Global stock markets came under renewed pressure in the second quarter of 2012 as the European financial crisis worsened, and world economies from China to the US saw a reduced rate of growth. The US stock market, as represented by the S&P 500 stock index fell 3.3% to 1362. As investors sought safe havens from financial turmoil, the yield on the benchmark ten-year note fell 56 basis points (hundredths of a percentage point) to 1.66%. Gold sold off on subdued fears of inflation, while oil and other industrial commodities declined in the face of slackening global demand. Gold closed the quarter down 3.8% at $1,599 per ounce. US benchmark West Texas Intermediate oil finished the quarter at $85 per barrel, down 17.6%.

The principal concern of global markets is the financial crisis in Europe. Simply put, the large economies of Spain, and most of all Italy, may be unable to borrow enough money to pay off existing debts and continue the operation of their governments. Of the two, Spain is in the weaker condition with banks on the verge of collapse, a large budget deficit, and extreme unemployment. Italy is in better condition on all three counts, but its debt is enormous, the largest in the world behind the US and Japan. If a failure of the Spanish bond market would push existing bailout mechanisms in Europe to the limit, an Italian failure would certainly overwhelm them. The countries that use the Euro currency must decide whether to more fully integrate their political and fiscal systems, or risk having the Euro torn apart by market forces. Such an eventuality would have devastating economic consequences for both Europe itself and for around the globe. The Euro leaders have always done just enough to avoid catastrophe, as they have just recently at the June 29 EU summit, where they began movement toward an integrated Euro banking system. Whether or not they can muster the political will to bring a conclusive end to the crisis remains to be seen, and therein lies the market’s fears.

Meanwhile, the American economy has shown undeniable signs of slowing in the spring quarter. Economic data ranging from unemployment, to consumer confidence, to industrial production have all weakened, pointing to growth less than the 2% needed to reduce unemployment. At such a slow rate, the US is also more vulnerable to external shocks such as those emanating from Europe or the weakening emerging economies of China, Brazil, and India. In the face of such weakness, American authorities have shown a disappointing inability to address the issues at hand. The Federal Reserve in its June meeting acknowledged the deterioration in economic fundamentals, yet decided merely to extend its current policies, deciding to defer on more aggressive action such as another round of “Quantitative Easing,” i.e. buying bonds and mortgages with freshly printed dollars. While the effectiveness of such action is disputable, whatever the case, it almost certainly is more effective than doing nothing, particularly with inflation firmly under control.

More effective at this juncture would be fiscal policy to stimulate economic growth. Yet our elected officials have shown an almost complete inability to work together to do anything beneficial for the economy. Even passing the once routine and bipartisan transportation bill, upon which many construction jobs depend, had become highly contentious, only to be agreed upon at the eleventh hour. It is next to impossible to see any new initiatives to spur economic growth taking place prior to the election. Furthermore, to make matters worse, the “fiscal cliff” of automatic tax increases and spending cuts looms at the end of the year. If unaddressed, these actions would put the US economy back into recession, as they collectively represent a 4% reduction in GDP. There has been no movement on dealing with this issue, and once again, it is difficult to contemplate any progress prior to the fall election. The ineffectiveness of policy makers and the tremendous uncertainty they have interjected into the economy, weigh heavily upon the market.

On a longer-term perspective, the US residential real estate market appears to be finally stabilizing after six years of decline. Price decreases have significantly moderated, while home sales and construction are up. Compared to renting, homeownership looks significantly attractive given record low mortgage rates. This dynamic has brought both individuals and investors back into the market. We have always felt that a recovery in residential real estate is a necessary precursor to a sustained and robust economic recovery. While there is still a large inventory of foreclosed properties overhanging the market, and many Americans remain underwater on the mortgages, we believe the improvements in the residential real estate market are real and are something to be optimistic about.

Forecasting is always difficult, and even more so when the fate of markets and economies lies upon politics and politicians. In such uncertain times, adherence to our four principles of investment: quality, value, diversification, and patience, is the way through the market wilderness. This strategy navigated client portfolios successfully through the 2008-09 subprime crisis, and we have high confidence that it will once again be able to deal profitably with whatever the future may hold. For the remainder of the year, we project that the S&P 500 will trade in a range of 1250 to 1450. As always, please do not hesitate to contact us with any questions or concerns.