Gale force winds are now blowing in from across the sea for both the U.S. economy and investment markets. After starting off the year strongly in 2012 Q1, the stock market is down over -9% thus far in the second quarter and has nearly surrendered all of its year to date gains. The sharp pullback is being driven by several factors.
First, the already sluggish U.S. economy is showing mounting signs of weakening back toward recession. Economic growth has been slower than expected in recent quarters and a variety of indicators have been falling short of expectations in recent months. Friday’s employment report was just the latest example, as the U.S. economy added only +69,000 net jobs in May, which fell well short of consensus expectations.
Also, the Chinese economy is also showing signs of deterioration. Economic activity has been decelerating for some time as both domestic and international demand continues to fade and inventory levels are rising. This growth deterioration is already having ripple effects across Asia as well as in the United States and Europe.
Lastly and perhaps most significantly, the debt crisis in Europe continues to descend toward full blown crisis. A variety of countries that share the euro currency including Greece, Portugal, Spain, Italy and even France are buckling under the weight of the rising cost to refinance their own debt. And some are unable to access credit markets whatsoever. The problems in the Euro Zone may soon be approaching a critical flashpoint when Greece holds elections on June 17. The current Greek government supports the required austerity measures to continue to receive rescue funds from the European Union. But if the upstart Syriza party prevails in the upcoming election, it is widely believed that they will reject the austerity program, which may ultimately lead to Greece’s exit from the euro currency. Such an event has a high probability of sparking a financial crisis both in Europe and around the world.
The impact of these forces highlights the advantage of broad asset class diversification beyond the stock market. While the above forces have placed meaningful downside pressure on the stock market, they have provided equally meaningful upside support to other categories. These include U.S. Treasuries and TIPS, Agency Mortgage Backed Securities, Municipal Bonds and the Japanese Yen currency. And although precious metals such as Gold and Silver have recently lagged, they also stand to benefit substantially from the developing economic backdrop.
Market activity on Friday highlighted the benefit of this broad portfolio diversification. Friday was by far the worst day of the year for the stock market with the S&P 500 declining by over 32 points or -2.5%. But Friday was also among the best days of the year for a composite portfolio that includes all of the asset classes above, as Gold gained nearly +4%, Silver rose +2.5%, Long-Term U.S. Treasuries advanced by +2.4%, and other categories such as Build America Bonds, Municipal Bonds, U.S. TIPS, Agency MBS and the Japanese Yen all posted solid gains between +0.1% and +0.7%. Thus, a composite portfolio containing all of these asset classes gained +0.5% or more on Friday when the stock market alone plunged -2.5% on the same day.
Looking ahead, June promises to be a critical month for investment markets. In addition to the Greek elections on June 17, the latest U.S. Federal Reserve stimulus program in Operation Twist is set to expire at the end of the month. And the stock market has performed poorly without the support of Fed stimulus in recent years. As a result, the upcoming Fed meeting on June 19-20 will warrant particularly close attention for any suggestions about further stimulus programs in the coming months.
In terms of strategy, portfolio allocations to stocks had already been meaningfully reduced ahead of the current correction in favor of many of the other categories listed above. And given the developing risks in the coming weeks, these stock allocations are likely to be reduced even further in the coming days in favor of more defensive positions that continue to perform consistently well. With this being said, if the economic outlook and the stock market sell off continues to accelerate to the downside, I will be watching closely in the weeks and months ahead for opportunities reestablish a greater allocation to stocks with the expectation that global central banks including the Fed and the European Central Bank are likely to launch fresh new stimulus programs in response to the situation. In the meantime, it is likely that portfolios will hold higher than normal allocations to cash, as such positioning provides the utmost safety during periods of unfolding crisis while providing the full flexibility to make tactical purchases following any major market sell offs.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.