Economic Commentary -- September 2011

By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company

Sideshows
There are pivotal moments in the markets and in economics, moments that are essentially “sideshows” - in other words, minor or diverting incidents that distract our attention from something more important.

Such a sideshow took place in early August, when the credit rating agency Standard & Poor’s downgraded the credit rating of the United States government from its top rating AAA to AA+. In response, markets reeled in the United States, Europe, Japan and elsewhere.

Or did they? Were the movements of the markets in response to this downgrade or were they in response to other economic news such as the slowing global economy, the worsening sovereign debt situation in Europe or the continual troubles of multinational banks? Most signs point to the S&P downgrade as more of a sideshow to the main events of slow economic growth and continuing sovereign and bank balance sheet problems both in the U.S. and in Europe.

In this month’s commentary, we’ll explore the S&P downgrade, debt problems in the U.S. and Europe, and the potential consequences of prolonged slow economic growth. We’ll also discuss how the markets are reacting to this news and where the economy is likely to go from here.

Debt Issues: The Big Picture
The global economy, particularly in the U.S. and Europe, is still suffering from a debt hangover from the financial crisis that began in 2007 and 2008. Governments are burdened with debt after bailing out struggling financial institutions and spending large sums of money on economic stimulus packages. In addition, many governments continually engage in deficit spending – spending beyond their means – in order to continue running their economies.

The debt burden on a nation is known as sovereign debt. Most developed countries run budget deficits to one degree or another and can usually manage to grow their economies and service their debt without problems.

Typically, nations issue government bonds to fund their deficits. Most of the time, those countries can pay interest on their bonds, redeem bonds and issue new bonds with little or no problem.

But when sovereign debt burdens grow as a percentage of a country’s gross domestic product, it can cause problems, as we’ve seen in countries like Greece, Portugal and Ireland. The interest on sovereign debt grows to be a larger and larger percentage of government payments, impairing a government’s ability to provide other services to its citizens. Additionally, many countries have entitlement programs similar to those in the United States, which are considered required spending by law. This only increases budget deficits and adds to the sovereign debt total, worsening the problem. At the end of 2010, the countries with the largest gross government debt as a percentage of GDP were Japan, Italy, the United States, Canada, France, Germany, the United Kingdom and Spain, according to the International Monetary Fund (IMF), Moody’s and Standard & Poor’s.

Many of those countries, including the United States, Ireland, France and the United Kingdom, provided massive bailouts to ailing banks during the financial crisis. Although banks are doing better than they were during the height of the financial crisis, many still haven’t recovered and still have large exposure to weak housing markets. In addition, many banks hold large portfolios of sovereign debt on their books, and they face problems when sovereign debt markets are in trouble, as the value of those holdings falls.

Uncertainty in the sovereign debt market, which has recently focused on the U.S. and economically weak countries in Europe including Greece, Portugal, Ireland, Italy and Spain, creates uncertainty in financial markets, especially on the bonds and stocks of multinational financial institutions. Participants in the financial markets dislike uncertainty and tend to sell stocks and bonds when they aren’t sure about the economic or financial condition of sovereign nations, financial institutions and companies. This is a major cause of the recent market volatility.

Here’s a specific overview of what’s happening with the debt problems in the United States, Europe and multinational banks:

United States
Following weeks of political squabbling over the debt ceiling, Congress and the President cobbled together a $2.4 trillion plan to cut the nation’s deficit and increase the debt ceiling to avoid a government shutdown. As part of the plan, Congress is appointing a 12-person “super committee” to discuss further spending cuts. Despite – or perhaps because of – this agreement, Standard & Poor’s downgraded U.S. debt from its highest rating, AAA, to its second highest rating, AA+.

S&P is just one of three major credit rating firms. The other two firms, Moody’s and Fitch, have not downgraded the U.S. credit rating. While most analysts believe that the U.S. will continue to be able to meet its financial obligations and repay its bondholders, S&P noted that the political gridlock in Washington, D.C. made it very unlikely that the government could make significant progress in reducing its debt in the near term. As of the end of 2010, the ratio of gross government debt to GDP stood at 90 percent, and it’s projected to grow to 110 percent by 2015 (Fig. 1).

Europe
The saga of European debt woes has been underway for more than 18 months, as we discussed in the June Commentary. Greece, Ireland and Portugal have all required bailouts from the European Central Bank and the International Monetary Fund, and they aren’t in the clear yet. These countries don’t have the money to pay interest to bondholders and repay them when their bonds come due. They’re also facing weak demand for the bonds they issue, and buyers of their debt are demanding unsustainably high interest as a result.

