Download Fourth Quarter 2012 Commentary

Fourth Quarter 2012 Investment Commentary
Stocks shrugged off numerous worries to log a good year in
2012. And when the bell rang to end the final trading session of
the year, the riskiest areas were the most profitable. Emergingmarkets stocks earned 19%, whereas the S&P 500 returned
13%. Mid-cap and small-cap stocks slightly outpaced large-cap
stocks.
The bond side also saw riskier asset classes out-earning
traditionally safer fixed-income market sectors for the year.
Domestically, high-yield bonds and leveraged loans returned
15% and nearly 10%, respectfully, while investment-grade
bonds returned 4%.
Can the markets continue to climb the proverbial wall of worry?
Certainly the worries remain. The most immediate has to do with
the spending side of the fiscal cliff. The cliff deal made permanent
the Bush tax cuts for all but high-income taxpayers but it did not
address spending. The threat of sequestration is still with us (these
are the automatic across-the-board spending cuts), though delayed
for two months. The timing now coincides with the need to extend
the debt ceiling in March. So while the worst case of the cliff was
avoided, the work is not nearly done. In the bigger picture, this
immediate concern is a sideshow
Key Macro Challenges
The first part of our commentary briefly discusses our current take
on the key macro challenges, which are primarily debt related.
Here in the United States we have made some progress in
reducing private sector debt:
·
The financial sector has completed most of its
deleveraging.
·
Household sector deleveraging has progressed, mostly
through defaults. And importantly, financial
obligations relative to disposable income are near a 30year low, largely due to the impact of extremely low
interest rates on debt service.
·
However, total household debt relative to income,
while improved from a few years ago, remains
historically high. This high relative level of debt
suggests the household deleveraging process is not
complete.
As we all know, the public sector’s debt (i.e., government
debt) has grown, and is a significant problem. We are all
aware of the longer-term challenge: how to reduce deficits so
we can maintain public sector debt at a sustainable and
affordable level, while avoiding a fiscal retrenchment that will
do excessive damage to the economy. The challenge is made
even more difficult by 1) current high debt levels, 2) the
impact of millions of retiring baby boomers and the resulting
demands on entitlements for seniors, and 3) the high rate of
health care inflation which impacts Medicare and Medicaid.
(The Congressional Budget Office forecasts that without
changes, by 2030, one in three dollars of federal spending will
go to health care.) This requires hard decisions about how
much government we can afford, what our priorities should
be, and ultimately a philosophical debate about the role of
government.
As we have written about often over the past four years,
deleveraging has consequences to the overall economy. We
are in a “paradox of thrift” world. This refers to a situation
where individuals voluntarily or out of necessity become
thrifty (saving more/borrowing less), but the impact on the
overall economy is actually less savings and spending. This
happens because what is good for the individual is not
necessarily good for the economy. In the overall economy,
more saving means less spending, which means less
immediate demand for goods and services, which result in
fewer jobs, which means lower income, which means less
ability to spend and save. This vicious circle is what is
happening in many parts of the developed world.
In the United States we can see it in the very slow growth of
disposable income and consumption. Both have been
abnormally low relative to past recoveries. This phenomenon
is absolutely expected in the aftermath of a major financial
crisis. And now fiscal stimulus is winding down and this
shift means that reduced government spending (though still
high) will offer less support to the economy relative to recent
years. A reduced rate of spending growth will continue to
serve as an economic headwind as we attempt to rein in the
growth of public spending. This same dynamic is playing out
in much of the developed world.
A key risk going forward is how our politicians deal with the
problem of growing public sector debt. Reducing the growth
of debt at the right pace and in the right way is necessary, but
not easily achieved. The risk is that this goal is not achieved,
or that it is only achieved after political dysfunction triggers a
crisis. 2013 will be an important year as politicians are
charged with putting in place a viable longer-term plan. If this
is not done in 2013, the risk is that it won’t be done until after
the next presidential election, unless a crisis comes first. The
lost time will mean we will face a bigger problem with
tougher choices and likely even greater consequences. The
markets will be watching and may not behave well if the wait
lasts until 2017.
