When you look at global returns, it becomes clear that U.S. stocks delivered standout performance compared with the rest of the world.  The widely-quoted S&P 500 index of large company stocks gained 10.03% for the quarter and celebrated a new closing high of 1,569.19 on the last trading day of the quarter.    While, the broad-based EAFE index of larger companies in developed economies rose 4.38% in U.S. dollar terms during the first quarter.

Investors who retreated to the safest bond categories deserve our sympathy, especially if they are using the coupons for retirement income.  Treasury bonds continue to post near-record low yields.  Today, if you lend the U.S. government money by purchasing a 2-year Treasury bond, your coupon rate is 0.24% a year; lend them a hundred dollars and you get back less than a quarter every 12 months.  Five-year yields are still below 1% (0.76%), and 10-year (1.85%/year) and 30-year (3.10%) T-bonds are not in danger of enriching their purchasers.

It’s hard to believe that the U.S. and global economies are still suffering a hangover from the Great Recession, but the fact that the Federal Reserve Board is keeping interest rates artificially low, coupled with still-high unemployment, makes the case.  So, too, does unusually slow economic growth; the U.S. economy, measured by the Gross Domestic Product, rose at a 0.4% annual rate in last year’s fourth quarter, after a 3.1% gain in the previous three months.

However, there have been some optimistic signs.  Home values and wage gains across the economy have made it easier for households to repair their finances.  Consumer spending, which accounts for roughly 70% of the U.S. economy, rose in February by the highest rate in five months, according to the Commerce Department.  Although the gain was still a modest, the fact that people were spending more surprised many economists, who expected that the two percentage point increase in the payroll tax would cause Americans to spend less when they received their paychecks.

Does this mean the economic recovery will accelerate, boosting stock prices to ever-higher levels?  Or are today’s record stock prices a sign that the market is about to take a plunge?  Only somebody with a working crystal ball can answer these questions.

All we can say for certain is that eventually the U.S. economy and the global markets will come out from the overhanging cloud of 2008, and the Great Recession will become a distant memory.  Historically, the markets have delivered positive returns about 70% of the time, which is something positive to hope for.

Article written by Bob Veres of Inside Information

Sources:

S&P index data: http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf–p-us-l–

International indices: http://www.mscibarra.com/products/indices/international_equity_indices/performance.html

Treasury market rates: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

Economic data: http://www.bloomberg.com/news/2013-03-29/consumer-spending-in-u-s-increases-by-most-in-five-months.html

Recently, a coalition of more than 80 CEOs of major U.S. corporations including GE, Boeing, Verizon, Aetna, Microsoft and Goldman Sachs have joined together to tell Congress that it needs to find a bipartisan solution to the so-called “fiscal cliff” (i.e., the changes in tax law and the federal budget that will take place December 31).  Longer term, they have asked Washington to address the deficit in a realistic way. The group has publicly argued that, despite the “no new taxes” pledge that many in Congress have signed, raising taxes in some form is inevitable if we are serious about paying down the federal debt.  So far, the coalition has raised $29 million to carry this “raise taxes” message to various Congressional districts.

The One Percent Solution came right out of their respective accounting departments. The CEOs say that it makes no mathematical sense to try to fix the deficit without raising taxes, but they also believe there is a significant amount of waste in current government spending. The group has asked Congress to follow a deficit reduction model which calls for both spending cuts and temporarily higher taxes which fall hardest on persons with the most income and wealth.

Why would the one-percenters lobby for a higher tax bill?  Interestingly, their letter makes clear that they are not necessarily putting the good of the country ahead of their own interests, but they are putting the welfare of their companies first.  They say that the looming fiscal cliff and uncertainty over the budget is costing their corporations meaningful business.

The Financial Services Forum–which brings together the nation’s largest banking institutions–has sent a letter to the White House and Congress asking them to negotiate a bipartisan deficit agreement as soon as possible–and the term “bipartisan” is clear code for “we will accept Democratic proposals to raise taxes as part of the deal.”

The CEOs of big banks and big businesses would almost certainly benefit personally from lower tax rates.  Their respective calls to action suggest that the threat of inaction on the economy has finally become too dire to ignore.  America’s one-percenters say they are willing to sacrifice a bit of their own income to help the country climb out of its fiscal woes and restore economic growth and prosperity.  It is possible that forecasts delivered by their own accounting  departments suggest that higher economic growth will more than pay for the temporary cost of higher taxes in the long run.

