Quarterly Comment

Market Commentary – Q2
William Priest, Chief Investment Officer
Epoch Investment Partners
Second quarter 2011
The most important problem facing the global
economy today is the increasing likelihood of a
prolonged slowing in aggregate demand. Should this
slowing occur, it will be driven by the deleveraging
process in the developed economies and by antiinflationary policies in the emerging countries.
First, let’s examine the issue of deleveraging. The
debt build-up in the developed countries began a long
time ago. With respect to the U.S., perhaps the best
way to gain perspective is to track the rise in
consumer and government debt as a percentage of
GDP. Figure 1 shows this data from 1980 to the
present day.
The most recent acceleration in our country’s debt
build-up was precipitated by the global financial
crisis of 2007/08. The demise of Lehman and AIG
caused a collapse in private sector demand and
widespread employee layoffs. In response, the
government stepped in with a fiscal stimulus program
– about US$1.2 trillion since President Obama took
office – and the Fed endorsed a very expansionary
monetary policy, cutting interest rates to nearly zero
and then, in two rounds of QE, buying US$2.3
trillion of government and mortgage-backed bonds.
These tactical actions, while necessary at the time to
stave off a calamity, failed to deal with the big
strategic issue at hand: the developed world’s
staggering over-indebtedness.
The best empirical evidence presented on the topic of
excessive debt appears in the book This Time Is
Different by Ken Rogoff and Carmen Reinhart. The
takeaway of their analysis, which encompasses 800
years of financial data, is quite simple: excessive debt
can be corrected only by a long period of
deleveraging. Fiscal stimuli, which replace private
debt with increased public borrowing, merely
postpone the inevitable and necessary deleveraging
process. Specifically, the “cash for clunkers”
program, incentives for new home purchases, and
temporary tax cut extensions and accelerated
depreciation rules have provided the U.S. economy
with a temporary boost, but have not offered any real
solutions for decreasing our debt, which, as Figure 2
shows, has reached very high proportions at the
household level alone.
And the situation doesn’t look much better across the
pond. The plight of the PIIGS (Portugal, Ireland,
Italy, Greece, and Spain) is now well-known and is
placing many European countries on the verge of
sovereign debt crises. Governments everywhere have
been forcefully reminded that heavy public debt risks
much more than just crowding out private
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Market Commentary – Q2
investments. It can, and ultimately will in the case of
Greece, bring on insolvency.
which makes it inevitable that Greece will eventually
go broke.
The recent Greek deal is another example of a tactical
solution to a structural problem. Restructuring for
Greece is inevitable, which will slash the value of
their debt by half. Although European banks will bear
most of the cost, U.S. institutions are not immune.
According to the Bank for International Settlements,
the U.S. has less institutional exposure than
Germany, but more than France. U.S. financial
institutions have written most of the credit default
swaps on Greek debt, and nearly half of U.S. money
market fund investments are European bank paper
credit instruments. According to Wolfgang Münchau
of the Financial Times, this exposure to the Greek
economy is comparable to an investment in a toxic
CDO. Münchau explains, “…if you own a Greek
bond that matures by June 2014, you keep 30% of the
redemption as cash and roll over 70% into a 30-year
Greek government bond. The Greeks will have to pay
an annual coupon, or interest rate, of between 5.5%
and 8% …Of the money received; Greece will lend
30% to a special purpose vehicle. The SPV then
invests into AAA-rated government or agency bonds
and issues a 30-year zero coupon bonds. The purpose
of this action is to guarantee the principal of the 30year Greek government bond that you just
bought…The complexity of the scheme is because of
the need to persuade the rating agencies not to attach
a default rating to Greek bonds. The rollover
agreement represents, from an economic point of
view, nothing but a collateralized bond. It
subordinates all other bondholders1.”
Greece, then, is the “canary in the coal mine” with
respect to deleveraging. There is a long list of
countries that will have to deal with their debt issues,
as outlined in Figure 3. Deleveraging will be a drag
on these economies for years, and will probably cost
the world 100 to 150 basis points of GDP growth.
Despite what Euro authorities would have us believe,
“private sector participation” is a misnomer here.
Rather, this rollover agreement is a private sector
bail-out. For the Greek economy to stay afloat, it
must be able to pay the interest on its debt, which
means the interest rate needs to be below the growth
rate of nominal GDP. Nominal GDP, however, will
decline this year and probably next year as well
As for the effect of Greece on the rest of the
eurozone, the fear of contagion is real. Irish and
Portuguese debt spreads hit all-time highs in the past
week, and Spain and Italy can’t be too far behind.
The Spanish and Italian economies carry four times
the debt load of Greece, Ireland, and Portugal
combined. For perspective, if the entire periphery
were to default, it would be the equivalent of the
1994 Mexican crisis, the 1998 Russian crisis and the
2002 Argentina crisis occurring five times over. In
light of this fact, why has the ECB elected on three
occasions to contract the monetary base? This
monetary policy has sabotaged the fiscal austerity
policy, leading to a dramatic conflict in strategy. In
our view, the ECB is quite likely to do a 180° turn as
Euroland’s outlook becomes more and more grim.
The emerging markets are also in flux, but for very
different reasons. Given that the Chinese peg their
currency to the U.S. dollar, the Chinese effectively
“import” our monetary policy, which is very
Market Commentary – Q2
inflationary in its intent. Since China will not allow
its currency to float, it has turned to clumsier
instruments in its battle against U.S.-derived
inflation. Reserve requirements have been lifted 12
times since 2010 and now stand at 21.5%; growth in
M2 has decelerated sharply (see Figure 4); EMBI
spreads have widened; and CDS spreads on the Bank
of China have soared.
yields well above “safe” bond yields. Remember:
these equity yields have growth rates attached to
them, which makes them significantly more attractive
than bond yields.
The world is a troubled place at present and 2012 will
likely prove no different. But there is reason for
hope: global firms with growing dividends, growth
footprints in the developing economies, and
managements that have proven to be wise capital
allocators sell at reasonable valuations. The road is
bumpy, but opportunities exist.
Commissions, trailing commissions, management fees and
expenses all may be associated with mutual fund
investments. Please read the prospectus before investing.
Mutual funds are not guaranteed, their values change
frequently and past performance may not be repeated. This
commentary is provided as a general source of
information and should not be considered personal
investment advice or an offer or solicitation to buy or sell
securities.
As a result, China’s growth rate is slowing. Unit
labor costs are increasing faster than prices, which
has hurt margins. Labor costs are rising 15% per year
according to Charles Dumas of Lombard Research.
By contrast, unit labor costs in the U.S. are falling,
with labor costs remaining flat. All of this suggests
continued pressure on China’s growth, with demand
falling in its end markets and its costs rising relative
to prices at home. From a global perspective, the big
picture is remarkably consistent: austere policies are
“in” at the fiscal level and most monetary policies are
tighter than they were a year ago. Needless to say,
this does not bode well for real growth expectations
in 2012.
From the investor’s standpoint, though, it is not all
gloom and doom. Investors buy companies, not
countries; and even though national economies are fl
ailing, company balance sheets are in excellent shape,
boasting lots of cash and little leverage. Earnings
yields are nearly triple government bond yields, and
large numbers of companies have cash dividend