.
Exacerbating the crisis recently has been spiking yields on sovereign debt of the most heavily indebted counties (Portugal, Ireland, Italy, Greece and Spain, commonly referred to as PIIGS). The fiscal austerity now being demanded is adding to economic woes, making a eurozone recession all but inevitable. Greece remains the most beleaguered of the eurozone nations, but Italy and Spain have come into the crosshairs more recently.
Turmoil in the European banking sector is raising fears of bank runs and/or failures. Thanks to the "haircuts" placed on Greek debts that didn't trigger credit default swaps (CDS), concerns have elevated about further contagion among global banks. If similar haircuts are applied to other countries in the zone, the problem grows. All of this has greatly raised fears of rating-agency downgrades and further spikes in yields, suggesting a vicious cycle of debt, instability and uncertainty.

Germany plays chicken

This is unsustainable longer-term, and policy makers know this. Many believe (as we do) that Germany is presently playing a game of brinkmanship: saying publicly it's against European Central Bank (ECB) initiating quantitative easing (QE) and balking at the issuance of common eurozone bonds. Both are seen as the only viable solutions to stem the crisis longer-term.
Germany's reluctance is understandable: If it rescues its most profligate eurozone neighbors, its own credit standing gets hit. If Germany does not come to the rescue, a eurozone collapse becomes likely. But a groundbreaking fiscal pact may be in the works, whick helps to explain today's market rally.
As reported in the November 28 Wall Street Journal, the fiscal pact aims to prevent the euro currency block from fracturing by tethering its members more closely together. Although not yet agreed to, the pact would make budget discipline legally binding and enforceable by European authorities, and would "mark a seminal shift in the governance of the 17-nation eurozone," according to the WSJ.
One of Germany's biggest concerns regarding QE by the ECB was that it didn't have the ability to control the finances of any country. This pact may be the "out" Germany needs to eventually support QE or eurobonds. QE and/or eurobonds would likely represent the "bazooka" needed to stem the crisis, akin to what the Troubled Asset Relief Program (TARP) was to the US crisis in 2008.

2011 versus 2008

This brings me to the comparisons between today's crisis and 2008's. I enlisted the aid of several colleagues on Schwab's Investment Strategy Council for this section, so thanks go to Kathy Jones, Brad Sorensen, Michelle Gibley, Rob Williams, David Kastner and Tatjana Michel. In fact, many of our discussion occurred on Thanksgiving Day (though it didn't spoil my appetite!)
The eurozone debt crisis is not distinct from 2008's, because what we're really dealing with is the finale of the global "Debt Supercycle" that took decades to brew. A breaking point was reached in the United States in 2008, and more recently in Europe.

The top five list of similarities between the two phases:

1. Perception: When Greece's troubles erupted, policymakers and investors downplayed it because of its size—similar to the initial perspective about Lehman Brothers' problems.
2. Liquidity: Eurozone policymakers initially assumed Greece's problems were about liquidity, not solvency, and blamed them on "speculators." This was similar to the initial reaction to the subprime crisis in late 2007; ultimately investors demanded a more comprehensive solution.
3. Reality: Investors are now faced with the reality that assets previously considered risk-free now carry much more credit risk. Financial engineering then and now had magically and falsely transformed the most-dodgy loans and bonds into highly rated securities. Banks holding eurozone sovereign debt can no longer be sure that the CDS contracts they used to hedge against defaults will be honored, so they've been selling bonds, causing yields to spike.
4. Contagion: Consistent over the period is a complex web of interconnections among global banks and limited transparency on credit-derivative exposure. Short-term funding risks today also mirror those in 2008, though so far to a lesser degree. The structure of the eurozone system has encouraged its financial institutions to become heavily reliant on short-term funding. The 90 banks covered by the recent European Banking Authority stress tests need to refinance debt in the next two years equivalent to 45% of EU gross domestic product.
5. Moral hazard: If there are policy options available, how far do you take them to ensure that the parties involved solve their fundamental problems? Bond markets and the cost of short-term borrowing, and/or the evaporation of short-term liquidity in both cases, were factors that exacerbated the crises.

A top-10 list of differences between the two phases:

1. Origins: The crises had different origins, with the 2008 US crisis spreading from the bottom up: starting with home buyers, through Wall Street's mortgage securitization and asleep-at-the wheel credit rating agencies, to the global economy. The global recession was triggered by the breakdown of the financial sector.
   
   Europe's crisis today started from the top: fiscally profligate governments and weak economic growth led to a loss of faith by the financial and business communities, which crushed private-sector spending and investment. In this case, one could argue that markets and financial institutions were not the criminals, but the victims.
   
2. Direction: The US private and financial sectors gorged on debt prior to 2008, and the subsequent (and forced) deleveraging caused a massive economic shock. Europe's crisis began with weak eurozone peripheral economies, prompting the private sector to hoard cash.
3. Solutions: The solution(s) to the 2008 crisis required government and central-bank interventions to provide liquidity via record-low interest rates and bank bailouts. The response was swift and coordinated, with the really big gun coming via TARP, which essentially took a massive chunk of private debt and made it public.
   
   Today, that response is hoped for in Europe, but it's been slow in coming (if it ever does). The primary problem today is a virtual absence of confidence among financial players of every variety in eurozone governments' and policy-makers' ability to stem the tide and stimulate growth. In addition, the bad debt at the heart of the eurozone crisis is already public.
   