As the news continues, investors may ask: How will Hurricane Sandy impact the U.S. economy?  Did the storm destroy the recent GDP growth momentum?  A recent article in The Atlantic notes that since around 1950, the U.S. economy has averaged just under $10 billion a year in hurricane-related property damage.  Interestingly, that comes to just 0.062% of total GDP.  By far the worst hurricane bills came due in 2005, when Katrina slammed into new Orleans, causing nearly $108 billion in damage.

However, the article goes on to say that the actual impact on GDP is more complicated.  As the storm approaches, people stock up on food and supplies, which registers as a small spike in economic activity.  All the rebuilding in the aftermath stimulates construction activity.  Some economists believe that when you factor in seven years of repair, Katrina actually stimulated the Gulf Coast economy. Property damage unquestionably reduces wealth, but the way we calculate economic activity, the overall impact tends to be recorded as a positive.

So what can we expect from Sandy when the economic numbers are finally published? The best early estimates put property damage at $20 billion, but more recently, the insurance industry has pegged the final bill at closer to $30 billion for the NY/NJ region, which could be matched dollar-for-dollar by the contribution to growth by reconstruction and repairs. What will not be matched are the losses of business activities at stores, restaurants and rental units.  In New Jersey, there is talk that the beaches that Sandy swept away may not be restored before the 2013 vacation season.

All together the total short-term impact is likely to be somewhere around 0.6 percentage points taken from U.S. economic growth in the October-December quarter, and something similar added on gradually over the three or four following fiscal quarters, as New York installs raised subway entrances and flood gates, as the New Jersey shore rebuilds its historic homes, beaches, boardwalks and vacation attractions.  To follow the reconstruction efforts, the federal agency FEMA may be the best source.

As you can see, this calculation doesn’t tell us whether any particular company is a good investment, because it doesn’t factor in what you would have to pay for a share of its stock.  But we routinely hear that “earnings per share is near record levels,” with the clear implication that the economy is recovering and the investment markets are healthy.

Is this true?  Earnings per share has been trending upward since 1926.  But this figure has become increasingly volatile over time, and recently the bumps have been pretty dramatic.  That means that any predictions you might hear about earnings per share should be taken with a grain of salt–and, maybe, a dose of aspirin as well.  Increasingly volatile share prices, an uncertain economy and other factors make it hard to rely on this measure as an indicator of anything in the future–especially the future returns on your investments.

 ”QE,” stands for “quantitative easing,” a term which refers to a simple tool that any government’s central bank can use to put new money into its economy.  In most cases, the central bank buys government bonds and puts them on its balance sheet.  QE1 was the Federal Reserve Board’s response to the 2008 global economic meltdown when it purchased $600 billion of toxic mortgage-backed securities (pools of home loans) of large lending institutions.  QE2 started in November of 2010, when the Fed purchased another $600 billion of Treasury securities. 

So what is QE3?  In its third round of stimulus, the Fed has pledged to buy $40 billion worth of mortgage-backed securities a month.  If QE3 works as expected, the additional money will drive down mortgage rates, make homes more affordable, attract new buyers of homes and stimulate the construction industry.  At the same time, QE3 will put a little extra money in the pockets of people who refinance their current mortgages at lower rates.  If they spend some of that money, then that, too, will help spur additional economic activity.

How is it working so far?  Interestingly, mortgage rates have hardly budged because banks haven’t relaxed their tight lending standards. Many banks currently have so many refinancing applications on their desks that they can’t process any more.  As a result, instead of lending more money at lower rates, banks are simply taking a larger spread on the loans they do make. 

The biggest impact, so far, has been on stock prices.  As the Fed buys mortgage pools, QE3 is driving down the returns that investors can get on Ginnie Mae and Fannie Mae mortgage-backed bonds, the most attractive fixed-income vehicles in a marketplace.  As those investments deliver lower yields, stocks, especially those of dividend-paying companies, become relatively more attractive.

The last and perhaps most effective stimulative effect is psychological.  Unlike the QEs of the past, the Fed has put no time or dollar limits on QE3.  The program will continue until the Fed has decided that there is “substantial improvement” in economic growth and the unemployment rate.  In real terms, it appears that the Fed has lost patience with corporations hoarding cash rather than investing in their own (and the economy’s) growth, and banks that have been sitting on all the cheap QE money that is available to borrow and re-lend at a profit to homeowners and corporate borrowers.  If these companies stay on the sidelines and refuse to participate in the economic growth that the Fed is determined to engineer, then they’ll be left behind and forced to answer to their shareholders.