Italy and Spain’s debt problems pose a bigger problem to the eurozone because their economies are much larger than those of Greece, Portugal and Ireland. The European Central Bank has been buying the debt of Italy and Spain to force yields down so that those countries can continue to access the bond markets. The European Union and European Central Bank are considering what further actions may be needed to shore up the eurozone – actions that may or may not include the issuance of eurobonds.

Multinational Financial Institutions
Financial institutions, particularly those that operate in more than country, are still fragile. They have not completely recovered from the 2007-2008 financial crisis. In the U.S., a number of large banks are also still contending with continued weakness in the housing markets compounded by allegations of fraud in packaging mortgages into securities and repossessing homes from borrowers without clear title. In Europe, banks are weak from exposure to U.S. mortgage-backed securities and housing bubbles in other countries.

Banks are required by their regulators to hold a certain amount of capital – many times in the form of bonds and cash – on their books. The bonds must be of a certain high credit rating. When sovereign debt is downgraded, banks can experience problems in their capital base because they don’t have enough capital to satisfy regulators or investors. This can cause banks to become insolvent or at least weaker financially, which can in turn cause investors to sell their stocks and result in further rating agency downgrades.

As part of mandated stress tests designed to determine how banks would fare in poor economic environments, many banks have been judged as needing more capital by their national regulators. However, some of the stress tests didn’t gauge how banks would fare if there were widespread sovereign debt downgrades, so it is unknown whether they would survive financially.

Recession Fears - Again
In June, we discussed the renewed fears of a double-dip recession in the U.S. The frustrating economic data that bedeviled economists in 2010 has continued into 2011. Data shows slow economic growth that hasn’t broken out either on the downside into a recession or on the upside on a sustainable growth path.

In mid-August, for example, U.S. industrial production rose slightly – but faster than expected – as car manufacturers rebounded from the effects of the earthquake and tsunami in Japan. Meanwhile, U.S. home construction dropped slightly after a gain in July. The housing sector, key to sustained economic growth, has failed to gain traction due to the overhang of foreclosed homes and general economic weakness, namely persistent high unemployment, following the financial crisis.

The employment market also remains dicey. Though not by much, weekly unemployment applications fell below 400,000 on Aug. 12 for the first time in 17 months, and the unemployment rate remains stubbornly high at 9.1 percent. In fact, state and city budget problems, in concert with federal budget cuts, are likely to weaken rather than improve the employment situation.

Europe’s economic situation isn’t much better. Germany, which had been the growth engine of the European economy, took a hit in mid-August when GDP rose an anemic 0.1 percent from the first quarter, which translates into an annual GDP growth rate of 2.7 percent (Fig. 2). This follows a report on the French economy that revealed their economic growth was essentially flat in the second quarter. The U.K., which has embraced austerity, is experiencing low economic growth as well.

Out in the periphery of the eurozone, economic growth is cratering. Greece, the recipient of serial bailouts from the European Union and International Monetary Fund, saw growth plunge by more than six percent in the second quarter. Ireland is in an economic depression. And Italy’s growth, which wasn’t that robust to begin with, is declining further as its bond markets remain under stress.

Looking at emerging economies, inflation is the fear. Economic growth is still rising at a decent clip although bank lending is slowing, which may signal slowing economic growth. Many investors, driven by low yields in developed economies, have moved into emerging economies in search of higher yields, an action that is fueling inflation.

Markets React to Debt, Economic Weakness
In the past several weeks, financial markets have demonstrated strong reactions to the debt problems dogging the U.S. and Europe and to the continued economic weakness in both regions.

The volatility of the markets was particularly evident for the seven trading days between Aug. 5 and 15. The market fell more than 600 points on Aug. 8 alone. Overseas markets, including Europe, Australia, Hong Kong, Singapore and Japan, were also extremely volatile (Fig. 3).

Corporate profits in the U.S. continue to be strong despite recent turmoil over the debt ceiling and concerns about global economic weakness (Fig. 4). Walmart’s earnings were up 5.7 percent in the second quarter, although same-store sales were essentially flat. Home Depot announced a 14 percent increase in second quarter profits, and Staples, Target and Deere all beat second quarter earnings estimates. Dell, however, cut its guidance for the 2011 fiscal year.

In mid-August, the Federal Reserve Board issued a statement committing to keep interest rates low for at least the next two years. A low rate environment is usually positive for business activity, as businesses can borrow money and issue bonds at low rates and use funds that would otherwise go toward interest payments to hire staff, acquire other companies or engage in business activities. Low rates can also be positive for consumers, as they can borrow at lower costs, potentially refinancing mortgages and buying big-ticket items like cars without having to pay as much interest over the long term. The downside of low rates is that they are tough on savers, especially retirees, who can’t get much yield on their investments.

