April 1, 2012

Global markets continued to rebound from the recent October 2011 lows and powered strongly higher throughout the first quarter of 2012 as confidence in the U.S. economic recovery grew and worries about the Eurozone crisis subsided.  U.S. stocks are off to their best start since 1998, with the S&P 500 Index advancing 12% and the Dow Jones Industrial Average up 8.14%.  Volatility was positively docile and with the exception of the Israel/Iran sabre rattling, a welcome lack of bad news during the quarter gave no one a really good reason to sell.  In Europe the stronger economies separated themselves from the weaker.  Germany’s DAX 30 Index, for example, was up 17.3% while Spain’s Ibex 35 lost 6.5%.  In China, where growth is slowing and debate centers on whether or not the economy will suffer a hard landing, the Shanghai Composite only managed a 2.9% gain.  Yields on the 10-year Treasury note rose 0.32% to 2.22% as investors poked their heads out of their bunkers to sell some government bonds and buy stocks.

Three big issues face investors as we head into the second quarter.  The first is whether or not the U.S. economy will continue to improve.  Employment data of late have been encouraging, with the U.S. economy adding an average of 245,000 jobs in each of the last three months.  This rate of job creation, while still below what is required to solve our unemployment problem rapidly, is nevertheless the best stretch of payroll improvement since 2006.  Retail sales trends so far in 2012 have also been strong, indicating that American consumers are feeling a bit better about the future.  High gasoline prices do threaten the economy somewhat and could weigh on consumer confidence, but they are to some extent offset (in northern states, mostly) by rock-bottom prices for natural gas.  With banks beginning to lend again and home prices groping for a bottom, there is reason for cautious optimism that the U.S. economy will continue its recovery in 2012.

The second issue is whether the Eurozone crisis will remain in its currently mollified state—or bloom anew.  The European Central Bank’s long-term refinancing operation (LTRO), which provided needy banks access to huge amounts of cash at a paltry 1% interest rate, seems to have been successful in staving off a banking crisis in Europe for the moment.  Both Italian and Spanish banks borrowed large sums of euros from the ECB, then promptly invested the cash in their own high-yielding Spanish and Italian government bonds, thereby earning themselves a tidy spread.  As the money has flowed into their government bonds, both countries have enjoyed flat-to-falling interest rates since the year started.  Even the Greek situation has moved off the headlines. While most Greek bond investors took a 75% haircut on the value of their holdings in last month’s debt “restructuring” there are still a few holdouts demanding payment in full. Broadly speaking, however, outside of Germany the situation in Europe remains grim.  With much of Europe likely in recession and government tax revenues set to contract, the spreadsheets around European capitals that project government debt service potential will probably have to be reworked to the downside.  Given the magnitude of the European debt problem, it would frankly be surprising not to see further drama unfold in 2012.

U.S. companies, after years of cost-cutting, streamlining and low investment, are on the whole in a very strong financial position.  The U.S. stock market is continuing to shrug off the economic uncertainty in both China and Europe and is attracting capital from those markets.  On a price-to-earnings (P/E) basis, the S&P 500 Index is trading at 13.3 times the current 2012 consensus earnings estimate of $105, a slight discount to its historical average.  On the face of it this valuation seems attractive, but corporate profit margins are also at their all-time highs and any future retracement to average margins could hamper earnings growth.  In any case, it would be prudent not too expect much further margin expansion for Corporate America as a whole, so additional earnings per share growth will have to come from revenue growth and/or share buybacks.

The third issue investors are monitoring closely is the slowdown in China, the world’s second-largest economy.  After several decades of rapid growth fueled by exports and domestic infrastructure investment, China is trying to transition its economy to one that has more sustainable growth drivers and more reliance on its own consumer base.  For the last decade in particular China has played a central role not only in the growth of the global economy, but also in the growth of the global resource sector.  It has consumed massive quantities of oil, coal, iron ore, copper, aluminum and virtually every other building material.  While the current guidance from the Chinese government is for “only” 7.5% growth in 2012, investors are looking askance at a weakening property market and slowing infrastructure investment and wondering where the declining growth rate will find a sustainable level.  A significant slowdown in China would certainly weigh on global growth, but it may also result in falling prices for many of the commodities of which the country was (and still is) such a voracious consumer.

All in all, 2012 is off to a good start.