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First Quarter 2012

In the first quarter, improving economic data in the U.S., as well as easing concerns over the European debt crisis fuelled a rally in the global stock markets, as unemployment fell to 8.2% and consumer spending improved for three consecutive months. Corporate earnings also gave a boost to the markets, as companies have trimmed costs to bolster their profits and improved their productivity.

The Federal Reserve has underpinned the market with either direct or indirect stimulus, promising to keep interest rates at zero until the end of 2014. This is reinforced by measures worldwide: the balance sheet of the Fed, the European Central Bank, the British and Swiss Central bank have ballooned in order to provide liquidity, while monetary easing is underway in Brazil, China, and India either through lower interest rates or through lower required reserve ratios for banks to stimulate credit growth. This continued “financial repression” continues to make the case for stocks, because “real” interest rates (adjusted for inflation) are negative for both cash or government bonds in developed markets, forcing investors into equities.

There is some evidence that the market’s strength in the first quarter may be due for some short term moderation, as much good news has been built in and stock valuations are approaching fair value. Investors should continue to favour yield stocks offering dividend growth as a means to partially hedge inflation.

The European debt crisis, far from over, may be getting worse as Europe’s economy continues to slow. In the short term, this may equate to some very real global market risks. Spain’s economy is the fourth largest in Europe, twice as large as Ireland, Greece, and Portugal all put together. A Spanish default would jeopardize the European currency and economy, and would hasten another global financial crisis. Spain’s debt to GDP ratio now stands at 80%, a 20 year high, and the cost of insuring a Spanish bond is accelerating sharply to around $50,000 for each $1 million of Spanish debt. Spain’s stock market index, the IBEX, has recently fallen to three year lows. The Spanish government has implemented severe austerity measures, including $36 billion in tax increases and spending cuts, which are only deepening the recession (depression) resulting in unemployment of nearly 24% and a youth unemployment rate of over 50%. Spanish financial institutions are in trouble, and find themselves on life support from the European Central Bank as housing prices continue to drop and rising unemployment aggravates further foreclosures. Unlike in the U.S., most Spanish loans are “recourse” loans, which allow a bank to pursue not only the loan collateral, (such as a home), but the borrower’s other assets as well, further deepening the recession as Spaniards sacrifice any economic investment in order to pay off debt. Short and long term solutions to the Spanish problem are few, and an economic collapse there is quite possible, although the timing of such an event remains opaque. Europe accounts for some 22% of all American exports, a figure which would surely decline in the face of a protracted European recession, a stronger dollar, or any likely exacerbation of the sovereign debt crisis.

Closer to home, the U.S. budget ceiling debate will reappear at the beginning of the third quarter, just ahead of the presidential elections. This could provide some volatility, if last year’s example sets any precedent. The end of year “fiscal wall” could result in a “mandatory sequestration” involving as much as $650 billion of fiscal tightening next year if the U.S. Congress does not agree on a budget this year. This is bound to produce fiscal drags on economic growth, and will begin appearing shortly in the public’s awareness.

Worries over an economic slowdown in China due to either slowing domestic or Western demand, are being allayed by data suggesting that a low point in Chinese growth may have been hit in the first quarter. Evidence that Chinese economic growth may have started to regain some momentum last month comes with renewed expectations that the government is encouraging more bank lending, spending on infrastructure, and easing taxes.

Grant Rogers

Partner

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