May was the worst month for U.S. and world equities since markets began to recover from the financial crisis in March of 2009. The primary cause continues to be unsustainable levels of sovereign debt, particularly in Europe, with the newly elected leaders of Hungary hinting of a possible default last week. There is also growing concern that growth in China will slow precipitously as policymakers attempt to stem inflation arising from the massive government stimulus program instituted in November 2008. Both European and Chinese stock markets began declining before the U.S. with the Shanghai Composite the worst performer of the group. While Europe has performed only slightly worse than the U.S., the drop in the Euro means that dollar investments there have declined nearly 20% for the year. The following chart shows the performance of Chinese, U.S. and European equities along with the Euro currency since January 1st.
Worldwide economic growth has been fueled by emerging markets and Asia for the last couple of years. Fear of a slowdown in China has caused a decline in all commodity linked markets - from the Australian dollar to the price of copper - and could be a more significant factor for U.S. growth than the European debt issue. There has been some evidence that these factors have already started to affect us as last month's employment report was quite poor
. The unemployment rate remained elevated and the growth in private sector jobs, which had been accelerating throughout the year, was basically zero. Retail sales and consumer spending in general were also been less robust than they had been in the earlier part of the year.
The upshot of all this has been a flight to "quality", i.e. U.S. Treasuries. Despite record debt and deficits, our government bonds are still seen as a relatively safe store of value in times of uncertainty. We are the best of a lot of bad options. The chart below shows how U.S. Treasuries have gained in value as investors have fled more risky investments.
As many of you are aware we reduced our exposure to equities last month due to poor market technicals and sentiment. In the longer run, we feel that the developed nations will get their hands around their fiscal problems and that China, while essentially a black box that defies forecasting, has enough reserves, incentives and people to at least maintain some level of growth over the next few years. However, we recognize the risks of another dose of contagion in financial markets and we feel comfortable with a percentage of our portfolios in safer assets for now until markets show some stabilization or offer a lower point of re-entry.
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