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Q3 2015 Market Commentary

Greece, China and the Fed. It sounds like the beginning of a joke, but in reality they are three sources of
near-term volatility that are no laughing matter. Of the three one is prominently in the headlines, one
seems missing from the headlines and one is seemingly never out of the headlines. As we see each of
these as the catalysts of market movement in the coming months we thought we would address each one
in more depth.
Over the 4th of July weekend the Greek people took to the polls and voted No to further negotiations
regarding their indebtedness. In essence the Greeks have announced they are willing to default on their
debts without significant restructuring of those loans and have perhaps set in motion a path that leads
them out of the European Union (EU).
It is a complex situation built through the years by poor decisions on the parts of the Greeks, equally poor
decisions on the part of the EU seeking Greeces entry into the Union to begin with, and greed on the part
of private lenders who then offloaded their investments to the public sector as soon as they saw their
risk rise dramatically in the wake of the financial crisis of 2008/2009. Since then, there has been a
significant overestimation, by all parties, of Greeces ability to meet its obligations.
There has also been political and moral obstinacy from EU members who continue to insist a country in
an economic Depression should find further cuts, and further cash flows, to support debt payments. This
stance has made the situation worse. The reality is that it takes a generation or more to change imbedded
social norms. As well, there is an inability for the EU leadership to overcome deep-seated ideological
positions to find a viable and sensible solution.
But no matter how the Greeks have arrived at this situation laying blame will not resolve the fact that the
debt cannot be paid. A solution to the Greek issue requires both sides to recognize that Greeces economy
needs resurrecting and that a declining GDP, when joined with increasing debt, is a no win situation for
anyone. The length and terms of the loans may need to be far more accommodative than northern EU
members are comfortable with, but the ECB, EU and IMF, much like the Fed, have the balance sheet
capacity to be as accommodative as possible for as long as needed to retain the solidarity of the Union. It
requires the world to understand that a No vote was cast out of desperation, from a people whose
outlook has denigrated to one of if I am to be poor I may as well be poor without someone telling me
what to do rather than from any desire to renege on paying back what is owed.
But it will also require that the Greek people understand that the capacity to lend is not a well of endless
depths. That a return to economic stability is a painful process when one has dug a hole so deep and that a
tradition of righteous tax-fraud and the shadow economy of Fakelaki (translated as little envelopes), a
socially acceptable (and untaxed) method of bribery that is rampant in all aspects of life and commerce
needs to end in order for Greece to be accepted as worthwhile members of the Union.

At $242 billion, Greeces economy is not very large and most of their debt is owned by the European
Union, the IMF and the European Central Bank, entities that can create Euros if need be. Some is still
held privately but it is a manageable amount. So a Greek default, in and of itself, will have minimal
economic impact. Additionally, if Greece were to stop using the Euro as a currency, or even if they were
to leave the European Union, there would be very little economic impact to the region as a whole.
It is more the possibility of contagion, and the chance for growing instability, that the market really fears.
How would the exit of an EU member be viewed by other financially stressed members? How would it be
viewed by competing interests (Russia or China)? Will the European quantitative easing mechanisms be
hearty enough to address any near term anomalies? Will distrust between members lead to bank runs in
other European countries? Would that lead to a full blown liquidity crisis in Europe and then beyond,
such as global markets experienced when the U.S real estate market slumped? Could such an event be
All these questions will take time to answer, and in that space there is more than enough uncertainty to
rattle markets. We expect this particular issue to take its toll on asset values in Europe, and globally, in
an off and on manner until it is resolved fully one way or the other.
Meanwhile, as the media was focused nearly exclusively on the Greek drama, China was quietly entering
into a bear market, losing nearly $3 trillion in value in about 3 weeks. Just as the Greeks set about voting
their fate, the central bank in Beijing froze all pending IPOs and set up a special stabilization fund in an
effort stop the free fall. A good portion of the fund will come directly from 21 major Chinese brokerage
houses and at least 25 independent Chinese mutual fund managers.
The investors announced that they will buy up to 120 billion yuan worth of Chinese blue-chip ETFs
(about $19 billion) to provide liquidity to the market. Additionally, several listed firms announced they
would be buying back their own shares alongside the brokerages efforts. This strategy is not uncommon;
the Bank of Japan has been buying shares on the Nikkei market as a part of their quantitative easing
program, and a similar effort was taken by investment banks in the U.S. in October of 1929. That
particular effort was spectacularly unsuccessful, but there is hope in the market that Chinas combined
public/private stimulus campaign may be having some effect.
The Shanghai stock market had exploded over the past year, clocking in gains of over 150% in just 12
months. Meanwhile, GDP growth in China has slowed to a 24-year low and remains below both global
market expectations and the central governments own forecast. As it happens, much of the gains in the
Shanghai have been predicated on very aggressive monetary easing by the Peoples Bank of China
(PCOB) in response to this slow-down. Though these moves are similar to those made in the face of
economic weakness by Central Banks in Japan, the US, and now the EU, the response by investors in
China has been much more credulous. As such, a decline in stock prices has been expected.
Individual Chinese investors have very little collective experience. As such there has been little in the
way of healthy skepticism while stock prices have risen far beyond what even the most optimistic bulls
would consider reasonable value. For more experienced investors, this pattern is familiar and even comes
with its own label a bubble.

