|The Great Recession may be officially over, but we continue to expect that sluggish economic growth may continue for years.We realize this is a similar story to what we’ve been writing in the last few quarters, and it’s not necessarily encouraging. However, it’s not all gloom and doom either. In the scenario we think is most likely, the economy continues to grind ahead slowly as we work through the aftermath of the recent crisis. While we think it will take years to work through all of the housing, debt, and job market issues, at least we are on that track.
Though we see few tactical opportunities at the moment, we believe that the longer term environment will be one that favors our tactical asset allocation approach, as periods of fear and volatility create compelling opportunities.
Quarterly Investment Commentary
The stock market continued its roller coaster ride in the third quarter, with strong September gains bringing returns solidly into the black for the full quarter. The large-cap Vanguard 500 Index (a proxy for the S&P 500) is up 11.3% for the third quarter, yet just 3.8% for the year. Foreign stocks had an even stronger quarter, with Vanguard Total International Stock Index up 17.9%, bringing the year-to-date gain to 3.7%, while Vanguard Emerging Market Stock Index gained 18.7% for the third quarter and is up 10.6% for the year. On the bond side, Vanguard Total Bond Market Index posted a solid 2.4% gain for the quarter and is up nearly 8% for the year to date. Emerging-markets local currency bonds climbed roughly 6% in the quarter and have gained about 16% so far in 2010.
Our portfolios have outperformed for the quarter and year to date even with our conservative bias. This outperformance was also enhanced by the strong showings of many of our active bond and equity managers, as well as our tactical position in emerging-market local-currency bonds and equities.
The National Bureau of Economic Research recently announced that the Great Recession officially ended in June 2009—marking the country’s longest and deepest recession since the 1930s—but our big-picture view of the economic environment in the United States remains cautious and is largely unchanged from what we have been describing over the past year. We continue to believe we are in for a sustained (multiyear) period of subpar economic growth as a consequence of the financial crisis of 2008 and its aftermath. Ongoing “structural” headwinds such as consumer deleveraging, high levels of unemployment and underemployment, weak wage and income growth, tight credit availability to households and small businesses, weak housing markets, higher taxes, and cuts in local, state, and federal government spending in response to their financial difficulties all imply that aggregate demand, and ultimately corporate revenues and earnings growth, are likely to be under pressure for a while. In short, this is not your typical post-WWII business cycle.
With regard to deleveraging, households have started to make progress reducing debt toward sustainable levels—although they still have a considerable way to go—but federal government debt has ballooned.
In the second quarter, household debt contracted by $57 billion (a 2.3% annual rate), marking the ninth consecutive quarterly decline. State and local government debt also declined slightly in the second quarter after five consecutive quarterly increases. However, growth in federal government debt continued to soar, at an annual rate of 24%. Over the medium to longer term, there is a great deal of uncertainty about the ultimate resolution of the growing government debt problem.
We realize this is a similar story to what we’ve been writing in the last few quarters, and it’s not necessarily encouraging. However, it’s not all gloom and doom either. To be balanced, there are some positive economic signs. Industrial production and earnings have rebounded strongly, profitability is high and companies also have very high levels of cash on their balance sheets. The personal-savings rate rose to 6.1% in the second quarter, which, while not helpful for near-term economic growth is necessary for the longer-term healing of the economy. Interest rates remain low and relatively stable. (But low rates also reflect the risk of deflation and even the Federal Reserve recently stated that inflation is currently “somewhat below” its target range.) Developing economies continue their high rate of growth (the IMF forecasts they will grow 6.5% next year versus 2.5% for the developed world) and have relatively strong fiscal/debt balances, which should drive growth in emerging-market demand for U.S. exports.
We Consider a Range of Outcomes in Making Portfolio Decisions
Meanwhile, investment opportunities are more a function of price than of the overall economic story. As we work through our analysis for each asset class across the various scenarios we think are most likely, the potential risk versus potential reward for most of them is not attractive. We need to be selective when deciding where to take risk. The following is a brief summary of our outlook for some of the key asset classes we closely follow.
U.S. Equities – At current prices, we think stocks are fairly priced and even inexpensive, but not cheap given our “muddling along” growth outlook. As a result, we continue to underweight small and mid-size equities in our portfolios. With this positioning, it important to remind our clients that if there is a strong upward move in stocks, we would expect to underperform our portfolio benchmarks. Given our overall views, though, we think it is prudent to accept that possible “opportunity cost” while we wait in a more protective position for more compelling opportunities.
While we don’t consider stocks overall as cheap, many of our active equity managers, on the other hand, still report finding good opportunities at the stock-picking level, for example, among high-quality U.S. multinationals. Many of our long-tenured managers are telling us that the expected returns from their portfolios are better than average right now, suggesting that they may be able to generate double-digit returns over the next three to five years from active stock picking.
Investment-Grade Bonds – Returns across the broad intermediate term, high-quality bond universe are similarly unexciting. We think this overall asset class is unlikely to generate more than low single-digit returns in the next five years. That said, we believe the bond market is generating good investment opportunities within certain bond sectors. As on the equity side, by identifying and investing with highly skilled, opportunistic bond managers – such as Loomis Sayles Bond, Eaton Vance Global Macro, and PIMCO Unconstrained Bond – we believe we can earn competitive returns at very acceptable risk levels.
Emerging-Markets Local-Currency Bonds and Stocks –We are especially enthusiastic about the opportunity we still see in emerging-markets bonds and stocks, denominated in local currencies. This is an asset class that has attracted more attention recently, with many others coming to recognize the characteristics that attracted us to take our tactical positions over a year ago. Current yields in these bonds are well above what we can earn in developed market bonds (including the U.S.), and their prices would further benefit if the dollar declines in the years ahead as we expect. Further, many of these emerging market economies are in far better shape than the developed countries, with trade surpluses, strong government balance sheets, and an emerging consumer class.
Alternative Strategies – In the past quarter, after spending many hours of research we started implementing a strategy in Alternative Investments. We view these strategies as a relatively low risk. Our goal is to get a return somewhere between investment grade bonds and equities, but with lower risk and correlation to those traditional financial assets. Therefore we will provide additional diversification to our Balanced Portfolios. These low risk, low return strategies are particularly attractive given our return expectations for stocks and bonds.
We’d like to reiterate several important points that define the environment we’re in and how we’re positioned.
First, this is not a typical business cycle; it is the aftermath of a financial crisis the likes of which the United States has not experienced since the 1930s. Therefore, one should not rely on the cycles of the past few decades as a road map for what the next five years are likely to entail.
The multi-decade tailwind of declining interest rates for bonds is likely over, so returns from traditional bond indexes will be low. Equity index prospective returns also look subpar relative to their long-term historical averages. The experience of 2008 through 2009 provided everyone a real-world test of their ability to handle extreme risk and volatility.
In light of the above, we believe this is an environment that favors JPH Advisory’s tactical asset allocation approach and opportunistic investments in asset classes and strategies outside of the standard stock and bond indexes. Our role will be to continue focusing our research efforts on assessing risks across a variety of scenarios, identifying compelling asset class opportunities when they occur, and owning active managers/strategies that we are confident can outperform.
Jon Houk, CFP®