Download Third Quarter Review Don`t Fight the Fed. Marty Zweig

Third Quarter Review
Don’t Fight the Fed.
Equity markets rebounded in the third quarter: mostly on optimism that
central bank intervention would revive a sluggish global economy and
mitigate ongoing uncertainty in the euro zone. Notably, both the
European Central Bank (ECB) and the U.S. Federal Reserve (Fed)
took additional (and extraordinary) steps in their efforts to revive
anemic economic activity. Investors seemed willing to dismiss
somewhat mixed economic data and instead followed the old maxim:
“Don’t fight the Fed”. All major markets advanced during the period,
with Canada leading the way on the strength of rising commodity
prices. The Canadian dollar was also stronger and therefore the gains
in foreign markets were offset somewhat by the conversion to
Canadian-dollar returns.
For some time the ongoing euro-zone debt crisis has been a major
depressant on the global economy and, in particular, stock prices.
What has been missing to this point has been any firm commitment by
the ECB to stand behind the euro. That changed in late July when
ECB President Mario Draghi announced they would do “whatever it
takes” to preserve the currency. His statement buoyed investor
confidence. Further, last month the ECB announced that, effectively,
they will be turning on the printing presses, much to Germany’s
dismay. Specifically, the ECB vowed they will purchase an
unlimited amount of bonds of struggling euro-zone members. Stock
Marty Zweig
markets rallied strongly on this news as, basically, it puts a cap on rising
bond yields in both Spain and Italy.
In America, Fed Chairman Ben Bernanke, concerned about weak
employment growth, announced that the Fed would purchase $40 billion
per month of mortgage-backed-securities indefinitely until a recovery is
firmly established. Further, he extended their commitment to keep interest
rates at current levels until 2015. Other central banks announced more
modest measures, but Australia surprised markets in early October with a
¼ point drop in their interest rates.
Canada was a primary beneficiary of these policy decisions as both gold
and oil prices rallied on the news. On the one hand, commodity prices
rose on improving sentiment for the global economy. On the other,
concerns about Europe and the U.S. printing more money pushed some
investors into “hard” assets like gold.
In fixed income markets, bonds were relatively flat across the yield curve
with all returns under 1% for the quarter. Overall, yields remain at
extremely low levels, particularly on Canadian and U.S. government
bonds. In the current environment, GICs continue to provide an
attractive return premium over both government and even high-quality
corporate bonds.
Following are the returns for the major indices for the period ended September 30, 2012:
rd
Canadian Short Term (DEX 30-Day T Bill)
Canadian Bonds (DEX Short Term Bond)
Canadian Stocks (S&P/TSX Comp.)
U.S. Stocks (S&P500)
Non-North American Dev. Stocks (EAFE)
Emerging Markets Stocks (MSCI Emerging)
N
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All returns in Canadian dollars. Source: SS&C Technologies and PalTrak
3 quarter
actual
1 year
actual
3 year
annualized
5 year
annualized
10 year
annualized
0.2
0.7
7.0
2.7
3.2
4.0
0.9
2.2
9.2
23.3
7.7
10.7
0.7
3.4
5.5
10.0
-0.8
2.6
1.2
4.9
0.2
0.8
-5.5
-1.5
2.1
4.5
9.8
3.0
3.2
11.6
Outlook
Leadership is solving problems.
Very respectable market returns have unfolded in the first nine months of
2012, despite a complicated, even worrisome global environment. The
future looks no less challenging for governments, other policymakers and
consumers alike. There is little debate that global economic growth will
be constrained for years to come as all participants must accomplish
massive debt reduction to ensure their future prosperity. This is a tricky
proposition since debt deleveraging by its nature means less spending,
which means fewer goods purchased, which means fewer jobs needed,
and so on. It sounds like a classic Catch-22. The question investors have
is whether stocks can continue to thrive in such an environment. We
would say that as long as everyone keeps their noses to the grindstone,
so to speak, there is a good case to be made. Let’s look at the facts:
First of all, we are finally seeing encouraging signs of monetary
leadership in Europe, starting last June when the ECB announced its
plan to monitor, insure, recapitalize or shut down banks as needed. More
recently they introduced “outright monetary transactions” (OMTs),
whereby the ECB directly purchases the sovereign bonds of a struggling
member country by offering much lower rates than would be otherwise
available in the open market. OMTs will be financed through a new bailout
fund called the European Stability Mechanism. Prior to this, both Spain
and Italy have had to finance their ten-year government bonds above 7%,
an unsustainable level. Those same rates have now declined towards 5%.
