Third Quarter 2012 Investment Commentary Key Takeaways
The third quarter was a risk-on period as markets reacted positively to global central bank moves to stimulate the economy. U.S. large-cap stocks were up 6% while core investment-grade bonds gained 1.5%, and from the stock market low on June 1, large-cap stocks were up 10.7% versus 1.6% for core bonds. Emerging-markets stocks gained 6.5% in the third quarter and also posted double-digit gains from the June low.
Despite our overall underweight to stocks during this year’s very strong rally, all of our balanced portfolios have outperformed their benchmarks. The main driver of this has been the performance of our fixed-income funds, which in aggregate have outperformed the core bond benchmark by several percentage points.
With the exception of the U.S. housing market, which is finally showing signs of improvement, the bulk of the economic news was not positive during the quarter and our concerns over the longer-term health of the global economy remain. The ECB’s recent actions, for example, don’t solve the underlying structural problems threatening the existence of the eurozone; they simply buy more time for political leaders to develop and implement real solutions.
At the broad asset class level, the central bank actions have not yet led us to make any portfolio changes. However, we would expect these policy actions and the markets’ reaction to them to impact our bond fund manager’s assessments of relative risks and returns across their investment opportunity sets.
Given the highly uncertain global economic and political environment, we continue to structure our portfolios to perform at least reasonably well across a wide range of outcomes rather than bet heavily on a single scenario. To the extent global central bank monetary policies continue to stimulate investor risk taking, our portfolios will benefit, but we are almost certainly not going to be adding to stocks and other riskier investments in that circumstance.
Our five-year base-case scenario continues to be one of subpar economic and earnings growth due to headwinds resulting from the ongoing deleveraging. Currently, our balanced portfolios are tilted away from core U.S. bonds because they have the least attractive risk-return profiles of the major asset classes and toward emerging-markets stocks and bonds, absolute-return-oriented fixed-income, and alternative strategies, which offer better returns relative to risk in our view. Should “herd behavior” cause markets to drop sharply over the shorter-term, we expect to take advantage by identifying and investing in compelling longer-term investment opportunities.
Third Quarter 2012 Investment Commentary
While there are always many factors that affect financial markets in the short-run, it seems pretty clear that a key driver of the rally in stocks and other riskier assets over the past few months has been global central bank monetary policy, with markets reacting positively to policymakers’ signals—and ultimately the announcements—of additional liquidity and market support by the European Central Bank and the Federal Reserve. With the exception of the U.S. housing market, which is finally showing signs of improvement, the bulk of the economic news was not positive during the quarter, highlighted by disappointing U.S. employment numbers. However, the stock market’s mindset seemed to be: bad news is actually good news because it means the Fed will step in with even more aggressive intervention, which will be a further boost for risk-taking. And the market was right (at least in the short term). Similarly in Europe, central bank action led European stocks to strong gains in the third quarter even as Europe’s economic fundamentals did not improve and the growth outlook remains pretty bleak for the eurozone over the next few years at least.
The Fed: “QE Infinity and Beyond!”
After foreshadowing further action several weeks earlier, Fed Chairman Ben Bernanke made yet another major monetary policy announcement on September 13th: 1)The Fed initiated a new program of quantitative easing (QE3) saying it would buy $40 billion per month of government agency mortgage-backed securities. An important distinction compared to QE1 and QE2 is that QE3 is open-ended, with no pre-defined end point in terms of its duration or magnitude. 2) The Fed said it will continue its Operation Twist program through year-end, buying $45 billion per month of longer-term Treasury bonds and selling shorter-term Treasuries. 3) The Fed emphasized that QE3 would be tied to conditions in the labor market—the unemployment rate in particular. 4) The Fed attempted to further influence market expectations regarding its commitment to reflation, and perhaps marked the initiation of a new inflationary monetary regime. 5) The Fed also said it expects to keep the federal funds rate at exceptionally low levels (0% to 0.25%) at least through mid-2015. Previously their expectation was through the end of 2014.
These are significant changes to Fed policy. There is already plenty of liquidity in the U.S. banking system and U.S. corporations are also flush with more than $1.7 trillion in cash on their balance sheets. In other words, there is plenty of credit potentially available if lenders are willing to lend and borrowers want to borrow, so the recent Fed moves are clearly not needed for liquidity reasons.
Instead, Bernanke and the Fed are trying to signal even more strongly that they have no intention of pulling back on their aggressively accommodative monetary policy and that they view unemployment as significantly greater risk than inflation. As Bernanke stated, with the prior two QEs, the goal is to depress interest rates even further in order to encourage (or push) investors further out on the risk spectrum, causing further inflation in asset prices, such as the stock market and housing, with the hope that the positive “wealth effect” will stimulate consumer spending and ultimately business investment and job creation. Whether this will lead to any significant real economic impact is questionable and the subject of debate among economists.
Changing gears: What about the U.S. Election?
Moving away from central bank policy, a question we frequently get from clients every two or four years is: What is JPH Advisory’s take on the U.S. election and how is it impacting your investment outlook? Our answer to this question hasn’t changed much over the years. In general, there is too much uncertainty and too many non-election variables that impact longer-term investment outcomes for us to see any value in positioning our portfolio for a particular election result. We aren’t saying the result of this election is meaningless to the path of the economy and financial markets over the next four years. We do believe that different fiscal and monetary policies are likely to be implemented depending on who is President and which party controls the Senate. But we are saying that 1) we are not willing to bet on a particular election result; 2) there is a wide range of potential macro outcomes around either election result, stemming from the uncertainty related to policy implementation and ultimate effectiveness in achieving desired results; and 3) there are a multitude of other variables and factors unrelated to the election results that are out of U.S. politicians’ control that are likely to have at least as meaningful an impact on the course of the global economy and financial markets over the next five years.
At the broad asset class level, the recent central bank actions have not yet led to any portfolio changes. (However we would expect these policy actions and the markets’ reaction to them to impact our bond fund managers’ assessments of relative risks and returns across their investment opportunity sets.) While central bank actions may continue to encourage investor risk-taking, pushing stock prices higher, we are not going to play that speculative game. It doesn’t fit with our investment process and discipline, which is focused on assessing asset class fundamentals and valuations over a longer-term time horizon, while being cognizant of the potential shorter-term downside risks in various scenarios. To the extent global central bank monetary policies continue to stimulate risk-on market behavior our portfolios will benefit from our already meaningful stock and other risk-asset exposures.
Given the highly uncertain global economic and political environment, our aim is to position our balanced portfolios to perform at least reasonably well across a wide range of outcomes, any one of which we think is at least reasonably likely to happen.
Currently, our balanced portfolios are tilted away from core U.S. bonds because they have the least attractive risk/return profiles of the major asset classes and toward the relatively more compelling asset classes/strategies of emerging-markets stocks, emerging-markets bonds, absolute-return-oriented fixed-income, and alternative strategies. We will continue to challenge the assumptions that underlie our views, consider new information as it becomes available, and stay intellectually honest in making well-reasoned investment decisions for our clients. We appreciate your continued confidence and trust.
Jon Houk, CFP®