2011 Investment and Market Recap
After huge volatility, the S&P 500 index ended 2011 about where it started. Small and mid-cap stocks closed the year down 4.2% and 1.7%, respectively, despite also posting double-digit fourth-quarter gains. Fear over Europe and slowing growth in China dragged foreign stocks down 11.8%, with China concerns and a flight from risk hitting emerging-markets stocks even harder; they fell 18.8%.
High-quality bonds were on the other side of the volatility, with sharp flight-to-safety rallies that helped net the Vanguard Total Bond Market Index a 7.6% full-year gain. Our allocations to flexible bond and absolute-return-oriented funds hurt performance in our portfolios because they provided less short-term protection than high-quality bonds, but we remain confident that our bond allocations will provide better longer-term returns at still-acceptable risk levels. Underperformance from some of our active managers also detracted from performance.
As we look back on 2011, it was a very frustrating year. Almost all economic or fundamental data points were better in 2011 than they were in 2010 but unfortunately, we did not get paid for it. Investor’s decisions about getting in and out of stocks were driven by macro headlines (often referred to as “risk-on, risk-off”) and there was less consideration for fundamentals of individual stocks. This creates long-term opportunities, but can be frustrating over shorter periods. Examples of data points that are better today than they were in the beginning of 2010 are: Unemployment, Retail Sales, Household Debt, Corporate Earnings, Inflation in Emerging Markets, Cash on Company Balance Sheets, Valuations of Equity Markets Worldwide, and Housing –yes even housing is slightly better! This is not an exhaustive list of areas that are better, but it is a starting point. In 2009 and 2010, we got paid handsomely in the equity markets for the tremendous increase in fundamentals. Not only did the markets go up, but our portfolios were able to outperform in both years by substantial margins, but again, 2011 equity prices did not reflect any of the improvements in fundamentals. The primary reason has to do with the overhang and concerns of the situation in Europe. I do not know what that outcome will be (we will discuss the potential outcomes here later), but I am confident that fundamentals do matter and will matter as they have in the past and will be reflected in equity prices over the long run.
2012 Outlook and Investment Commentary
As most of the developed world struggles to dig out from under a mountain of debt, all of our options involve economic pain that is compounded by political uncertainty. Having hit debt levels that are unsustainable, deleveraging (debt reduction relative to GDP) is necessary. Ideally this comes from economic growth—increasing the denominator in the debt/GDP ratio. But when debt is so high, it becomes a headwind to growth. Governments try to use fiscal stimulus to counterbalance the private sector’s retrenchment, but this can only continue for so long as increased government spending/stimulus add to the growing burden of public debt. That leaves spending reductions and tax increases as solutions at the government level (austerity), or some degree of debt default. Default can happen in two ways: (1) not repaying debt, or (2) creating inflation by “printing” money so that money is devalued. Both of these options create other problems.
Governments can also attempt to force “financial repression”, where they use all possible tools to keep interest rates low. This serves several purposes including keeping their borrowing rates low so that the debt-service burden does not explode to impossible levels. For investors, this means low returns from fixed-income investments.
The lesson from economic history is that, without exception, a debt-induced financial and banking crisis results in a lengthy period of subpar economic growth. This is exactly what has been happening throughout the developed world economies since the 2008 financial crisis and this is something we have written and talked about extensively. Weak economic growth leads to periodic recession fears and unacceptably high unemployment. Moreover, high debt levels mean that we will likely be living with large macro-level risks for a few more years at least. If we are right, it is probable that we will experience (1) continued high financial market volatility and (2) reduced investor risk appetites, meaning lower prices for risk assets like stocks and high-yield bonds than would otherwise be the case.
There are many debt-related risks in the world today. Europe is an obvious big risk in the near term. What we’re seeing in Europe is that investors are afraid that the region lacks the political unity and possibly even the financial capacity required to provide a sufficient financial backstop for the Eurozone. As the risk of weaker governments defaulting on their debt increases, investors demand even higher yields for taking on that risk. Higher yields, in turn, make a default even more likely, because governments can’t sustain interest payments above a certain level. (This phenomenon is known by economists as an “adverse feedback loop.”) Therefore, only some type of unified policy action and intervention can allow governments to roll over all the debt that is coming due.
It is very possible that we will find out during the next year whether Europe can keep the EU together and get through the crisis with a mild recession or, at the other extreme, a disorderly EU breakup, which would create severe global ramifications. There are other outcomes in between these two extremes. The most common outcome would be some type of orderly breakup of the EU. This would most likely take place in the form of removing some of the weaker countries (Greece, Portugal, etc.) which would take place over a multi-year period of time. However, any result other than a disorderly breakup of the EU, we would consider as positive. Most of Europe is probably in recession as I write this and will most likely continue in a recession for much of 2012.
The worsening of the crisis actually increases the likelihood that the European Central Bank will finally step in more decisively and provide major support for the sovereign debt market and the banking system, e.g., by buying Italian and Spanish government debt via “quantitative easing” (much as the Federal Reserve has done with Treasuries) to bring down interest rates, restore confidence, and break the debt-contagion adverse feedback loop. But this is not certain and the question of whether they will do it in time to avoid a serious and potentially devastating economic downturn is one we can’t confidently answer. The costs of a European Union break-up are high so there should be strong motivation to avoid it, but the political and practical realities are highly complex.
The U.S. economy in contrast is a bright spot, though still weak, has performed somewhat better recently and appears to have moved back above stall speed, but our own maddening political dysfunction, severe debt problems, and continued housing weakness makes the United States susceptible to economic shocks (think Europe) and policy errors.
So Where Are We? Our Portfolio Strategy
In the 20 years since JPH Advisory Group was founded we have managed through many challenging environments. However, none has been more challenging than the recent financial crisis and the aftermath that continues. The weight of the evidence suggests to us that it is right to be cautious, but there are bullish arguments (case for equities) worth examining. By far, the strongest bullish argument in the short run is that authorities will do whatever it takes to avoid financial catastrophe and therefore much stronger steps will be taken in Europe. For example, if the ECB undertakes major quantitative easing, the global stock markets could experience a massive rally. If this coincides with continued improvement in the U.S. economy, 2012 could turn out to be a very good year for the stock market. Secondly, companies have piles of cash and are ready to spend it if uncertainty declines or demand increases. If policies are pushed forward that reduce some of the scariest risks, we could see companies loosening up their purse strings. This could be a positive double play for the economy and markets—as we’d have both policies that reduce uncertainty, and a business sector that is poised to expand.
In the next several weeks and months, we will be getting together for our annual reviews. At that time I will discuss in more depth what our strategies are in your individual portfolios in regard to balancing the concerns with Europe, the current financial repression in the bond market, the opportunities that we see with the strong fundamentals of our economy and the low valuation of markets around the world (some of the cheapest we have seen in recent history). As always we thank you for your confidence in JPH Advisory Group as we navigate these unprecedented times.
Jon Houk, CFP®