The worry is that the current slump could be exacerbated by the need to cover margin debt that will surely
get called in as stock prices continue to fall. Margin debt levels on the Shanghai exchange have hit
alarming records as working class Chinese borrow money to buy the hottest stocks total lending is
(unofficially) estimated at about $3.6 billion. And lower GDP forecasts going forward (China is expected
to average only 4.6% growth over the next decade - lower than all other emerging markets except
Mexico) makes it less likely that foreign investors will pour in to help prop up the Shanghai, which was
the hope when China recently opened a connection with Hong Kongs market and published plans for its
own commodities exchange.
So, as with the Greeks, much of the pain of Chinas bear market would be borne by the Chinese.
However, the economic effects of a slow-down in China are already being felt globally, and the central
governments extraordinary efforts to prop up stock prices may end up making matters worse (some
Chinese have suggested expanding margin debt even more to buoy stocks). Beijing is trying to extend the
stock market bubble while prior bubbles real estate, manufacturing infrastructure and government debt
have yet to deflate. This cascade of intervention will work up to a point, but as global investors become
increasingly wary of such imbalances, China may be forced into a no-win situation similar to Greeces,
but with a much greater impact on other economies.
The Fed
Given all the uncertainty playing out globally, the Fed has found itself in a position of being able to
justify holding off on their impending rate increase. At this point it is no longer a question of if they will
raise rates but when. Many had anticipated September (which we feel is still possible) or December at the
latest, but with recent events in Greece and the volatility in the Chinese markets, there is speculation the
Fed will hold off until into 2016 as it tries to manage economic stability and market volatility.
Despite the unknown timing, the market seems fairly sure that rates will increase in the near future. This
has had, and will continue to have, an effect on the stock and bond markets and so wed like to review its
impact on each.
Fixed Income
The beauty of the fixed income market is that, unlike the stock market, it is driven far more by simple
math than by emotion. As the Fed funds rate begins to increase, it will cost companies, municipalities and
the government more to issue debt as the interest they pay must compete with rates of riskless assets
(cash and cash equivalents). Similarly, with higher rates in newly issued debt, older debt with lower
interest coupons must decline in price in order to compete with these higher yielding new bonds.
When thinking about bond pricing it important to keep in mind the three main components of debt
securities. First is the coupon or stated interest to be paid, second is the remaining number of years to be
paid that coupon (or put another way, how long must I, as an investor, wait to get my capital back), and
third is the price paid to own that bond. All three of these components factor into the yield that security

