We expect the challenges investors will face in 2012 will be as formidable as last year. As we look at our economy, the capital markets, and our political environment since the Financial Crisis of 2008, it seems we still haven’t addressed the big issues; and, it appears we don’t have much of a plan to address these issues in the near future. So, with a pragmatic sense of the current environment, we offer three general themes for 2012:

1. Our economy is deleveraging which raises unique challenges for investors;
2. Traditional monetary and fiscal policies are running out of ammunition;
3. The structural problems imbedded in the economy and capital markets, which include the political environment inWashingtonDC, will hinder economic progress.

The single biggest risk to the rate of economic growth in this country is the debt burden of the federal government. It took 228 years for our country to achieve $7 trillion in federal debt. It only took us the last seven years to double it to $14 trillion.  Like Europe andJapan, we have reached the limit to how much debt we can assume and we lack the courage to address the problem effectively.

There is a difference between an economy that is in a recession and one that is deleveraging. An economy that is deleveraging is plagued with benign growth, dismal credit expansion, and low demand. In a recession, banks loosen lending standards to extend credit which stimulates growth. In a deleveraging, credit remains tight as banks focus on increasing capital levels. Domestically, we have not experienced the pain of a sustained deleveraging since the 1930’s. The process will likely last the better part of a decade and will be complicated by the lack of consistent financial regulation. We expect the backdrop of deleveraging will be a constant theme for developing investment strategies and assessing relative value in the capital markets.

Since the Financial Crisis, we have recognized there are structural problems that exist in both the economy and the financial system. We believe that these structural problems are so powerful and deterministic to the performance of financial assets that we need to break them out separately to better assess risk and return. By reference, in last year’s Economic and Capital Market Outlook | 2011, we wrote:

…we believe that the inherent risks to investors are deceptively high in today’s markets given the extended government intervention in our capital markets, the huge budget deficit, the muted outlook for job growth and the lack of business formation that currently exists. The Fed is hopeful that the economy can grow its way out of these excesses and generate enough demand to drive tax revenues and consumption to absorb the slack resources in the system. Our concern is that a massive global debt crisis has already formed and, left unaddressed, will ultimately threaten the fragile economic recovery that is taking place.  Thus, our investment theme for 2011 is again focused on conservatism and principal preservation and less on extended risk strategies.

As we look at 2012, our view remains consistent with last year’s. We are cautious on the fragile state of theU.S.economy and believe that some markets are not pricing risk efficiently due to the Federal Reserve’s intervention. We are in the throes of a global debt crisis and world leaders have not been effective in addressing the problems. And, we believe volatility will remain at last year’s escalated levels.

Gregory J. Hahn, CFA

President & CIO

Europe is center stage in the current chapter of the global debt crisis and is facing its biggest challenge since World War II. With an agreement to write Greek debt down 50%, and the country taking its sixth installment of a bailout, Prime Minister Papandreou has stepped down. Shockingly, now we find that Italy has too much debt and, in order to fix their fiscal problems, their Leader Silvio Berlusconi should step down as well. Truly, there is nothing that we have learned today, that we didn’t already know yesterday and frankly we didn’t know at the beginning of this year related to the European debt crisis. Europe has too much debt. The United States has too much debt. We are living with the consequences of years of global excess consumption that will ultimately require austerity which will lower the standard of living in developed countries. This recent Investment Perspective A Context for Understanding the Global Debt Crisis attempts to provide a context to develop investment strategies and help navigate these volatile markets.

Democracy and Capitalism

At its most basic level, democracy and capitalism go hand-in-hand. A true democracy allows liberties and freedom for its citizens including freedom of expression and religion. A fundamental principal that supports a democracy is that we have a common set of rules that everyone understands and agrees to live by. By way of a simple example, when we get a speeding ticket in the United States we pay a fine to a municipality because we broke the rule. However, in some countries when you are pulled over by the police, you pay them directly – that is an arbitrary corrupt enforcement of the stated laws which is inconsistent with true democracy.

In a democratic society, capitalism is the engine that drives economic growth. There are two fundamental tenants for capitalism to work – a strong and healthy financial system and a set of rules that everyone understands and agrees to operate by. With a strong financial system and common rules we have the confidence to deposit money with banks, extend credit, and to make investments which further grow the economic base. However, the Financial Crisis of 2008 resulted in severe erosion in the confidence and strength of our financial system and revealed that the opaque set of rules in the capital markets and banking system was not effective in protecting businesses, consumers, savers, and investors.

