2012 Second Quarterly Letter to Clients

After a calm start to the year, volatility returned to the markets during the second quarter with the Dow posting 22 days of triple digit moves. This quarter proved even JP Morgan is not infallible as the company lost $2 billion following a hedging operation that went wrong. The seemingly neverending saga in Europe was headline news for most of the second quarter, with Greece being the focal point and then Spain emerging as the latest flashpoint by quarter end. The Greek stock market tumbled 34.4%, Germany fell 20% and France fell 17%. At quarter-end, Eurozone chiefs produced an agreement that bailout funds could be used to directly recapitalize struggling banks, effectively relaxing austerity measures for Spanish loans and offering possible aid to Italy.

The Eurozone is a very slow moving train wreck. Markets don’t like surprises though. Perhaps the best scenario may be to stretch this crisis and delay the breakup of the Eurozone for a few years so it may fade away quietly, if possible. As the 17-nation Eurozone faces a prospective Greek exit, I thought it would be an ideal time to focus on it.

The Eurozone was intended to create a common identity but the crisis is dividing European countries along the very lines that this collaboration was intended to remove. France has recently elected socialist leaders and other northern governments are objecting to Germany’s fiscal austerity. Resentments long thought dead have resurfaced as Greek newspapers publish caricatures of Germany’s Angela Merkel as a swastika-carrying Nazi. In other countries, anti-German sentiment is prevalent. This begs the question: what went wrong? Perhaps it is best to start from the beginning.

After World War II, Europe was in ruins and the goal was to create a new safe, prosperous and peaceful Europe. France and Germany, two bitter enemies, would clearly emerge as the dominant financial entities in this new Europe so it was critical that they reconcile. An alliance was formed that grew with time; however the goals of the two countries differed. Germany wanted to immerse itself in a broader union with friendly countries of diverse economic stages. France aimed for a political union that could extend its power while subduing Germany’s. As the union grew, countries had less in common economically, making economic and political unity difficult.

The Maastricht Treaty of 1992 provided for European monetary union, the Euro. Due to a belief that central banking was above politics, Europe’s leaders were not concerned about the union’s governance deficit. Economists were quick to point out how fragile the euro system’s design was because as some countries prospered more than others, a single currency would pit countries against one another without the governance to mediate problems. This is exactly what the EU faces now as the citizens of fiscally sound countries balk at the prospect of subsidizing their fiscally irresponsible neighbors. As resentments resurface, these neighbors, in turn, resent being dictated to by Germany. It seems certain that all of the EU nations understood the economic demands of the euro, but it did not stop some governments from overborrowing (and then hiding their actions from member nations) and others from overlending. The European Commission, the executive arm of the EU, neglected to regulate this and as a result, the breakup of the Eurozone has gone from unthinkable to probable.

US markets will be shaped by many factors in the second half of the year. Corporate profits and to an extent, consumer spending, have gotten us this far. Future US corporate profitability will depend on a brighter employment picture. During the US economic recovery over the last few years, the better educated, wealthier workers have continued to spend. Conversely, the less educated, less affluent workers have spent more conservatively. The former group of workers has been one of the chief contributors to domestic growth while the latter has been the biggest drag on it. As the stock market has risen sharply since its lows in March 2009, the more affluent “spenders” have seen a gain in their financial assets, thus increasing their confidence. However, the real estate market has remained weak and this has led the less affluent “savers” to feel less confident, as their main asset is their home. Many economists believe we have seen a bottom in housing prices. If they are correct, a rise will lead to increased confidence for all workers. A resurgence in the housing market will lead to more jobs, then more confidence, then more spending, then more growth.

During the second half of the year, attention will turn to the US presidential election and the looming budget showdown, known as the fiscal cliff. If no action is taken by Congress, Bush-era tax cuts will expire and large mandatory spending cuts will occur. Since this is an election year, there will be a narrow window to come up with a viable spending plan. Stay tuned for the next quarterly letter, which will be an opportune time to take a look at the US political landscape.

Please find enclosed your 2nd Quarterly Portfolio Report for 2012.  If you have any questions or concerns, please call me at 518-867-4245 or email me at olivia@mussettwealth.com.

Warm regards,

Olivia A. Mussett, CFP®