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February 2012 Investment Journal 

 

Since we published our year-end review "Pernicious Conditions" last month, markets have embraced the "risk-on" trading mentality to drive share prices higher. The S&P 500 advanced 4.3% in February, for a year to date (YTD)  gain of 9%. Bonds were flat in February, and are slightly positive YTD at .9% (Barclays Aggregate Bond Index). Gold saw its largest one day loss in years as February closed, but still finished up 1.5% for the month. Year to date bullion is up 15.6%. Closer to the wallet, NY unleaded Gasoline was up 4.6% in February, and is up 12.1% so far this year.

Much of the advance so far in 2012 has been based on the notion of a steady if unremarkable "recovery" in the US, and manageable outcomes for the various European debt problems. Except for food and gas prices, inflation is not perceived to be a problem. In short, volatility is low, complacency has returned, but no one wants to talk about the elephant in the room: too much bad debt everywhere you look.

In February, the European Central Bank (ECB) dominated the news, as they launched their second round of LTRO operations. Following in the US Fed's "Quantitative Easing" footsteps, the ECB "created" 500 million euros which they lent to member banks at a cost of 1%. The idea is that this new capital will improve bank balance sheets, which have wilted under the weight of soured loans and investments. The banks, fearing the financial health of other Eurozone banks, have mostly re-deposited these funds with the ECB, earning .25-.50%.

Why would a bank choose to earn a negative return on such large sums?

The answer is that it beats the alternative, which is to continue to endure erosion in the value of current assets which are declining at a rate far in excess of the measly -.5% this latest "loan" is costing them. Besides, the ECB is giving all takers long repayment terms. (Prior to December 2011, the average maturity of an ECB loan was 46 days. It is now 942 days. Thank you Mario Draghi, new ECB chief.)

And, as a further sweetener, the ECB is lending even more euros to the banks in exchange for any manner of loan collateral, including unsellable condos on Marbella, over-leveraged sausage factories in Silesia, and, maybe, even used candy wrappers from St. Tropez! Yet Senor Draghi opined in a recent post-LTRO statement that the three year refinancing operation had been an "unquestionable success" and had "removed tail risk from the environment".
      
Some people, however, have noticed that the balance sheet of the ECB, just like that of the US Fed, has mushroomed in size, to over 3 trillion Euros. (This added liquidity is another factor in the markets rise this year.)  Jurgen Stark, a former Bundesbank executive board member, told a German newspaper that "the balance sheet of the ECB is not only of gigantic dimensions, it is also of shocking quality". Ouch. Sounds like the Germans have a slight disagreement with the ECB (and no current representatives on the Executive Board either).

Meanwhile, Eurozone politicians strong-armed Greek bondholders in February, forcing them to exchange their old bonds for new ones, threatening all sorts of nasty outcomes if they didn't go along. As we go to press, the "fresh start" Greek bonds are trading at 20 cents on the dollar, for an immediate loss of 80%!  The "implied re-default probability" is 98%, meaning that it's a sure thing these new bonds will be worthless at some point down the road.

Greece itself is in an economic depression, with its economy having shrunk by a fifth since 2008. Q4 GDP just printed at -7.5% -- that's an annualized contraction of 30%! Unemployment just hit 21%, a record, with youth unemployment at 51%. The situation is not only getting worse, it's getting worse at a faster rate. It is, effectively, collapsing.

It is hard to envision then how this example of the "austerity" solution would appeal to other short list candidates like Spain and Italy who also have big time debt issues. Investors should not be surprised if one or both of these countries decides that defaulting on their bonds is the lesser of two evils. This is our #1 candidate for "what could roil markets" this year. Stay tuned to Radio Rome and Madrid.

Back over the pond in the US, unemployment numbers continued to improve, with the latest rate at 8.3%. GDP growth showed some improvement, increasing at an annual rate of 3% in Q4 2011. The housing market had some good news, with housing starts, new building permits and consumer confidence up (albeit from very low levels). The macro picture is a continuation of the slow, grinding recovery process that confirms the "new normal" of lower trend growth around 2%. The key for investors is to find the "pockets of strength" that buck this overall sub-par trend.

U.S. election campaigns are also revving up, but none of the talk centers around making long term structural reforms leading to fiscal health (as called for by the Bowles-Simpson commission, for instance). Now is the time to get in front of this, before markets decide the issue.

Significant news also came out of China this month, as the government lowered its estimates for 2012 growth to 7.5%, an 8 year low. Recall the many glowing reports that paint China as the leading growth engine for the emerging economies and the world. How will markets perform if China slows? Is it built into the forecast? We don't think so, and it's not a good idea to assume markets have become decoupled either. Whether it's Europe going into recession, or China taking a breather, US investors will be impacted, and the evidence is mounting in favor of a coming global slowdown.
           
As we head into the end of the first quarter, central banks are sending the unmistakable message that "all's clear; it's safe to get back in the water". They will print any amount of money to patch over and salve the debt fuelled sins of the past. Meanwhile, analysts are maintaining their cheery growth forecasts for stock earnings, and US election year magic (i.e. federal spending) looks set to support the economy further. Global growth is slowing, but investors have not fully embraced that theme. They are thinking about it though, and that means markets are probably entering a consolidation phase.

However, as Greece has so clearly demonstrated, the world cannot ignore basic math: you can't spend more than you earn indefinitely. Governments refuse to reduce their size and scope, and central banks accommodate their spending addiction by going ever deeper into debt. Citizens and savers suffer but the party will continue until...
     
It won't. And can't. Something will give. When and how is anybody's guess. But it is imperative that investors of all types are prepared for a wide range of outcomes: these are not normal times. That means thinking and re-thinking diversification strategies. It means having cash on hand, gold bullion, foreign stocks and bonds, non-Dollar currencies, real estate...the list goes on. Modern security markets provide solutions. Embrace them. And be ready for anything. 

 
 
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