By Ron Albahary, Chief Investment Officer
Posted 11/10/2011

Some of you have heard me talk about the bad case of debt indigestion being experienced by many of the world’s developed nations due to massive financial liabilities accumulated mostly during the past 25 years.  The pains associated with this condition have been wreaking havoc on our global gastrointestinal system (aka, the financial markets). We can expect this condition to continue to plague markets at varying levels of intensity for years to come.  Why? There is no economic antacid or soothing herbal remedy to eradicate trillions of dollars of debt. 

Chart source: Thomson Datastream

Over the past few days markets have turned their attention away from Greece with its nearly paltry $500 billion in debt. Now the focus is on Italy and its $2.7 trillion debt load, which, by the way, is more debt than Greece, Ireland, Portugal and Spain combined.  Since Italy is the third-largest debtor nation in the world after the U.S. and Japan, it appears the market’s concerns regarding the European Union’s willingness and ability to develop and execute a decisive, clear and convincing plan to contain their collective debt issues are escalating to a fever pitch. While Italy is not insolvent today, the near-term issue is one of evaporating liquidity (i.e., fewer buyers of Italian bonds), which can devolve into insolvency if not addressed swiftly and earnestly. 

Today, the yield on Italy’s 10-year bonds (+7% yields, +4.50% above comparable Germany bonds) breached levels that, in the cases of Greece, Portugal and Ireland, have led to accelerating spikes of yields. Higher interest rates will greatly impact Italy’s ability to service its debt, which amounts to nearly $800 billion in financing needs (€650bn) over the next three years.  

Impact on the U.S.

The global economy is interconnected, more today than ever. An Italian liquidity crisis (and possibly default) would send economic shock waves throughout the world, leading to draw-downs in risky assets in the short to intermediate term. It also would put our own U.S. economic recovery at risk.  In addition, we have our own sovereign debt/deficit issues that will come to the forefront of the media with this month’s Super Committee deadline looming. All of this is likely to cause more volatility as it goes to the wire.  With that said, in times of stress when the news seems overly negative, we need to take stock of the positives.
 

• Overall, our banks have done a much better job than their European counterparts in fortifying their balance sheets since 2008/2009. Also, only about one-third of all U.S. banks have more than 5% of their loans to companies with significant exposure to Europe.
• Exports’ contribution to GDP is 13%; our exports to Europe represent 13% of that 13%, or less than 2% of our total economy.
• Several economic indicators have been better than anticipated, thereby lowering the risk of a recession (barring a European collapse).
• Large, non-financial U.S. corporations generated 12% revenue growth and 16% earnings growth in the recent quarter and have a cash hoard designed to help them weather uncertainty and a volatile world economy.
   

What Needs to Happen?

Since the markets are challenging the EU’s declaration last week to stem the crisis, Europe needs a shock and awe strategy.  In the early days of our credit crisis, it seemed like banks were falling like dominoes and, as a result, investor confidence began to erode at an alarming rate.  The U.S. policymakers and the Federal Reserve realized the urgency of putting a net underneath the spiral of confidence and essentially said, “Don’t worry.  The U.S. government and the Fed have put a backstop on everything.  We will use every means possible to support the banking system and the economy as a whole.  It’s OK—calm down, everyone.”  

It’s debatable as to whether the many strategies known by their acronyms (e.g., TARP, TALF, etc.) actually paid off, but it’s undeniable that these steps were effective in arresting the immediate plunge in confidence.  Europe’s policymakers and the European Central Bank (and, in all likelihood, the International Monetary Fund) need to show a united front by declaring their intent and developing a detailed plan to support the EU at all costs. First, a mountain of liquidity is needed to act as a bridge until they can address the longer-term structural changes required to ensure the EU’s long-term viability. This also allows policymakers time to work on the previously unthinkable -- a breakup or significant transformation of the EU membership.

What Does This Mean To Your Portfolio?

While we aim to build client portfolios aligned with your goals and risk tolerance, these historic swings in market volatility are challenging even the most disciplined investors’ adherence to their long-term plan. As many of you have heard me say, this kind of volatility is normal in a post-credit crisis world.  Establishing the expectation that volatility is here to stay (both upside and downside) can help you tune out the short-term noise and stay focused on the long-term plan. It’s vital to remember that over time, assets will be priced according to fundamentals.  In the meantime, my general investment themes (subject to your tax situation, risk tolerance, time horizon and goals) are as follows:

• It does not hurt to raise 5%-10% cash into rallies; if markets rise, you benefit because your remaining exposure to risky assets rises, and, if markets decline, we have some dry powder to be opportunistic. This is not market timing as I acknowledge that policymakers could surprise us with a substantive move to address the debt and deficit issues, thereby causing markets to rally strongly given the extreme negative sentiment currently exhibited by investors (e.g., October’s surge).  I simply think it is sensible to take advantage of rallies to put some capital aside given the major structural headwinds, and to reserve the option to capitalize on additional bouts of risk aversion.
• Get paid to ride out the volatility by owning high-quality, yield-producing strategies as part of a well-diversified portfolio.
• Lastly, own managers that have the ability to be nimble and adaptive to markets.

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© 2011 Threshold Group, LLC.
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