A Greek Tragedy
Recent headlines notwithstanding, the list of positive contributions that can be traced back to Greece is rather impressive. Ancient Greece is often referred to as the “Cradle of Western Civilization.” It was the birthplace of democracy, the predominate form of government in the Western World today. The philosophic approaches espoused by Greek philosophers such as Socrates, Plato, and Aristotle are the basis of most intellectual endeavors throughout the Western World. Drama, something the world seems to have plenty of, is a Greek word meaning “action”; the Greeks not only introduced this form of entertainment, but they also refined it by sub-dividing it into comedy and tragedy. With the World Cup having garnered the world’s attention, it is worthwhile remembering that the Greeks initiated the first, and the most well known, large-scale athletic event - the Olympics.
Unfortunately, that list of positive contributions tends to leave one with the question, “What has Greece done for me lately?” A blunt answer is “not much.” In fact, Greece has become the “stone in the shoe” of the financial markets. That might seem derogatory, but the point is that even a very small stone can be surprisingly painful and economically speaking, Greece is a rather small stone. In 2009, its Gross Domestic Product (GDP) was just under $350 billion USD, making it about 2% of total Euro-zone GDP (which was about $16.18 trillion USD) and less than 1% of world GDP (which was over $60 trillion USD).
Greece became the twelfth country to adopt the euro at the start of 2001. Certain requirements had been established before a country could become a member of the euro. One of those was that the country’s budget deficit not exceed 3% of GDP. As long ago as 2004, Greece admitted that it had fudged its deficit figures so that it could join the euro, and that it had in fact, not run a fiscal deficit that was less than 3% since the inception of the euro in 1999. In response, austerity measures were enacted so that the country’s deficits might be brought back in line. The efficacy of those measures was masked by relatively strong GDP growth during the middle of the decade. However, last fall a new party was elected in Greece and it announced the country’s deficit was projected to be 6% of GDP in 2009. At that point, investors became increasingly concerned about Greece’s ability to service and/or roll over its debt; rating agency downgrades ensued and Greece’s borrowing costs spiked significantly higher. It reached a crescendo during the first half of this year when Greece had no choice but to implement radically austere measures, which resulted in numerous violent demonstrations within the country.
While tragic from a Greek perspective, one does wonder exactly how and why this impacts the rest of the world. After all, Greece is a country whose GDP is a tiny fraction of the world’s GDP. Unfortunately, Greece’s problems have the potential to impact the rest of Europe. It is important to remember that it takes time for austerity measures to work and in the interim, the country’s economy will suffer. On its own, it is likely that Greece is incapable of servicing its debts while it waits for the austerity measures to take effect. Numerous banks throughout Europe hold Greek debt, so a default and/or a restructuring would materially impact bank capital across the continent. Europe’s banking system is still recovering from the 2008 credit crisis, so taking another hit would be somewhat difficult. The last thing any country or region wants is a damaged banking sector since it never bodes well for that country’s rate of economic growth. In this case, we are talking about a region (Europe) that accounts for about one-quarter of the world’s GDP.
There were also concerns about a Greek contagion effect. In 1997 and 1998, when the Pacific Rim crisis impacted the markets, problems first popped up in Thailand; another relatively small economy. Since many other countries within the region were dealing with similar issues, those problems spread relatively quickly throughout the region. Outside of Greece, Portugal, Ireland, Spain, and Italy are all dealing with similar issues. If the markets start to doubt those countries, their borrowing costs will also rise. It is possible that some or all of them could head down Greece’s path, requiring the enactment of especially austere policies. That is not a comforting economic scenario.
At this point, the European Union, the International Monetary Fund, and the European Central Bank have put in place a coordinated plan to bail out and support Greece, as well as other European countries on an as needed basis. The success or failure of the plan is unlikely to be known for at least a year or two, so the markets are forced to deal with a relatively high level of economic uncertainty; markets don’t like uncertainty.
This uncertainty was especially evident during the month of May. The Dow Industrial Average1, the S&P 500 Index2, and the NASDAQ Composite Index3 were all down approximately 10% during the month. The market sell-off continued in early June, however all three indices rebounded nicely in the middle of the month.
Of course, the problems in Greece were hardly the only factors impacting the market. The economic releases were decidedly mixed, which simply added to the market’s angst. There were good and bad payroll reports, good and bad retail sales reports, and good and bad releases associated with the housing market. Inflation continued to grind lower and the trade-weighted dollar continued to grind higher. There was also the BP accident in the Gulf of Mexico, the resolution and cost of which won’t be known for months, if not years.
One of the most intriguing things about the financial markets is how a relatively obscure event can snowball and then drive the markets. In this instance, it was the announcement by the newly elected government about the fiscal profligacy in a country that most are really only familiar with due to its cultural contributions from over 2,000 years ago. Looking back, we now recognize the importance of that announcement, but at the time there were very few who truly grasped the ramifications. While we believe that the importance of obscure events might distress or even defeat some investors, Manning & Napier has been able to deal with those by applying longer-term, fundamentally-sound investment strategies. To paraphrase the ancient Greek philosopher, Epictetus, “The markets turn aside to let those pass who know where they are going”.
