October 2011 Quarterly Investment Commentary
By Jean Brunel, Chief Investment Officer

A Long Overdue Unwinding?

Equity investors around the world have experienced tough times in the last three months. In our view, this probably reflects the fact that market participants are coming to the realization that three of the issues which have been worrying us are serious. The economic stability of the European Union is at stake, not only because of the debt repayment challenges faced by a few peripheral European economies, but principally because of the knock-on effects of a possible default in one of these smaller countries on the European financial system. The financial posture of the U.S. public sector is almost as bad as what we observe in Southern Europe, with the difference that it does not seem as high in the proverbial "generic investor consciousness." Finally, geopolitical tensions are many, and the economic challenges before most governments do not make for more of a cooperative stance across the major political powers, even if a solution was within their grasp, which it does not always seem to be.

Only one of the issues which have been worrying us since the beginning of the year has failed to come to the fore: inflation has not become an issue outside of the emerging world. This is mixed news. On the one hand, it is obviously somewhat of a relief that this worry does not have to be addressed. On the other, the mitigating factors preventing inflation from flaring up more than it has include a growing recognition that economic expansion is not a given, a concomitant decline in the price of many commodities, and a failure of real wages to keep up in several developed countries, the U.S. most visible among these.

The fundamental question which any serious investor should be asking is this: are we witnessing a major structural re-adjustment or is this just a form of an extended and direr than usual cyclical downturn? If the former, the likelihood is that capital markets may well remain unpleasant and uncomfortable for some time yet, possibly for several years. If the latter, one should be looking for signs that fundamental deterioration is being reversed, that valuations are reaching extremely low levels and that investor sentiment is at or close to the point of capitulation.

At this point, our fear is that this is a structural re-adjustment, driven first by excessive household leveraging in several Anglo-Saxon countries, second by the failed experiment of attempting to bring traditionally profligate countries into a tent dominated by Germany, third by the continued failure of the Japanese government to engineer an end to its self-imposed bubble bursting of 1989 and finally, and as a consequence of the former three, by the massive global government indebtedness resulting from misguided attempts of governments around the globe to solve problems through unbridled fiscal pump priming. Our own bias is thus that this is most probably a secular rather than a cyclical development, with the implication that economic growth will continue to disappoint and that systemic instability will be greater than feared. Correspondingly, we are maintaining our current defensive recommended portfolio posture, though we recognize that dislocations almost always bring along a few fascinating opportunities.

In the balance of this note, we shall first review broad economic developments since the beginning of 2011 and, second, a possible and so far not discussed parallel between the U.S.—and selected Anglo Saxon countries on the one hand—and Japan, concluding that caution is still warranted. For our readers concerned with taxes and who can take advantage of realizing capital losses, we will finally note a few opportunities to make the recent past less painful.

A global economic slowdown

The main fundamental theme remains: the global economy is slowing down, faster in the developed world and less so in the emerging countries of Asia and South America. In fact, we feel that Europe is on the verge of a recession, and that the risk is that the rest of the developed world may not be too far behind.

Focusing first on the U.S., the first graph above suggests that growth in personal consumption in the U.S. has remained anemic for the last three years. It has been pressured by little or no growth in personal income and the need to rebuild the savings that were depleted in the early to mid-2000s. Real wages, for the lucky part of the labor force that is employed, have been lagging. This likely reflects the fact, suggested in the second graph above, that total employment has been flat to down since 2003. The key to renewed consumer spending growth must therefore be growth in employment in excess of labor force growth, as an inability to provide jobs for new entrants should enhance uncertainty and thus increase the propensity to save.