If I buy a bond when first issued I would pay $100 a unit for that bond and my yield to maturity would be
the same as the stated coupon. If I buy a bond in the secondary market in a time when rates are low, I will
likely pay a premium since the coupon of that older bond is higher than what is being offered on a new
issuance. But when that bond matures I only receive back $100 a unit. Therefore my total return, or yield
to maturity, is all of the aggregated interest coupons paid minus the excess premium I will not be paid
back at maturity. Conversely, when rates are high prices are low in order to compete with new bonds
being issued. If I buy a bond at a discount then I not only receive the coupon but I also gain capital when I
am paid back $100 a unit at maturity. Thus my total return is higher than the stated coupon, and more
equal to what I could get by buying a newly issued bond.
So a see-saw effect is in play as the Fed raises and lowers rates. Given that the Fed will be raising rates in
the future, bond prices will begin to reflect that increase and in fact have already been pricing in the future
increases as reflected in falling bond prices. We expect this to continue, though the price trajectory may
be quite volatile through the year as risk assets are subjected to various adjustments in response to Greece
and China. Either capital depreciation in bond prices are typically offset by the income that continues to
be paid, so we are not overly concerned about bond exposure.
Typically rates rise when the economy is firing on all cylinders, so one might expect the stock market to
react favorably to news of a rate hike because investors can extrapolate the economy is strong. But the
stock market tends to be more concerned about the future than the present, so a rate hike also means we
are later in a business cycle and that at some point growth will be harder to come by.
Stocks usually bid up during a recovery period in anticipation of better times, so the price being paid for
stocks often is ahead of any actual improvement in the economy, reflecting the hopes for higher earnings.
But higher interest rates means higher costs for companies to borrow money, which can dampen earnings
growth. In other words, a rate hike could be a signal that the increase of earnings is already accounted for
in the price of stocks, and expectations of even higher earnings may not be in the cards as the fuel for
growth (cheap money) is being cut off.
As such some areas will experience weakness during a rising rate environment. Capital intensive
industries such as energy, utilities, real estate and telecommunications tend to suffer as debt payments are
a function of their normal operating costs. Additionally, investors have been bidding up the prices in
these areas due to their higher dividend yields, so these stocks must also compete with higher interest on
risk free investments (so think of these as acting similar to a bond).
Banks, insurance companies and brokerages tend to perform better during a rising rate environment as
they profit from the difference between what they can earn and what they will pay in interest. Banks can
start charging more to lend money and experience fewer defaults in a stronger economy while still paying
less on existing deposits, and insurance companies earn more on their portfolio (as they roll over their
maturing bonds) even as the costs they carry stay the same.
In a normal business cycle, consumer, technology and healthcare stocks fair pretty well in a rising rate
environment as individuals and small-businesses take advantage of a more stable environment but again

certain of these sectors have recently been favored by bond investors hungry for yield generating assets,
and so a change to rates may cause instability even in these areas at this point.
That being said, the potential increase in rates is an uncertainty that has become increasingly more certain
as time goes on. And the Greek tragedy was written some time ago, with many economists and market
participants predicting this very sort of dire scenario as early as 2010, when the first round of debt
payments were extended in trade for austerity. So of the three big issues facing the market this quarter, it
is the one we are hearing the least about China that has us concerned the most.
China is 40 times larger than Greece, and is currently the largest importer of energy (India is close on its
heels). It is also in the midst of trying to transition its economy from an export-based market to a
consumer market, so a market correction there is worrisome in that it will impact their growing domestic
consumer economy, which could impact global demand for raw materials. Additionally, the central
government is not known for its transparency and so as far as uncertainty goes, the future path of Chinas
economy ranks fairly high, with or without bubbles.
One thing is certain 2015 has been a volatile year for the markets. As of this writing, all major U.S.
indexes are posting minor YTD losses, and it is our feeling that this weakness could persist until we put
all three of these issues behind us. But eventually, they will be behind us, and it is for this reason that we
have maintained a cautiously optimistic allocation in most client portfolios, and why we continue to
caution against any investment decisions made as a reaction to near-term fluctuations in prices.
Our long term clients know that time is their ally and that the potential for investing success is generated
by a strategic financial plan, proper and ongoing asset allocation, quality investment management and
resisting knee jerk reactions to near term news. Those who are more recent in their investing, whose
experience may be riding the peaks and valleys of the last fifteen years of bubbles and bursts, should
remember that investing is the proverbial marathon. Capital gains accrue over long periods of time which
include price corrections, pockets of market weakness, and even stretches of negative returns. Time will
surely be your ally as well, if given the opportunity.
As always should you have any questions regarding your planning, your portfolio or this commentary
Julia and I are always available to talk things through with you and we can be reached by email at and or by phone at 800.220.2161.
Steven B Girard

The opinions expressed are those of Northstar Financial Companies, Inc. and are based on information believed to be from reliable sources.
However, the informations accuracy and completeness cannot be guaranteed. Past performance is no guarantee of future results.

Northstar Financial Companies, Inc, 1100 East Hector Street, Suite 399, Conshohocken, PA, 19428 Tel: 800 220 2161
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