|A number of major problems have been weighing on the markets in the last few months.A Greek default is a significant concern, particularly the risk of contagion spreading to the other weak EU countries and the broader financial system.
We are increasingly concerned that China could face a “hard landing” for its economy.
At home, the debt/deficit problem is significant, but we probably have a few years before borrowers start demanding higher rates for the risk of lending to a fiscally challenged U.S.
Given the wide range of potential outcomes, which are skewed to the downside, we remain underweighted to equities and overweighted to non-traditional, lower-risk asset classes.
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Quarterly Investment Commentary
There are a handful of important points that underlie how we view the world in general and the investment landscape in particular. If this brief summary section is all you choose to read, we hope it gives context for the investment decisions we are making on your behalf. If you want more detail, the subsequent sections provide it.
First, we continue to see potentially serious risks out there that could be damaging to the investment markets. The possibility of a Greek default is in the headlines, but there are other significant risks as well including the chance that China sees a sharp slowdown that affects the global economy, our own debt problems (both at the household and government level), and ongoing weakness in the economy highlighted by persistent weakness in jobs and housing. These issues matter because they have the potential to roil markets and, in a bad-case outcome, cause significant losses. And, even if they don’t, they still strongly suggest that it will be harder for the economy to grow at a normal pace in the years ahead.
Second, it is especially difficult to predict how these global and domestic issues will unfold in the years ahead because complexity is so high. We are confident, though, that there is more downside in a bad outcome than there is upside in a good outcome.
This brings us to our third takeaway, which is that stocks and other risky assets are currently fairly priced, but aren’t priced cheaply enough to reward us adequately for the risks we see. However, we believe we can get similar or better returns with less volatility and less downside from other investments that we own, such as flexible bond and absolute return/alternative strategies which don’t depend on tailwinds from rising markets to earn their returns. The net of this is that our portfolios are conservatively positioned at this time and we expect this to continue until we see better return potential from riskier assets.
Finally, in terms of setting expectations markets could continue to climb in the short term. Very low interest rates encourage investors to take risk and, as time passes, can contribute to complacency. But time won’t fix the problems such as our federal deficit or Greece’s unsustainable debt load. These problems will either come to a head on their own, or actions will be taken to fix the problems—either course will result in pain. If we do see markets get roiled, we will be prepared to take on more risk at levels that promise better returns. In the meantime we will probably lag in a rising market, which brings up a different kind of risk—the risk of being “wrong” in the short term. To that point, our process is one that demands we make decisions based on analysis of longer-term factors, which we can do with much higher confidence. Predicting the short term is not something we believe anyone can do reliably and consistently. This is why we want to be sure you have the opportunity to fully understand our reasoning and the depth of work we’ve done to arrive at the conclusions we have. For that, please continue reading, and if you have further questions don’t hesitate to contact us.
Greek Debt Crisis Fears (Again)
It appears that the European Union, the European Central Bank, and the International Monetary Fund will once again provide Greece with additional financial assistance (i.e., loans at below-market interest rates) in return for Greek promises of more fiscal austerity. The aim is to buy more time with the hope that Greece will ultimately be able to get its fiscal house in order and pay back the debt. However, we, and most other investors, believe some type of Greek default or “restructuring” or “reprofiling”—in which the debt repayment schedule is extended but the principal value is not marked down—is inevitable given the severity of their situation. As one investment strategist put it, “Everyone knows Greece will default—it’s just a question of whether it’s orderly or disorderly.”
China Hard Landing
Another risk that we have highlighted recently and that is growing in importance in our macro assessment is a potential “hard landing” for the Chinese economy (as opposed to a smooth manageable slowdown) and the global ripple effects that would result. Most experts we have talked to agree that there is a bubble in at least some segments of China’s property market. The general consensus is that this bubble is not widespread and can be managed by the Chinese government, as it has been in the past. There is a risk, however, that the bubble may have already grown very big and, if pricked, will result in a sharp contraction for China, which we believe has not been priced into risk assets. A hard landing will be negative for equities, commodities, and also for our allocation to emerging-markets stocks and local-currency bonds. We have talked to and read analysis of both the optimists and the pessimists, and it is hard to really know who is right, partly because of the lack of reliable information from China. However, in the past China has been able to manage their growth remarkably well and we hope that continues.
The U.S. Economy Is Still Muddling Along
Recent U.S. economic news has been disappointing, not necessary bad, just not as strong as anyone would like. There is continued weakness in employment and housing (which are important drivers of consumer confidence, income, and spending). On the jobs front, the latest employment report for May showed growth in nonfarm payrolls of only 54,000 for the month, a big drop from the 220,000 monthly average increase in the prior three months. We have seen estimates (from various economists) that the economy must create anywhere between 100,000 and 200,000 net, new jobs each month just to absorb the natural flow of new entrants into the labor force and keep the unemployment rate flat.
A Concluding Reminder about Downside Risk
We will conclude with a reminder about the potentially severe downside, e.g., in the event of a European debt contagion, China hard landing, or some unexpected systemic shock. In that event, we’d expect riskier assets to depreciate. As we’ve said, we don’t manage our portfolios to a worst-case scenario because the opportunity cost from foregone returns in the event less-dire scenarios play out can be significant.
The good news for clients who are in the appropriate risk tolerance/profile is that in the event of a severe market downturn, our relatively defensive positioning should enable us to redeploy capital from lower-risk investments into equities or other higher-risk assets with (at that point) much better return potential. As we’ve written in our past commentaries, if there is one thing we can be almost certain of, it is that there will be market shocks over the next few years and they will create investment opportunities for us to take advantage of. There may also be events that magnify risks that we will want to further protect against. In either case, we will continue to invest based on where our research and analysis leads us, not based on what the investment herds are doing, “common industry practice,” or anything else of that nature. In the long run, investing based on our research conviction has paid off for our clients, and we are confident it will continue to do so.
Jon Houk, CFP®