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Crisis of Confidence

“How did you go bankrupt? Two ways, gradually, then suddenly.” So wrote Ernest Hemingway in The Sun Also Rises. It is an apt lesson for our times. A profligate borroweqr can pile up debts for a long time but when lenders have a crisis of confidence, the jig is quickly up.

Creditors around the world are nervous. In the Eurozone, Greece, Ireland and Portugal have effectively gone quickly bust after years of piling up debt. They can no longer raise money in the capital markets leaving them dependent on other Eurozone members to lend them money to pay their bills. In return, these countries have been forced to cut back government spending dramatically in an attempt to put their finances on a stronger, sustainable footing. The markets in turn are facing a crisis of confidence, not fully convinced that the Eurozone can be saved. Questions about the credit worthiness of Spain and recently Italy continue to roil markets internationally. European leaders are struggling to find a solution to the insolvency of Eurozone members.

In the US, the government faces its own crisis of confidence. To date, Congress has refused to raise the limit on government borrowing which by August 2 will cause it to run out of money to pay all its bills, including interest on government debt. This could trigger a default on US government bonds and close down parts of the government. Words like “catastrophe” and “disaster” are used to describe the possible effects on the economy. The US could lose its AAA rating and borrowing costs would rise, hurting the economy. Since the US has the economic capacity to borrow more and retain its AAA rating in the short run, the issue here is clearly a political unwillingness to reach a compromise. The markets and pundits generally agree that the borrowing limit will be raised by the deadline. A failure to come to terms would be received poorly.

Another area of concern for some is China. Critics worry that the country’s rapid growth has been fueled by easy money and lax lending standards. Even a modest slowdown in growth, they argue, would hobble the economy with an avalanche of bad debt. Since China requires high economic growth to meet the employment needs of a growing population, any significant setback could be politically destabilizing. So far, such scenarios are considered remote. But in a crisis of confidence, as Hemingway reminds us, events unfold quickly.

It has been an up and down year for the market so far. The S&P 500 registered a strong rally into May, followed by a nine week sell-off followed by a strong rally the week before the Fourth of July. Since then, results have been uninspiring. The S&P 500 is up 7.5% on the year as we write this note.

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Optimists argue that the market will improve in the second half of the year as the negative effects on the economy of high oil prices and the Japanese tsunami-related supply chain disruptions begin to ease. It has been estimated that these events shaved US GDP growth by 1% in the last quarter. Euro debt developments and the resolution of the US debt limit will be movers of sentiment, for good or bad. Weighing on investors' minds are the shockingly weak June employment numbers, which underscore the systemic imbalances that limit growth in Western economies and Japan. Meanwhile early corporate earnings reports suggest many corporations continue to enjoy strong profitability from operations outside the US, Japan and the Eurozone.

During the 2008/2009 panic, stocks traded like commodities driven by supply and demand rather than underlying cash flows and asset values. As fear and panic ran their course, cooler minds came to bear. Prices rose dramatically off the panic lows despite the fact that economic growth was depressed. We do not envision a repeat performance. Obstacles to strong economic growth are still to be dealt with. The housing market remains crippled, for example, and unemployment refuses to decline. The Euro crisis will drag on for years.

We note that non-financial corporations are positioned to do well. Valuations overall are modest; earnings and balance sheets are strong. It remains to be seen whether the market as a whole can continue to outpace sluggish US economic growth. Nonetheless, we expect it will be sensitive to economic and political developments. Given the state of affairs, we expect challenges ahead, perhaps even another crisis of confidence.

We have written before at some length of the attractive prospects for the development of domestic shale oil and gas. In the past few months, there have been a number of acquisitions of independent companies with strong prospective reserves. Most recently, BHP Billiton, the Australian natural resource giant, is acquiring Petrohawk for $15 billion. We expect further deals as oil majors anxious to build reserves buy out entrepreneurs who first identified the opportunity but who lack the resources to develop their properties.

Tom Herzig


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