| The overall environment has improved, but plenty of problems remain.
Macro issues are unusually important in this environment, and there are several key areas we are assessing to help us make portfolio-level decisions.
Highly significant questions include when housing will bottom, what the longer-term impact will be of government stimulus and other policy actions, and whether investors will remain risk averse in the years ahead.
In all but our optimistic scenario, the returns we expect from broad asset classes are not exciting in the years ahead, not bad returns, just not exciting. But we think continued tactical opportunities and value added from our active managers improve our return outlook.
Quarterly Investment Commentary
As we look back on a tumultuous first half of the year, we are struck by the degree to which conflicting signals characterize the investment and economic environment. After a horrendous 2008 and a dismal first quarter in 2009, the second quarter saw robust gains – stocks in fact had their best quarter in more than 10 years. Our portfolios, boosted by successful tactical shifts in our portfolio allocations and by significant outperformance from our managers, did considerably better than their market benchmarks.
The Market and the Economy – Uncertainty Reigns
The conflicting signals on the economy include several positives that helped drive the market’s rebound from its March low. The prospect of a meltdown of the financial system appears past; the government has demonstrated it will do whatever is necessary to avoid a disaster of this scale. And though some economic activity continues to worsen, it is doing so at a slower rate, which suggests that we are getting closer or we have reached to an economic bottom. However, the global economy remains in a fragile state as the effects of massive wealth destruction and the unwinding of huge debt bubble continue to play out. The ultimate result will likely be lower spending by both consumers and businesses in the years ahead, as the economy in effect resets to the level where it might have been without the artificial boost of the credit bubble. While it probably allowed us to avoid a depression, the massive bailout and stimulus spending (along with longer-term demographic factors such as spiraling health-care and other entitlement spending) is causing the federal deficit to balloon, which could lead to dollar weakness and inflation down the road.
Other conflicts are at play that will influence how the environment unfolds in the years ahead. One of these is housing, which started the cycle of damage we are now in. There have recently been a few positive signs including stronger demand and historically high levels of affordability. But a wave of new supply from foreclosures over the next two years suggests the market will continue to struggle. Our view point is that house doesn’t have to recover….it just has to stop getting worse.
Another question is whether we should be worried about inflation or deflation. At present, there is an enormous amount of excess manufacturing capacity and available labor so it is unlikely there will be higher costs to pass along. Demand-driven inflation also is unlikely. Over the intermediate-term there is even some concern that deflation could take hold if the global economy doesn’t experience a sustained rebound. However, looking out a few years, the bigger risk is that policy makers’ efforts to avoid a deflationary cycle are too successful and trigger a run up in the inflation rate to modestly high levels or worse.
That brings us to another issue, which is the tightrope that policy makers have to walk with respect to stimulus. We believe that in aggregate, government intervention probably saved us from an economic depression, but have we dodged the only bullet? What are the long term “costs” of these government actions?
Given the actions to date, the Fed and the Treasury are clearly committed to doing whatever it takes to help the economy find a floor so that it can grow again. On the other hand, if there are no more bullets to dodge, it will be difficult to know when the timing is right to unwind the stimulus. If it is unwound too early the economy could relapse (as happened in the U.S. in the 1930s and Japan in the 1990s) and if it is extended too long it will add to budgetary woes. In any event, there will be great political pressure to deal with on both sides of the issue.
Investment returns will also be influenced by investors’ willingness to take on risk, which tends to build during bull markets and break down in bear markets. The degree of investor risk aversion is an unknown that will impact returns in the years ahead. Our working assumption is that it is more likely than not that higher-than-normal risk aversion will subside very gradually and that stock P/E multiples in five years will be average or below average relative to the last 50 years. This partly explains why expected returns in most of our equity scenarios are generally mediocre. If we look beyond five years we can anticipate a gradual return of normal risk taking leading to higher returns.
We Consider a Range of Outcomes in Making Portfolio Decisions
Broadly speaking, these conflicts create a very wide range of possible outcomes. Our intellectual honesty demands that we recognize that no amount of analysis will allow us to determine exactly how the coming years will unfold, so we direct our analytical effort toward thinking carefully about what would happen across a range of outcomes. This process of scenario analysis gives us important insights about how to position our portfolios.
In all but our most optimistic scenario, we believe returns from stocks and bonds over the next five years will be no more than mediocre. Fortunately, as we invest for our clients we are not limited to just what the broad stock and bond markets give us a source of optimism. Because this is an environment in which many stocks and bonds have traded at prices below what their fundamentals suggest they are worth, our managers have made investment selections that added a lot of value over their market benchmarks. While some of the lowest-hanging fruit may have been taken, pricing disconnects remain that we think could continue to give our managers a tailwind in the years to come.
Pricing disconnects exist at the asset class level as well, and we expect to see more opportunities if markets experience further periods of high volatility. We have already enjoyed strong returns from our tactical position in bonds. We also added to our position in emerging-markets equities in the second quarter, based on our analysis that over the next five years emerging-markets equities will have higher returns than large-cap U.S. equities. We also think this will be a position we will add to again in the future. In addition to these tactical asset class moves, we have added a convertible bond position to get high on the capital structure that also came from our large-cap U.S. equities position.
Looking ahead, although we are not concerned about imminent inflation, we are considering asset classes that could help protect our portfolios in the case of a declining dollar and/or increased inflation. These could include emerging-market bonds, Treasury Inflation-Protected Securities and possibly commodity futures.
Thank you for your continuing confidence in myself and JPH Advisory Group. Please contact us if you have question or just want to discuss how the above information affects your personal portfolio and financial goals.
Jon Houk, CFP®