How much growth are we talking about?  Estimates vary, but the U.S. economy needs to reach 3% annual GDP growth before hiring levels absorb new job market applicants and start to reabsorb the people who lost their jobs in the downturn.  The Fed seems to have decided that reviving the construction industry is the most focused possible way to bring about the growth that economists would expect America to achieve by 2014 without the benefit of a stimulus.

Also expiring: a provision that eases the so-called “marriage penalty,” some deductions for college tuition, child tax credits, dependent care credits and a particularly harsh phase-out would eliminate up to 80% of some taxpayers’ itemized deductions for mortgage interest, state and local taxes, and charitable donations. Making the cliff a bit steeper, the Budget Control Act of 2011 calls for automatic government spending cuts of $1.2 trillion from the federal budget over the next 10 years. The Obama-era payroll tax cuts (reducing taxes by about 2% for workers) are also set to expire.

All of this would boost government revenues and lower government spending–the opposite of a government stimulus–and suck some of the spending power out of consumer balance sheets. How much? The Congressional Budget Office estimates that if we go over the cliff–that is, if Congress doesn’t act between now and the end of the year–a total of $560 billion would exit the economy to pay down the government deficit. That’s the good news. The bad news is that the CBO estimates that this would reduce America’s total economic activity in 2013 by four percentage points. To put that in perspective, last year our economy grew at a 1.7% rate. 

So is a recession inevitable? What are the odds that Congress will take bold, decisive action during a Presidential election year? Some believe the magnitude of the economic consequences has gotten the attention of Congress, and no matter who gets elected, something will be done. The most likely possibility is yet another stop-gap measure which might extend some of the tax cuts but repeal some of the automatic spending cuts, pushing the cliff out so that future lawmakers will have to deal with it.

You might be inclined to guess troubled or developing nations like the African nation of Eritrea (134% of its 2011 GDP), Lebanon (136%), or Jamaica (139%).  After reading so many headlines, maybe you guess that Greece (161%) is in the deepest debt hole, or perhaps the United States (103%). As it happens, none of these countries is even close to the runaway leader in government debt as a percentage of its economic output: Japan, which is paying interest on bonds whose face value equals more than 229% of Japan’s GDP. Perhaps the most interesting thing about this bit of trivia is that bond traders don’t seem to be worried about Japan’s ability or willingness to pay back its creditors. As you’ve probably seen from the headlines, when investors are worried about a country’s soaring debt levels, they will often demand higher rates–so the rate that a country pays is a pretty good proxy for how concerned (or not) investors are about the country’s solvency. With that in mind, look at the little table below, which shows the debt to GDP levels of various countries next to their 10-year bond rates. Think of it as a comparison between how much global bond investors SHOULD be alarmed vs. how alarmed they actually are.

Comparing the right-hand column with the one in the middle, you see some head-scratching anomalies. Greece, which has the second-highest debt-to-GDP level in the world, pays by far the world’s highest interest rates on its debt, which seems appropriate. But Italy, which is not far behind on the debt list, is paying interest rates somewhere near the middle of the pack, and the U.S. and Singapore, which have significant debt levels compared with the rest of the world, are paying almost nothing for the privilege of borrowing from global investors. Meanwhile, relatively thrifty countries like Colombia, Peru and Indonesia are paying much higher yields than debt-burdened Belgium, France and Singapore. By far the biggest outlier on the table, however, is Japan, with debt-to-GDP levels more than twice as high as the U.S., paying rates lower than anybody on the table but Switzerland. How can that be? Because more than 90% (some estimates say more than 95%) of Japan’s government bonds are owned by Japanese citizens, compared with an estimated 57% in Italy, and 54% in the U.S. In other words, the global bond markets cannot demand higher interest rates on yen-denominated government bonds because they don’t own Japanese debt; global investors are looking for more return on their money than Japan is currently offering.