And low rates can only do so much to encourage economic growth in the absence of consumer spending or fiscal stimulus by the government. Consumer sentiment has been negative lately, impacted by the political squabbling over the debt ceiling and continued high unemployment. In mid-August, the University of Michigan’s index of consumer sentiment fell to its lowest level since 1980, lower than during the 2008-09 and 2001-02 recessions (Fig. 5).

What to Watch For
In some ways, the issues with the markets are as much about politics as they are about economics. On the political front, the legislation that was passed to raise the debt ceiling in the U.S. also provided for the creation of a bipartisan deficit “super committee” tasked with identifying $1.2 trillion in budget savings by the end of November. The findings of that committee could impact the markets heading into 2012. Political posturing by the parties may make it impossible, or at least very difficult, for any significant deficit-cutting measures or job-creation measures to pass Congress and be signed into law.

In Europe, political issues surrounding the bailout of the peripheral countries and the potential strengthening of the economic and political bonds between eurozone members are also on the front burner. Markets have been skeptical that the eurozone can produce enough funds to bail out larger countries such as Italy and Spain, should they require more financial support.

Keep an eye on political developments and how the market reacts to them. On the economic front, GDP numbers are important. Second quarter figures showed slowing growth across the developed world, which adds to the fears of a double-dip recession. Watch unemployment, housing, retail sales and consumer and business sentiment to get a feel for the direction the economy is trending.

Inflation is another vital metric. With inflationary pressures on the rise in developing markets and commodity prices under pressure, consumer price index and producer price index figures over the next few months will be analyzed closely for hints of inflation on the horizon.

Where We Are Headed
While the debt-ceiling furor has died down, long-term issues over the large U.S. budget deficit haven’t been solved by any means. Until there is some meaningful progress towards reducing the deficit over the long term, this issue will likely continue to hang over the markets and the economy. Quite simply, the U.S. is on a path of running up federal deficits that is unsustainable, and eventually something has to give.

The situation is similar in Europe, where most of the solutions so far have only kicked the can down the road. European leaders have yet to find any solution that solves their fiscal problems, creating continual uncertainty in the markets. The slowing growth of developed economies doesn’t help market psychology, although any positive signs on the economic front may create some positive momentum.

In times of market turmoil, it’s important to avoid reacting emotionally to movements in the markets. A day or even a week of movements up or down isn’t a reason, in and of itself, to make changes to one’s investment strategy or asset allocations. Changing your asset allocation in challenging times may damage your potential to meet long-term goals.

Stock valuations, as measured by Price-Earnings (P/E) ratios, are at lows that haven’t been seen in years. Additionally, stocks on the S&P 500 are, on average, out-yielding 10-year Treasuries, allowing investors to receive a higher stream of dividend payments compared to interest payments from government bonds, with the potential to capitalize on price appreciation when the markets eventually come back (Fig. 6).

Looking ahead, investors must decide whether the recent selloff was only a correction, which typically is short-lived, or an unwelcomed start to an economic recession. According to J.P. Morgan, the S&P 500 has experienced 30 severe corrections, meaning a 15 percent or greater drop in the index level, since 1939. Only two of those corrections predicted a recession and six others were concurrent with one, illustrating that markets do not necessarily predict recessions.

Investors will do themselves a service in not getting caught up in the media headlines that add to fear in the markets. Your investment policy was designed to withstand periods of market volatility by taking the emotion out of investing. Keep your long-term investment goals in mind.

Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Bond or debt investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. Government debts are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest when held to maturity.

Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics and news.

The International Monetary Fund (IMF) is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments.

Moody’s, Standard & Poor’s (S&P) and Fitch Ratings are the three major credit rating agencies. A credit rating agency is a firm that provides its opinion on the creditworthiness of an entity and the financial obligations (such as bonds, preferred stock, and commercial paper) issued by an entity.

The European Central Bank (ECB) is the institution of the European Union (EU) which administers the monetary policy of the 17 EU eurozone member states. The current President of the ECB is Jean-Claude Trichet, former president of the Banque de France.

The European Union (EU) is an economic and political union of 27 member states which are located primarily in Europe.

The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters. At least 500 telephone interviews are conducted each month of a United States sample and 50 core questions are asked.

The U.S. Department of Labor Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.

The U.S. Department of Labor Producer Price Index (PPI) program measures the average change over time in the selling prices received by domestic producers for their output. The prices included in the PPI are from the first commercial transaction for many products and some services.

The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country.

A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorized according to the currency in which it is issued. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world.

VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options.

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