And, with the deterioration in the credit quality of our banks, and the uncertainty to what regulatory reform for the financial system will look like, the banks have been unwilling to consistently extend credit to small and mid-size companies. This has two important consequences. First, without the expansion of private credit in our economy it will be nearly impossible to experience sustained economic growth. And second, the banking system is no longer an efficient means for the Federal Reserve to implement monetary policy. As a result, the Federal Reserve directly invested $2.5 trillion to purchase mortgage-backed and Treasury securities in the open market.

How did European Countries get into their current debt problems?

While they are democratic societies today, immediately following World War II many European countries, including France, Italy, Czechoslovakia, Belgium, Sweden and Norway were rooted in socialism. The socialistic government put a high priority on a state controlled economy with the government providing for its working class citizens. This included a job with a reasonable wage and health care benefits. After the cold war ended, western European socialists were pressured to reconcile their socialist economic programs with a free-market-based communal European economy. Up to this point the government took care of its citizens; yet, many countries never moved away from this premise as they moved further into a free market economy.

In 1992, European countries entered into the Maastricht Treaty which paved the foundation for a common currency, the euro. In essence, each participating country gave up its currency and pledged to abide by certain rules including limiting a country’s government deficit to 3% of its Gross Domestic Product (GDP). The European Union provided only for a common currency, not a common form of debt. Each country issued its own debt. Now, let’s fast forward to 2008 and the Financial Crisis. As the global banking crisis spread through Europe, member countries were forced to inject capital into their respective banking system. However, in some cases the size of the banking system, including Ireland and Switzerland, was bigger than the GDP of the entire country. In essence, the capital infusion by each government resulted in the debt burden of the banks being transferred from the individual banks to the tax payers.

While the Greek banking system is relatively small by comparison, their poor fiscal management and excessive pension benefits compounded their growing debt problems. By 2009, the world realized that the disclosures of Greece with respect to its debt and the European Union’s oversight of compliance had proven ineffective. Greece simply ran out of money first.

Why can’t the European Union effectively resolve its debt crisis which has been going on for over two years?

The Maastricht Treaty was essentially limited to the establishment of a common currency for its member countries. The European Union did not set up a mechanism to effectively deal with the deleveraging and insolvency issues related to its member countries. As a result, each country has had to go back to their respective governments and get approval for the recommendations to deal with the growing problems related to the weakening banking system and the necessary bailout of Greece. The process of recognizing the problem, developing a plan to fix the problem, developing a consensus around the plan, and getting member country approval has taken two years. Unfortunately, the plan to bail out Greece, prop up the European banking system, and build confidence in Europe’s capital system is still incomplete and ill-conceived.

Why is there concern about the solvency of Europe’s banks and how does that impact the growing debt crisis in Europe?

Arguably, the different members of the European Union have various forms of democracy and socialism today. But, remember that democracy and capitalism go hand in hand. And, capitalism requires a solid financial system to instill confidence. One of the problems for the European Union is that the largest holders of its member’s sovereign debt are the European banks. Thus, any impairment in the bonds of Greece, Italy, Ireland or any other Eurozone country is a corresponding hit to the capital of the bank. The consequence of deleveraging is that impairments on loans need to be realized and the result is pressure on capital ratios as bank balance sheets shrink.

In general, relative to the United States the European banks have always been more leveraged and more lenient from an accounting and regulatory standpoint. Regulators in Europe ordered banks last month to increase core capital to 9 percent of risk-weighted assets by the end of June 2012. The banks, which are now facing a 106 billion-euro shortfall in order to hit the 9 percent capital target, are reluctant to plug the gap by cutting dividends or bonuses and are struggling to sell assets or raise cash in rights offerings.

Given the reduced options that the European banks now have to support capital, the regulators are allowing a practice known as “risk-weighted asset optimization,” which allows banks to boost their capital ratios without cutting lending, selling assets or tapping shareholders. Effectively, the banks can increase their capital by changing how they calculate risk-weightings (the probability of default lenders assign to loans, mortgages and derivatives). While the banks are required to submit their models to the regulators once a year, they don’t have to disclose them publicly, and risk- weightings for the same assets vary among banks. The use of these financial gimmicks will erode confidence and prove ineffective in containing the crisis. As a result, the banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.

What will happen to the European Economy and the Euro?

We believe that the real cost of the Eurozone bailout, including both sovereign debt and bank capital, is in excess of 2.5 trillion euro. To achieve this will require a level of austerity that brings spending down, targets a budget deficit that is closer to the original target of 3 percent, and brings the total debt to GDP below 100 percent over a reasonable time frame without gimmicks. The most likely result of these austerity initiatives will be a severe recession that will impair credit expansion, consumption, investment and business growth. And, while it is conceivable that the collective Eurozone economies could “grow into the problem” and through economic growth generate revenues that would support the demise of the debt burden – we would bet against that ever happening. The most current GDP growth assumptions from the International Monetary Fund only have the economy of Greece contracting in 2012. We believe the IMF expectations for European economic growth are overstated.

