Centre Street Cambridge Corporation

Private Investment Counsel


July 2012

Europe, the seat of great empires ancient and modern, which carried its languages, religions, and customs to imperial outposts around the world, is now viewed with wonderment and frustration as it threatens to become the locus of a worldwide financial conflagration. The group of “Old World” countries constituting the Eurozone finds itself facing challenges involving heavy debt loads, falling property values, weak banks, and slowing economies, but without possessing the overarching governmental mechanisms present in nations such as the U.S., which enabled a much more rapid and decisive response to the financial crisis of a few years ago. Unfortunately, the longer corrective measures are delayed, the more intractable and costly the problems become, and the higher the probability of the common currency breaking down. Already we have heard anecdotal reports of people in countries most impacted by the recession being reduced to bartering for goods, and in some places farmers have had to take steps to protect their livestock from slaughter at the hands of nighttime raiders, and their produce from theft. Add rising unemployment—especially among the youth in the southern European periphery (it has reached 30%-50% in countries such as Spain and Greece)—and the situation becomes potentially explosive.

While the prospect of human suffering in Europe is disconcerting, our own immediate concern is with the financial implications of a weakening Eurozone, or even its potential collapse. Fears of that possibility produced some unusual financial market behavior in recent weeks. Germany, Europe’s bastion of economic strength and fiscal probity, sold two-year maturity debt with a negative yield; buyers were in effect paying the German government to keep their money in a safe place. In the U.S., ten-year treasury securities traded at record low yields of less than 1.5%; you’d have to go back to World War II with its economic regimentation and price controls to find anything like it. Clearly, this is an unusual environment. While partly attributable to the deliberate policy of central bankers to keep rates low in response to the European crisis, and poor employment figures in the U.S., a slowing global economy and the “flight to safety” phenomenon are contributing factors. While there is no way of knowing how long this situation will continue, ultimately crisis conditions pass and normalcy returns. We have little doubt that in time, buying securities that offer little hope for any real return will appear to have been pretty foolish. But financial distress and panic often lead people to do silly things, such as paying high prices for comfort and “safety.”

The action in equities reflected both hopes for resolution and fears of irresolution with respect to the world’s—particularly Europe’s—problems. After a first quarter for the record books, stocks gave up almost all of their year-to-date gains by early June, and then bounced in an advance punctuated by relatively sharp gains or selloffs. The “risk-on/risk-off” (Newspeak for “stocks fluctuate”) mentality of market participants reacting to each news report out of Spain and Greece was clearly evident. There were other noteworthy concerns; a possible “fiscal cliff” of tax increases and spending cuts loom in the U.S. at year-end, unless the politicians who created that precipice find some way to avoid it. Then there was the reality of slowing economies everywhere—Europe, China, South America, the U.S.—which deflated earlier hopes for more robust global growth this year.

Near the quarter’s end, hopes for additional aggressive action on the part of the Federal Reserve were dashed when the central bank announced only a continuation until year-end of its “operation twist” policy of extending the maturities of its bond holdings, instead of a third, full-fledged quantitative easing program, or “QE3,” that many in the markets expected. The continued dithering among European leaders also impacted stocks. After the unusually strong first quarter we suggested that the balance of the year would either be extraordinary, or a time to try men’s souls. So far our forecast is spot-on.

Nevertheless, the popular averages did not do too badly at all—hope springs eternal, perhaps, or more proof, if it was needed, that markets are inherently unpredictable. It was also a tribute to strong corporate balance sheets, dividends, low interest rates, and a lot of people controlling gobs of money with little else to do.

Whatever the cause, U.S markets led world stocks to their best June gains since 1999. While the averages saw modest second-quarter losses, the June boost and a record first quarter left the averages solidly positive since January 1. Our own S&P 500 index rose 9.5% year-to-date and a broader index of international markets gained 6%. The losers this year have been commodities, not so long ago touted as wonderful diversifying agents for anyone’s portfolio. Materials lost 9% on average. Crude oil is down 14% year-to-date, but speculators’ losses are everyone else’s gains, since lower energy costs provide a needed boost to the economy.

Deutschland Siegt, But is it a Pyrrhic Victory?

Europe’s political cartoonists are having a field day with Germany’s chancellor Angela Merkel. In some caricatures she has been pictured as a dominatrix dressed in garb resembling an imperial German military uniform, complete with spiked helmet—provocative stuff in a continent with bad memories of certain nasty episodes in the history of Germany’s dealings with its neighbors. Such portrayals probably strike a chord with many non-German Europeans, however. The country’s economic and financial power has given it a dominant position in European councils. Coupled with an uncompromising insistence on an austere and contractionary approach to dealing with Europe’s debt and competitiveness problems, it appears overweening and arrogant, especially to those on the receiving end of austerity.

Germany’s entry into the Eurozone proved to be highly beneficial to its economy. The Euro’s value relative to other currencies has been such to favor its exports to a greater extent than had it retained its old Deutschmark. (The Euro, incidentally, initially boosted the economies of countries like Ireland, Greece, and Spain as well, but with very different ultimate outcomes.) It is the country’s exporting prowess that has spared it, at least until recently, from the fate of economic sluggishness or recession afflicting much of the developed world. As long as Europe’s economy remained reasonably healthy, Germans were content with their position, especially as the European monetary authority policies were modeled on those of the Bundesbank, Germany’s conservative central bank. Now that Europe has entered a period of difficulty, Germany appears unwilling to accept the other side of the coin, namely the responsibilities and costs that come with membership in a currency union, particularly helping out weaker regions during times of distress. Such reluctance to take quick and convincing steps to shore up European economic activity may very well backfire, since fully 40% of German exports go to other members of the EU. Already the country’s economic statistics have begun to weaken.

To be fair, in return for their assistance, the Germans want greater control of national finances to reside in the EU, something the receiving countries have been slow to accept—but herein lies the crux of the problem. A country such as the U.S. might also be thought of as a “currency union.” Note the contrasts. When a catastrophe occurs (Hurricane Katrina, for example) national funds pour into the area to aid the local population and jump-start reconstruction. If a state or region suffers from economic weakness, its congressional delegation can propose a new military base, funds for new bridges and roads, etc., to “create jobs” and stimulate growth. It’s the political ties that bind us, overcoming regional cultural differences and objections to providing support for the “undeserving.” Ultimately such measures benefit the entire country via the stimulation of demand for goods and services.

It is these ties that are lacking in the European situation. For the most part we view ourselves as Americans, but the Germans, French, and other nationalities are not yet “European” enough to overcome different national perspectives or objections to helping the “profligate,” a complaint often heard in the current debate over southern European bailouts. Perhaps over time the “European Project” will evolve into such a union, but it is not the case now when it is sorely needed. So far, Germany’s fiscal and monetary conservatives have been winning the debate.

The announcements coming out of Brussels at the end of June with respect to the regulation of Eurozone banks and the recapitalization of troubled lenders were steps in the right direction, representing a move towards a centralized banking authority and promising to reduce pressures on sovereign borrowing costs in the European periphery. The markets responded in a positive fashion but remain “uncertain” and fragile owing to previous disappointments with European policymakers. While “Grexits” and a disintegrating Eurozone would not necessarily mean the end of the world, they would be extremely costly, so what happens in Europe continues to be a matter of concern. Already we have seen slower economic growth in the U.S., along with lower interest rates and falling oil prices. Though welcome in themselves, lower borrowing costs and cheaper energy are not unalloyed goods if they are the result of safety concerns or declining demand from a world economy brought low by a collapse in Europe. Given its own economic challenges and political uncertainty, the U.S. can ill afford such an outcome.


Dennis Butler, MBA, CFA