By now most of us have read our fill of 2011 post-mortems—but we’re compelled to add a few thoughts of our own before we look ahead, seeking to apply the experience and perspectives gained to our outlook on global markets in 2012.
A year ago we remarked on three items which we saw as potential underpinnings of a better year both economically and market-wise than we actually ended up with. They were; 1) the expectations borne out of the Fed’s QE2 policy announcement in late 2010, 2) Post mid-term political loggerheads, and 3) freedom (if temporary) from income tax uncertainty. In truth, we commented at the time that we were more impressed with the expectations of growth from QE2 than the actual quantifiable results from QE1. Certainly we witnessed a sharp slow-down in economic activity in the middle of the year that ultimately justified this suspicion. Political gridlock, on the other hand, seems to have had an interesting impact: First, we can clearly trace the historic loss of America’s AAA credit rating to this impasse. Ultimately, given the events of the year, this development had zero economic or market impact from our perspective. Credit strength is a relative metric. Given the concurrent credit meltdown in Europe this year, the immediate result of the US downgrade was an influx of funds into US Treasuries (hence the relativity). The second impact of this grid-lock has been an effective end to the current administration’s policy implementation, pending the outcome of this year’s election.
In the end, what eventually trumped all these considerations in 2011 was the panic surrounding the European PIGS (Portugal, Italy, Greece and Spain), and its influence on global markets. We’ll touch on several specific topics throughout this Outlook, but in our view the dominant investment theme that kicked-off in late summer with the break-down of EU member cooperation was a global correlation compression. In essence, the “lingo” in investment media became hyperbolically concerned with “risk-on”, “risk-off”, meaning that risk assets (i.e. anything that was not backed by the full faith and credit of a AAA rated sovereign with a printing press) all moved in the same general direction based on daily, often overwrought headlines rather than reacting with more nuanced and predictably distinctive responses that logic and fundamental basics would otherwise dictate. We touched on this “headline risk” in our August Outlook, and again briefly in October. While the measure of volatility was less pronounced than in 2008, diversification lost its “buffering” properties nonetheless, as in that fateful year.
We’ll close our post-mortem with two reflections. The first is really just a reminder; the media’s principal role is to sell advertisement. The quality, consistency, or objectivity of their reporting does not feed their quarterly bottom line. The number of eyeballs they attract does. “Bears” are trotted out during declining markets to foretell further gloom and doom (i.e. Mark Mobius, Exec. Chairman Franklin Templeton on CNBC in October), and “Bulls” make up the majority of interview experts when markets are rising (including Mark Mobius on CNBC in December). Thus has it always been. Allowing this characteristic to influence one’s investment decisions can have unfortunate long-term consequences. Just something to consider in the midst of the next bout of market volatility—which is coming. In truth, the S&P 500’s fall from the top in May to the bottom in August was never more than 18% (a standard market correction).
Our second reflection is actually a recognition and acknowledgement of the fatigue some investors may be feeling as a particular result of volatility like that witnessed in 2011, not to mention recent years. We all feel like the mythological Sisyphus—condemned to push a boulder up a mountain for eternity, only to watch it roll back down again. The US broad market index levels are essentially where they were last March, in September of ’08, December of ’04, January of ’01, and in April of 1999. The only difference among these periods was which direction the market was heading when it passed through this level. In fact we addressed this in our January 2008 Outlook:
The 10 year total return for the S&P 500 index (reinvesting dividends) through October 1, 2008, is 3.059%.** Factor in inflation—and the real return is basically nil.
Here too, there is historical precedent: There have been two other “lost decades” in the last century: 1929–1942, and 1966—1982. In both these periods, stocks floundered, rallied and failed, but ultimately ended with flat returns over the periods listed.
The silver lining: One must examine the returns after these extended periods of lack-luster performance. Both the late 1940’s into the 1950’s, and again the 1980’s into the 1990’s were marked by extraordinary stock market returns.
We continue to believe the “silver lining” lies with a meaningful allocation to emerging markets in both equity and fixed income asset classes. While these markets were also roiled last year (and very much so in 2008), investors must note these average annual returns for the MSCI Emerging Markets Index through 2011: 3yr: 25.31%, 5yr: 2.39%, 10yr: 11.94%.
We are today digesting both positive recent stock market performance and economic data which has (thankfully) trended as such for the last six weeks or so. Encouraging manufacturing ISM data since the fall, coupled with a generally positive trend in weekly unemployment filings and the last two months’ payroll data seem to give hope for continued strength in domestic consumption, which is vital. However, for balance, we should also take into account the most recent Fed comments following the FOMC meeting in which Fed Chairman Ben Bernanke announced the need to keep near-zero interest rates in place for another three years—extending the already unprecedented policy horizon originally made in August by another year! He even floated the possibility of another QE should growth trends falter. Either Mr. Bernanke sees the US economic condition as continuing to be excessively fragile, or the Fed has virtually abandoned one of its two mandates.