4. Geography: In 2008, the epicenter of the crisis was the United States, a single nation. Today's the crisis is spread among 17 countries, with surplus economies pitted against deficit economies.
5. Speed: The crisis in 2008 hit quickly and fiercely with the collapse of Lehman Brothers, even though there had been previous warning signs. The eurozone crisis is moving much more slowly. Although kick-the-can effects are in play, they do give leaders and financial institutions time to make adjustments.
6. Bullets: Global central banks had more bullets in their guns in 2008 than they do today. Monetary policy in the United States is as close to loose as it can get. Both the Federal Reserve and the ECB have injected massive liquidity into their financial systems, but there are limits to these strategies' effectiveness. This means stimulus is more likely to come from politicians today as compared to central bankers in 2008.
7. Stress tests: Unlike in the United States, where regulators built a credit stress test for the systemically important financial institutions, European regulators used much less rigor. No write-downs were taken on sovereign debt in held-to-maturity accounts and funding pressure has become more acute. With no credible plan, European banks are forced to sell non-core assets, which will exacerbate the global deleveraging cycle.
8. Health and liquidity: US Banks are far better capitalized, with much lower leverage than in 2008. Regulation is likely to keep leverage ratios lower going forward, which, although bad for earnings, is good for bondholders and the stability of the financial system. You can see this below in key charts of the Tier 1 Capital Ratio of US banks, US banks' earnings, the Bloomberg Financial Conditions Index and the TED Spread.
9. Inflation: Commodity inflation was on a tear in 2008, putting significant pressure on emerging-economy central banks to adopt tight monetary policies, which fed into the negative global growth loop. Today, inflation pressures have eased and many global central banks (including the ECB) have moved toward looser policies.
10. The US economy: Unlike in 2008, when the economy and jobs were imploding, the US economy is much healthier today (if not healthy in an absolute sense). Corporate earnings are on a tear whereas they were pummeled in 2008. Pent-up demand among the household and business sectors should support growth over the next few years.

Tier 1 Capital (as Percent of Risk-Weighted Assets) Much Improved Since 2008

Source: FactSet, Federal Deposit Insurance Corporation, as of September 30, 2011. Tier 1 Capital is primarily common equity and certain perpetual preferred stock for FDIC-insured institutions. Chart represents ratio of capital to risk-weighted assets.

Banks' Operating Income Has Surged Since 2008

Source: FactSet, FDIC, as of September 30, 2011.

Key Measure of Financial Conditions Much Healthier Than 2008

Source: Bloomberg, FactSet, as of November 25, 2011. The Bloomberg Financial Conditions Index combines yield spreads and indices from the short-term debt markets, stock markets and bond markets into a single normalized index.

Key Measure of Banking System Stress Well Off 2008's Crisis Level

Source: FactSet, as of November 25, 2011. The TED spread is the difference in yields between three-month London InterBank Offered Rate loans and three-month US Treasury bills.

Conclusion … if there is any to glean

There's no shortage of worries for investors, and when it seems like the negatives begin piling up, the market takes a hit and moves into risk-off mode. But, as we're seeing today, with any sign of good news, the market can shift to risk-on and stage an impressive rally. It's frustrating for investors, but is illustrative of why taking an all-or-nothing approach to being invested in stocks can be dangerous.
These are difficult and somewhat dangerous times. Rolling crises are likely inevitable, leading to shortened economic and market cycles. We're in a period of history with challenges that are new and more powerful than what have been dealt with in the past. But it's also helpful to remember what Warren Buffet once wrote in a shareholder letter: "…we have usually made our best purchases when apprehensions about some macro event were at a peak."

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

On the Market

Beyond the Supercommittee

November 22, 2011
by the Schwab Center for Financial Research

After months of negotiations, the Joint Select Committee on Deficit Reduction (the "supercommittee") announced that it could not reach agreement, stating: "we have come to the conclusion today that it will not be possible to make any bipartisan agreement available to the public before the committee's deadline."
The supercommittee had a deadline of November 23 to make recommendations to trim at least $1.2 trillion from the budget deficit, but the law required that the supercommittee post publicly any recommendations at least 48 hours before the deadline, or on Monday, November 21.
What's beyond the supercommittee? Schwab answers the key questions.

• Why did the supercommittee fail?
• In the event of a supercommittee failure, automatic spending cuts are supposed to take effect starting in 2013. How large are those cuts and which programs are affected?
• Will these spending cuts actually happen, or is there a mechanism for either Congress or the President to intervene?
• A significant number of tax cuts are due to expire in 2011. What are they, and will they be extended?
• Are there other important provisions of the tax code that must be addressed before the end of 2011?
• The Bush-era tax cuts are due to expire at the end of 2012. When will their fate be addressed?
• The 2012 election is less than a year away. Did either party's chance for gaining ground benefit from the supercommittee failure?
• What are implications of the supercommittee's failure for the stock market overall?
• What's the bullish case for US stocks?
• What's the bearish case for US stocks?
• Are we more persuaded by the bulls or the bears?
• Are specific sectors or industries at greater risk in the event the automatic cuts happen?
• Is there a chance that Moody's will downgrade US debt as a result of the supercommittee's failure?
• What would happen if there were another downgrade of US debt?
• Are US Treasuries still a safe-haven investment?

Why did the supercommittee fail?

The 12 members of the supercommittee struggled to bridge a huge philosophical gap between the two parties in an effort to come up with a plan. The main issue has been the desire of the panel's six Republicans on the committee not to increase taxes, while the panel's six Democrats have opposed significant entitlement cuts without tax increases. This is the same fundamental disagreement that led to the near-shutdown of the government in March, and to the debt ceiling crisis in August. The two sides were never able to come to any agreement.

In the event of a supercommittee failure, automatic spending cuts are supposed to take effect starting in 2013. How large are those cuts and which programs are affected?

Under the law, automatic, across-the-board spending cuts totaling $1.2 trillion will take effect on January 2, 2013, and will be spread out evenly over the next nine years. About $200 billion of that figure comes from savings on interest on the debt, so the total amount of cuts over the nine-year period is about $1 trillion. Half of that amount will come from defense spending and half from non-defense spending. In the latter category, a number of programs are exempt from the cuts, including Social Security, Medicaid, veterans' benefits, children's health programs, and the Earned Income Tax Credit.

Will these spending cuts actually happen, or is there a mechanism for either Congress or the President to intervene?

Because the cuts do not take effect until January 2013, there is more than a year for Congress to undo the cuts. Legislation to exempt more programs could be introduced, approved by both chambers of Congress and signed by the President. A number of members of Congress from both sides of the aisle have said that they will make attempts in the coming year to reduce or eliminate many of the planned cuts. The President has indicated that he would veto such efforts, but no specific proposals have been put forward yet.

A significant number of tax cuts are due to expire in 2011. What are they, and will they be extended?

Over the next several weeks, Congress will have to scramble to extend tax cuts that are set to expire at the end of this year. Lawmakers were waiting to see what the supercommittee did with some of these tax items, and now that nothing has happened, they must be addressed.
Topping the list is the 2011 payroll tax cut. In 2011, the amount of payroll taxes an employee saw taken out of each paycheck was reduced from 6.2% to 4.2%, but that amount is set to revert to 6.2% on January 1, 2012. President Obama has proposed reducing the payroll tax further, to 3.1% for both employees and employers. That proposal has not yet been considered by Congress, and its price tag—about $245 billion—may make it impossible to get through a divided Congress. Just extending the current law for a year would cost about $100 billion. Congress is expected to consider some kind of payroll tax cut extension in December.