Expectations Versus Reality
At the beginning of this spring, expectations seemed to be building momentum. Stock market prices were moving higher, reflecting optimism about the U.S. economic recovery and the projection for corporate earnings. Fears of a double-dip recession had subsided, and the American consumer seemed to be showing signs of life. The picture looked a lot better than the dark days of the recession.
Fast forward to early May, and sentiment shifted. Concern over Europe’s sovereign debt problems contributed to a decline in the equity markets, and we witnessed a “flight to quality” into investments perceived as safe, such as U.S. Treasuries. Expectations came down from levels that were likely getting ahead of fundamentals.
As Manning & Napier discussed in last quarter’s Update, such fluctuations in expectations are likely to be part of the investment landscape over the next few years while global economies recover. However, these swings in sentiment do not necessarily indicate a change in reality. As a result, periods of excessive optimism and pessimism can provide opportunities to buy fear and sell greed.
It can be easy to get caught up in expectations, so having a realistic perspective on the economy is important. In particular, the details of GDP provide a helpful vantage point for gaining insight into the economy and its reasonable growth prospects for the coming years. As the equation below shows, the economy depends on four main areas for growth.
C: Can consumers act as an engine for growth? Following prolonged weakness during the downturn, consumption improved noticeably at the start of 2010. Consumers returned to stores and retail sales rose, giving a boost to the economy. However, this renewed consumption seemed at odds with weak wages. Instead of income growth, government transfer payments seemed to be generating much of the buying power. Also, consumers appeared to be dipping into their savings to spend, which is not a seemingly healthy or sustainable trend. Despite this short-term strength in consumption, we believe most consumers remain burdened by heavy debt loads. With credit no longer readily available, we find it likely that consumer spending will recover gradually over the next few years.
I: Will business spending come to the rescue? For the most part, companies have strong balance sheets and plenty of cash. The corporate sector is in the position to make investments, as evidenced by the jump in business equipment and software spending during the first quarter. Also, after extensive cutbacks in the downturn, companies are starting to add to their inventories again, and this inventory stabilization has contributed to growth over the past two quarters. Nonetheless, business investment will ultimately correspond with final demand. Why would companies invest, hire, or build up inventories if their end demand stays weak? Until consumers are healthy enough to return to the market, businesses will have little incentive to invest.
G: Can government stimulus drive a recovery? Federal government spending has provided a key source of economic growth during the recession, but stimulus money is likely to fade in the second half of this year. Additionally, state and local government budgets remain tight, while defense spending could be a drag on growth going forward as well. With rising debt levels, pressure could be mounting to reduce fiscal stimulus and/or increase taxes, neither of which would be positive for economic growth.
X: What about exports? With imports rising faster than exports, the trade deficit detracted from growth in the first quarter, and recent data suggests that trend is poised to continue. Overall, we don’t anticipate that net external trade will be a catalyst for broader economic growth.
An understanding of these current GDP realities drives Manning & Napier’s outlook for slow growth ahead, but we must recognize that swings in sentiment will probably occur around that viewpoint, creating opportunities to buy pessimism and sell optimism. Importantly, the economy faces many challenges and uncertainties that could change the course of growth or contribute to large shifts in expectations. For instance, year-over-year earnings comparisons are set to become more difficult in the second half of 2010, the health of the banks and their lending operations remain fragile, and the outcome of financial regulation is unclear. The keys to navigating this type of uncertainty and changing expectations are to remain focused on reality and to be prepared to actively take advantage of shifts in expectations that will create opportunities.
Looking Beyond Market Expectations
The general economic backdrop provides a valuable context for expectations and helps guide investment decisions. However, a focus on company and industry specifics is critical at this phase in the recovery. As we highlighted in the previous two issues of Update, investment opportunities are likely to be found by analyzing company and industry dynamics, a bottom-up approach that has been at the core of Manning & Napier’s investment strategy for 40 years.
In a slow growth environment, we can’t count on a sharp rebound in demand to lift all companies. Therefore, using our disciplined stock selection process, we must seek to identify the winners – those companies that should be able to grow and gain market share at the expense of their competitors. In this “zero-sum game” of slow growth, for every winner there will likely have to be a loser that gives up share.
As the markets reacted to negative news over the quarter, Manning & Napier focused on high-quality stocks, particularly growth companies with a sustainable competitive advantage that fit our Strategic Profile strategy. For instance, we have invested in some first-class Consumer Staples companies that possess worldwide brand recognition and distribution. Through the criteria of our Hurdle Rate strategy, we have also invested in strong companies that should benefit when weak players cut back or exit their struggling cyclical industries. Specifically, we have targeted industries that have a tight relationship between supply and demand, such as airlines or aircraft manufacturers.