We expect that the euro will survive; however, it will likely exist in a different form five years from now. Clearly, we can see today that Greece would not qualify to be in the European Union. While it is impossible to predict, we expect the European Union will likely be constructed differently over the next decade. The journey through debt reduction and austerity will embolden the Eurozone leadership to expand the governance structure of the Euro which may ultimately include Euro-denominated debt. Consequently, we expect to see another Treaty over the next three years that would address many of these issues.

October 11, 2011

As we move into earnings season, we believe the two key drivers to financial market direction today are the problems in Europe and their inability to deal with Greece’s debt burden and the outlook for the U.S. economy. Soon, investor attention will turn to next year’s election campaign and what that means for entitlement programs, debt reduction, spending, and tax policy. However, a quiet cancer creeping through the capital markets is the disconnected process of financial regulatory reform. The combined effects of inadequate regulation of the financial industry will likely perpetuate many of the inadequacies that lead to the Financial Crisis, and ultimately may lead to further severe capital market turmoil.

Financial Regulatory Reform

One of our main tenants for analyzing the capital markets and developing investment strategies after the financial crisis is that we need to see financial regulatory reform. More specifically, we need financial regulatory reform that has teeth and provides a set of rules that everyone in the financial services industry follows, and can deal with the complex securities and transactions that are prevalent in the markets. As capital markets and securities have become more complex over the past 15 years, the regulatory framework has remained largely untouched since the securities laws that were implemented following the market crash of 1929. After the Financial Crisis, Congress passed the Dodd-Frank Act, which provides a framework for regulatory reform; however, it requires that roughly 100 rules be written which will address some of the gaps in the financial regulatory framework. We are growing more discouraged by the slow progress toward financial regulatory reform.

The incremental changes in the capital markets that have occurred over the past decade which include the repeal of Glass-Steagall, the unchecked growth in the use of derivatives, the rapid electronic trading systems that now account for over 60% of the volume on the exchanges, and the pervasive misrepresentation within the industry of structured securities (which are not registered with SEC) to individual investors, in the aggregate have shifted the stability of our capital markets and financial system resulting in a “buyer beware” oriented market. Last month Reebok settled with the Justice Department for $25 million over false claims advertising its athletic shoes that tone your legs better. While the company has no proof of the claim, the company paid the fine, yet continues to stand by their assertions. Unfortunately, that illustrates the American business culture today – see if you can get away with it and deny it if you get caught. We believe that investors need the Consumer Protection Agency which was formed as a result of the Dodd-Frank Act to better protect us from the predatory practices that are still pervasive in the investment industry. Also, we believe that investors would benefit from all securities, regardless of their offering status, being registered with the Securities & Exchange Commission.

The Fiduciary Standard Initiative is De-Railed

Last month, the Department of Labor withdrew its recommendation for a consistent Fiduciary standard over the entire investment industry casting a cloud over the progress toward a higher standard of responsibility and accountability for the industry. Fiduciary duty is considered the highest standard of care at either equity or law. A fiduciary is expected to be extremely loyal to the person to whom he owes the duty, must not put his personal interests before the duty, must take responsibility for his actions and must not profit from his position as a fiduciary, unless the principal consents.

Right now, only Registered Investment Advisors are held to a fiduciary standard. All brokerage firms are held to a suitability standard, which only requires that what ever security be considered suitable for the individual client that it is sold too. So, for example, when the $200 billion Auction Rate Preferred securities seized up in early 2008 and investors couldn’t get their money out, many of the brokers that sold the securities and represented them as substitutes for cash landed in arbitration over whether the preferred stock was considered suitable for the client that utilized them as a cash vehicle based on the representations of the financial advisor. While the original proposal was aimed at returning to the original intent of the Employee Retirement Income Security Act (ERISA), the issues are complex. Raising the industry to a fiduciary standard could increase the costs and reduce access to investment advice. So, it appears that we are no further along.