The predictable short-term stock-market response, as has been the case for the last three years, is to cheer these reaffirmations of easy money. In April last year we commented on the “Power of Zero Interest Rates” as the primary driver of capital flows from one asset class to another—or even from one geographic region to another. But it is clear now that this policy is also at least partly responsible for the increase in volatility that investors have experienced within their own portfolios, and in our view, will likely continue to experience in the quarters ahead. This policy is, in part, the cause of correlation compression. Mohamed El-Erian (co-CEO of PIMCO) summed this up in a recent Wall Street Journal commentary, saying, “Investors must…stay ahead of a whole range of “unconventional” policy interventions that alter the very functioning and liquidity of markets, including large-scale use of public printing presses by central banks in Europe and the U.S. By driving interest rates to very low levels, central banks are pushing investors out on the risk spectrum.” He goes on to say “being pushed into an activity by the actions of others feels (and is) very different than being pulled in by the inherent attractiveness of the activity. It is a fundamentally less stable situation” (emphasis ours).
In sum, we expect the continued, gradual growth rate of the US (2%-3%) to support an ultimately improved investment climate domestically—but we are convinced we will remain in a low-return environment in 2012 as it seems cash-rich corporations have by and large opted to remain very cautious in deploying this capital. A fear of external risks (most perhaps emanating from Europe) has trumped zero returns on cash for the time being. In addition, we think investors should gird for bouts of volatility as European dithering will likely continue throughout the year.
Speaking of volatility; did we point out that it’s an election year?
- Our equity model today is balanced between large-cap growth and value, particularly as it pertains to “new money”. In the September-October period we discussed with our clients the need to take advantage of significant dividend yields which became available as a by-product of the down-side volatility of that period, in part to offset future expected volatility with the total-return characteristics of dividends. As a result, some accounts may screen slightly to value, which is fine. We think most of the “low hanging fruit” has been picked as stock prices have recovered (and yields have dropped). We would likely return to this exercise should volatility increase significantly in 2012 to once again pick-up yield for the long-run.
Within the value universe we have positive expectations for the energy and materials sectors, particularly as it appears Chinese and Brazilian demand should stabilize. For the fifth year running, we recommend avoiding the banking sector.
Within the growth universe we expect computers (and smart phones), network technology and biotechnology to continue to attract dollars, and therefore investors. One caveat remains corporate technology spending, which a recent Goldman Sachs survey suggests could be somewhat lower than that of 2011, so “tech” returns will likely be divergent among the many sub-categories.
- In October we moderately reduced our small-cap weighting, and it currently stands at a 10% equity weighting within our model. Our move was predicated on our skepticism of the business cycle then. We remain comfortable at 10% today—though it was recently voiced in our Investment Committee meeting that economic sentiment could possibly shift later in this election year, in which case we could be revisiting this weighting.
- We have reduced our broad non-US equity weighting to 36% from 40%, simultaneously increasing the growth market weighting within the category to maintain its 16% weighting of total equities. The net result is primarily a reduction in European exposure.
- EUROPE: It became difficult in 2011 to comment on European developments and their impact on both macro-global economics and portfolio implications without regurgitating the granular details that so much was being made of in the daily news cycles. This has limited utility in portfolio strategy discussions.
In short, we’ve witnessed policy implementation in Europe being carried out by diplomats, which is why they are really no further along in solving the Greek debt crisis than they were two years ago, in our view. We expect the bizarre ritual of faux-summits & grand announcements to continue for some time. Ultimately, Greece will default (it’s a mathematical certainty). By the time it does, maybe this year, it likely won’t be termed a “default” anymore. Something more diplomatically palatable will replace that word—but the end result will be the same.
Europe is heading into (if not already in) a recession. In our view, this is not the end of the world. As with all recessions—this fact has been telegraphed by the MSCI European Index which was down 15% last year. Like the US, Europe is home to many multi-national corporations in the energy, pharmaceutical and technology sectors that will continue to benefit from non-EU global growth, and may even reap further benefits from the decline in the Euro. Valuations in many cases now look attractive. We also believe Spain and Italy will prove more stalwart in reform than many suspect.
We have reduced our weighting to this region for two reasons: 1) the inability of EU policy makers to agree on and implement a solution for the more fiscally dire members has negative long-term internal growth implications for the entire region, and 2) in the near term, our concern regarding the health of the European Banking sector, which is inextricably tied to the so-far fumbling crisis response from EU governments. European Banks will be at the epicenter of future risk-volatility in Europe.
We narrated the entire decline of the emerging markets indices last year in our 2011 Outlook series. Central governments from China to Brazil implemented tight hawkish policies (both fiscal and monetary) in an attempt to stem rising inflation. Markets reflected this in their price decline. In our July Outlook we pointed to evidence that suggested a “soft landing” ahead for the Chinese economy (a major barometer within the growth market universe) in both their manufacturing and GDP data.
Skipping ahead to today, it is apparent that this soft-landing thesis has come to fruition, though market responses lagged somewhat. Chinese GDP growth has slowed, and continues to slow—likely hitting a pace of 7.5%-8% later this year. More importantly, this engineered economic slow-down seems to have occurred in an orderly fashion, with manufacturing production within the economy remaining relatively strong. We feel investors should sit-up and take notice of this successful monetary endeavor, as it contrasts sharply with the havoc-causing devaluation responses we witnessed in emerging economies in the 1990’s. Both the MSCI BRIC and Emerging Markets indexes have outperformed the S&P 500 for the past 6 weeks. While we don’t want to make too much of such a short time-frame, this hasn’t happened for over 18 months, and we feel there is a significant turn of sentiment in the markets.
