Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
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