Become a Client Service Advisor!

Markets closed the first half of the year with a bang. Through June 24th the S&P 500 was up just over 1% for the year. Then, in the last four days of June the market rallied over 4% to bring the S&P 500 up to a total return of 5.01% for the first half of the year. So, essentially the market was flat for the year until the last 4 days of the quarter. Most of the stock markets of international developed nations around the world show a similar story of small gains for the year. However, emerging market countries, specifically the BRIC (Brazil, Russia, India and China) countries are all in down trends and some have flirted with bear market territory (down more than 20% from market tops). Both the developed nations and emerging markets have their fair share of economic problems and market risks, but the issues are quite different between the two.

Developed Markets
Essentially, all of the developed markets (with the focus on America and the European Union countries) went through a real estate bubble for the first two thirds of the last decade that popped between the years of 2005 – 2007. Then their stock markets came crashing down in 2008 as banks, companies and the population de-leveraged (paid back their debts and raised cash reserves) which caused a financial, consumer and credit crisis. Governments reacted by providing massive government stimulus meant to kick start their economies which were facing extremely high unemployment rates and frugal consumers. Most of the government stimulus came through government spending and quantitative easing (a policy meant to keep rates low so consumers borrow, invest and spend more) thereby causing these countries to go even further into debt from a federal/public level. Although most of the stock markets in the developed countries have had relatively strong bounces since their 2009 bottoms none of them are above their pre-crash 2007 highs. Economically though these countries still face high unemployment and slow to no-growth economies. Making matters worse they now have to deal with all the consequences of the massive government spending. So, most of these countries are countering their extremely high budget deficits through austerity measures (spending cuts) and raising taxes, both of which are bad for the economy over the short term although they are essential for the long run to avoid default and to regain a solid financial future.

The difficulty that these countries are running into as we’ve seen recently in Greece is that when governments start to cut spending, the biggest drivers of the deficits are entitlement costs and therefore the biggest opportunity to save is to cut entitlements (see chart titled: “Healthcare as a percentage of GDP” on page 3). Populations that have become accustomed to generous health care, government pensions and other benefits don’t like it when you take them away. Recent austerity measures in Greece have caused riots and uprisings by the population. These spending cuts can be political suicide for the elected officials in future elections. So although governments know they need to make necessary cuts to entitlements they have been skirting the issue in the hopes of getting reelected and not losing their jobs.

In the U.S., debate over raising the debt ceiling and cutting the deficit is running into similar problems. Most intelligent officials on both sides of the aisle know they need to cut entitlements like Medicare/Medicaid and Social Security, the two biggest line item expenses in the federal budget, or eventually face the serious risk of default. But, making the necessary cuts could cause them to not get reelected, so they continue to kick the can down the road for future politicians to take care of. The problem is that eventually you run out of road and these issues will have to be dealt with. Currently the U.S. is hitting its debt ceiling limit of $14.3 trillion in national debt. More worrisome, and rarely reported, is our unfunded liabilities (Medicare and Social Security) which totals $114 trillion! (www.usdebtclock.org) With federal, state and local governments collecting about $5 Trillion a year I don’t see how it is possible we will be able to continue to pay for the unfunded liabilities indefinitely, especially considering that they increase every year. I personally don’t see how America won’t be forced to break contract and cut entitlements regardless of the political ramifications.

Most developed countries are faced with large budget deficits and huge debt loads. As a result they are forced to cut spending usually resulting in cuts to entitlements plus raising some taxes. Although necessary and healthy for the long-term these political moves can cause an already slow economy to slow down further potentially pushing developed countries back into a recession. The U.S. is on a similar path and is faced with the same difficult decisions so it is important for us to keep an eye on the current debate over raising the debt ceiling and watch our elected officials debate over spending cuts and raising taxes. Although I’m not confident that they will make the necessary cuts this time around I do believe they will avoid a default and I also think that there will be some seeds planted for future budget balancing efforts.

In economics the debt-to-GDP ratio is one of the indicators of the health of an economy. It is the amount of national debt of a country as a percentage of its Gross Domestic Product (GDP). A low debt-to-GDP ratio indicates an economy that produces a large number of goods and services and probably profits that are high enough to pay back debts. Governments aim for low debt-to-GDP ratios and can stand-up to the risks involved by increasing debt as their economies have a higher GDP and profit margin.
Source: (http://en.wikipedia.org/wiki/Debt-to-GDP_ratio)

Gross domestic product (GDP) refers to the market value of all final goods and services produced within a country in a given period.
Source: (http://en.wikipedia.org/wiki/Gross_domestic_product)

As you can see in the chart above more than half of the top 22 countries in the world are developed countries with debt to GDP ratios of greater than 70%. Countries with ratios over 90% over history have shown slower growth than countries with sub 90% GDP ratios.

Source: (http://en.wikipedia.org/wiki/File:International_Comparison_-_Healthcare_spending_as_%25_GDP.png)

The above chart illustrate the amount of spending in healthcare (most countries largest entitlement cost) as a % of GDP. All of the top countries on the list are developed countries.

Emerging Markets
In countries like Brazil, China, India, Turkey, Thailand, Indonesia, Vietnam, Chile, Columbia, Peru and other emerging markets and even two developed countries Canada and Australia these countries face a different set of problems. These countries and their respective populations are living in the euphoric state of housing bubbles and perceived unlimited credit. Prices for almost all goods in these countries have been increasing at unsustainable rates, most notably housing prices. The common themes of these hyper growth economies which have become problematic now, after years of unsustainable growth rates, is high levels of inflation and high levels of debt from the citizens of these countries, not the federal level like the domestic economies are experiencing.

