December 20, 2011

Are Financial Markets Broken?

As 2011 comes to a close, investors continue to be bombarded by daily news of economic and political problems.  In the U.S., housing prices remain depressed, the unemployment rate remains stubbornly high, and the politics surrounding the upcoming Presidential election and taming the federal debt have raised questions as to the political will to fix the problems.  In Europe, debt levels are at dangerous highs and climbing, economic growth is weakening, and investors are questioning the ability of politicians to put in place an effective, timely, and long lasting solution to the Euro crisis.  Is it any wonder that investors are losing hope?

While we believe that the U.S. economy will continue to recover, and that Europe will eventually resolve its debt crisis one way or another, these events highlight how difficult it is to foresee the direction of the market over the short term.  That is why it is more important than ever to use history to put today’s events in context and to focus on indicators of long-term value.

A common concern for the U.S. economy is that this recovery looks quite different than any other since World War II.   In fact, if you look over the past five U.S. recessions, you see a consistent pattern where this recovery has been much slower in terms of economic growth and unique in terms of the lack of improvement in the unemployment rate.

However, it may be that the last five US recessions are not the most appropriate comparison.  What makes the 2008 downturn unique among post World War II recessions was the severe financial crisis and synchronous global contraction that accompanied it.  To better understand the path to recovery, it is necessary to look at a broader set of economic crises across countries as well as over time.

At last year’s Federal Reserve symposium at Jackson Hole, Wyoming two economists named Reinhart presented a paper titled “After the Fall” (footnote: www.kansascityfed.org/publicat/sympos/2010/reinhart-paper.pdf).  The authors looked at 15 severe post-World War II financial crises in advanced and emerging economies and three synchronous global contractions.  A disquieting finding was that while the biggest impact of these crises occurred in the first few years after the event, the negative effects persisted for a full decade or more.  Specifically, they found that over the next decade, economic growth tended to be about 1% slower and unemployment tended to be on average 5% points higher.  Real house prices tended to be 15 to 20% lower at the end of the decade compared to the year before the financial crisis started.  Also of note, despite massive stimulus from fiscal policy, monetary easing, and currency devaluations, inflation was typically lower, not higher.

So are we headed for a lost decade in the U.S., similar to the Japanese experience of the 1990’s?  Both have suffered a real estate crisis.  By some estimates, close to a quarter of US mortgage holders owe more than their mortgages are worth.  Even with the current high levels of foreclosures, we are likely several years from clearing through this “shadow inventory” of yet to be foreclosed upon homes.  This will continue to weigh on house prices as well as consumer confidence.

On the other hand, there are two key differences in the U.S. that we think will drive a different course.  First, the U.S. corporate sector is in much better shape than its Japanese counterpart was.  Corporations are not overly levered and are holding record cash balances.  Second, banks in the US have been much quicker to take write-downs from non-performing loans and raise capital to improve their capital situation.  We expect the strength of the corporate balance sheet in the US will likely continue to support modest capital expenditures and job growth.  After all, despite the headlines, the US has created almost 3 million net private sector jobs over the past two years.  However, the overall level of unemployment will most likely be held back by a mismatch in the skills of workers and jobs as well as the skill degradation that comes from long-term joblessness.

Europe is another matter, and is the biggest risk to this more tempered view of the US economy.  The term “sado-fiscalism” has been coined to describe the fiscal austerity needed to resolve the government debt crisis and keep the Euro currency in place.  This will likely lead to a sustained economic slowdown in Europe that will reduce US exports and the revenue growth from multinational corporations.  However, the larger risk is from financial market contagion and the impact of sovereign bond exposure on European banks.  Policy makers are very focused on trying to control the potential risk of a messy 2008 like collapse, however the risk remains elevated and has been a key driver of recent capital market movements.

So what does this mean for a Canadian investor?   While history tells us that there is a long road to recovery after a crisis, the good news is that the level of valuations for equities is consistent with long-term returns in the high single digits.  Although these returns are below those of the 80s and 90s, they are still quite attractive, especially when compared to the low level of yields offered from fixed income investments.  The real challenge for investors will be developing a strategy to weather the volatility that is required to capture these returns.

In highly volatile markets, we advise investors to take one of two approaches.  The first is to ignore the temptation to react too quickly to the headlines and focus on the longer term.  Easy to say, but it can be challenging for even the most patient investors.  Alternatively, investors can take advantage of the opportunities that arise as market corrections punish both strong and weak companies.  We look to add to companies where expected returns have improved from market declines and where we can build the confidence that the company's business model is robust enough to weather this sustained period of uncertainty.

Jim Gilliland is head of fixed income at Leith Wheeler Investment Counsel Ltd. of Vancouver, a firm with assets of $11 billion.  David Schaffner is the firm’s president and CEO.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. All tax decisions should be made after discussing your individual positioning with a qualified tax accountant, as everyone’s tax situation is unique. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.

Jim Gilliland

Managing Principal, President & CEO