2011 Q2 Letter
The second quarter of 2011 saw equity markets close down slightly over the last quarter – the S&P 500 began the quarter at 1,325.83 and ended at 1,320.64. Losses were on track to be far more substantial until the last week of June when the S&P 500 rallied over 50 points in the final 4 trading days after news of the Greek bailout and some encouraging US economic data.
Commodities, after experiencing an impressive two year long run-up, fell sharply in the second quarter. Crude oil, which touched $115.52 per barrel on May 2nd, sold off to $89.61 by June 27th as economic indicators pointed towards a slowing global economy. Mirroring the equity market rally, crude oil (and commodities as a whole) rebounded a bit in the last week of the quarter, closing at $95.08 on June 30th.
Perhaps the biggest news this quarter was the highly anticipated end of the Federal Reserve’s second quantitative easing program. QE2, as it has come to be known, saw the Fed invest $600 billion into US treasuries in an effort to keep interest rates low, promote economic growth and stave off any signs of deflation. It is debatable whether or not this program resulted in any long-term benefit for the US economy, but it certainly did provide monetary rocket-fuel for the rally in stocks and commodities.
When Ben Bernanke announced the QE2 plan on August 27th, 2010 the S&P 500 was trading at 1,064 (mired in a summer slump after peaking at 1,217 on April 23rd). Once the QE2 announcement was made, equity markets promptly rallied for the next 8 months, peaking at 1,370 in April 2011 on the belief that the Fed’s policies would provide the necessary support and impetus to boost economic growth.
Now that the second round has expired, and the possibility of a third round looks ever less likely, market participants may wonder whether equity markets can continue to move higher without that monetary stimulus. We are a bit skeptical that equity markets can rally further without this backstop and recommend clients remain defensive until it becomes clearer that the economy can stand on its own two feet absent the crutch of Federal Reserve support.
Greek Debt. Another summer and another quarterly letter with a section devoted to the debt problems in Europe. And despite the passage of the latest round of bailout/austerity measures in Greece, we don’t believe this problem is going away anytime soon. Most observers expect Greece to restructure its debt over the next few years. As with the Russian default of 1998, any restructuring or default, though widely anticipated, will shock the markets. We expect concern will move rapidly to other countries in peripheral Europe as Portugal, Ireland, Spain and Italy will likely be the next group to find themselves sitting in the debt crisis crosshairs. As with most crises of confidence, European authorities will have to decide where best to build a firewall. Tough decisions will be made and in its exhaustion, Europe will likely realize that not every troubled sovereign can or should be saved. We believe neither Spain nor Italy can be abandoned, and we do not believe Ireland deserves to be. But as with many things that spur strong emotions, these events may take on a life of their own and force elected representatives to act in a knowingly destructive manner, simply to deflect virulent public opinion.
Debt ceiling debate. Meanwhile back on our side of the pond, a similar dynamic is playing out. With their 2010 reclamation of the House still fresh, Republicans appear determined to use their voting power to force budget cuts before approving a raise in the debt ceiling. Democrats, meanwhile, strongly prefer reducing corporate tax breaks and other revenue raising measures as a solution. Both sides are still far apart, but we expect they will find a workable solution before the August 2nd deadline. In our view, a workable long-term solution must involve both revenue raising measures and cost-savings in major programs, especially Medicare/Medicaid. We agree with many market commentators that a default on US debt would be catastrophic and hope cooler heads will prevail ending this game of debt/budget chicken sooner rather than later.
Regards,
Louis Berger Subir Grewal