This bias toward quality and our reduced exposure to economically sensitive stocks led our clients’ accounts to lag behind market returns earlier this year as investor expectations became overly optimistic. The subsequent market correction impacted all sectors, without discriminating between high-quality companies or economically sensitive ones. As a result, short-term swings in expectations have hurt our results over recent months. Looking ahead, we recognize that our clients’ accounts could continue to underperform in the near-term if investors once again become overly excited about an economic recovery and reward cyclical stocks such as Financials, Consumer Discretionary, and Industrials. For reasons cited above, we do not believe that there will be a return to strong economic growth in the near-term, which is why our portfolios are focused on high-quality growth companies that could take market share from weaker companies in this difficult economic environment. We believe this focus will be rewarded over the long-term, as the reality of slow economic growth becomes accepted.
Manning & Napier has always been an investment manager that seeks, above all else, to achieve absolute returns over full market cycles. With this mindset, we know that short-term comparisons may be difficult in our pursuit of long-term gains. Over the course of four decades, we’ve employed an active and flexible investment approach that has successfully navigated multiple bull and bear markets. In an economic reality that points to slow growth ahead, these qualities remain as important as ever.
Understanding the Headlines: Municipal Bonds
One outcome of the global credit crisis has been budgetary pressures for many state and local municipalities. In some cases, such as Vallejo, California; Jefferson County, Alabama; and Harrisburg, Pennsylvania, these pressures have been severe and well documented in the headlines. As is often the case, actual risks and opportunities are not quite as straightforward as the headlines suggest.
From a simplistic supply and demand standpoint, the outlook for municipal bonds looks positive. Investor demand remains solid, as evidenced by low yields in the current environment. As yields tend to increase during periods of stress or perceived risk, today’s low absolute yield levels (1%-3% for 5-10 year issues and around 4% for 20-30 year maturities) suggest that investors continue to be attracted to municipal bonds. We expect demand to remain strong given expectations for higher future income tax rates in the face of rising budget deficits. In contrast to this strong demand, supply of traditional municipal bonds has decreased as municipalities are increasingly opting to issue Build America Bonds, whose interest payments are partially subsidized by the government and taxable at the federal level. We expect this continued strong investor interest in true municipal securities to bode well for the market overall as supply remains constrained.
Beyond supply and demand, the headlines are highlighting the budget pressures. While these pressures are real, it is important to understand the differences between budget pressures on a municipality and those on a corporation. Historically, the default potential in the municipal market is much lower than that in the corporate market. Unlike businesses, municipalities do not cease to exist. Rather, bankruptcy is a voluntary event that allows the municipality to construct a plan to cut spending while seeking temporary debt relief. While a corporate bankruptcy may lead to full loss of principal for an investor, the “permanent existence” nature of municipalities generally translates into higher recovery rates as the municipality generally remains a going concern.
While this certainly doesn’t guarantee that a default in the municipal market cannot occur, it does imply that defaults are far less likely. In fact, a recent report published by Moody’s Investors Service calculates the average 5-year historical cumulative default rate for investment-grade municipal debt is 0.03%, or about three out of 10,000. This compares rather favorably to the 0.97% default rate of corporate issuers (just under one per 1,000), which makes a corporate bankruptcy about 30 times more likely.
With strong supply and demand dynamics and lower overall default potential for municipal securities, we continue to believe that municipal bonds can be a driver of return potential in a diversified, balanced portfolio or a fixed income portfolio for high income earning taxpayers. However, we are clearly cognizant of this more troubling landscape for issuers and, as a result, we are taking the following steps to account for the current environment:
1. As always, we remain focused on “plain vanilla” general obligation (G.O.) bonds that are backed by the taxing authority of the municipal entity or revenue bonds backed by necessary services (e.g., water and sewer authorities). Doing so lowers the chances of default as interest payments are backed by more predictable cash flows (e.g., taxes, utility bills) rather than special projects (e.g., sports stadiums or other recreational projects).
2. We continue to ensure diversification of our holdings, limiting the maximum allowable allocation to specific issuers and, when allowed, diversifying by state.
3. In the current environment, we are placing a higher emphasis on credit ratings, supplementing information provided by the major rating agencies with our own analysis of additional financial and demographic factors. Specifically, we are looking more closely at overall net debt per capita, operating fund balances relative to revenues, debt ratio(s), total annual debt service coverage, median household incomes within the municipality, median real estate taxes, and the poverty rate.
Similar to our approach to investing in equity securities, we continue to place a strong focus on issuer selection within the municipal bond marketplace. We recognize that the same budgetary pressures that are causing severe distress for some municipalities can also lead to opportunities within this space for issuers that have maintained clean books and can issue true tax-free investments for high income earners looking to manage their tax situation. We believe this due diligence, along with a heightened review of financial and demographic factors, is a prudent means for navigating this area of the market to identify both risks and opportunities. As we’ve seen many times over the past few years, areas of market weakness can often give rise to the best opportunities, and we remain focused on understanding the full dynamics of this area of the market.