Europe also made some progress in 2012, but most of that
progress has been in the form of buying time by reducing
borrowing costs and thereby lessening the “tail risk” of an
imminent Eurozone breakup. There has been some
improvement in the peripheral countries as most seem likely to
have current account surpluses in 2013; capital flight appears
to have stopped, and there are signs that the push for austerity
may soften a bit.
Europe is now back in recession. Severe austerity has taken a toll
on growth and appears to be counterproductive. It remains an
open question whether European governments will be able to
make the right decisions with respect to: growth policies,
pursuing competitive balance, debt relief, and the fiscal and
banking integration that is needed to hold together the single
currency over the long run. As challenging as the politics are in
the United States, the challenges are even greater in Europe where
countries with different cultures and economic characteristics are
being asked to give up some of their economic sovereignty.
Solving these problems will take a long time and along the way
they could trigger more serious social unrest. As in the United
States, Europe’s problems are all about debt-related economic
headwinds and the threat of political mishandling of a fragile
economy. But in Europe, the problems are more complicated
because the weaker countries don’t have the option of devaluing
their currencies to improve their competitive position relative to
Germany. Instead they must accomplish this with structural
changes such as labor market reforms and real-wage cuts. One
important distinction between the investment prospects for the
United States and Europe is that European stocks are cheaper.
So the developed world continues to face significant debt-related
challenges. The solutions are not easy and there are no quick fixes.
Failure could play out in various ways, from another financial crisis
to sharply higher inflation several years down the road. A brighter
spot is that developing countries are generally less indebted and
growing faster. However, growth has slowed there as well, partly
due to the impact of reduced demand from the heavily indebted
developed countries. Then, of course, there is the Middle East—
always a wild card and perhaps even more so right now with
continued shifting sands from the Arab Spring, and the possibility
of military conflict with Iran that would likely lead to an oil shock.
Reasons to Be Bullish
The next part of this commentary lists a variety of bullish
factors that could drive stocks to strong returns over the next
five years.
1. The passage of time has led to an improvement in our
expected returns for stocks.
This happens as we anticipate a return to more normal
earnings growth in the later years of our analysis. As we write
this, our five-year expected returns for U.S. stocks is in the
low double-digit range. This scenario now assumes a gradual
return to trend-level earnings and also assumes that as we put
deleveraging-related headwinds behind us, earnings can
temporarily overshoot the long-term trend level in five years.
Expected returns in this scenario for emerging-markets stocks
are materially higher than for U.S. stocks. The passage of time
is important in another way as the fact that stock prices were flat
over the past 12 years, returns are poised to be higher than they
have been.
2. The risk of another financial crisis has declined.
Time has allowed for some healing, some deleveraging has happened,
and Europe has made some progress. So the risk of a crisis that leads to
deflation is less than it was. Over time, this should have some impact
on investor risk-taking, especially if this trend continues.
3. There have also been enormous changes with respect to
investor sentiment and fundamentals that drive
expectations.
For example, stocks recently comprised 35% of household
financial assets compared to over 50% in early 2000. Over that
period of time, households withdrew about $1 trillion from
stock funds. And almost the same amount has flowed into
bond funds since March 2009. U.S. public pension funds have
also been selling stocks, with allocations falling from 70% to
52% over the past 10 years, according to the Financial Times.
These shifts reflect huge changes in investor confidence.
Confidence about the economy was very high in early 2000, about
double today’s level. Today’s low confidence is clearly related to
the losses experienced during the financial crisis and its aftermath
as we deal with the related problems of debt, lack of demand, and
weak job growth. The labor market is particularly important. In
early 2000, the unemployment rate was just over half of today’s
7.7%. The takeaway is that bull market peaks are characterized by
overconfidence. Back in 2000, when optimism was unrestrained,
we recall a consensus forming that the economy would be less
volatile with fewer and shallower recessions. There was growing
belief that asset valuation didn’t matter. Conversely, bull markets
are born from pessimism that makes investors cautious and keeps
expectations low. Fears of another financial crisis are a good
example of this. When expectations are low and fundamentals have
been weak, improving conditions are more likely, i.e., it is easier to
have a positive surprise. When expectations are very high, there is
greater risk of disappointment. This confidence obviously has an
impact on stock prices, with optimism usually leading to
overvalued stocks and pessimism leading to undervalued markets.
