Fourth Quarter 2012 Key Takeaways


Stocks shrugged off numerous worries to log a very good year in 2012. The riskiest areas were the most profitable. Emerging-markets stocks earned 19%. In the U.S., mid- and small-cap stocks slightly outpaced large-cap stocks, 17% to 16%.

The bond side also saw riskier asset classes out-earning traditionally safer fixed income sectors. Emerging-markets local-currency bonds notably gained 17%. Domestically, high-yield bonds and leveraged loans returned 15% and nearly 10%, respectively, while traditional investment-grade bonds returned 4%.

Our actively managed portfolios performed well relative to their benchmarks. Our active bond funds, in particular, added significant value versus the core bond benchmark over the last year.

Our expectation of slow economic growth has largely been right over the past four years, but, because stock and risk investment were so depressed, we have still had very good returns.

A key risk going forward is how our politicians deal with the problem of growing public sector debt. The last-minute fiscal cliff compromise buys politicians a little time to address the more important longer-term fiscal issues, but does little to resolve them. Europe also made some progress in 2012, but most of that progress has been in the form of buying time by reducing borrowing costs.

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.

We recognize that there are a variety of bullish factors that could drive stocks to strong returns over the next five years. However, the odds of the bullish case playing out are probably less likely than they were, and in our view a slow-growth environment is still the most likely outcome.



Fourth Quarter 2012 Investment Commentary


Slow Growth As Expected—Now What?

For several years we have said the most likely outcome for the developed world economy would be years of slow growth. This view was based on our assessment that excessive debt levels in the United States and around the developed world had to be reduced, and that this lengthy period of deleveraging would suppress spending and be major drag on economic growth. This belief has largely been right over the past four years, even though we have had very good returns in the stock market as corporate earnings have rebounded. In addition, our actively managed portfolios have performed well relative to their benchmarks over the full four years since 2008, despite our conservative approach.

The risk of another crisis has declined, but it remains possible and is not easily dismissed. 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. This 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, there is a risk that it won’t be done until after the next presidential election without a crisis coming first. Each year we delay will mean an even bigger problem with tougher choices and likely 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 catastrophic scenario of a disorderly 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.

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. However, one important distinction between the investment prospects for the United States and Europe is that European stocks, as a whole, are cheaper.

It is Important to Consider the Optimistic Scenario

An important part of our investment discipline is to challenge our own conclusions and expose ourselves to alternative points of view through our reading and working our extensive industry network. Most importantly, our scenario approach forces us to think through a variety of possible outcomes. We recognize a variety of bullish factors that, though counter to our base-case view, could drive stocks to strong returns over the next five years. These include:

  • As we move further along in the deleveraging process, expected returns for stocks will improve as we anticipate a return to more normal earnings growth in the later years of our analysis.
  • The passage of time has also meant that an enormous amount of froth has been taken out of stock prices. The stock market, as measured by the S&P 500, is at a level first reached 13 years ago and multiples are much more reasonable than they were at that time.
  • The risk of another financial crisis that leads to deflation has declined. Time has allowed for some healing, some deleveraging has happened, and Europe has made some progress. Over time, this should have some impact on investor risk-taking, especially if this trend continues.
  • Relative valuations driven by the Fed’s low interest-rate policies could continue to play a big role in stock returns going forward. We assume macro forces will result in below-average earnings growth, so stocks look fairly valued. However, 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.
  • If politicians can agree upon a credible plan for long-term deficit reduction, that could go a long way toward mitigating concerns about future debt build-up and related policy errors. In the United States, 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. In Europe, while fear of policy errors is justified, it is also possible that 2013 could see progress toward banking and fiscal union and a return to growth later in the year.
  • The global economy has experienced some encouraging macro developments. In the United States, housing is now a driver of growth rather than a drag on growth. Credit markets also continue to improve with easier lending standards. And the labor market is slowly healing, though it remains historically weak. 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 (though not to previous growth levels). Even Europe, currently in recession, could start growing again in the second half of 2013.

The odds of the bullish case playing out may be increasing, but in our view they are still not high. There is no easy road out of our debt bind and there are consequences to that reality. The only easy road would be robust growth, but this is close to a mutually exclusive condition with a deleveraging global economy. So despite somewhat improved odds of the bullish scenario, it is more likely that we see a slow-growth environment with a continuation of some aversion to risk. In this environment, corporate earnings will be challenged as growth through cost cutting has largely played out. Revenue growth will need to be a driver and ultimately that will depend on demand. Partly due to very high (and potentially unsustainable) profit margins, earnings growth will be muted.

How This Impacts Portfolio Positioning

Our portfolio positioning reflects several considerations:

  • Caution because of low expected returns in our most likely scenario (continued subpar growth). However, it also reflects 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 material allocations to U.S. stocks.
  • Potentially higher return expectations for foreign stock markets, but along with that comes high risk.
  • Fixed-income opportunities, while muted everywhere, are more appealing outside the investment-grade bond market, including parts of the mortgage market, short-term high-yield bonds, and emerging-markets local-currency bonds.
  • Opportunities to capture higher returns than bonds, and more stable returns than stocks in alternative strategies, such as merger arbitrage, and also in flexible fixed-income strategies.

During 2012, our fixed-income positions added enormous value to our portfolios and helped to offset the impact of our equity underweight. Our view is that there is still potential for returns from our fixed-income positions in coming years, but the magnitude is likely to be less than what we captured in 2012. Most of the bond funds we hold pay much higher yields than the bond index and have less interest-rate risk. The lower-interest-rate risk is a function of lower duration and more credit exposure, which is likely to perform better in a rising interest-rate environment. However, yields have come down and this means lower potential returns than what we were able to capture in 2012 and over the past several years.

Looking Ahead

Our commentaries have been rather depressing reads in recent years. This one may have been somewhat cheerier as we laid out factors that could result in a more optimistic scenario playing out. However, the weight of the evidence still suggests global deleveraging will create an environment that will mute returns.

Given the unsatisfactory return expectations for most asset classes across our macro scenarios, 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. This can be a frustrating strategy that requires the patience to wait for better opportunities. However, this past year was an example of this strategy working as our portfolios beat their benchmarks despite being conservatively positioned in a very strong year for the stock market.

We appreciate your continued confidence and trust.


Jon Houk, CFP®