Greek Tragedy, French Farce or German Opera
As the second quarter ends and a new one begins, markets are focused on the financial travails of Greece, the cradle of western civilization, fount of democracy and home of the Parthenon. The grand past of this great nation is somewhat belied by the size of its economy - not much larger than that of the state of Rhode Island.
Debt-burdened Greece captures financiers’ attention, not because they are fascinated by the philosophy of Aristotle, but because of their experience of Lehman Brothers, the second tier Wall Street investment house whose ignominious failure in 2008 is widely viewed as the catalyst of the recent unpleasantness we refer to as the financial crisis. The Lehman failure set off the seizing of financial markets across the U.S. and the wider world. Will the failure of Greece’s government to make good on its promises to its creditors set off a similar firestorm that will consume the Euro, or will the damage be contained to Greece’s immediate creditors?
We think the latter outcome is far more likely for the following reasons: First, this crisis in Greece’s finances has been about as well-predicted as an event can be. Anticipating this event, the European Central Bank (and its German and French sponsors) have taken much of the default risk out of Europe’s fragmented banking system and put in on safer balance sheets. However, since the mechanism for a sovereign nation’s exit from the Euro currency system was not provided for, skittish market participants are discounting the worst. German truculence is not helping matters, but even with all of the Wagnerian Sturm und Drang, at present we believe the financial system damage will be contained.
What present factors are relevant for U.S. investors? In order of importance, we believe they are earnings, valuation and the dollar. On the earnings front, improving economic data is putting upward pressure on wages which will impact profit margins. The torrid pace of stock buy backs is set to level off. This financial engineering allows companies to report higher earnings per share even when revenues are mostly flat. We enter a more challenging time for earnings with valuations that are elevated (a position we have been flogging hard for the past year or so) and with a strong dollar that makes our exports less competitive.
So while current U.S. stock prices discount a more optimistic scenario than we believe is likely, an expanding economy and a dovish Fed may continue to provide a certain level of support under the market. With the first policy rate hike likely in the next quarter or two, we continue to recommend a slightly defensive posture emphasizing higher quality shares of large U.S. companies. Europe and emerging markets offer better value than the U.S. but macro concerns argue against an aggressive position in those markets at this time. This adds up to keeping a higher than normal position in cash and reserves.
Interest rates are more likely to rise than fall, but deflationary forces will likely keep a cap on longer term rates. Fixed income portfolios should generally be positioned shorter than the benchmark and weighted toward investment grade credits. The cycle which began with the recovery in asset prices in 2009, is not over and investors have profited by sticking with risk in that time period. However, as Aristotle said “Well begun is half done.” We will stay vigilant as this cycle plays out.
The Altavista Investment Team- Summer 2015