Confidence, while improving, is not high as we head into 2013. As
a contrarian indicator, this is a positive.
4. The Fed’s low interest-rate policies could continue to
play a big role in equity returns going forward.
If economic growth gradually improves, tail-risk fears subside, and
as time further distances investors from the financial crisis, investors
could find stocks far more appealing than bonds or cash. Cash yields
nothing and bond yields are also painfully low which in turn could
cause stocks to benefit from the mountain of cash allocated to bonds
in recent years starting to be reallocated back into the stock market.
5. Uncertainty about policy decisions and debt-related
risks continue to drive investor concerns.
However, these risks are the subject of great focus and real progress
could be made in 2013. As we mentioned at the outset of this
commentary, Congress’s last-minute compromise on the fiscal cliff
on January 1, 2013, allayed the worst fears of tax increases
combined with abrupt spending cuts. However, President Obama
and Congress will still need to address the spending cuts, which
were delayed for two months and it remains to be seen if politicians
can agree upon a credible plan for long-term deficit reduction. If
they do, that could go a long way toward mitigating concerns about
future debt build-up and related policy errors. In the United States,
this could unleash corporate animal spirits as the fear of tail risk
subsides. The corporate sector is sitting on a lot of cash that could
be used for capital investment and hiring as some of the uncertainty
recedes.
6. The global economy has experienced some encouraging
macro developments.
In the United States, the housing market may be in a sustainable
upturn. Home values are increasing and are cheap relative to
replacement costs, and interest rates are exceptionally low for those
who can get a loan. Credit markets also continue to improve with
easier lending standards. And the labor market is slowly healing,
though it remains historically weak. Overall, there is no robust
growth story, but the recovery is broadening out and the
participation of the housing sector is important. Outside the United
States, the growth slowdown in the emerging markets may have
ended and there are numerous signs that China’s economy is picking
up. Even Europe, currently in recession, could start growing again in
the second half of 2013.
The odds of the bullish case playing out is increasing, but when it
comes to investing we are still cautiously optimistic.
How This Impacts Our Portfolio Positioning
So where do we net out after fully considering the positives and
weighing them against our concerns?
Our portfolio positioning reflects several considerations:
·
·
Caution because of elevated risks: We continue to
maintain our equity positions but, also continue to
utilize our covered call writing strategy in most
accounts to help offset the economic risks that
remain.
The real possibility of a better environment and the
expectation that in all but the most pessimistic
scenarios, stocks should significantly outperform
bonds over five years. This is why our portfolios
continue to hold agreed upon allocations to stocks.
·
Higher return expectations for foreign stock markets.
·
Longer term Investment grade bonds and aggressive
fixed-income strategies we employ such as Loomis
Sayles Bond should continue to add value.
At present we are not anticipating major changes in our
portfolio positioning unless we see a significant change in
market pricing or fundamentals.
Conclusion
Our commentaries and our investing style have been
cautiously optimistic in recent years. We continue with this
thought pattern because the weight of the evidence still
suggests global deleveraging will create an environment that
will mute returns and carry outsized risks. And we also are
aware that some policies already in place are virtual
experiments—specifically Federal Reserve monetary policy.
As the Fed buys assets their balance sheet is growing.
Currently, their balance sheet equals 18% of GDP and heading
much higher given their commitment to continue to buy
Treasury and mortgage securities each month. These policies
are unprecedented and are goosing financial asset returns
higher. We all hope they will be effective and can ultimately
be reversed without causing a harmful inflation problem down
the road. But while we are not concerned about this risk in the
near term, longer-term we can’t be confident how this will
play out.
What would shift our outlook to be less cautious? One factor
would be policy decisions that credibly address the structural
problems relating to debt and the need for economic growth.
Positive surprises with respect to economic fundamentals
would also be a significant development and would help us
foresee an easier path to debt reduction.
Our portfolios are positioned in a moderate but not excessively
cautious way, and we hold some niche assets that we believe
offer the potential to add value relative to our benchmarks.
At this time, we would like to take this opportunity to wish all
of you a Happy and a Healthy New Year and to thank you
for your business and any business you may have referred to
us.
Mark Spielberger
Craig Brooks