In BSW Blog, Economic Outlook, Emerging Markets, Portfolio Commentary

What do the Flagstaff fire slurry bombers, Operation Twist, and the European Financial Stability Facility have in common? Read on . . .

With forest fires recently visible from downtown Boulder and debt-fueled conflagrations in Europe, the summer of 2012 is shaping up to be one to forget. In many ways, the two situations are remarkably analogous.  The fires now plaguing the western US are largely the result of decades-long fire-suppression policies producing forests choked with a veritable tinderbox of desiccated underbrush.  By some estimates, 70% of US forest land is actually fire starved, as historically most forests experienced a mild burn-off every 15 to 30 years, an essential process of the forest ecosystem.  These days, as evidenced by the devastating events in High Park and Waldo Canyon, fire-starved forests burn bigger, faster and are very difficult (nay, impossible?) to contain cost-effectively.

Looking to Europe (and the United States), the same ill-conceived approach of forestalling sour medicine and opting instead for temporary fix after temporary fix has produced the weakest post-recession recovery in stock market history. From my perspective, Too Big To Fail Banks surviving on government largesse look a lot like sickly forests in desperate need of a cleansing burn. Just like those forests, if and when they do catch fire, the damage will be big, happen fast, and may now also be impossible to contain.

That said, despite the fires and heat we’ve endured in Boulder, life’s proverbial glass is absolutely half full as opposed to half empty.  Likewise, on the global stage, many (but not all) companies and individuals have stepped up, taken their required dose of sour medicine, and are now reaping the bounty of better times.  Indeed, as financial markets and economic growth figures lost ground during 2Q12, many commentators switched from ebullient to dour tones.  Are there risks?  Certainly. But is the global economy and recovery coming off the rails?  No – I don’t buy it.  To that end, below please find a summary of our view on the three biggest risks ahead, why we are still rationally optimistic as investors, how we are positioned, and year-to-date the BSW Diversified Growth portfolio results.

The Three Big Risks Ahead:

  1. Europe: While the results of the recent Greek election suggest that a “Grexit” from the Euro is not imminent, Greek’s upside down fiscal situation remains painfully unresolved.  Worse, the banking sectors of Spain and Italy have sent warning signals and their demise would certainly rock financial markets.  We have asserted for some time that, eventually, Greece will either leave or get kicked out of the Euro.  There’s no feasible way for Greece to cut their way out of debt. However, the price tag to Germany of letting the Eurozone collapse is equally infeasible. The most likely outcome is more piecemeal patch jobs and more muddling along with its concomitant volatility.  German politicians, despite their waffling, are more credible and competent than their American peers.
  2. US Fiscal Cliff: Unless current law is changed, taxes will rise by $600 billion while federal spending is cut by $130 billion – roughly 4% of GDP. Recall that this is the result of the Congressional Super Committee failing to reach a compromise agreement on spending cuts.  While I am usually a fan of the “cold turkey” approach, going over the fiscal cliff is akin to throwing someone in the deep end of the pool so they will “learn” how to swim. Better to start in the shallow end – and our odds still favor an 11th hour compromise that moderates the cuts and tax increases, albeit without strong conviction.
  3. Chinese Soft Landing: The three legs of the global economic stool are the US, Europe/Japan, and Emerging Markets.  But as goes China, so goes emerging markets (China is 30% of emerging markets GDP).  Many commentators have fretted about the slowdown in China – down from 9% GDP growth – and whether its nascent private banking system can sustain itself absent government stimulus and rampant construction spending (sound familiar?).  However, of the Three Big Risks Ahead, I have the most (which still isn’t much) conviction about a positive outcome here.  China will have a leadership transition this fall for which they will, in our view, do whatever necessary to ensure a smooth transfer without growth hiccups.  More importantly, China’s central bank still has room to move on rates and monetary policy.

Summary:

We hope this Portfolio Commentary provides you with better insight into your BSW Growth Portfolio and our economic and investment outlook.  If you would like to discuss these positions or your portfolio in greater detail, please don’t hesitate to contact BSW.  As always, we are happy to help.

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