Download The Year in Review Benchmark Returns Ending 12/31/2012

The Year in Review
2012 was a year that experienced many ups and
Benchmark Returns Ending 12/31/2012
downs. We began the year with major concerns
Benchmark
QTR
YTD
regarding Greece, the Euro’s viability and the
S&P 500
-1.0% 13.4%
European debt crisis as well as worry over the US
Russell 2000
1.4% 14.6%
government’s ability to meet its debt obligations.
MSCI EAFE
6.2% 13.5%
Given the significant market volatility we have
MSCI Emerging Markets
5.2% 15.2%
experienced over the past several years, investors
Barclays Domestic Aggregate
0.2% 4.2%
remained on edge. As our clients have weathered
Bond
the tech bubble, two recessions and a major
*Benchmark returns without
financial crisis in good shape, they have also
dividends
expressed major concern over the future of
financial markets and the country’s position in the global economy. In conversations with clients, it was
evident they have been suffering from investor fatigue. We agreed that economic headwinds and
macro problems in the beginning of 2012 were significant enough to justify larger cash positions during
that time, as well as diversify into non-core asset classes (high yield, foreign bonds and commodities) to
reduce risk and enhance principal protection. Despite less than favorable investor sentiment, the
riskiest asset classes performed the strongest. Equity markets grew significantly during the first quarter
of 2012 and flattened out for the remainder of the year, resulting in double digit returns.
Our market outlook spans a full market cycle, generally five to seven years; however, we are fully aware
that clients measure us on a shorter interval. Given continued risk and unsatisfactory return
expectations for most asset classes across our macro scenarios, our portfolios are positioned in a
moderate but not excessively cautious way. The benefit of this positioning is greater principal protection
should the market experience a shock. The tradeoff of positioning for a longer time frame is that on a
short term basis we have a bad period along the way. This can be a frustrating strategy that requires the
patience to wait for more favorable opportunities. Our clients that have been with us through many
volatile periods understand that a well-diversified portfolio of core and non-core investments
outperforms its benchmarks despite being underweight to equities in one year of a strong stock market.
We are willing to accept this tradeoff because we are highly confident we will experience stronger
returns over a full five-year window.
What to expect in the New Year
While there have been signs that the economy here in the US has remained in recovery mode, we
continue to keep a watchful eye overseas for signs of economic weakness. The European economy
continues to be a drag on the world’s economy, as evidenced by the recent economic data points from
France showing that the manufacturing sector continues to slow. In addition, the unemployment
situations in both Greece and Spain remain at epic levels, with the younger population facing in some
cases 50% unemployment. Asia remains the economic growth engine of the world, although there are
concerns that China’s economy is heavily leveraged towards European exports and future potential
growth could be weakened by a European recession. In spite of these concerns, we believe that
economic growth will continue here in the US as more clarity is gained around the new tax rules and the
outcome of any deficit agreement. However, that growth will most likely be below the long-term
average as Americans adjust to the new tax rates that potentially could be a drag going forward.
The folly that is The Fed
Since the start of the fiscal crisis in 2008, the Federal Reserve has been trying to combat deflation
(declining prices) by generating inflation. The Fed has two ways of doing this: keeping short-term
interest rates low, and engaging in buying bonds in the open market in order to generate liquidity for
the sellers of the bonds. These programs are commonly referred to as quantitative easing or QE for
short. Last spring, with the economy remaining in a slow growth mode, the Fed decided that, in
addition to its mandate to promote growth, it would undertake the responsibility to reduce
unemployment. In an effort to do both, the Fed decided it would proceed by announcing a third round
of quantitative easing. Since we’ve been down this road before with QE1 and QE2 and the outcome
was higher energy and commodity prices, should we expect a different result with QE3?
Despite all of the Fed’s efforts to
Annual Budget Deficit
jumpstart the economy, we have
remained in a below average
growth pattern for several years
now. The issue that is just now
starting to garner national
attention is the amount of debt
currently in the system and the
expected new debt needed to fund
the government’s operations.
When the government borrows to
finance its programs, it is in
competition with the private sector
for capital. From the chart above,
you can see that based on the
forecast from the Congressional
Budget Office, even with the new
tax rates set to take effect this year, outlays will exceed revenues resulting in another year of $1 Trillion
dollar deficits! Clearly, this puts the efforts of the Fed into question given that private companies will
remain starved for capital thereby delaying any further economic recovery. In addition, the study
assumes that the current interest rate environment remains low for the foreseeable future. Should
interest rates move higher, the amount spent on servicing our national debt will increase as well,
thereby making an already bad situation worse.
What we are watching
While our crystal ball remains a bit hazy, there are a few items that have come into focus, the first being
the US Dollar. Congress and the President decided to kick the can down the road one more time with
the most recent agreement on tax increases. However, this has done nothing to address the spending
problem. As a result, the focus has now shifted to the pending debt ceiling fight due sometime towards
the end of the first quarter. The consensus is that the borrowing limit will be increased, and little if any
real cuts will be made to the growth rate in spending. If this scenario does come to fruition, we would
expect the US Dollar to continue to weaken versus the world’s currencies. Additionally, we would
expect to see assets such as commodities appreciate given their perceived store of value. Finally, while
inflation remains low, mostly due to how the index is calculated, we would expect that certain items
such as food and energy would reflect the weakening Dollar and continue to move higher.
The last time Congress went down the path of negotiating an increase in the nation’s debt ceiling,
Standard and Poor’s downgraded US debt from AAA to AA+ as a result of another increase in the limit. If
our thesis about the debt ceiling being raised again holds true, we would expect to see another round of
downgrades on US Treasury bonds. While there wasn’t much collateral damage the last time this
happened, it’s difficult to imagine that a second downgrade in less than a year would not go unnoticed
by the bond markets. Certain buyers of bonds, specifically insurance companies and pensions, are
required to hold a minimum percentage of their assets in AAA rated bonds. As a result, we believe that
while the immediate reaction to a US downgrade would be muted, we would expect that high quality
corporate and municipal bonds would fare better than US Treasury and government bonds. In addition
to a potential change in allocation away from US Treasury bonds, we believe long-term debt yields on
corporate and municipal bonds could move lower in the near-term as investors are forced to shift to
higher credit quality bonds.
As for stocks, corporate earnings and revenue growth showed signs of slowing in the second half of
2012 which, in the long-run, are the real drivers of stock market performance. While the unemployment
situation here in the US has at least stabilized, a higher-than-average unemployment rate does not bode
well for companies in the future being able to increase sales if there are fewer employed consumers.
Still, we believe that given the option of investing in bonds at historically low interest rates, stocks will
remain attractive if for no other reason than the fact that the Fed has pumped so much liquidity into the
system that excess dollars have nowhere else to go. The key going forward be when the Fed decides to
raise interest rate and the effects that will have on growth here in the US going forward. Until then, we
believe that clients should remain fully invested in the US.
With regards to foreign stocks, we remain cautious given the political uncertainty in Europe and the
potential for slowing growth in the developing world. In light of our concerns, and given our thesis on
the long-term trend of the US Dollar, we believe that on a relative basis foreign stocks are attractive and
do offer our clients both diversification and added value to their portfolios.
Finally, with market volatility and interest rates so low, and the stock market up considerably, we are
looking to make some adjustments to certain asset classes in order to mitigate risks while improving
upon our returns. Specifically in 2013, we will be looking for opportunities to add to our strategic or
non-core positions such as; extending further into high yield municipal and taxable bonds and possibly
emerging market debt.