If a Domino Falls in the EU, Will the Market Remain Sound?

March 1, 2010

"Blessed are the young, for they will inherit the national debt." — Herbert Hoover (January 1936)

After ringing in the New Year with decent market gains, investors have been hit with a credit crisis hangover courtesy of varied foreign governments. The news that Greece had hidden its debt troubles reminds us of British author Jonathan Glancey's statement, "The pen is mightier than the sword, but no match for the accountant" (or in this case, the investment banker). The reason this Greek tragedy is important to North American investors is its impact on markets. In the days following public disclosure of Greece's budget scheme the S&P 500 Index declined more than 4%. Similar equity market declines occurred following Portugal's failed treasury auction in early February (selling only €300 million of €500 million offered), and Dubai's announcement late last year that it would seek to impose a standstill agreement on its creditors. More recently, concerns over a repeat negative jolt to the market were assuaged when Portugal's February 24th treasury auction ended fully subscribed. Yields, however, increased from 2.759% to 3.498%.¹

While these foreign economies are relatively small, the market's reaction to their impaired ability to rollover debt (typically a pedestrian endeavor) underscores how delicate the underlying economic recovery really is. In Dubai's case, neighboring Abu Dhabi's guarantee offer quelled the market's nerves. The panics over Greece's circumstances were hushed once Europe offered to provide unspecified support. Still, the risk of sovereign default remains an unpredictable aspect of the current recovery:

Unlike public companies, sovereign government accounts and financial circumstances are relatively opaque.
Sovereign debt crisis tends to be more of a surprise to markets than a bad corporate earnings report, and the consequences are much higher as risk perception rises across asset classes.
There may be an element of the domino effect at play, with one sovereign default triggering other sovereign defaults, increasing the risk of a double dip recession for several countries.

China Is Still In Love With the Dollar (But Past the Romance Stage)

One by-product of this fear within Euro Land has been the rally in the U.S. dollar. Despite President Obama's penchant for printing dollars, the greenback remains a haven in times of uncertainty (see chart at right).

This rally in the U.S. dollar has allowed China to reduce its portfolio of U.S. government bonds (see chart below). Some commentators have sounded the alarm over the change in Chinese investment policy suggesting it will trigger higher interest rates.² Yet, we note that the Chinese have long ago announced their desire to play the field and diversify their currency risk. This recent rise in the dollar has simply provided them the opportunity to reducetheir positions in U.S. denominated debt without risking their domestic currency subsidy. It's a virtual certainty that Chinese purchases of Treasurys will resume, especially given the risks in Euro Land. Why? They're addicted to it, and their exportoriented economy thrives on it.

The Fed's Low-Rate Party Drags On

Despite these uncertainties, the environment for equities remains modestly positive. Concerns about inflation are all but non-existent as evidenced by recent headlines: "Deflation warning bells ring louder" (CNNMoney.com, 2/19/10) and "Is Deflation About to Rear Its Head?" (Seeking Alpha, 2/26/10). The recent Consumer Price Index (CPI) release confirms this with Core CPI reported at a negative 0.1%. With economic growth expected to remain low and inflation tame, there does not appear to be a catalyst for a change in Fed rate policy. Indeed, the Fed remains committed to topping up the punch bowl well into 2010.

At a February 19 economic conference in Puerto Rico, New York Fed president William Dudley indicated that policy makers should remain focused on growth rather than inflation. Consistent with this view, an internal Saturna Capital research report recently suggested that unemployment is a larger factor in U.S. monetary policy than core inflation — supposedly THE key policy indicator. Accordingly, we are confident that Federal Reserve Chairman Bernanke will assure legislators that Fed rate policy will remain the same despite last week's 25 basis point increase in the discount rate³. With consensus unemployment expected to remain close to 9% for the year, it could be 2011 before we see a Fed rate increase.

Shrinking Credit Spreads Bode Well For Equities

S&P 500 vs. Investment-Grade Credit Costs

Also positive for equities is the decrease in credit spreads (despite the recent bad news out of Greece). Looking at investment-grade credit costs (as proxied by the Markit North America Investment-grade Credit Default Swap Index) relative to the S&P 500 Index, we find that equities have responded closely to changes in credit costs. This was particularly true of equities as credit costs increased from July 2007 until November 2008. Note that the right-hand scale of the chart below was reversed to more clearly illustrate their inverse relationship.

Yet while equities have rallied, they have not kept pace with the decreases in corporate credit costs. A good example of this can be seen by comparing corporate bond yields to dividend yields. For instance, the March 2014 Pepsi bond yields only 2.4% while the Pepsi stock has a dividend yield of 2.9%. Even high-yield instruments continue to perform reasonably well in these circumstances. While the news headlines warn about the increase in high-yield spreads, this recent change looks somewhat inconsequential when examining a longer dated time-series.