The Volker Rule Gets Watered Down

Another area for concern is what has become known as “The Volker Rule”, named after retired Federal Reserve Chairman Paul Volker who assisted in the development of the rules following the Financial Crisis. A hotly contested part of the Dodd-Frank Act, the Volker Rule is designed to restrain banks from proprietary trading and curtail the abusive risk taking and conflicts of interest that resulted from trading for their own account. It is widely believed that a contributing factor to the Financial Crisis was the trading activities by banks for their own profit, and at the expense of their clients, by encouraging the bank to take excessive risks. However, with the help of financial service industry lobbyists, it has now become a political football. It is expected that the draft proposal to be released this month could allow banks to trade for their own account for “hedging purposes”. However, containing trading by defining the word “hedging” has been impossible for regulators since hedging a portfolio can pretty much allow for any type of trading activity by the bank. Also contributing to the delay in the release of the Volker Rule has been the turf war between the Commodities Futures Trading Commission and the SEC over whole should be governing derivatives trading. We believe that the passion for reform in this area is being diluted over time.

The Growth in Structured Products Raises Concerns

The growing use of structured securities in the wealth management industry is a significant concern since these securities are not registered with SEC, offer no transparency and have lock up clauses that restrict the distribution of funds at maturity under certain market conditions. As these securities are only offered to accredited investors, the sales practices surrounding these complex securities can appear dubious given the conflicts of interests.

A structured product, also known as a market linked investment, is generally a pre-packaged investment strategy that is based on derivatives transactions which are designed to replicate the movement of a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps. These structured products are underwritten predominantly by major banks, without any uniform standards and have no single, uniform definition. A feature of some structured products is a “principal guarantee” function, which offers “protection of principal” if held to maturity. But, be careful because the guarantee is often from the bank holding company, not the bank itself which puts the security in a subordinate position during any restructuring. Lehman Brothers, once considered a top tier investment bank, filed for bankruptcy three years ago. As a result, their structured products are effectively worthless.

Structured products are a huge source of profits for the banks because they take an asset management fee in addition to the profits earned on the derivative transactions. With the large profits and the promise of returns linked to an index with little downside, many of the major banks, including JP Morgan, Morgan Stanley and Goldman Sachs are selling these securities into their wealth management client base.

We are in a new paradigm for investors. In our view, the role of banks in the economy has changed, leverage in the capital markets is massive, financial regulation is not keeping up with the complexity of the markets, and the credit quality of the US government is deteriorating. In addition, the structural problems in our economy and capital markets are impeding business development and the expansion of credit. In our recent article The Downgrade of the United States we discuss the issues that may impact investors as a result of the deterioration in the credit.

1. Repurchase Agreements and Collateral Transactions.
   While there may be some initial pressure on the repo market, US Treasury securities are still some of the most liquid and safest investments in the world. As a result, we expect collateral transactions in the money markets backed by US Treasuries will remain stable over the near term. US Treasuries also are the primary collateral for the swaps and derivatives markets and given the unregulated nature of these transactions, we expect to see higher margin requirements over time. Higher collateral requirements will ultimately restrict credit growth which will negatively impact credit expansion and economic growth.
2. Interest Rates will Increase.
   We live in a world with government manipulated interest rates. With the deterioration in the credit fundamentals of the United States and the rise in the expected rate of inflation, a rational investor should expect the nominal rate of interest to increase. Yet, we have historically low interest rates.
3. The Marginal Cost of Credit will Rise.
   The deterioration in the credit quality of the United States is first and foremost a credit issue. US Treasury securities are used as collateral for all types of global securities transactions including credit derivatives, certain swap agreements and repurchase agreements. To the extent that any bank around the world requires a counterparty to post a higher level of collateral against a US Treasury position, we expect to see a marginal tightening of credit. As a result, we would expect over time to see higher interest rates which would further impair the expansion of credit, business development and economic growth.
4. Volatility will Increase.
   As we adjust to a new paradigm where the debt of the United States is rated AA+, we expect volatility will increase. Buy and Hold investment strategies will suffer in a range bound market given the low expected returns for cash and fixed income asset classes. Tactical strategies that take advantage of the dislocations in the market or changes in the value of risk should perform well if volatility increases.
5. Equity Prices will Remain Range Bound.
   We expect corporate earnings will continue to show strength; however, the structural problems in the economy will limit the incentive for business investment and employment growth. The downgrade of the United States will not immediately affect the earnings of Johnson & Johnson, Caterpillar and other domestic companies. However, until there is clarity to corporate tax policy, regulation and the solution to the global debt problem, management will focus on stock buy backs, dividends and their own compensation. Given the recent sell off, with the S&P 500 trading at 1220, we believe equities offer good relative value.
6. The Municipal Bond Market will Survive the Downgrade.
   A significant portion of the $2.9 trillion municipal bond market is prerefunded or escrowed to maturity with US Treasury bonds. With the downgrade of Treasury securities, these municipal bonds will also be downgraded. However, since most of these securities are held by individuals, we expect the downgrade to be a manageable event for the municipal bond market.