While other nations still hold the AAA rating, the U.S. is still offering a very attractive rate despite its downgrade. Treasury rates actually got better during the angry debate in Washington, as investors continued to beat down our doors to lend money to our government.  Why?  The downgrade and recent weakness in the stock market have made bond investors nervous, which usually causes them to buy the safest paper they can find.  As an Associated Press report notes, the U.S. still offers the deepest and most liquid bond market in the world.

The second thing to understand is that, despite the high levels of government debt, there is really no crisis in the government finances or in the economy.  S&P officials made it clear that they were more influenced by the recent messy debate in Congress than the fundamentals of government finance.  They may have been particularly rattled by public statements by key members of Congress that it might not be a bad thing if the U.S. government defaulted on its sovereign obligations to its global lenders. David Beers, global head of ratings at S&P, said in a supporting statement that the agency was concerned about “the degree of uncertainty around the political policy process.”  A separate statement by the rating agency said that policymaking and political institutional control had weakened “to a degree more than we envisioned.”

What does all this mean for investors?  The investment markets were clearly rattled by the tone and uncertainty of the debt ceiling debate, with the S&P 500 losing 10.8% of its value over the ten trading days of the Congressional standoff.  But a Money magazine report points out that when a country loses its AAA rating, that is not always terrible news for the nation’s stock market.  Canada, for example, was downgraded from AAA status in April of 1993, but the country’s stocks gained more than 15% the following year.  The Japanese government’s bonds were downgraded in 1998, and the Tokyo stock market climbed more than 25% in the next 12 months.

In the short term, emotions rule the market, and they are visibly tilting toward panic right now.  Longer-term, the market prices always tend to return to fundamentals, and it’s helpful to remember that corporate profits remain strong, new jobs are being added and the economy is still growing.  The U.S. markets weathered much worse than this in 2008, in 2000, during the first and second world wars and a lot of panic-stricken times in between.  Without the ability to see the future, our best prediction is that the Sun will continue to rise each morning and the U.S. will emerge from this crisis like it has all the others–and reward those who managed not to succumb to the panic like so many did last Summer and so many other inevitable periods of anxiety when things don’t go exactly as we’d hoped.

We haven’t experienced something quite like the current economic situation since the 1970′s. In the aftermath of World War II we also experienced a similar situation and therefore it is wise to analyze how stocks and bonds performed in these two periods in order to plan for our present position. During the 1940′s, large-company stocks yielded a 11.4% return which was well ahead of inflation at the time and the small- company stocks did even better with an average of 65% over the three year period of 1942-1945. But while stocks were cheap and gaining great returns, bonds were barely keeping up to the level of inflation, yielding less than 2% compounded. Although bonds weren’t necessarily losing any capital, investment in them did not provide the needed growth to keep up with the rate of inflation.

One possible strategy to investing in a period of high inflation is the consider gold as an inflation hedge. Two gold-mining stocks were analyzed during the 1970′s, The Barron’s Gold Mining Index and the Van Eck International Investors Fund. BMGI showed compounded 6.5% from 1975-1981 but then lost over 37% in the final year after the peak in gold prices while Van Eck grew at over 22% annually despite three years with losses of 20% of greater. Gold can be a great asset for growth during inflationary periods but should be taken with caution because gold stocks are nearly 2.5 times more volatile than the average stock. As quoted by advisorperspecitves.com, ” Clients want more of anything when it is going up substantially.  The problem is, they rarely have a plan of for when to get out.  Most people cannot deal with the downside volatility that is inherent in investing in the stock market and it worsens with precious metals stocks”. There needs to be managed risk in the portfolio if gold is to be hedged.

In analyzing the previous two high inflationary periods in our country’s history, we see that small stocks outperformed inflation in both periods, large stocks outperformed in the 1940′s but lagged in the 1970′s. Gold and gold stocks weren’t investable in the 1940′s but did well in the 1970′s but with noted volatility. Lastly, bonds lagged significantly in both inflationary periods. Obviously bonds are noted to be the most vulnerable to poor relative returns based on history during periods like today.

Although history has indicated certain patterns during periods like today, this does not mean that it will repeat itself. Past performance does not guarantee future. As advisorperspectives.com states, “At present, we see both inflationary and deflationary forces.  Prices are rising for food, energy and healthcare, while interest rates are falling, the economy is slowing and housing in particular is distressed.  This is stagflation — inflation with slow economic growth and relative high unemployment — such as took place in the 1970s”. In this current situation, treading water with your portfolio may be the best we can ask for.