Investment Commentary Key Takeaways
Appropriately, the second quarter of 2012 closed with a spike in volatility, this time on the upside, as news out of Europe sparked hope that fiscal and monetary cooperation in the region could keep the worsening fiscal crisis from spinning out of policymakers’ control. However, after factoring in market declines in both April and May (driven by more pessimistic news out of Europe), U.S. stocks finished the quarter down almost 3%, while developed market foreign stocks were off 7% and emerging-markets stocks lost more than 8%.
On the bond side, investors’ almost binary attitudes toward taking or avoiding risk were similarly evident. While the Treasury-heavy Vanguard Total Bond Market index fund and the junk-bond Merrill Lynch U.S. High Yield index both gained about 2% for the quarter, the latter earned all of its gain in June as risk assets rallied, while the former earned all its gain in April and May.
Recent market optimism aside, the debt-related fault lines in the global economy have not stabilized, and are likely to be with us for at least a few more years. We continue to believe that debt-deleveraging headwinds will continue to hamper economic growth and create macro risks over the next five years.
Because of exceedingly poor returns in the last 12-24 months outside of the United States, we believe that investments in Europe and particularly Emerging Markets are looking more attractive. We have looked long and hard at increasing our foreign exposure in June, but ultimately decided against it. While the long term opportunities have improved, big risks remain that we cannot dismiss or effectively quantify.
Our portfolio positioning is driven by a weighing of risk and potential reward and patiently assessing opportunities before investing more aggressively. As a result, our portfolios are not only somewhat underexposed to risk, but are also invested quite differently from their benchmarks.
In each of the last three years, there have been strong market rallies early in the year followed by market corrections ranging from about 9% to 19%. These volatile market conditions are one reason why we make a consistent effort to remind our clients of our long-term fundamental and valuation-driven approach that tends to result in more gradual portfolio shifts. A disciplined, unemotional investment approach is absolutely necessary in order to resist the emotional pull of these ups and downs so that decision making is not impaired. For long-term investors, the silver lining is that the price declines that could come with these risks will likely generate good buying opportunities, and allow us to generate better long-term returns than what the broad markets offer.
Second Quarter 2012 Investment Commentary
We continue to be very concerned about the same problems we’ve written about repeatedly in recent years. Europe seems to be close to either spinning out of policymakers’ control, or nearing a trigger point of more comprehensive and effective action. While the wrong outcome here could be extremely harmful to global equity markets and the global economy, the crisis is beginning to create some opportunities.
In the 2nd Quarter, the sharp selloff in European and Emerging Market stocks had, in our view, started to price in the slow growth scenario that we believe is likely. However, they are not yet a fully fledged “fat pitch” on an absolute basis. The most pessimistic scenario, which we cannot dismiss, foreign markets would likely experience a sharp selloff. Consequently, we have decided not to increase our foreign exposure, but I do believe we are getting close and it will most like happen near future. Context is always critical to decision-making, so let us walk you through some of what we think we know, what we don’t know, and how this informs our decisions.
What We Know
We know that extremely high debt levels have created a headwind to global growth resulting in a weak economic recovery with risk of another significant economic and market downturn. This risk has been turning into reality in Europe for a number of months and is reflected in an economic recession, which includes extremely high unemployment in the weak peripheral countries, slowing growth in the core countries, and a large decline in European stock prices.
Generally, we know there is no easy solution to the problems of excess debt that almost all of the developed economies are suffering from. It is likely that taxes will rise and spending growth will decline over the next several years, and this will continue to be a drag on economic growth.
We know that conflicting political motivations and economic circumstances across nations in Europe are huge impediments in dealing with the crisis there. The need for a fiscal union or fiscal integration is central to the problem, but it requires surrendering some control of country budgets, tax policy, etc. Gaining agreement will require heroic efforts on the part of politicians. (Germany’s concessions at the June 28 EU summit suggest compromise is possible but very difficult decisions and negotiations lie ahead so uncertainty remains very high.) All of this suggests that a partial breakup of the eurozone is very possible. If that happens, the hope is that it will be well planned so as not to unnerve the markets, thus avoiding a possible credit freeze and increased capital flight, which would exacerbate the risk to the entire eurozone and trigger a major economic downturn. This scenario is a major worry and has been rapidly intensifying.
