|We saw decent economic growth in 2010 but a number of significant stresses remain.
Household debt and unemployment are slowly improving but remain high.
Most economic data points have shown improvement over the last year.
The huge government debt will pose a major challenge in the years ahead that is made tougher by exploding growth in federal entitlements. State and local gov-ernments are stressed as well.
The most likely outcome for the US economy is to continue to “muddle along”
Despite our conservative bias, our portfolios have performed well over the past two years thanks to our tactical calls and strong performance by some of our ac-tive equity and fixed-income managers.
With return potential for riskier asset classes muted, we are satisfied that our current allocations can provide competi-tive returns at less risk over our multiyear horizon. We also expect periods of fear to create com-pelling opportunities, and that our discipline and patience will allow us to take advantage of them when they do occur.
Quarterly Investment Commentary
A strong fourth quarter rally, punctuated by a December sprint, turned an okay year for stocks into a very good one. The large-cap S&P 500 Index gained nearly 11% for the quarter, and ended 2010 up 15%. The small-cap Russell 2000 and Russell Midcap both returned in the mid teens in the fourth quarter, and gained 27% and 25% for the year, respectively. Looking abroad, the story was similarly positive for emerging markets, with the MSCI Emerging Market GR Index climbing 7% in the quarter and 19% for the year. Developed-market foreign stocks also had a good year, but returns were restrained by concerns over Greece’s fiscal problems earlier in the year and Ireland’s later in the year, which drove the euro (and therefore returns to U.S. investors) lower. The benchmark MSCI EAFE Index nevertheless gained a healthy 7% in the fourth quarter and 8% for the year.
Turning to fixed income, the Barclays Aggregate Bond Index, a proxy for high-quality intermediate-term bonds, saw most of its 1.4% fourth-quarter loss come in December. Still, its strong performance earlier in the year left it with a full-year gain of just over 6%. Foreign bonds also struggled through the fourth quarter, with the Citigroup World Government Bond Index falling 1.8% and the emerging-markets JPMorgan GBI-EM Global Diversified Index down 0.4%. Each index was in the black for the year, with emerging market debt returning a notable 16%.
The recent strength in the stock market along with a gradual improvement in the economy should not lull us into a state of complacency. Though the economy is improving at the margin and could exhibit stronger growth in 2011, structural risks remain. In fact, the story is not very different from the one we’ve been telling for the last 20 months…we will continue to “muddle along.”
Last Years Worries – And Where They Stand Today
- Household Debt Levels: The trend in household debt levels is down and that’s good. On an absolute basis and relative to income, household debt has declined at the fastest rate on record. However, much of the decline is due to defaults. The overall level of household debt remains about where it was ten years ago. Deleveraging will continue to be part of the economic discussion.
The Weak Labor Market: In short, the labor market is recovering but it’s a wimpy recovery compared to past expansions and in light of the number of jobs lost. It will get better. There are multiple indicators that suggest the job market should strengthen, but we have a long way to go to bring employment back up to acceptable levels…it will be years, not months.
The Housing Market: The good news is it has stabilized in most markets, but the bad news is it is not any better than it was one year ago.
Consumer Spending Headwinds: Consumer spending has increased for the last six months in a row, but ability to grow faster is dependent on the labor market.
The Government Debt Explosion: Government debt levels remain very high both on the Federal and the State level. And the absolute level of debt is only part of the problem. The impact of aging baby boomers will exacerbate the problem as Social Security trust fund and state pension fund expenditures increase along with increasing demands on Medicare and Medicaid. The growth rate of government debt is not sustainable. We’re all aware of these problems and the economic risks that accompany them. This is likely to be a very important issue during the next five to ten year horizon that could have a material impact on the economy and financial markets.
European Sovereign Debt Crisis: While it’s possible Europe will muddle through, it is the region that seems most at risk for falling back into recession. And although the risk of a destabilizing breakup of the euro is now on the radar, it remains unlikely in the foreseeable future because the benefit of any breakup relative to the costs is questionable. The negative scenarios for Europe would impact the global economy and are therefore a key risk factor.