Growth markets in general, and certainly BRIC and Frontier market indexes have shown sharp declines throughout 2011 in our portfolios. While we’ve made adjustments in our models pertaining to Europe, large and small cap equities, and within the fixed-income allocations, we’ve remained steadfast that investors must embrace growth markets for the long-term, and with a meaningful allocation. It is here where the words of Mohamed El-Erian intersect with the growth-realities of the developed world, and where, in our opinion, investors will gain the long-term risk premium they seek on invested dollars. China in particular, along with Brazil and most of the developing world represent the future of global economics, and global markets. Demographics and technological proliferation drive this, and are immutable forces. As advisors we must empathize with the higher volatility many of these investment categories engender, but we say again—this should be addressed on the asset allocation level.
Both the Chinese and Brazilian policy makers have publicly announced the end to their hawkish monetary policies. Our comfort level will be higher when we see inflation in China dip towards 3%–hopefully in the first half of this year.
CCR Wealth Management’s emerging market allocation remains at 16% of equities in our models.
It is said a stopped clock is right twice a day. If that is truly the case, then less than six hours have passed since our initial supposition that interest rates must go higher given a modicum of economic growth in the system (circa 2010), and that higher market rates would eventually trump low Government and gov’t-backed yields (meaning we haven’t been right yet!). Clearly we’re still waiting….and Mr. Ben Bernanke seems determined to continue priming the pump. Being wrong about the direction of interest rates in 2011—and particularly about the valuations of Treasury and related debt has us in good and plenty company, which is of no solace.
- A year ago CCR Wealth Management made the call for significant use of short-term bank loans (floating rate bond class) within our fixed income models. The “August Surprise” (loss of AAA, yet ever-lower bond yields), along with subsequent announcements from the Fed caused us to re-think this weighting. While floating rate funds remain an allocation in our models, their weight has been reduced in favor of more “fixed” fixed-income funds (traditional bond funds).
- We believe investors should make an effort to understand the math (or physics) of the bond market—particularly that of sovereign governments (our own especially) as it differs substantially from that of the equity markets. In the bond market, an investors chooses to loan $X in return for $Y interest payments for Z years. If $X continually moves up, and $Y continually moves down, eventually you will reach a point of a negative return by the time you arrive at Z. As we know, in the short-term Treasury universe, Y interest rates have been virtually zero now for nearly three years—yet $X has continued to climb. Conversely—no one can really put a cap on the stock price of, say, Apple Computer. AAPL’s price will always be a function of investors willing to pay $X for what they believe will be $Y earnings—which itself is a complex derivative of how many devices they sell, revenue they reap on-line, ect. Theoretically there is no cap on the stock price of Apple (or any other equity share), whereas mathematically there is a point where logic must break down for investors to buy certain bond yields. We have reached that point. Investors in any Treasury instrument less than three years in maturity are receiving a negative real return. Even investments in Treasury TIPS (Inflation Protected Securities) are priced to produce a negative nominal return, as buyers seem content to net less than 100% of the inflation adjustment. Investors seem to be content with the “devil they know” (a known short-term loss in US Treasuries) rather than the devil that must exist somewhere further out on the yield curve.
- In general, we’ll characterize our current approach to the bond market as a “barbell” strategy, employing plenty of short duration on one end of the barbell, with higher yielding, higher duration on the other.
We have not adjusted our commodity models since our October Outlook commentary. We’ve seen the resurgence in oil we anticipated in July (below $80/barrel), and it closed the year roughly where it began—around $100/barrel. Gold is off from its “panic” high in September of just below $1,900 an ounce (it stands at $1,731 today). Base metals prices were hammered in 2011, in full correlation with global economic fears—particularly that which afflicted emerging markets.
- We continue to favor crude oil based on more optimistic global economic assumptions, particularly those of the Americas and China. It is true that oil prices could be subject to spikes as tensions remain in the supply bottlenecks across the Middle East region—however we do not speculate on such things.
- Gold has historically been viewed as the quintessential inflation hedge, but the spike we witnessed in late Summer 2011 was driven by the financial, fiscal and political chaos emanating from Europe (with an assist from S&P’s US downgrade). We reiterate that gold’s real dollar all-time high was $2,400/ounce some 30 years ago. We see upside potential from both continued EU chaos, as well as inflation potential, however precious metals have generally taken a back seat to oil in our allocation model due to elevated volatility at these levels. It is for this reason as well that we have further reduced silver positions.
- We are focused on buying industrial metals (copper, aluminum, zinc) at opportune times given the drubbing these prices took last year. While we do not necessarily pin pricing hopes on the continued (or resurgent) infrastructure-building explosion in China, their prices generally reflected overly pessimistic assumptions about growth market prospects, to which they’ve been correlated for the last decade or so.
Our investment models continue to reflect a 6%-8% allocation to non-correlated assets, primary commodities.