Sovereign debt fears roil global markets, threaten recovery

 

It’s clearly been a volatile year so far for equity investors. After a dramatic rebound off the market’s March 2009 12-year low, equities in 2010 have been erratic in their search for direction, even as strengthening economic indicators in the United States and other developed markets bode well for global recovery. The anxiety is not unwarranted. Greece, the area of most immediate concern, has been a focus for the markets as far back as November of 2008. But other sovereign debt nations quickly came into sharper focus, including Italy, which has five times more debt that Greece and is on the brink of insolvency, and Portugal, Ireland and Spain.

 

On Thursday, May 6, ahead of the dramatic global sell off, Jean-Claude Trichet, the head of the European Central Bank and the person the investment world is most looking to for leadership, made a defining statement at the conclusion of a meeting of the ECB. His comments, particularly significant against this backdrop of heightened anxiety, alluded to the fact that this problem has gone on too long and the ECB would not monetize European debt. But then, ahead of the market open on May 10, the ECB, European Finance Ministers and the IMF surprisingly announced their backing of a €750 billion bailout plan; Spain and Portugal will implement austerity measures to reduce budget deficits; the ECB will buy up debt of European countries in the open market; and the ECB reintroduced a dollar swap line with the Fed to calm the interbank market between Europe and the United States. This was positive news. We believe the ECB has now gotten ahead of the curve and the contagion to the banking system has been halted.

 

Closer to home, the U.S. cyclical recovery remains on track, from both a profit and gross domestic product (GDP) point of view. The dollar should continue to benefit from capital flows into the United States, as the dollar continues to be the only “reserve” currency in the world. We’ve been asked if, given the huge amount of mortgage resets in 2010 and 2011, along with commercial real estate refinancing, if we are concerned that a second major credit crisis could occur in the United States. We are not. The reason for that is the massive amount of spread tightening around mortgage and commercial mortgage-backed securities. On the commercial side, cap rates have been falling, indicating demand to buy commercial real estate assets, which has led to easier refinancing. On mortgage resets, write-offs on adjustable rate mortgages have been substantial and look adequate to cover any losses that occur on the resets. We think this mitigates the credit issue surrounding resets. 

Despite the magnitude of last week’s decline (which has largely been erased), our attention right now is not focused on what drove the decline – it’s focused on the future. Buying Asia at low valuation is key in our strategy, and right now, those markets are very attractive to us on a valuation basis. Our unhedged exposure has led to some of the Fund’s recent volatility, which is not surprising. Investors are anxious and even doubtful about the sustainability of China’s GDP at a level of 8 to 9 percent. The focus of that discussion is the viability of the upper end of the property market in cities including Beijing, Shanghai and Hong Kong and the Chinese government’s recent efforts to slow the economy down. That has scared investors away from the Asian market and made it attractively valued, in our opinion.

 

It’s important to remember that monetary policy works with very long lags. The Chinese economy and monetary easing peaked in the third quarter of 2009, which drove an uptick in inflation. The Chinese have been tightening monetary aggregates and property since November 2009. We expect inflation to peak around the middle of 2011, at roughly 5 percent, but then drop about 2 percent by the end of the year. We also expect China to raise its benchmark rate one time in the second or third quarter, along with more Reserve Requirement hikes and some gradual currency appreciation. This, in our view, will signal the end of the tightening cycle and the market will get more comfortable with a soft landing.

 

We think that when investors have a chance to reflect on the whole picture, they will, as we have, recognize the investment desirability of the Asian markets and, oddly, their appeal as a safe haven. We base this thinking on the fact that the fundamentals in Asia, and again, China in particular, support a very strong fundamental outlook that will result in GDP growth that will be much more favorable than any place in the world.

 

In addition to the hedging strategies we have implemented, we are maintaining our position on gold bullion, as we think gold bullion will become even more attractive than it was before, as a currency, because investors will increasingly begin to question the viability of fiat currencies (most national currencies). We remain very optimistic about the outlook for the emerging middle class, in Asia and China in particular, and we are actively buying in that sector. We have for some time thought the S&P 500 Index would outperform all other country indexes in 2010, and we still think that. There is big dispersion globally among the indexes and the S&P has clearly led the pack. We think that will continue to be the case going forward.

 

The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through May 12, 2010, and are subject to change due to market conditions or other factors. The Fund allocates from 0-100% of its assets primarily among stocks, bonds, and short-term instruments, across domestic and foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. With regards to fixed income securities in which the fund may invest, these are subject to interest rate risk and, as such, the net asset value of the fund may fall as interest rates rise. Because the Fund may concentrate its investments, the Fund may experience greater volatility than an investment with greater diversification. The Fund may use short-selling or derivatives to hedge various instruments, for risk management purposes or to increase investment income or gain in the Fund. These techniques involve additional risk. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time. These and other risks are more fully described in the Fund’s prospectus. Holdings information is not intended to represent any past or future investment recommendations. Holdings and allocations can and do change frequently. S&P 500 is an unmanaged index of common stocks. It is not possible to invest directly in an index.