Investment-Grade Credit Costs vs. High-Yield Credit Costs

Insiders Are Buying Again

We also note that insider selling has moved from negative to neutral territory. Not something we're apt to write home about, but also a sign that corporate insiders are regaining a degree of confidence in underlying fundamentals.

While all these factors should be positive for equities, some warning signs suggest a cautious approach. The recent 42% decline in the Baltic Dry Index⁴ from 4661 on November 19, 2009 to 2714 on February 19, 2010 comes to mind. The high level of government indebtedness and the cavalier attitude of politicians toward spending is another concern. As former U.S. Senator Everett Dirksen is famously quoted as saying, "A billion here, a billion there, pretty soon it adds up to real money." But the biggest unknown that weighs on the market is the risk of an exogenous sovereign debt crisis, which would allow investors little warning or clarity. Consequently, current conditions make it especially difficult for investors to estimate what the market is discounting into stock prices. For now, the dominoes are still standing.

¹ See "Yield rises in Portugal 5yr bond auction," http://www.reuters.com/article/idUSLIS00230720100224) There was no resulting decrease in the S&P 500 Index, however, the auction was fully subscribed at the higher yield. The concern was whether or not the entire issue would be sold.

² China has been a prodigious purchaser of U.S. Treasurys, providing support for American deficit financing and depressing the value of the Chinese Yuan, thereby supporting their export-focused industries.

³ The spread between the discount rate and the federal funds rate has tended to average 100 basis points. With the current increase of 25 basis points, the spread has only risen to 50 basis points. It appears that the Fed is attempting to normalize credit relationships, but there is no indication of a change in monetary policy.

⁴ The Baltic Dry Index tracks pricing of bulk dry goods and raw materials shipments via the world's major ocean shipping routes.

Important Disclaimers and Disclosures

This report is intended only for the information of the reader, and is not to be used for or considered as an offer or the solicitation of an offer to sell or buy any securities or other financial instruments of any kind, including without limitation, any mutual fund or other product offered, sponsored, created, or managed by Saturna Capital Corporation or its subsidiaries or affiliates (“Saturna”). This report is not intended for distribution to, or use by, any person or entity who is a citizen or resident of, or located in, any locality, state, country, or other jurisdiction in which such distribution, publication, availability, or use would be contrary to law or regulation or which would subject Saturna to any registration or licensing requirement within such jurisdiction.

This document should not be considered as providing investment advice or services, or any service offered by Saturna. Saturna may not have taken any steps to ensure that the securities referred to in this report are suitable for any particular investor. Saturna will not treat recipients as its customers by virtue of their reading or receiving the report.

Nothing in this report constitutes investment, legal, accounting or tax advice or a representation that any investment or strategy is suitable or appropriate to a particular investor’s circumstances or otherwise constitutes a personal recommendation to any investor. Saturna does not offer advice on the tax consequences of any investment.

All material presented in this report, unless specifically indicated otherwise, is under copyright to Saturna. None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of Saturna. Unless otherwise indicated, all trademarks, service marks and logos used in this report are trademarks or service marks of Saturna.

The information in this report was obtained from sources Saturna believes to be reliable and Saturna believes the information and opinions in the material are accurate and complete as of the date of this material. However, information and opinions contained herein will change over time and without notice. Saturna has no obligation to update or amend any information or opinions at any time. Saturna makes no representations as to the accuracy or completeness of this material, nor does it have any responsibility to ensure that any other materials, including any containing materially different information, are brought to the attention of any recipient of this report.

Under no circumstances shall Saturna, its employees, or any affiliate, be responsible for any investment decision by any recipient. This material is distributed on condition that it will not form the sole basis for any investment decision by any recipient. Any recipient who is not a market professional or institutional investor should seek the advice of an independent financial advisor prior to taking any investment based on this report or for any necessary explanation of its contents.

Saturna does not provide tax, legal or accounting advice. Investors should consult their own tax, legal and accounting advisers before engaging in any transaction. In compliance with IRS requirements, recipients are notified that any discussion of U.S. federal tax issues contained or referred to herein is not intended or written to be used for the purpose of (A) avoiding penalties that may be imposed under the Internal Revenue Code; nor (B) promoting, marketing or recommending to another party any transaction or matter discussed herein.

Past performance does not imply or guarantee future performance, and no representation or warranty, express or implied is made regarding future performance. The price, and value of, and income from, any of the securities or financial instruments mentioned in this report can fall as well as rise. The value of foreign securities and financial instruments is subject to exchange rate fluctuation that may have a positive or adverse effect on the price or income of such securities or financial instruments. Investors in securities such as ADRs — the values of which are influenced by currency volatility — effectively assume this risk.

To obtain more detailed information, including investment objectives, risks, expenses and charges and the current prospectuses, please visit Documents & Forms or call 1-800-SATURNA. Please read the prospectuses carefully before you invest or send money. Distributor Saturna Brokerage Services, Member FINRA / SIPC.