With the shortened holiday week, one would expect the global investment and geoploitical environment would be somewhat calm and uneventful. As most of us were eating our turkey and enjoying time with our friends and family the rest of the world was dealing with artillery shells, bankrupt governments, a dismal housing environment, and the prospects of a slowing economy. The financial markets in the US were down nearly 1.5% last week, as tensions in Korea continued to worsen, and another round of European bailouts took center stage. To make matters worse the US housing market continues to decline and the Federal Reserve believes the US economy is at risk of future deflation. Just two short weeks ago the stock market was at its highest level since Lehman Brothers collapsed in the Summer of 2008, and corporate profits were at record levels. The financial markets, however, are only concerned with the future and how current geopolitical and financial events will affect corporate profits. Hence, the reason why equity markets are declining.
The financial situation in Europe remains one of the biggest uncertainties surrounding the equity markets. Ireland's banking and sovereign debt issues may only be the tip of the iceberg. With an increasing amount of uncertainty within the 27 countries of the EU, it is extremely difficult to isolate which countries are in fiscal duress. As a result, Europe's trading partners are becoming more reluctant to do business with them for fear of default and currency devaluation. This will undoubtably create an overall slowdown in domestic output and possibly create another global recession. The European Union may be in worse shape than the US mainly because each country does not have the power to manipulate its currency or the ability to print money in order to offset weak global demand.
The situation in North and South Korea only adds to investor's uneasiness. Needless to say the tension in the Yellow Sea should not be any surprise nor should it directly cause investors to worry of an all out global war. North and South Korea have been fighting since the 1950's, and their disagreements have only steadily gotten worse in the past decade. The issue investors should be concerned with is how China and United States defuse the current conflict with its respective allied countries. Both the US and China, have no desire for these two nations to elevate their conflict to a global scale. Therefore, diplomatic solutions should prevail.
The United States housing market continues to contract, with existing home sales down 8.8% last month putting more downward pressure on home valuations. The latest data from the US Federal Reserves states that 1 and 7 home owners have negative equity in their primary residence. Moreover, lenders are increasing the rate of foreclosures which is estimated to exceed 1.5 million in 2011. With the unemployment rate near 10%, and an earnings cycle that may have peaked last quarter, its no wonder the Fed is concerned about future deflation.
We remained defensive in our overall investment strategy, with varying maturities of our market hedge. The high overall valuations in stocks, commodities and foreign currency, lead us to believe the balance of risk in the short-term is once again characterized by a day to day risk on or risk off environment. Even though the bullish percent index has contracted from its lofty levels of just three weeks ago, investors optimism still remains stubbornly high. Again, It is important to note that because the financial markets are at such lofty levels relative to just a year ago, any negative surprise within the geopolitical environment will cause dramatic sell-offs with in risky assets. Therefore, we continue to remain cautious going into the end of the year.
