Europe Again ?

The stock market has taken a bit of a breather during April due to concerns over corporate earnings, moderation in economic growth, and concerns over the potential for a repeat of the last two years in which the market peaked in April. So far this month, corporate earnings have been good with about 80% of reporting companies exceeding analyst forecasts. Also while some recent economic indicators have been a touch softer, it is normal for economic data to modulate throughout a cycle and the data would not portend a new recession or serious slowdown.

The other problem? Investors have begun to fret again over the European financial situation. This started several weeks ago when both Spain and Italy experienced a significant increase in interest rates in issuing sovereign bonds. Spain recently indicated that its fiscal deficit this year would be higher than expected. Greece downgraded its forecast for economic growth. Political developments in France have raised concerns that potentially new leadership there would not be as supportive of austerity regimes in Euro countries.

While investor concerns regarding Europe are warranted, in our opinion, they may be overdone. Let’s look at a few facts:

1)      U.S. combined import/export trade with EU countries is about 4% of U.S. GDP and about 13% of total U.S. import/export trade. These are not levels which have the potential to dramatically impact U.S. growth or drag us into another recession by itself.

2)      The U.S. economy is large, diverse, and resilient enough to generate self-sustaining growth without high levels of demand from Europe.

3)      The U.S. is experiencing rising export demand from developing and emerging economies.

4)      The IMF and World Bank have recently boosted the European financial rescue fund to $1.7 billion (increasing protection for European banks).

5)      Many economists believe Europe could emege from recession by early 2013.

6)      The outlook for corporate earnings in both the U.S. and many developing countries remains positive.

From a financial planning perspective, one of the best ways to insulate against the risk of the European crisis is to properly diversify portfolios by both asset class and by country and industry sectors. Underweighting exposure to the Euro countries is still appropriate, in our view. Overweighting exposure to areas like emerging Asia, Latin America, and the U.S. can provide portfolios adequate exposure to growth. Also, a good financial plan takes into account the fact that there will undoubtedly be good and bad periods for which one can plan. In addition to proper portfolio diversification, tools like Monte Carlo analysis and gaining a deeper understanding of client risk tolerance can increase confidence in a plan during periods of volatility while capturing returns in more attractive market and geographic sectors.

The Income Conundrum

We recently held our first quarter investment committee meeting. From a macro perspective, we continue to believe the near term outlook for interest rates and inflation remains relatively benign. While we believe inflation will eventually accelerate, given continued high unemployment, low wage growth, accommodative Federal Reserve policy, and slack capacity utilization, we believe the prospect for a significant acceleration in inflation is still a ways off.

With respect to equities, we remain generally positive. We see further evidence of improvement for the U.S. economy reflected in recent employment growth, retail sales, consumer confidence, and durable goods orders. Additionally, the U.S. housing market appears to be in a bottoming process and Europe’s recession appears to be milder than expected. Large corporations continue to generate high profit margins and cash flow, which we believe will continue to support capital investment, dividend increases and share buybacks, all positive for U.S. equities. A couple of macro risks that bear watching include the potential for an escalation of the situation in Iran as well as slowing of the economy in China.

An interesting feature of the current environment is the very low yield on bonds. This has created a conundrum from a financial planning perspective for people who have counted on bonds to deliver a steady stream of retirement income. With yields so low for bonds, alternatives to bonds may have to be considered. These alternatives include equity securities such as preferred and utility stocks, high dividend stocks, and high yield bonds, all of which entail higher volatility (risk).

So the question becomes “are we in an environment in which people must take on more risk to achieve their income goals?” Perhaps, but there are ways to improve portfolio income (and growth) without having to take on significantly more risk. How can this be done? In a word, “diversification”. Through diversification a portfolio can be structured that is appropriately allocated with respect to major asset classes (stocks, bonds, real estate, etc.) but that also provides a higher income component through incorporation of higher dividend stocks and higher income alternatives to bonds.  In this way, the potential for higher volatility arising from holding more equity-type investments can be offset by asset class and geographic diversification and by holding a diversity of asset types that have low correlation to each other.