Global equity markets continued to be volatile during the second quarter of 2012. Two distinct economic phenomena – the ongoing fiscal crisis gripping the weakest members of the European Union and the advent of slowing GDP growth in China – have been the root cause of this instability.
The challenge in Europe remains the inability of several countries in southern Europe to continue to deficit finance their generous social programs. While recently elected governments in Greece, Spain and Italy have pledged austerity, this seems to be easier said than done. A series of “to the brink” summits and negotiations between the weaker nations and the strongest, notably Germany, have recently resulted in an agreement to utilize substantial bailout funds to both fund the sovereign debt needs of the weaker countries and to backstop their troubled banks.
While this is a good start, much work remains to be done. Individual European countries must implement austerity without driving their economies into recession or depression. The keys to stability in Europe are to provide more firepower and authority to the European Central Bank, create a new class of mutualized Eurobonds and implement a combined fiscal policy for the entire European community. The last issue is the most thorny, as individual nations would have to surrender at least a portion of their sovereignty with regards to fiscal spending. Germany is insistent upon this issue, as it will be the one providing the majority of the backing for the new Eurobonds and will face higher interest costs as a result.
Over the past number of years, investors have viewed China as a good counterbalance to the problems plaguing Europe. Recent data, however, indicates that the rate of economic growth in China is indeed slowing. Following three decades of double digit annual growth, it appears that their economy is now expanding in the range of 7% to 9% per annum. With reduced demand for their manufactured goods in both Europe and the United States, Chinese exports have moderated. On the other hand, the emerging middle class in China is creating stronger domestic demand that should help offset the decline in exports. In addition, China’s political leadership is in transition, with a new government taking the reins later this year. If the past is any indication, this will spur increased fiscal stimulus, particularly on infrastructure, in latter half of 2012 and beyond. The new Chinese government will have the means to spur such economic stimulus, with an estimated $3.5 trillion in cash reserves on hand.
Since the economic recovery in late 2009 – early 2010, we have been forecasting steady growth for the US economy. This forecast has played out well, as the US economy continues to deliver growth in the 2% to 3% range annually. This has been reflected in the strong performance of US equity markets over the past two years. We believe that this trend will continue through the late 2012 U.S. election period and into 2013.
With steady growth in the US economy continuing, growth in China moderating but not stalling, and a gradual improvement in fiscal and monetary policy in Europe, we believe that the equity markets will weather the storm over the foreseeable future. We continue to invest in companies with industry leading characteristics, growing cash flows, and responsible management of free cash flows. We believe that this fundamental analytic focus, even in times of market volatility, will generate positive returns for our clients.