Winter Solstice

In the U.S., daylight grows increasingly shorter until the end of the year, when the process reverses. The switch to slowly increasing hours of sunlight from the short dark days of December symbolizes the hope that is associated with the start of the New Year. Therefore, the Winter Solstice often brings to mind a time of reflection on lessons learned throughout the past year. The Investment Policy Committee has been reflecting on the market turmoil of the last year and working to put these lessons learned to use in the New Year.

The first six months of 2011 were filled with hope for an economic recovery and a false sense of security. The last six months of the year revealed how fragile the economic recovery was and the strong headwinds slowing global economic growth. As thoughts turn to the New Year, there is again hope of better economic times ahead. The U.S. has shown unexpected resilience in the last three months and there is much debate as to whether or not the U.S. economy is showing signs of strong growth for 2012.

We are not alone in advising caution when looking at the recent surge in growth. In November, economists from the Federal Reserve Bank of San Francisco released an updated assessment of recession risks through the end of 2012.* They conclude that the risk of recession remains high and may have actually increased throughout 2011. The economists found that the odds of a recession resulting from purely domestic factors peaks in the second half of 2012 with a probability of approximately 30%. When looking at purely international risk, the probability of a U.S. recession peaks at over 45% early in 2012. A combined measure of the two factors places the probability of recession at over 50% in the first half of 2012, declining to slightly over 30% by the end of 2012. In reflecting on their predictions it is important to note the source of the most risk is international and therefore the recent rosy U.S. data runs the risk of painting an overly optimistic picture.

Reflecting on 2011, it is easy to see the impact of the global economy on the domestic U.S. economy. The tsunami and earthquake in Japan caused large supply chain disruptions which contributed greatly to the slowdown in U.S. growth over the summer. Additionally the worsening European debt crisis created headwinds throughout the fall that constrained U.S. growth. Reflecting on the situation a year ago shows the promise of U.S. growth, but a troubled European economy. On November 28, 2010, Ireland joined Greece in accepting bailout loans from the European Financial Stability Facility. By May, Portugal also needed assistance and accepted help on May 3. Since then the European community has proposed many solutions which have been received by equity markets with mixed results. Looking at the volatility of S&P 500 illustrates this. In the last ten years there have been 42 days where the S&P 500 gained more than 3% on a given day and 44 days that it lost more than 3%. During 2011, there have been 3 days of gains over 3% and six days with losses of over 3%. All nine of these days occurred since August 1, 2011. Thus, there has been a 3% swing in over 9% of the trading days since August.

The natural question to ask is whether the crisis in Europe has improved and what is the potential impact of the crisis over the next year. The Investment Policy Committee believes that while the headlines have recently improved slightly, this improvement may only be a temporary pause. Much of the economic data coming from Europe signals a recession for much of the continent. If this occurs, it makes the sovereign debt crisis worse. The recent downgrade of many EU members by S&P is a reflection of the increased risk and the markets have also taken note. In early November, yield on long term debt issued by Italy crossed the 7% level. It was this same level that caused concern for Greece, Portugal and Ireland. As the third largest economy in the EU, Italy represents a much greater risk than the countries who have already accepted help. Recently there have been many reports of scenario planning by financial institutions focusing on the potential impact of the end of the Euro. While we believe this event is unlikely, the fact that institutions are considering its potential impact is a sign of concern.

Looking at the domestic economy, the recent increase in consumer sentiment, and strength in retail sales are a positive note for the short term. However, there are four major components to U.S. gross domestic product: consumption, business investment, government spending and net exports, and for growth to remain positive, all four components need to be functioning well. With the fiscal issues in Washington and decreased tax base for many state and local governments, it is unlikely that there will be fiscal stimulus and growth in government spending to propel the U.S. economy forward. What’s more, the European debt crisis has resulted in a strengthening dollar, decreasing the attractiveness of U.S. exports and limiting the potential positive impact of trade on growth.

That leaves growth in the hands of the U.S. consumer which is why the recent data have been received so positively. While the holiday shopping season appears to be very strong and there was growth in sales prior to the holiday season, it is too early to tell if the recent strength of the U.S. consumer is a short lived result of pent up demand from the summer or a true sign of changing long term consumer attitudes. While reflecting on the past year, it is important to note that it was just in August that U.S. consumer sentiment bottomed out after a dramatic two month drop. The recent growth has not returned us to the levels of confidence we had in June and only time will tell if the U.S. can ride the coat tails of the consumers to a prolonged period of growth.

Based on these concerns, we are lowering our exposure to both European debt and equities. However, the Investment Policy Committee is not yet ready to declare that the worst is behind us and make a dramatic move back into U.S. equities. Therefore, we are placing funds raised from selling our European debt exposure into cash or cash equivalents and only funds raised from selling our European stock exposures into domestic small and mid cap stocks. We will continue to look for signs that the promising developments at the beginning of 2012 are true indicators of a time for action. If you have questions about this article, please contact our office at (515) 422-9040.

Investment Policy Committee

*Future Recession Risks: An Update. Travis Berge, Early Elias and Oscar Jorda. Federal Reserve of San Francisco Economic Letter 2011-35. November 14, 2011.