During November, hopes for a resolution of the European debt crisis faded as sovereign bond yields reached record highs and wholesale funding sources for Euro area banks continued to dry up, crimping lending in both Europe and the emerging nations. Amidst disagreements between countries and conflicting statements by politicians and bureaucrats, these events trumped continuing improvement in the US economy. (The recent downward revision in third quarter GDP was due entirely to a runoff of inventories, which sets the table for a strong fourth quarter. Final demand grew a solid 3%.) The Standard & Poors 500 Stock Index declined 0.5% for the month from its 1253 close in October to 1247 at month end. At one point, however, the Index was down 7% in the month. At its month end level the Index was valuing the current run rate of earnings at 12.5x, which is roughly 20% below a more normal valuation of 15-16x that would typically prevail at this time of year, particularly since the consensus of analysts expects at least a modest increase in 2012 profits. Unfortunately, stocks are now in between quarterly reporting periods, and although the data so far suggest a strong fourth quarter earnings season, those results will not be available until mid-January. In the meantime, equity valuations continue to be held hostage by global macro events, particularly the crisis in Europe, but also by the gridlock in Washington and the slowdown in growth in the major emerging economies, part of which reflects conditions in Europe.
In the United States, the Super-Committee failed to agree on deficit reduction measures, which will lead to a $1.2 trillion sequestration over 10 years, but, of course, this doesn’t start until 2013. So on the surface there will be no fiscal drag next year except for the fact that the payroll tax holiday, the bonus depreciation and the extended unemployment benefits that formed part of last year’s bargain, all expire at year end. Failure to renew these and a few minor others would cut about 1.5% off the economy’s growth rate for next year, and if there is another ugly fight over their extensions, with the Republicans demanding a spending reduction to offset the loss of revenue, investors will likely abandon equities once again, fearing a double dip recession.
A second major depressant on values is the ongoing crisis in Europe. It seems almost pointless to discuss in this memo the current status of the various plans that are being floated to impose fiscal discipline on overspending countries, recapitalize bank balance sheets and promote a tighter fiscal union, because the state of play changes almost daily. The only thing one can say for sure is that the political leaders in Europe are very far behind the curve, and the deterioration in the markets for sovereign debt, bank funding and bank lending is so far advanced that at this point the prospect of a breakup of this monetary union can no longer be dismissed. The odds may not yet be high, but they are rising daily. So far, European political leaders cling to the mistaken notion that insolvency can be cured by injections of liquidity. At the very least Europe is in recession, which will have some negative impact on US corporate profits next year. This may be offset in large part, however, if the emerging economies of Asia and Latin America begin to restimulate their economies, which is highly likely since the rate of inflation is coming down all over the world and the fear in China, as well as in other emerging economies, is that a European recession is now a much more serious threat than domestic inflation. What the markets fear most, however, is a Lehman-type financial meltdown that causes a global recession or worse. No one knows for sure the extent of the derivatives exposure among the major banks, here and abroad. Thus, the fear of a cascade of defaults is palpable.
As a result, there have already been thirty-five examples of Central Bank monetary easing around the world with a high probability of more to come. The ECB has cut its rate once, and more reductions are likely, but until the bank stops sterilizing its bond purchases, money supply growth in Europe will remain sluggish at best, and the drying up of badly needed wholesale funding will crimp lending not only within Euroland but also to many emerging economies. Here at home, despite irrational cries from the political right, the Federal Reserve is edging ever closer to a third round of quantitative easing.
Throughout all of this, as we have noted repeatedly, American corporations are coping exceedingly well with the incompetence of political leaders around the world, but fears of a possible global financial crisis and a recession continue to trump their successes. As a result, we expect continuation of a volatile, range bound equity market until the politicians on both sides of the Atlantic wake up to the realities facing both Europe and the US. We continue to have high conviction in our portfolio companies, not only in their strong finances and leading industry positions but also in the execution of their profit growth strategies. Virtually all of these companies are significantly undervalued, and for investors willing to ignore the daily headlines, patience and conviction will be rewarded in the not too distant future.
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