Well, we’re at the half way point for the year and time to reflect on investment strategy and the economic recovery and the overall health of the capital markets. This may be a little random so we apologize up front.

1. Measured by the S&P 500, stocks are up 5.01% so far this year. We are about to go into earnings season next week and we expect earnings on the S&P 500 to exceed $96. We are watching top line growth for indications on overall economic health and growth in demand. More on that in a minute. Corporate America remains extremely healthy. Operating margins will remain strong; however, will likely be negatively impacted by higher commodity prices. The dividend yield on the S&P 500 is 1.77% – better than the 1.75% yield on the five year US Treasury note.
2. Equity prices will be buoyed by an increase in M&A activity, increased share repurchase programs and increased dividend payouts. The Obama Administration believes that they have saved the business sector from near ruin three years ago but can’t figure out how to translate the improved earnings into tax revenue and job growth. Healthcare reform continues to inhibit job creation. Loans to small business are up 25% year-over-year. This will do more to stimulate the economy and create jobs.
3. We are looking for three things before we are bullish on financial assets including financial regulatory reform that has teeth, a plan to reduce the deficit, and a plan for the Fed to withdrawal its money from the capital markets.
4. Financial regulatory reform is taking too long. The SEC released new rules for derivatives this past week and so far we are under whelmed since they address disclosure requirements and counterparty due diligence (which should have been done all along). The process of financial regulatory reform is a proving to be a prohibition to increased bank lending as it is inhibiting loan growth, capital formation and business expansion. The uncertainty is forcing banks to hoard capital.
5. The plan to reduce the deficit is political sausage in the making. We expect ultimately both Republicans and Democrats will claim victory but any progress in reducing the deficit will be masked by a cloud of assumptions that ultimately will prove elusive. As a result, five years from now we will still be under the shadow of a huge debt burden trying to figure out how to reduce it without cutting spending.
6. And the Fed still hasn’t figured out how to withdraw its money from the markets without spooking the bond market forcing interest rates higher and negatively impacting economic growth. In the end, rising interest rates will compound the debt burden as higher interest expense curtails economic expansion. This is the “Keynesian Trap” and it will make the early 1980’s look like a time of prosperity in comparison (it wasn’t).
7. The bond market is offering investors negative real rates of return. In other words, the rate of inflation is actually higher than the yields on intermediate US Treasury securities. Yes, this is distorted. However, we’re going to be here for a while so be careful. This is another unintended consequence of the Fed’s low interest rate policies designed to stimulate increased economic activity and bailout the banking sector.
8. Ah, the banking sector. Bank of America announced an $8.5 billion settlement with investors covering its role in perpetuating fraudulent practices in creating and selling mortgage-backed securities leading up to the financial crisis. Bank of America will take a $20.6 billion charge tied to its acquisition of Countrywide, the embattled mortgage company that underwrote many of the troubled mortgages. So, Bank of America bought Countrywide for $4.5 billion in 2008 and has incurred $30 billion in charges and losses on the Countrywide acquisition since it closed the deal. And, the executives still make millions of dollars.
9. We believe the economy is not going to roll over in the second half of the year but approach stocks with a caution. We remain opportunistic. It is hard to convince ourselves that bond investors are compensated for taking risk out by extending out the yield curve. still, bonds play an important role in diversifying a portfolio today given the global challenges investors face.

1. US Stocks had one of the biggest one day rallies of the year yesterday as the markets anticipated the result of Greek Parliament’s confidence vote.
2. Greek Prime Minister George Papandreou’s victory in a confidence vote bolsters his new government’s chances of pushing through austerity measures to secure further international financial aid for the country.
3. However, there still is not a consensus on a way forward to keep Greece from defaulting on its debt next month.
4. The International Monetary Fund controls the purse strings and wants to continue to provide financial assistance. However, unless the European Union can come up with concrete assurances on financing for the next year, the IMF is not expected to disburse any funds.
5. In addition, several members of the EU would like to see the private sector take a hit to principal in the restructuring of Greek debt which would effectively be a default.
6. Greece won’t be able to pay wages and pensions after July 15 if the government doesn’t secure the EU financing, government spokesman Elias Mossialos said yesterday.
7. Every global financial crisis is spread through the banking system and Moody’s has place several of the largest banks in France on review for downgrade due to their large exposure to Greek debt. In turn, the money market funds in the United States have over $ 1 trillion in the debt of European banks effectively putting US investors at risk.
8. Greece will be a continual problem for the EU and the Euro over the next several years. Next up – Portugal…..then Spain and Italy. The problem is not going to fix itself. We would not be surprised to see the Euro currency reformatted within five years.