These countries are following in a very similar path to the developed markets pre-2007. The growth of most emerging economies and their respective housing prices merely took a brief pause in the financial crisis of 2008 only to resume their unsustainable growth paths soon after. The populous is borrowing at levels that are unsustainable and governments have encouraged lending institutions to lend to the poor. Lending institutions in most of these countries have loaned to those with poorer credit qualities, lengthened their loan terms and made them more creative…sound familiar? All is “fine and dandy” until housing prices stop going up. Then people can no longer continue to borrow and spend, because falling home prices mean less equity which means financial institutions will tighten up and stop lending out of fear of increased defaults, the result is a downward spiral which causes the economy to slow down possibly even contracting and potentially even deflating.

Up until now prices have continued to rise and that encourages the populous to remain in a euphoric, complacent state until eventually all the credit is tapped out and the prices of the assets that back the loans start to fall. But, as their housing prices have continued to increase so have the consumption of these emerging market populations causing their economies to grow just like America’s economy grew up until 2007. When your house and your investments are going up you feel richer and you spend more, this is called a “positive wealth effect”. But, when the opposite is occurring and your home value and investments are declining you tend to spend significantly less even if you are still making the same amount of money from your income this is called a “negative wealth effect”. Your spending is based more off of emotional forces than actual realities. That is why I believe that even though these emerging market economies are booming right now all of that can come to a screeching halt and even reverse and contract if housing prices start to fall and consequently consumer spending slows.

Sooner or later these housing bubbles along with their consumption bubbles will pop and I feel strongly that it will be sooner rather than later. The reason I believe that the bubble will pop soon in the emerging market countries is because of the combination of the following: High debt loads of the populous, low rental yields and irrational price expansions in recent years.

As you can see in this chart credit has exploded in Brazil since 2005, this is similar to other emerging market nations. This shows the high amount of debt that consumers are taking on.

In Brazil, consumers’ debt service burden is now at 24% disposable income as compared to the U.S. in 2007 at 14%, according to Paul Marshall of Marshall Wace, a London Based Investment firm.
Source: (http://www.globalpropertyguide.com/Latin-America/Brazil/Price-History)

As you can see in this chart, annual price increases of new apartments were growing at rates above 10% per year from 2000 to 2005, then they took a brief pause from 2005 to 2007, but from 2007 to 2010 they have skyrocketed to 30% annual increases, which most experts would agree are not sustainable growth rates, but rather the parabolic increase that usually occurs prior to a bubble bursting.

Rental Yield is a measurement of value for real estate. You simply take the monthly rent x 12 to come up with the annual rent and then divide that by the price. A fair value would be considered 7-8% anything below 7-8% is considered overvalued and anything above 7-8% is considered undervalued. Although rental yields in Brazil seem to be fair valued, rental yields in Rio De Janeiro, Brazil’s hottest market are below 6% on average. As you can see most of the above rental yields are closing in on 3% which would be considered extremely over valued using this measurement. Rental yields in the U.S. got to the 3% level in 2007 before housing prices crashed.

Going Forward
Both developed nations and emerging market nations face completely different sets of problems; yet the ramifications for both would have ripple effects across the whole global economy. As money managers we must pay close attention to the macro developments so we can try and navigate through the upcoming years in the stock and bond markets. As we try and gauge the current environment we have come to the conclusion that what’s most important right now is to manage the major potential downside risks as the economies around the world battle their monumental problems. Our first objective in managing money in normal times is to manage risk first and avoid large losses. In times like these that effort is stepped up even further. We have increased our cash reserves on average across all of our client accounts and have focused on investments that have a history of holding up better in bad markets. In our actively traded accounts we are holding even higher levels of cash and have focused on “safe haven” types of investments. Safe haven are ones that have historically gone up when the market has gone down. The specific stocks that we have bought into recently are ones that have shown great value compared to the rest of the market. Going forward we plan on maintaining our defensive posture until either the markets take a significant pullback and valuations are brought back in line or the macro picture starts to improve. The biggest detriment to respectable long-term returns is taking a large loss. There are times where you should be aggressive and opportunistic and try to take advantage of increasing stock prices, then there are also times where you should play defense and avoid taking too big of a hit. We believe the current environment is the latter.

Allgen’s Investment Approach
Allgen specializes in active and strategic money management. Through technical and fundamental analysis, along with a contrarian mindset, we strive to successfully navigate the markets during periods of prosperity and decline. We constantly research and study the markets to find the next emerging area even in asset classes that are typically not used in your “buy and hold” asset allocation portfolios. When we invest for

Allgen’s clients there are two main objectives:
1) Manage Risk First – Preserve capital and avoid major losses
2) Produce superior risk-adjusted returns over a full market cycle (Bull and Bear Market)

If you want to see how Allgen’s money management may help your investment portfolio then please email us at advisors@allgenfinancial.com or give us a call at 1-888-6ALLGEN (625-5436).

Written By:
Jason Martin, CFP®, CMT
Senior Partner & Chief Investment Officer
Allgen Financial Services, Inc.
martin@allgenfinancial.com
888.6ALLGEN