This is very important as interest on debt is becoming the largest
expense for governments. For instance, if either Germany or the U.S.
had to issue bonds at 7% versus the 1½%-2% they now enjoy, it would be
calamitous for them too. These big announcements are merely the
beginning of a long, arduous process which will require step-by-step
action, but the agreement on a rough plan for such major issues is a
refreshing first step in the right direction.
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Colin Powell
The U.S. will also require some groundbreaking policy leadership after
the November 6th election. In order to avoid a future debt crisis of their
own, leaders face the Herculean task of finding ways to keep the
economy recovering, yet at the same time formulating credible plans to
not only balance the budget but ultimately reduce debt. Almost certainly,
the new Congress will have to address the touchy issue of
“entitlements”, such as Social Security and Medicare, for example.
But even before then, the lame-duck Congress must deal with the socalled “fiscal cliff”, a looming crisis of its own making. You may recall
that in August of 2011 when faced with the debt ceiling impasse,
Congress set the “far-off” deadline of December 31, 2012 to reach a
bipartisan deal on deficit reduction….and now here they are with no
deal. If no agreement is reached before year end, drastic, even arbitrary,
spending cuts and tax increases (expiry of the Bush-era tax cuts) will
automatically occur and almost certainly tip the U.S. back into recession.
No one actually expects that to happen, but uncertainty lingers in the
market and many businesses have delayed their own spending plans
until it is resolved - plans that would boost growth and employment, by
the way.
Next year and beyond, markets will be focused less on who resides in
the West Wing and more on whether there is a functioning Congress on
Capitol Hill, one where, once again, bipartisan compromise and
negotiation result in good governance. The heat is really being turned up
as Washington grapples with finding ways to make meaningful progress
on the deficit. “Problem identification” is a leading indicator of
policy change and though it may be messy, deficit reduction will occur,
if for no other reason than because the consequences of doing nothing
are worse.
A second reason to be constructive on stocks is this: monetary policy
continues to be both supportive and creative. In the U.S., where
interest rates are now at rock bottom, the Fed has found other
unconventional ways to stimulate growth, such as the recently announced
round of Quantitative Easing (QE3). Importantly, the Fed has also
committed to keeping interest rates low for years to come. Similarly, in
Europe, the ECB has maintained low interest rates and announced a
number of other helpful initiatives (as discussed above). Clearly monetary
policy has done its part to lay the foundation for economic recovery
globally. While central banks still have some additional means at their
disposal, it is now mostly up to governments to address their serious fiscal
imbalances that otherwise threaten sustainable growth.
Third, businesses are strong and profitable. In the headline news cycle
this important fact is forgotten. Profits are at all-time highs and companies
have stockpiles of cash. This is largely the result of cutting costs rather
than increasing revenues, and without a pickup in future sales, further
profit growth may be limited. Aggressive expansion of operations and
hiring has been hampered by the weak global environment. Again, as
governments repair their balance sheets, business decision-makers will
pursue innovation and expansion, as they always have. In the meantime,
investors are the direct beneficiaries: companies are using some reserves
for dividend increases and share buybacks.
Finally and perhaps surprisingly, valuations on stocks are cheap
despite the recent run-up in prices. This is due to the worries we have
discussed above which all boil down to frustration and uncertainty in the
marketplace. European stocks are among the cheapest, given their more
depressed economies and perceived political risk. Importantly for
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investors, yields on stocks continue to outpace the yields on
“credit-worthy” bonds. With additional dividend increases, this
premium should widen further.
As always, there is risk in owning stocks. Currently, the risks include:
continued gridlock in Washington, any number of possible threats on the
euro, as well as things we haven’t mentioned like a faster-than-expected
slowdown in China or a pre-emptive strike on Iran. Setbacks are
inevitable, but as we have noted many times in the past, risks and
returns are related. These risks are well-known in the marketplace, and
relative to bonds, the return potential is very favourable.
With respect to bonds, yields are expected to stay very low for the
foreseeable future. Milestone’s strategy is to maintain the highest quality
issues using short- to mid-term maturities. This ensures capital
preservation in almost all imaginable environments. The risk of loss is
very low and the return potential is also very low, so in this environment,
the main purpose of the asset class is to provide portfolios with essential
price stability.
In many respects, we are operating in an environment that sometimes
feels like maneuvering through a minefield. Some “explosion” or
other will likely cause temporary setbacks, but will not ultimately stop
markets moving forward if the fundamentals are there. Progress through
the minefield seems too slow and it is slow, but it is progress
nevertheless. Therefore, investors must ensure that the asset class
weightings in their portfolios are properly positioned to stay on course
according to their carefully constructed risk parameters, such as time
horizons, risk tolerance and risk capacity. This sounds like an old saw,
but it’s true.