Are there other important provisions of the tax code that must be addressed before the end of 2011?

Yes, there are a host of other tax provisions expiring at the end of this year.
Businesses are particularly concerned about the expiration of the research and development tax credit, and several other expiring business tax provisions.
On the individual side, among the items set to expire are the deduction for state and local sales tax, the deduction for college tuition and the IRA charitable rollover. Also expiring at the end of this year is the Alternative Minimum Tax (AMT) "patch." For more than a decade, Congress has passed a series of patches that increase the amount of income exempt from the AMT. Without this fix, the exempted amount would tumble, potentially exposing an estimated 20-30 million Americans to higher taxes. However, the provision is in place for the 2011 tax year (for which taxpayers will be submitting returns in April 2012), so this does not need to be addressed until sometime before the end of next year.

The Bush-era tax cuts are due to expire at the end of 2012. When will their fate be addressed?

This is the biggest issue. These tax cuts include the reduced income tax rates, the 15% tax rate for capital gains and dividends, the estate tax, and other provisions.
Congress will need to deal with those before the end of 2012. There is a good chance that Congress will wait until after the 2012 elections to address the issue, in what is known as a "lame duck" session of Congress in November/December 2012. That's what happened in 2010, when Congress waited until December 17th before passing a two-year extension of the tax cuts.

The 2012 election is less than a year away. Did either party's chance for gaining ground benefit from the supercommittee failure?

It's hard to say, but our first reaction is that neither party will benefit from this failure. Public reaction is very negative, and there appears to be plenty of blame for both sides.

What are implications of the supercommittee's failure for the stock market overall?

The market action on Monday was grim, but we believe it may have had as much to do with the ongoing eurozone crisis as it did with the failure of the supercommittee to come to an agreement.
It does add to the confidence crisis that's been pervasive, however, and the market will remain attuned to the payroll tax cut, which is due to expire at year-end. Failure to extend that cut could cut shave as much as 1% from gross domestic product in the first half of 2012.
In the meantime, the market continues to resemble a see-saw, moving from risk-on to risk-off mode, depending on news flow. After a nearly 10% rally in the first four months of the year, the market suffered a near-20% correction over the next five months, before rallying a big 17% in October. Since then, the market has been consolidating some of those gains.
We continue to believe the market is in a trading range, but with an upward bias—because although the picture is mixed, there are plenty of positives going for both the economy and the market.

What's the bullish case for US stocks?

We believe there are many positives for US stocks right now, including better economic news from the United States and recent moves on the part of global central banks.

• Better US economic news:
  
  • Recent weekly unemployment insurance claims below 400,000¹; layoff announcements down; and job postings up (strong Job Openings and Labor Turnover Survey report).
  • Bank lending up, both among consumers and businesses.
  • Business and consumer optimism ticking back up after the summer swoon.
  • Inventories have been cut to the bone, taking growth from the third quarter, but are set to be additive in the fourth quarter, as they are now too low relative to sales growth.
  • Leading Economic Indicators (LEI) up sharply in latest report, with positive contributions from nine of the 10 sub-components².
  • Core inflation moving lower, which should boost "real" gross domestic product (GDP); gasoline prices near their lowest levels of the year.
  • Much better housing news: building permits, new home sales and recent National Association of Home Builders housing index all exceeded expectations.
• Global central bank and eurozone political leadership capitulations. Although decisive plans to stem the crisis are lacking, the European Central Bank (ECB) and other global central banks have moved into loosening mode, which should help boost growth.
• Eurozone recession likely underway, but trade with Europe only accounts for 1.3% of US GDP.
• Strong third-quarter corporate earnings: 18% year-over-year growth in the S&P 500, with companies beating expectations by an average of 6%³.
• Cheap stock valuations: The S&P 500 has a forward price-earnings ratio of 12 vs. a median of 16.8 since 1990 (the period through which we have data)⁴.
• Paltry bond yields: If they begin to rise (while bond prices fall), money could re-allocate from bonds to stocks.
• Over the past five years, outflows from equity mutual funds of over $400 billion and inflows to bond mutual funds of over $800 billion: $1.2 trillion spread is by far an all-time record flow in favor of bonds.
• Still-pessimistic investor sentiment, suggesting the "wall of worry" markets like to climb is intact.
• Market has consistently bounced back quickly after sell-offs, suggesting market players are underinvested and worried about missing out.

What's the bearish case for US stocks?

We believe the bearish case rests on a number of factors.

• Spikes in yields have moved from the eurozone's periphery to core countries like Italy and Spain.
• Germany and the ECB are (so far) rejecting calls to bail out struggling countries by buying bonds and acting as lender of last resort.
• Eurozone is likely already in a recession.
• Consumer confidence taking another hit from the supercommittee's failure.
• Oil prices are climbing on Middle East tensions flaring again.
• Ongoing debt deleveraging by private sector with public sector just starting.
• Rampant market volatility is keeping individual investors on the sidelines.
• "Stall speed" of economy means recession risk is not eliminated: downward revision to third quarter GDP adds fuel to that view.
• The Federal Reserve is pushing on a string; if another round of quantitative easing is coming, it brings unintended consequences, including commodity inflation.
• Concerns about a hard landing in China, the world's second largest economy.

Are we more persuaded by the bulls or the bears?

The bulls. Admittedly, the bearish case is the more intellectually powerful and will continue to put pressure on the US economy and markets. But we believe much of it is already built into expectations (and prices). When the expectations bar gets set as low as it has been, the ability for results to hurdle that bar becomes easier. As the market's huge rally in October attests, you don't need a rash of exceptionally good news—just marginally better news than the consensus expects—to pull some of the massive sidelined money back into the market.

Are specific sectors or industries at greater risk in the event the automatic cuts happen?