Emerging Markets: A new worry is the economic strength in many emerging markets. The problem is not that the economies are strong, but rather that in a number of cases, policies to prevent their currencies from appreciating (and hurting their export competitiveness) necessitate low interest rates that can ignite inflation and asset bubbles. Inflation in China is the most visible problem and it is already driving a tightening of monetary policy and fears that this will cause growth to slow too much.
Deflation/Inflation: Deflation has been our biggest worry of the last two years. Given the actions of the Fed over the last few months, I think it is safe to say that Fed Chair Ben Bernanke will do whatever is necessary to keep deflation from taking hold. We don’t see evidence of inflation today. If we do have any significant inflation in the near term, it will be imported from emerging markets.
All that said, we don’t mean to paint a depressing picture that suggests the need to “hunker down.” Things are better, actually much better. Consumer spending is edging up, employment is less bad, and we are seeing companies around the globe benefitting from increased demand in the stronger emerging market economies. We expect that stocks will deliver mid to high single-digit returns and bonds to deliver in the low single-digits in our more likely five-year scenarios.
With that said, here are some more specific thoughts on each of the major asset classes:
In the past 20 months or so, the majority of financial investments have had a huge move to the upside. Fixed income was no exception. Today however, we stand at a 10 year treasury of approximately 3.3% with the possibility (hope) of interest rates going higher over the next several years.
Given the low interest rate environment, traditional fixed income will be hard pressed to deliver returns above their coupon rate. Our portfolios are focused on taking interest rate sensitivity out of the equation without taking undue credit risk. We have done this through a number of “absolute return” portfolios – Eaton Vance Absolute Return, PIMCO Unconstrained and the Loomis Sayles Bond fund. These portfolios (along with others) can handle a rising interest rate environment and still produce positive returns.
The most popular question that I answer today regarding fixed income is, “Why do we own it at all given the extremely low returns we are discussing going forward?” The answer is simple; we own it for protection. Fixed income in general is your best investment when equity markets do poorly. We believe in diversified portfolios in which fixed income would almost always have a role, regardless of what the short-term viewpoint may be on interest rates.
At the beginning of 2010 the conventional wisdom was that international equities were the place to invest. What actually happened is that US equities significantly outperformed developed international equities, and as you know, we were rewarded handsomely for that. (US equities doubled the returns of international stocks last year). Today, with the S&P at about 1293, we believe US equities are fairly valued. While there are good opportunities in both growth and large companies, we don’t really believe that the domestic market is undervalued any longer.
International developed equities performed poorly in 2010 relative to other equity investments primarily because of the European Debt Crisis. We believe that a large portion of the European Debt Crisis has been priced into equities, but the problems are not over or resolved, there is significant headline risk.
We are overweight in emerging market debt and equity for two primary reasons: (1) we believe those currencies will have an opportunity to appreciate versus the US dollar, and (2) the majority of the world’s growth is taking place in these markets. Although emerging markets are the most aggressive investment we own in our portfolios, we still believe they have favorable risk/reward characteristics.
The alternative investment category is one that we created for our portfolios in 2010. The premise is very simple: given the muted returns expected from fixed income and equities and given some of the structural risk we have discussed, we want exposure to investments that don’t have that traditional financial market risk.
We believe the investment in alternative investments can do this for our portfolios. We are using a combination of alternative strategies from arbitrage to managed futures to traditional long/short strategies to create a diversified portfolio of alternative investments. In this strategy, as in all strategies, it is critical that we that invest in the right funds and managers. We are confident we have hired the “best of breed” here.
As we look ahead to next year, we continue to believe the range of possible outcomes is wide. We are not confident that we can precisely predict what next year will bring, but our investment approach does not require us to have an answer for the next year. Our analysis covers time frames that are likely to reward us for getting the fundamentals mostly right; understanding that our clients have investment needs that last far beyond one year. As we said last year, if risk-taking takes hold for a while, our portfolios could well underperform. However, we continue to be confident in our positioning over our multi-year time frame, and ready to take advantage of tactical opportunities to add to our risk exposures should fear reassert itself in the markets.
Jon Houk, CFP®