The Euro flu - a third quarter perspective

Greece sneezed and the world economy caught the flu.  The fact that troubles in Greece can wreak such global havoc is amazing. Greece is tiny. By population it is roughly the size of Ohio and its GDP is smaller than Maryland’s. Nevertheless, despite its diminutive stature, its outsized impact is being felt in almost every corner of the world. In the second quarter alone, renewed concerns about Greece and the euro zone helped spark a flight to quality that reduced the value of global equities by more than $1.7 trillion. Of course, there are other factors at play besides Europe, but the ongoing drum­beat of bad news from Greece and the euro zone is clearly taking its toll.

World equity markets fell 5.8 percent in the second quarter, with riskier markets taking the biggest hits. U.S. large cap stocks fared better than most, falling only 3.2 percent. Developed inter­na­tional markets dropped 7.2 percent and emerging markets slid 8.9 percent.

On the other hand, bonds did  well and long treasuries did best of all.  Thirty-year treasuries gained 12.6 percent on the quarter after falling nearly 8 percent in Q1. Ten-year treasury notes gained 5.8 percent as it’s yield fell to within a hair’s breadth of its lowest level ever. Other fixed income sectors had a much more muted response to falling rates as their interest rate sensitivity was offset by credit spread widening. It was definitely a “risk off” quarter.

Contagion from Europe is also hitting the real economy.  After three years of decent per­for­mance, manufac­turing in the U.S. and overseas is showing signs of weakness. In June, the ISM Purchasing Managers Index sig­nal­led contraction for the first time since mid-2009. In addition, three out of four surveys pro­duced by regional Federal Reserve banks now show that manufactur­ing in their regions is sluggish at best. Even China is reporting slower growth as stag­nant demand from Europe dampens the Chinese manufacturing outlook.

The employment situation is another concern. The U.S. econo­my added 677,000 jobs during Q1, but only 225,000 in Q2. Unem­ploy­ment remains sticky at 8.2 percent while under­employ­ment remains stub­born­ly high at 14 per­cent. The work force partici­pation rate is falling dramatically faster than in the past and is now three percen­tage points lower than before the crisis. The fact that today’s labor force participa­tion is three percentage points lower than pre-crisis levels means the U.S. unemploy­ment rate is probably closer to 11 percent.

Faced with such challenging news, one might be tempted to sell everything and head for the hills. (Judging by the continuing strong inflows into government bonds at record low yields, it appears that many investors are doing just that.) However, following one’s emotions rarely leads to investment success. Instead, we follow an analytical framework based on a clear understanding of client goals, horizons and return requirements. We carefully weight these factors in light of long-term investment opportunities and build portfolios customized to our clients' unique situation.

The past few months have been a test of patience and we expect the coming months will test our patience further. As if Europe weren’t enough, we also face the heated rhetoric of presidential politics (always good to boost volatility!) and a looming “fiscal cliff” as Bush-era tax cuts expire and new healthcare taxes kick in. Yet through all this, we feel confident that the portfolio structures we put in place will continue to serve our clients well. As always, we are monitoring developments at home and abroad.