We know that in the United States, recovery continues and there has been improvement in most areas. We believe the housing crisis is over. The labor market has improved, though more recent data has been less encouraging. All of the data points are consistent with our “muddling along” scenario that we have been discussing for the last three years.
We know deleveraging in the U.S. private sector is progressing (16 consecutive quarters of debt reduction), but mostly through debt defaults. This progress is important, but we also know that this process is by no means complete. Overall debt levels in the private sector are still high, though debt service is low compared to incomes due to low interest rates. This is a big help. Also, in the public sector, debt has been building so deleveraging there has not yet begun, but it will have to. Our deleveraging analysis last year suggested that the process could take another five years.
We know that if business confidence increases, U.S. companies and many global multinationals not domiciled in the United States will have large amounts of cash and the potential to move quickly into a more investment/expansionary mode.
What We Don’t Know
The bottom line is that while we believe the subpar growth scenario is most likely, we are not highly confident in making this prediction. However, it is very helpful in our decision making to be able to be honest about our uncertainty and to instead define and understand the range of potential outcomes.
One of the most important unknowns is that policymakers have the potential to take actions that could have various outcomes, positive or negative, for the global economy and the markets—including actions that could trigger positive market surges. While we think it is more likely than not that their choices will be a net positive (because the consequences of bad choices could be truly awful), we are not confident which choices they will make, especially given the politics involved.
We continue to worry about the possibility of a hard landing in China impacting the global economy. Developments in the Middle East (e.g., war with Iran, etc.) could also significantly impact oil prices. As always, there are unknowable risks and developments that could blindside us either positively or negatively.
This all nets out to an investment environment that is most likely positive, but yet volatile, as was the case in 2010, 2011, and so far this year, with periods of strong market performance followed by sell-offs. Given this context, we will continue to refrain from trying too hard to capture uncertain returns in a choppy, potentially very high-risk environment. But, we do seek to add value where we can while we wait for better opportunities. While we are not excessively defensive, we are conservative enough that we risk underperforming if the stars align: the eurozone pushes the right buttons, U.S. and global growth accelerates, and China avoids a hard landing.
Structure all balanced portfolios so that risk is somewhat below average: This will provide some protection in down markets and importantly, will leave us with some dry powder that we can re-deploy if stocks get cheaper.
Maintain exposure to “at risk” assets but skew towards the US equity markets: We are focused on Large U.S. based franchise companies as we have been for the last couple of years, as you can see from the chart, this has been a good position. We remain somewhat cautious because there is still much tension between short-term risk and long-term opportunity. We believe there is a good chance that given the debt-related risks (especially from Europe), that there will continue to be volatility.
Focus our fixed-income exposure on the best value that also allows us to capture more yields: The more flexible fixed-income funds we hold in our portfolios will probably not help us as much in a market downturn as Treasuries. We are very confident that they will be a source of major value added over our five-year horizon and even over much shorter periods (but not necessarily measured over a few months), as the higher yields we capture more than compensate us for the ground we would temporarily lose in a market scare that drove investors into Treasuries.
Diversify into some liquid alternative investments: These investments have the potential to provide somewhat more return than fixed-income investments (and potentially competitive with equity markets) over the coming years at a level of risk that is likely to be quite a bit lower than the stock market.
Wanting to Feel Better, But Not There Yet
The fault lines in the global economy, mostly debt-related, have not stabilized and are likely to be with us for at least a few more years. There are no easy solutions and we are all tired of it. We are also tired of the risk-on/risk-off related volatility. It is confusing for clients to see the markets roar for a month or more, only to be followed by a surge in scary headlines and sharp sell-offs. A disciplined, unemotional approach is absolutely necessary in order to resist the emotional pull of these ups and downs so that decision making is not impaired. We believe this is one of the many values we bring to our clients. For long-term investors, the silver lining we expect is that the price declines that could come with these risks should generate good buying opportunities. As always our motivation is stay clearly focused on our goals of long-term performance, risk management, clear communication, and a high level of service.
Jon Houk, CFP®