By far the largest industry at risk is in the defense area, which could see up to $900 billion in cuts over the next decade, according to Strategas Group in their report dated November 21, 2011. Highly placed officials inside the military and members of both parties have criticized the cuts, but the President has said he would veto any attempts to "undo" the automatic cuts triggered by the failure of the supercommittee. Should the cuts go into effect, revenues, profits and ultimately the share prices of companies that are heavily dependent on US defense contracts would likely be impacted negatively.
While not as severe, health care companies that deal with the government, especially with Medicare, also stand to be hurt should nothing be done. In the same report, Strategas estimates $120 billion in cuts for those companies that provide Medicare services.
Obviously, there is a long way to go, but we advise investors to keep an eye on the negotiations and monitor their holdings in the above-mentioned industries, as the impact could be substantial if the cuts proceed as planned.

Is there a chance that Moody's will downgrade US debt as a result of the supercommittee's failure?

There's always a risk, but for now the rating agencies appear to be waiting for further developments. After the supercommittee announcement, all three of the major rating agencies—Standard & Poor's, Moody's Investors Service and Fitch Ratings—reaffirmed their current ratings. S&P, which downgraded longer-term US sovereign debt last August, affirmed its AA+ rating, indicating that the imposition of automatic spending cuts is enough to keep the rating unchanged for now. In our view, Moody's, which has the United States still rated Aaa but on negative outlook, could downgrade the US debt if the automatic spending cuts are canceled. Fitch indicated that it is reviewing its AAA rating with a stable outlook in light of the committee's failure to come up with an agreement. Regardless of the debt rating, Treasury yields continue to trade near 40-year lows and the United States continues to see inflows of foreign capital. Even with downgrades, the market action suggests that the US Treasury market remains the benchmark for global investors. We believe that the market will determine interest rates on US debt, not the rating agencies.

What would happen if there were another downgrade of US debt?

If Moody's does downgrade the United States, we doubt it would have a major impact on the market. Rates fell sharply after the S&P downgrade, showing that the focus is more on economic growth, inflation expectations and the safe-haven status of US Treasuries. Some institutional buyers may need to change investment guidelines to hold US Treasuries if two out of three agencies lower the rating, but it is likely these guidelines have already been changed as a result of the S&P move.

Are US Treasuries still a safe-haven investment?

We continue to view the US Treasury market as the benchmark safe-harbor rate even if there is another downgrade. Most tellingly, Treasury yields fell on Monday, which suggests a greater concern about Europe than the supercommittee's failings.

1. United States Department of Labor.

2. The Conference Board.

3. Thomson Reuters, as of November 14, 2011.

4. FactSet, Standard & Poor's, as of November 11, 2011.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or "informational") purposes only and not intended to be reflective of results you can expect to achieve.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. For municipal securities, income may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Schwab Market Perspective: Missing the Forest for the Trees?

October 28, 2011

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Brad Sorensen
CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Michelle Gibley
CFA, Senior Market Analyst, Schwab Center for Financial Research

Key Points

• Earnings season was good and economic data in the United States has shown signs of improvement. Although we don't believe we'll see robust growth in the near future, we do believe the economy is improving. But investors appear to be unconvinced that the picture may be brightening.
• Headline inflation continues to run higher than we'd like to see but we don't believe sustainable price gains are likely.  The Fed continues to be extremely accommodating, seemingly more concerned about the potential for deflation.
• Although Greece has garnered the headlines, Italy has the potential to be a much bigger problem. There are positive signs of progress in Europe and a tentative agreement has been reached, but hopes for a true long-term solution remain thin. Conversely, Chinese growth, while slowing, is likely to suffer no worse than a soft landing.

In investing, a danger is getting caught up in day-to-day, hour-to-hour developments. And typically, it's the negative news that gets the majority of the attention from the media.  Looking at the bigger picture is important for investors that have longer-term horizons.
The market continues to be at the mercy of developments out of Europe, with much of the recent focus on Greece. Discussed in more detail below, Greece itself is a relatively small country in terms of economic size and importance, but is getting the lion's share of media and market attention. Its importance is heightened due to it's interconnectedness with other European nations, but overemphasizing its problems can obscure the bigger picture solutions that are being formatted. But even the broader European focus has largely seemed to overshadow developments in the United States, which remains the world's largest economy.

US growth improving and recession risk is ebbing

We are seeing signs of better growth that we believe is supporting an upside breakout of the recent range-bound equity market. But despite a nice rally in the markets since the beginning of October low from just under 1100 on the S&P 500, investor sentiment remains quite dour. The Ned Davis Research Crowd Sentiment poll does show improving confidence, but it remains in the "extreme pessimism" zone, which contrarily bodes well for the potential of a continued move higher in equities.

Investors appear unconvinced despite recent rally

Source: FactSet, Standard & Poor's. As of Oct. 20, 2011.

We are now well into third quarter earnings season and it has been better than anticipated. The vast majority of companies reported both bottom- and top-line results that met or beat expectations, while outlooks were mildly optimistic. Demand has held up relatively well, and companies continue to hold their costs down and maintain solid balance sheets. After factoring in the latest results and guidance, valuations are attractive, especially relative to bonds.
Economic data also supports a modestly improving picture. Although the NY Empire Manufacturing Index remained in negative territory, important subcomponents including orders, employment and shipments all moved from territory depicting contraction to expansion. Another regional manufacturing survey, the Philly Fed Index, surged from -17.5 (which shocked markets two months ago) to 8.7, a six-month high; while new orders, shipments, capital expenditures, and employment all either remained in or moved into positive territory. Additionally, industrial production moved higher by 0.2%; durable goods order ex-transportation surprised significantly on the upside; and the Index of Leading Economic Indicators moved higher by 0.2%, the fifth-straight monthly increase. Finally, third quarter real gross domestic product (GDP) came in at 2.5%  growth, up from 0.4% in the first quarter and 1.3% in the second quarter, further helping to dispel fears of a renewed recession. While encouraging, we continue to believe business confidence needs to strengthen in order to really get the economy moving in a sustainable way.

Small business confidence better, but still too low

Source:  FactSet, Nat'l Federation of Independent Business. As of Oct. 20, 2011.

Murky jobs picture, but maybe better than portrayed

Improving employment growth continues to be the focus of both the Federal Reserve and the government, and we are seeing nascent signs of improvement. Initial jobless claims continue to hover around the 400,000 level; various surveys, as mentioned above, indicate improving employment conditions; and the often-ignored JOLTS (Job Openings and Labor Turnover Survey) report showed that at the end of August there were 3.1 million job openings, up 200,000 from a year ago and 944,000 greater than the trough seen in July 2009. While the long-term unemployment rate is far too high at over 6 million, that number has remained relatively stagnant over the past year.

