Perspectives on Europe and the Global Economy
It was agonizing for investors to watch the correction in May, attributable mainly to concerns in Europe, erode most of their gains from the first quarter of 2012. Then on June 1, the May declines were punctuated with a dismal U.S. jobs report, sending the S&P 500 within a few points of its yearly low.
The financial markets continue to reflect the effects of a global financial crisis. This crisis caused strains in the banking system of many developed economies and continues to cause ripple effects today, particularly in Europe. Since concerns began about the level of sovereign debt back in September 2009, European leaders had been very careful not to use language relating to a Greek departure from the Eurozone. In May, that changed when European Central Bank (ECB) officials began weighing the arguments for and against a potential Greek exit from the currency union.
For context, it is important to note that Portugal, Italy, Greece, and Spain (the so-called PIGS), represent less than 3% of world equity market capitalization. A Greek departure from the euro would be disastrous for Greece, as there would almost certainly be a run on its banks and another default on its debt. And while the fear of increased deterioration among the weaker peripheral countries might cause increased market volatility, the turmoil in Greece would be a motivator for other countries to comply with the ECB’s demands for austerity. Similar to the way the Federal Reserve provided liquidity to U.S. banks in 2008, the ECB would then provide needed capital to financial institutions in Europe, allowing them to recapitalize while they tightened their budgets.
Now consider this: for all of its troubles, the world economy is still growing. The International Monetary Fund estimates global economic growth this year of about 3.5%, accelerating to 4% in 2013. For emerging and developing economies, the growth assumptions are about twice that.
As an investor, your role is to supply the financial capital to finance this growth. In doing so, you take a risk. But you also get to share in the profits of this endeavor. That capital is not free. It costs companies to tap the savings of others. And that cost is your expected return as an investor. That return is not there every day, every week, every month, or even every year. But over time, there is a return on capital for those who are patient and who diversify away risks they don’t need to take.
Throughout the year and in late May, we have been diligently rebalancing client portfolios as foreign stock market declines provided buying opportunities. Of course, we have no way of knowing when the discipline of this activity will be rewarded, but history and experience tells us it will be rewarded. To be sure, a good deal of bad news is already priced into the markets, and while the situation could worsen before it improves, we must also recognize that stocks look extremely cheap today relative to bonds.