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First Quarter Review
George Santayana once remarked, “Those who cannot
Benchmark Returns Ending 03/31/2012
remember the past are condemned to repeat it.” In many
Benchmark
QTR
S&P 500*
12.0%
ways, the first quarter of 2012 began much like the first
Russell 2000
12.0%
quarter 2011. With the Federal Reserve in full monetary
MSCI
EAFE
10.7%
easing mode, and working in concert with the Central Banks
MSCI
Emerging
Markets
17.4%
of the world, risk assets rallied as trillions of dollars were
Barclays Domestic Aggregate Bond 0.3%
pumped into the economy in an effort to kick start growth.
*Price Returns
As a result, US Large Company stocks gained an impressive
12.1%, while Small Company stocks rose 12.0%. Overseas markets participated as well with developed
international stocks climbing 10.7%, and smaller emerging country stocks moving higher by 17.4%. Even
in the face of stocks moving higher, bonds continued to maintain their value with US Domestic bonds
adding 0.3%.
Traditional Monetarist policy would argue that the role of the Federal Reserve is to keep the pace of
growth of dollars in circulation to
a reasonable level in order to
ensure that inflation doesn’t rear
its head. In the chart to the right,
we can see between 1985 and
2007, the total adjusted
monetary base effectively
doubled. However, post the 2008
financial crisis, the Fed used its
power to print dollars in an effort
to stave off what was considered
at the time the beginning of the
next Great Depression. In a
matter of four short years, the
Federal Reserve increased the
monetary base again by more
than three times to roughly $2.9
Trillion! The recent rise in food
and energy costs can be directly related to too many dollars chasing too few assets. And while the
consumer has been the first to feel the effects of inflation, the real concern in the near-term is the fact
that the velocity of money has remained fairly muted.
However, with the Fed now looking to keep interest rates at record lows in an effort to stimulate the
economy, capital is beginning to flow into risk assets like stocks and commodities. And while higher stock
prices give the impression of increased wealth, wage growth isn’t keeping up at the same pace. As a result,
consumers are no longer able to absorb cost increases passed along. Additionally, with the housing market
still in a funk and unemployment remaining stubbornly high, any cost increases passed along to the
consumer will result in declining corporate profits as more of the consumers’ disposable income is
reallocated to life’s necessities. Our concern going forward is that if the Fed is forced to continue
abnormally low interest rates in an effort to stimulate the economy, how long will it be before economic
gains are offset by rising inflation?
It seems like years ago that we were worried about whether or not Greece was going to default on their
debt (they did by the way). And while things have been quiet as of late, signs of renewed stress in Europe
are beginning to show up again in the form of higher bond yields for Italian, Spanish and Portugese
Government bonds. Real GDP growth in all three countries continues to decline while unemployment is
spiking, currently at ~23% in Spain. Recently, Spain tried to auction government bonds and the market
reacted negatively with bond yields moving significantly higher based on deteriorating economic
conditions. As evidence of continued European economic stress surface, there have been calls for even
greater monetary actions on behalf of the European Central Bank (ECB). Much like our Federal Reserve, the
ECB controls monetary policy and can print Euros, which they’ve done to the tune of more than €1Trillion
since last fall. However, Germany, Europe’s largest and most important economic power, dislikes the idea
of further easing, given that it essentially allows struggling countries to remain in the Eurozone at the
expense of Germany, and to a lesser extent, France. Politically, Euro printing is being met with resistance in
the Northern states, and the Chancellor of Germany is facing a stiff election this fall. Our guess is that any
further easing on the part of the ECB will face the same fate as that of the Fed: higher consumer prices,
more debt issuance and further economic deterioration.
What we are Watching
Since the end of March, the markets have been moving mostly sideways, with the S&P 500 caught between
a range of 1,360 and 1,420. However, there have been a few disconcerting signs that market risks are
beginning to surface again. China, the growth engine of the world, has shown that their economy is
slowing, with GDP growth coming in at a robust 7.5%, but down from the +8% readings that we’re used to
seeing. Most of Southeast Asia is running trade deficits for the first time in quite some time, evidence that
economies and exports are slowing. And while things in the US aren’t quite as bad as elsewhere, the
consumer remains squarely in the crosshairs, with unemployment and the housing markets struggling to
gain traction. The one thing that the market does have going for it is the fact that 2012 is an election year,
and the Fed, in concert with the administration, will do just about anything to ensure the markets move
higher going into the fall. While in the longer-term, further monetary easing will be met with continued
inflation worries, in the near-term risk assets such as stocks and commodities will move in lockstep with
monetary intervention by the Fed.
As for bonds, we are watching closely our intermediate and longer-term holdings. If the economic recovery
were to take shape, we would expect the Fed would discontinue further monetary easing, which would
most likely lead to higher rates. As such, we prefer shorter dated bonds in anticipation of higher yields and
TIPS as a hedge against inflation.
Finally, we continue to watch the US Dollar closely. Much has been made of the Dollar’s decline, especially
since the summer of 2011. For better or worse, the US Dollar is still the world’s reserve currency.
Commodities are priced globally in Dollars, so when the dollar declines, the US consumers’ purchasing
power is negatively impacted. The value of the Dollar can be traced to what foreign holders think of our
economy, both the current and the future. It is expected that sometime later this year Congress will have
to revisit the debt ceiling debate again. Currently, the US is running an annual fiscal deficit of greater-than
$1.3 Trillion. In the last three fiscal years, we have added almost $5 Trillion in new debt outstanding.
For the average investor, the size of the US debt outstanding is simply too large to comprehend. However,
we believe that the pending fiscal debate in Congress on what to do going forward will become much more
meaningful to everyone very soon. With interest rates at their lows, foreign buyers are beginning to show
signs that they are willing to seek higher returns elsewhere. As a result, the US will be left with several very
untenable options: European-like austerity leading to massive cuts in public programs, raising long term
rates to attract buyers of US Treasuries, a government default on debt (extremely unlikely), or allow the
dollar to continue to slide and inflate away the debt. Given our political history and the willingness of the
Fed to ensure that the economy does not become an issue in the fall, we are willing to wager that option
four is the most likely outcome. The result of that policy choice will be the significant loss of purchasing
power and lower quality of living by US citizens. However, we believe that by creating diversified portfolios
with global exposures to hedge our US Dollar holdings, we are well positioned to ride out any volatility that
may ensue due to US Dollar weakness.