Fed continues to swing away

The Federal Reserve continues to be concerned with the over 9% unemployment rate and the still moribund housing market that appears to be, at best, bouncing along the bottom. Although new home starts jumped by 15%, permits were down 5% and both of those number were greatly affected by the volatile multi-family component. Additionally, existing home sales fell.
In response to these concerns, the Fed adopted "Operation Twist" at its most recent meeting, attempting to bring down longer-term mortgage and Treasury rates. So far, the impact hasn’t been felt as mortgage applications actually fell by close to 15% a week ago and are now at a 15-year low; and longer-term interest rates are now higher than when the program was announced. But, although there appears to be increasing dissention within the ranks of the Federal Open Market Committee (FOMC), the majority still seems ready to attempt to do more if they deem it necessary. The Fed appears unconcerned about stoking inflation, despite the headline Consumer Price Index (CPI) rising by 3.9% year-over-year, and the core rate at the upper end of their implied preferred range of 2.0%. Despite these readings, we too remain relatively unconcerned about inflation in the near term. We've seen commodity prices move lower recently, which should alleviate pressure on the headline rate, while continued high unemployment, minimal wage gains, and capacity utilization of 77.4% (still 3% below its 1972-2010 average) should keep inflation relative low.

Washington continues to underwhelm

Focus will likely return to Washington over the next month as the debt Super Committee's deadline for coming up with a deal approaches. Early reports are that there’s little positive movement toward a deal that both sides can agree on. But in addition to the fact that most deals like this get done at the last minute and we are hearing rumblings that a "grand bargain"-type deal is not out of the question.
Although a recent University of Michigan survey reminded us that the government is doing little to help confidence, as the ratio of those thinking the US government was doing a good job versus a bad job fell to a record low -53%, we do believe they will manage to cobble together some sort of agreement that avoids some of the more draconian outcomes currently predicted. However, any chance of a long-lasting, credible, plan that stimulates growth, cuts spending, and lowers debt before the 2012 elections seems slim at best.

Is Italy or Greece Europe’s weak link?

Across the pond, however, some progress was made on finding at least a temporary solution to the Greek debt problem. Although still short on critical details that could derail any feasible agreement, it appears that participants have started to realize the reality of the situation. The recent summit ended with private Greek debt-holders agreeing to a "voluntary" 50% haircut in the value of their bonds, while also announcing the bolstering of the European Financial Stability Facility (EFSF) and increased capital to the continent's financial institutions. However, where that money is coming from is unclear at this time—a major question still looming. Despite the vagaries, it is a glimmer of hope. Although global risks have intensified in recent months, a meltdown of the global banking system has significantly moderated in our view; with the mere acknowledgement and progress toward actions to fight the eurozone debt crisis. That said, the fallout from the crisis will likely continue, in three significant areas: Italy, the European banking system, and the overall eurozone economy.
Italy is in focus due to its large debt load. At 1.9 trillion euros ($2.6 trillion) Italy has the world's third largest bond market; behind the United States and Japan. It represents nearly 120% of Italy's GDP. Italy needs to continually raise vast sums of money to roll over maturing debt. If they are unable to find investors willing lend at reasonable interest rates, its debt would likely be too big to bail out. Lastly, with growth nearly stagnant, Italy needs changes to the status quo to put its financial future on a sustainable path.
Reforms in Italy needed to both reduce spending and spur growth are similar to changes needed in many of the "Club Med" countries: overhaul the pension system, reduce the protection from new entrants in certain "closed" professions, and reduce red tape. The World Bank ranks Italy 87th globally in its latest ease-of-doing business survey and 158th in terms of enforcing contracts. Markets question Italy's resolve to adhere to an austerity plan and implement reforms. Infighting within Prime Minister Berlusconi's fragile coalition government, allegations of corruption and scandals, and reversals of prior promises undermine confidence as well.
Italy's situation is not entirely dire though—it should not be considered the next Greece. Italy suffers from liquidity concerns due to low confidence; not from questions about solvency. Unlike Greece, Italy has a primary budget surplus; a surplus before debt payments; as well as high percentage of domestic, long-term holders of its debt, and long debt maturities. This suggests that any crisis should be slow to develop. We believe that Italy, like governments of other peripheral nations, will likely eventually come to grips with tough decisions. If the current government doesn’t make good on its promises, markets and constituents could force a change in leadership.
Another victim of the prolonged debt crisis is the eurozone economy broadly, as European banks could limp along. To achieve the higher capital ratios mandated as a part of the "recapitalization plan," European banks could sell assets or reduce dividends, diluting equity holders. And there is potential for increased demand for claims on collateral (bank assets).

Eurozone banks likely to rein in lending

Source: FactSet, European Central Bank. As of Oct. 25, 2011.

A weakened eurozone banking system is likely to reduce lending, the lifeblood of economic growth. Over the summer, eurozone banks started to tighten lending standards at the fastest pace since 2009, and indicated they expect tightening to worsen. In response, businesses could begin to protect cash by freezing or cutting employment, capital investment and discretionary spending, reducing production or reducing inventory.
In addition to economic headwinds, we've kept our neutral intermediate-term view on European stocks believing that there may be more downside risk to eurozone earnings estimates than elsewhere globally. Third quarter earnings season may bear this out, as only 52% of European companies reporting through Oct. 26 beat earnings estimates, well short of the 72% rate in the United States, per Bloomberg.

Longer-term investment implications from the eurozone debt crisis

Investors likely have whiplash from month-to-month swings in sentiment regarding the eurozone debt crisis, but there are longer-term implications. In our opinion, the euro "experiment" of a common currency for countries with different cultures, economic make-up and growth, without fiscal union, is flawed. What may be needed is fiscal coordination on budgets, tax rates and collection; debt issuance; and enforcement of budget discipline. The adjustment to supra-national oversight is likely to be unpopular with constituents who may see this is as "taxation without representation." Social unrest and discord could continue to be a staple in the eurozone.
Big picture implications from the eurozone debt crisis could shape investment philosophy for several years. In an era of painful debt reduction realities in many developed economies, there is the potential for uncertainty to result in more frequent and shorter business cycles, while pressuring economic and earnings growth.
Alternatively, emerging markets could grow in relative investment attractiveness. Emerging market economies tend to have lower debt levels. Additionally, generally younger demographics create a lighter burden on public finances and potential for more output. Meanwhile, expectations for emerging markets are low, with valuations at the lowest levels since 2009. Emerging market stocks came under pressure earlier this year amid monetary tightening headwinds; and further intensified with market volatility and concerns over a hard landing in China.

