Stocks declined modestly during the second quarter as investors in the United States turned their focus to the potential 2013 “fiscal cliff”. The fiscal cliff is a combination of tax increases and government spending cuts that will automatically become policy in 2013 if Congress does not intervene before year-end. This combination threatens to dampen growth for an economy that is still struggling to recover from the financial crisis. Many doubt that an already divisive Congress will revise these policies prior to the November election, leaving the decision to a lame duck session of Congress with little time for negotiation at year-end. The fiscal cliff is likely to be an ongoing source of debate, and volatility, for the remainder of 2012.
U.S. large, small and value stocks posted similar single-digit declines. Real Estate Investment Trusts (REITs) were a bright spot as investors sought out yield in an environment of low interest rates. REITs are required to pay a majority of earnings in the form of shareholder dividends so yields often exceed the level offered by other stocks. The highly-anticipated Facebook initial public offering debuted during the quarter; a lukewarm reception increased volatility within the technology sector. The NASDAQ, however, held on to double-digit returns for the first half of the year despite challenges.
Bonds posted positive returns as interest rates declined during the quarter. U.S. government securities continued to benefit from their status as a perceived safe haven in times of uncertainty. Despite ongoing concerns about the financial condition of municipalities, tax-exempt bonds continued to generate positive returns. Investors may conclude, at least for now, that taxes will be higher in the future and are therefore satisfied to assume the risks associated with municipal bonds in order to shelter income from taxation.
Foreign stocks declined during the quarter but held on to positive returns for the year-to-date period. Europe continues to be the lightning rod for investor angst. The continued threat of a global slowdown resulting from recession in Europe spread investor concern internationally. Export-dependent emerging economies, including China and the rest of Asia, were hardest hit during the quarter as Europe’s cold threatens to become exporting-Asia’s pneumonia.
At the end of the second quarter, stocks rallied when the European authorities announced an agreement to form joint oversight of the Eurozone’s banking system. A future banking union would be structured with three pillars including the supervision of all Eurozone banks by the European Central Bank (ECB), a deposit-guarantee fund similar to the FDIC insurance fund in the U.S., and a mechanism to liquidate failed banks. Though the development will be an incredibly complex and long-term undertaking, this is an important and long-overdue step to further unify the European financial system.
The European authorities were forced to address a banking oversight as Spanish bank Bankia teetered on the brink of failure. Bankia was formed in 2010 as a conglomerate of seven Spanish banks and is the third largest lender in Spain. The merger combined community banks that were heavily involved in lending to local real estate borrowers. With the Spanish economy suffering, real estate borrowers have been unable to repay their loans, resulting in large losses for the bank. Depositors learned of the bank’s losses, became concerned about the safety of their deposits, and began withdrawing funds. The process occurred rapidly and the potential for a full-scale bank run became a possibility.
The Spanish government, already having provided billions of euros in bailout funds to Bankia, couldn’t afford to continue alone and needed help from the European Central Bank. With no official oversight in place, the stronger European countries, particularly Germany, were unwilling to bailout the Spanish bank without some authority to regulate its future activities. A stalemate ensued, investors worried and Spanish borrowing rates rose to unaffordable levels. With such a vicious cycle underway, European authorities recognized that they must regain the perception of control even though solutions would be difficult and costly.
During the quarter, CNBC ran an interesting story that discussed the risks of “the street” taking control of Europe’s financial crisis. Street control happens when citizens perceive that government policy can no longer contain the problems associated with a crisis and take matters into their own hands. Citizens attempt to gain control via voting, social unrest, and more extreme measures that influence the financial system, such as staging a run on a weak bank. We have seen glimpses of “street control” over the past few years including the ouster of France’s Sarkozy, the near-run on Bankia and wide-spread protests in Europe. However, authorities eventually acknowledge citizens’ concerns and come together to show they are willing to cooperate on the most pressing issues of the day. So far, the credibility of the European authorities has been enough to quell the street’s fears. The European authorities remain in control of the situation and this perception will be imperative for the development of an ongoing resolution to Europe’s sovereign debt and banking crisis.
Just as the European financial crisis has evolved over time, solutions are likely to come over a period of years, not weeks or months. With positive returns in stocks for the first half of 2012, it is possible that investors have become willing to accept this long workout as long as the European authorities can maintain credibility and continue to develop – and implement – solutions that further the healing process. We continue to believe that foreign stocks are an important part of a well-diversified portfolio and long-term investors are best served by maintaining, and even adding to, investments in their portfolios that have underperformed. As history informs us, long-term investors are most often rewarded for buying investments when the prospects seem most bleak. We are always available to talk with you more about your foreign stock allocation in light of your overall risk tolerance.
Written by Colleen S. Supran, CFA, Principal; [email protected]
Key Economic Indicators
Key economic indicators compiled by Barbara A. Ziontz, CFP, Portfolio Manager; [email protected]
|Index||Market||Last 3 Months|
(04/01/2012 – 06/30/12)
|Year-to-Date as of|
|Standard & Poor’s 500||Large Co. U.S. Stocks||-2.90%||9.31%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||-2.20%||8.68%|
|Russell 2000||Small Co. U.S. Stocks||-3.47%||8.53%|
|Russell 2000 Value||Small Co. Value U.S. Stocks||-3.01%||8.23%|
|FTSE NAREIT Equity REIT||Real Estate Investment||3.72%||14.92%|
|NASDAQ 100||Technology Stocks||-5.06%||14.83%|
|MSCI EAFE*||Foreign Stocks||-7.13%||2.96%|
|Barclays Capital Aggregate||U.S. Dollar Bonds||2.06%||2.37%|
|Barclays Capital Municipal||Municipal Bonds||1.88%||3.66%|
|BofA Merrill Global Gov’t||Global Bonds||2.35%||0.17%|
Source: Thomson Financial’s Investment View; www.REIT.com
Source: DFA Quarterly Market Review (July 9, 2012)
Data Sources: The Wall Street Journal; US Dept. of Commerce – Bureau of Economic Analysis; US Dept. of Labor; Bloomberg.com; Live.Lehman.com; MSCI.com; REIT.com; NYTimes.com; StandardandPoors.com; Vanguard.com. ; Dimensional Fund Advisors
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