Are China fears justified?

Growth in China slowed to 9.1% in the third quarter from the 9.5% rate in the second quarter, hardly qualifying as a hard landing. However, due to lack of transparency and mistrust of government statics, it is useful to look at other proxies of economic growth. The HSBC survey of purchasing manager intentions of over 400 companies—a broader version than the government’s as it includes smaller companies—increased to 51.1 in September.

Soft landing in China looks likely

Source: FactSet, Bloomberg. As of Oct. 25, 2011. Seasonal average over a six-year period excluding a one-year period from May 2008—June 2009. October data is preliminary.

Despite low 2011 figures, HBSC notes that a PMI reading as low as 48 is consistent with annual growth of 12-13% in industrial output and a 9% rate of increase in GDP. Other positive proxies of growth include healthy freight volumes and an acceleration of electricity output in September to 12.2% from 9.1% in August.
We believe a hard landing in China would probably need a US and global recession to occur, and policymakers have many levers to arrest a slowdown. While Chinese officials have yet to decisively move away from inflation vigilance, they have started to sound a more conciliatory tone. They are talking about support for small businesses; adding jobs as an explicit priority for the first time in recent history; reduce fuel prices; and making bank stock purchases.
A shift in policy bias in China could be nearing and fulfill the last condition needed for emerging market stock outperformance, as cited in Emerging Markets: A Bright Spot?
Visit http://www.schwab.com/public/schwab/resource_center/expert_insight/investing_strategies/international for more international perspective.

Important Disclosures

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 27, 2010, the MSCI EAFE Index consisted of the following 22 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 27, 2010, the MSCI Emerging Markets Index consisted of the following 21 emerging-market country indexes: Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

STOCKS IN THE FOURTH QUARTER

Can the last quarter of 2011 live up to historical averages?

Is a rally ahead? You may have heard that stocks tend to do well in the fourth quarter. History affirms that perception: while past performance is no guarantee of future results, the last quarter of the year has historically been the best quarter of the year for U.S. equities. As data from Bespoke Investment Group notes:

·         The S&P 500 has averaged a +2.44% performance in fourth quarters since 1928.

·         In the last 20 years, it has averaged +4.57% in fourth quarters.

·         In the last 30 years, it has advanced in 24 of 30 fourth quarters with an average price return of better than 7%.¹

Will the Street put its anxieties aside? Right now, you have a lot of uncertainty. Many analysts see a stock market unimpressed by tepid domestic growth and waiting fearfully for the other shoe to drop (meaning Greece).They see more pain ahead for U.S. investors. On the other hand, there is also talk of when a point of capitulation might be reached, i.e., is Wall Street simply ready to rally even in the face of the debt troubles in Europe and the slow recovery here.

You could argue that certain Wall Street psychologies (and tensions) aid 4Q rallies. After all, the pay of money managers relates to performance and there is renewed pressure on them to come through as the end of a year looms.

Could new optimism surface? Perhaps it is surfacing now. As the third quarter wrapped up, Reuters polled 350 stock market analysts worldwide. Their consensus forecast was that 18 of 19 major world stock indices would either advance or suffer insignificant losses in the fourth quarter (Taiwan’s TAIEX was the lone exception in the forecast).²

They also felt that two indices would achieve 2011 gains: South Korea’s Kospi, and the Dow Jones Industrial Average. They think the Dow will end 2011 up about 2%. The Dow was at -5.74% YTD at the closing bell on September 30.^3,4

On a particularly bullish note, Bloomberg surveyed

12 Wall Street

strategists in early October and found them collectively forecasting the greatest 4Q rally in 13 years. They think that the S&P 500 will rise 15% this quarter, which would mean a push to 1,300 by New Year’s Day.⁵

Stocks certainly are cheap. Bloomberg data also indicated that when the S&P nearly closed at bear market levels in early October, it was down to 12x reported earnings; valuations were lower than they had been at any point since 2009. At the end of September, the MSCI World Index was trading at just above 10x its 12-month forward earnings, well under its average of 14.3x earnings since 2001.^2,5

Some analysts are optimistic about the coming quarters. Indeed, the 350 analysts surveyed by Reuters are envisioning some impressive bull runs. They think Russia’s RTSI will advance 32% between now and mid-2012; they feel Brazil’s Bovespa will rise approximately as much in the next three quarters. If you follow emerging markets, forecasts like these may not surprise you much. However, they also see double-digit advances for the Dow, Nikkei 225, All Ordinaries, CAC 40 and DAX by mid-2012.²

Historically, stocks have had impressive resilience. Here are two other encouraging statistics in the wake of the Dow and S&P’s double-digit third quarter drops:

·         The Dow had 14 quarterly losses of 10% or more in the period from 1962-2009. In 79% of the ensuing quarters, the Dow pulled off a quarterly gain.

·         The S&P suffered 11 quarterly losses of 10% or more during a stretch from 1981-2009. In 80% of the following quarters, it posted a quarterly gain.⁶

Another 4Q rally depends on many variables, but if Greece avoids default and 3Q earnings don’t disappoint, we might see a better end to 2011 than the bears anticipate. 

Citations.

1 - moneywatch.bnet.com/investing/blog/investment-insights/stocks-ready-for-fourth-quarter-rally/2833/ [10/3/11]     

2 - reuters.com/article/2011/09/29/us-markets-stocks-poll-idUSTRE78S4EK20110929 [9/29/11]             

3 - montoyaregistry.com/Financial-Market.aspx?financial-market=an-introduction-to-the-stock-market&category=29 [10/7/11]       

4 - cnbc.com/id/44729786 [9/30/11]

5 - bloomberg.com/news/2011-10-07/stock-index-futures-in-u-s-rally-after-employment-growth-beats-forecasts.html [10/7/11]    

6 - cnbc.com/id/44677114/Third_Quarter_Pain_Fourth_Quarter_Gain [9/29/11]

Nice writeup on the dollar/market relationship. RGW

 

On Strategy

Million Dollar Question: Dollar and Recession Risk Up Together

October 3, 2011

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Recession fears have mounted, but the picture is still mixed and it's not yet conclusive.
• The US dollar is winning the "least ugly" currency contest, but isn't helping stocks or commodities. 
• Short-term, a stronger dollar is a negative for riskier assets … but not necessarily longer-term, if history's a guide.

No matter the subject to be tackled, it's appropriate these days to update readers on the latest economic reports and what they say about the likelihood of recession. After that I'll tackle the subject of recent strength in the dollar and what it may mean for the economy and markets.

Recession fears mount

Recession fears grew last week when the chief economist of the Economic Cycle Research Institute (ECRI), which has a weekly leading index (WLI), wrote that the US economy was dipping into recession. Their index has been right in calling for recessions over the past three cycles, but doesn't have a long history. It also dipped to an even lower level last year and no recession was forthcoming, as you can see in the chart below—so it has given false signals.

ECRI's WLI Double Dips

Source: ECRI and FactSet, as of September 23, 2011.

The Conference Board's index of leading economic indicators has a longer track record, and it's been stellar. I've written about the yield curve and money-supply biases of the LEI and why you need to discount their strength. Even so, the Conference Board has its own recession probability model and it's still reading sub-50%, though not by much. For what it's worth, that's close to my assessment of the situation.

Mixed bag

Here's an update on the latest economic readings, which I believe support the mixed picture outlook for the economy (but don't support a definitive recession):

• The ISM manufacturing index for September increased from 50.6 to 51.4, which was better than the 50.5 consensus, and keeps the index above the 50 line dividing expansion from contraction. Within the report, the employment and export orders indexes rebounded nicely, but the recent strengthening of the dollar (addressed below) suggests some damage to come in the latter.
• Construction spending in August increased 1.4%, much better than the -0.2% consensus, with the jump coming from a 3.1% increase in public construction (hugely volatile) … but private sector activity rose, too. Construction will likely be additive to gross domestic product (GDP) growth in the third and fourth quarters of 2011.
• Real GDP growth for the second quarter of 2011 was revised upward from 1.0% to 1.3%. The Blue Chip Consensus expectations for the third- and fourth-quarter GDP growth are 1.9% and 2.1%, respectively.
• Corporate profits increased to a record high of $1.517 billion and corporate cash flow also increased to a record high of $1.773 billion during the second quarter; up 9.4% and 5.5%, respectively.
• Personal income edged down 0.1% in August as personal spending increased 0.2%, both slightly better than expectations.
• The Chicago purchasing managers' index came in at 60, much better than expected.
• The Case-Shiller home price index was down 4.1% on a year-over-year basis (better than the -4.4% expectation) in July, but on a monthly basis, the index was unchanged (supporting the bottoming case for housing).
• Durable goods orders decreased 0.1% in August, better than the -0.2% expectation.
• Consumer confidence has stabilized, albeit at a very low level.
• Initial jobless claims declined sharply to 391,000, but due to seasonal factors, they're likely to move up again.

The bottom line, as noted by The Conference Board: "Whether the National Bureau of Economic Research at a later date officially decides that the current slow growth constitutes a recession, however, is somewhat academic to business leaders and investors who already are dealing with growth that is uncomfortably slow. The one silver lining is that any recession in the next few months is likely to be short and shallow, since it would not be a typical business-cycle downturn characterized by high-capacity utilization rates in the labor and product. In other words, the sluggish expansion to date means that output should have less to fall in a downturn."  That last part is the tune I've been singing for some time.

Dollar: winning the "least ugly" contest

Accompanying the latest economic weakness has been a strengthening US dollar, as you can see below.

US Dollar Breaks Out

Source: FactSet, as of September 30, 2011.

Its rally has been triggered partly by the Federal Reserve's recent announcement of Operation Twist, which—unlike quantitative easing (QE), which was dollar negative—didn't expand the Fed's balance sheet, which has been dollar positive. The dollar has also gotten a boost from the narrowing gap between US and foreign policies. The former has had loose fiscal and monetary policies for some time, but foreign policies are quickly becoming looser as well as they combat slowing economic growth and lessening inflation risk.
I asked Tatjana Michel, Schwab's currency analyst, for her thoughts, and here's what she had to say: "In addition to the European crisis, the slowdown in global economic growth is increasingly worrying investors and driving them into the safety of the US dollar. Slowing global growth implies weakening demand for goods and services, which is likely to hit currencies of countries most dependent on exports to generate growth. Less demand for exported goods also means less demand and more weakening for the currencies of those countries. As their growth falters, they're also likely to ease monetary policy and lower interest rates, which adds pressure on their currencies."

Dollar strength hurts exports but helps consumers

The US economy has the biggest spread between exports and consumption as economic drivers. US GDP can reap rewards from dollar rallies as they feeds into lower inflation and better consumption. You can see this visually below.

Source: Wolfe Trahan & Co.

Strong dollar = weak riskier asset classes … for now

The rub is that the benefit of a stronger dollar will unlikely be felt in short order. At present, and since the financial crisis erupted in 2008, most risk assets—including stocks and commodities, as well as exports and manufacturing—have had inverse correlations with the dollar. Assuming present trends continue, dollar strength in the short term would have a negative effect on the euro, emerging-market stocks, the S&P 500 Index and all commodities (including gold), but be beneficial to corporate bonds and other fixed income assets.
But these correlations haven't always been negative. Take a look at the chart below, which shows the correlation between the S&P 500 and US dollar.

Negative Correlation Between Stocks and Dollar

Source: FactSet, as of September 30, 2011. Chart shows one-year rolling correlation of daily percentage changes in S&P 500 and US Dollar Index.

Only since 2008 did the correlation plunge into negative territory; prior to that, the correlation was largely positive. You can also see what could be a bottoming pattern in the correlation—similar to what occurred in the mid-2000s.
Looking further back, as you can see in the table below, stocks historically performed better overall in dollar bull markets than in dollar bear markets.

Source: Bespoke Investment Group and FactSet, as of September 30, 2011.

Given that lower commodity prices are good for US consumers, and US consumers drive the US economy, why the current negative correlation? It's probably a function of the "risk-on, risk-off" trading environment that's had all risk assets moving largely in tandem. That may not be permanent, and you can already see that the correlation between stocks and commodities is starting to turn back down.

Positive Correlation Between Stocks and Commodities

Source: FactSet, as of September 30, 2011. Chart shows one-year rolling correlation of daily percentage changes in S&P 500 and Commodity Research Bureau Index.

The path the dollar takes from here will depend on several factors. As Tatjana mentioned to me, "there are one or two question marks concerning the dollar in the future. The current global growth slowdown is also being felt in the United States. Depending on whether and how much the US economy weakens from here will affect Fed policy. This might come in the form of QE3, which would likely put renewed downward pressure on the dollar (and upward pressure on riskier asset classes). In addition, the US debt crisis is not off the table and any flare-up, political or otherwise, could prove to be a stumbling block for the dollar."

In sum

I think there's risk of a pullback in the dollar if the economy weakens further and additional Fed stimulus is put back on the table. Were that to occur, I'd expect a rally in risk assets. However, if recession risk is overblown, the dollar could keep a bid under it. In the short term, that would likely continue to hit riskier asset classes, including stocks and commodities. Longer-term, though, a stronger dollar is in the best interest of the US economy, and probably even the stock market.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Schwab has posted their latest commentary:

http://www.schwab.com/public/schwab/resource_center/expert_insight/todays_market/recent_commentary/schwab_market_perspective.html

The following is analysis from outside sources. I have included WBFG views on some of the comments. RGW

What IS THE IMPACT OF A GREEK DEFAULT?

Many economists think a Greek default is inevitable. As we enter 4Q 2011, Greece has a debt-to-GDP ratio of about 160% (and that percentage is rising). While Greece accounts for less than 3% of Eurozone GDP, ripples from a Greek default could strain the European banking sector and global financial markets.

Struggling for the best worst-case scenario. Greece is redoing its financial system, but it is still facing one of five potential (and painful) outcomes.

1. Greece renegotiates its debts & forces its lenders into write-offs. Many Greek banks are nationalized; Greece endures a long recession.
2. Greece can’t renegotiate its debts. It sinks into a multi-year depression exacerbated by additional austerity measures.
3. Greece rejects further austerity cuts recommended by the EU. A standoff with the International Monetary Fund and European Central Bank results; the ECB and IMF blink and continue bailout payments to Greece; Italy and Spain see the way Greece made the ECB and IMF cave in and later wrestle the ECB and IMF into submission in the same way; Germany gets frustrated with all this and ditches the euro.
4. Greece rejects more austerity cuts & the EU stops bailout payments. Civil unrest jeopardizes the country. Its banks close; its public services halt. The CIA has advised that a coup may occur in Greece in such a scenario.
5. Greece lapses into a banking/cash flow crisis & leaves the euro. This is the “doomsday” scenario. Assume #4 occurs with Greece also electing to go back to the drachma. That could mean a run on Greek banks, and then Spanish and Italian banks. A return to the drachma could mean frozen borrowing for Italy and Spain and possibly lead to insolvency for major banks in Europe. Picture 17 nations trying to agree on and quickly implement an EU version of TARP. Havoc could result for stocks and the global economy.
   

This all sounds very gloomy, but prospects may emerge from the gloom.

A(nother) golden opportunity? In the event Greece defaults, the search for safe havens could mean a quick flight to gold. If a Greek bailout succeeds, there may still be fiscal instability among EU members, and presumably an easy monetary policy fostering loose credit. If Greece defaults, then you could see big drops in the spot prices of currencies plus some competitive devaluation. All of this could make gold look very, very good.

On the other hand, if true systemic risk hits global markets, investment banks and hedge funds might need capital fast – and gold is easily liquidated. So a gold selloff could also possibly occur if the situation becomes dire.

WBFG View

WBFG holds a negative view of gold and does not recommend it has a long term investment for clients. Its current role in the market appears to be as a speculative tool. This view has appeared to push gold into bubble territory with the possibility of rapid price deprecation (as seen last week when gold dropped around 10% in two days.

What about Treasuries & the dollar? Treasuries remain popular, and demand for them could jump after a Greek default. What other choices do central banks have if they want to shop around for a stable, readily available, reasonably liquid investment? The euro is hardly a rival to the greenback right now.

WBFG View

WBFG believes it is appropriate to hold short term, high quality, multi currency fixed income holdings in this environment. This view is reflected in the fixed income positioning that the Investment Committee has recommended.

How about emerging markets? Here is another option. The BRICs and some of the other emerging-market nations have managed to ride out the recent volatility fairly well – there has been some “decoupling”, if you will.⁸ No one is saying these markets would be immune from a continental banking crisis or a flight from stocks, but you have to concede that emerging markets have the capability for independent behavior.

WBFG View

WBFG believes a position in emerging markets is still appropriate and provides diversification.

Would it still be worthwhile to own blue chips (stocks)? Keep in mind that the Dow did not fall to 4,000 after the Lehman Bros. and Washington Mutual failures and the initial rejection of TARP by Congress. Stocks did pull out of that plunge, and spectacularly so; bargains abounded, for that matter. So it might certainly be worthwhile to hold onto stocks in the coming months, especially as some European governments have hinted at possible capital injections for banks if the need arises. On September 13, German chancellor Angela Merkel noted that the EU would not let Greece fall into “uncontrolled insolvency” and reports surfaced of China getting ready to purchase Greek debt. Treasury Secretary Timothy Geithner even got involved in the search for solutions in mid-September.

Europe’s biggest private lenders may be deemed “too big to fail” by the EU and ECB, and if unwinding of any financial institutions is needed, the authorities should do everything within their reach to try and make it gradual.

It could be that Wall Street has already priced in a Greek default and will just wince, not stumble, at its confirmation – assuming the news arrives with more inevitability than frenzy.

WBFG View

From a fundamental standpoint, stocks appear to provide relative valuation advantages to bonds and cash. Accordingly, the equity positioning that is consistent with our clients’ long term plan is appropriate even in this period of uncertainty.

The biggest fear of all: contagion. Italy and Spain may be “too big to fail” in the eyes of the EU and IMF, but they also face big debt problems. Standard & Poor’s cut Italy’s credit rating to ‘A’ in September; Moody’s Investors Service is weighing downgrades for Italy and Spain before November.

                                                                                                                  

WBFG View

As with risks in the past, the market provides the appropriate pricing for contagion risk as well as other risks. As long as we have the appropriate long term position and appropriate diversification, we have the right portfolio positioning for our clients.