Counterpoint —
A Commentary of Jurika, Mills & Keifer LLC
First Quarter: January 2013

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Looney Tunes

Watching our political process in action – or inaction – is starting to bear a close resemblance to Looney Tunes cartoons.

And at year-end, Congress, playing the part of Wile E. Coyote, briefly ran the economy off the “Fiscal Cliff” before looking down, holding up a “Yikes!” sign, and then scrambling to get back on land. Genius.

Looney Tunes

As in Looney Tunes, in the cartoonish world of politics, different rules of physics and reason seem to apply. And our political leaders, like Wile E., Elmer, Daffy and Bugs seem predestined to stay true to character, repeating the same mistakes over and over again, always acting surprised at the inevitable outcome. We know Wile E. will go over the cliff and that every scheme will backfire. We know that Bugs will always get the best of Elmer and Daffy. And we know that our elected officials will fail to lead and legislate effectively and on a bipartisan basis until they have no other choice. It might be funnier if it were not so damaging to the long-term potential of our economy.

We wish we could say “That’s all folks,” and be done with politics for a while, but as we look forward into 2013 and beyond, we think that political Looney Tunes will continue to play a major role in shaping the course of the economy and financial markets.

A case in point is the recent Fiscal Cliff saga.

Danger! Fiscal Cliff

The Fiscal Cliff came about because of the planned expiration of the Bush-era tax cuts, as well as the automatic spending cuts Congress enacted in the Fall of 2011. Like the old lady who swallowed a spider, Congress put these automatic cuts in place because their Debt Super Committee failed to come up with a “Grand Bargain” solution of spending cuts and tax increases in the Fall of 2011. They created the Debt Super Committee following their failure to increase the debt ceiling in June of 2011. This was after the White House failed to adopt any of the recommendations of the Simpson/Bowles National Commission on Fiscal Responsibility and Reform, which in turn originated as part of a failed bipartisan commission on debt reduction in early 2010. Meanwhile, the majority of all Republican Senators and members of the House signed on to Grover Norquist’s Americans for Tax Reform Taxpayer Protection Pledge promising not to raise taxes, while many Democratic leaders pledged not to cut any entitlement programs.

So Congress created the fiscal cliff, knew about it for over a year, pledged not to compromise, and committed themselves and the economy to a dangerous game of chicken. They then waited until the 13th hour to go over the edge, look down, and run back to cut a deal. To their credit, they did agree to some tax increases and more importantly, they created some certainty on how people will be taxed going forward. But they failed to agree on any meaningful spending cuts, which both sides say they want, but for which neither side wants to be blamed.

Norquist Guarding Tax Hikes

Now we have the prospect of a new debt ceiling debate and a new sequestration to be avoided. Didn’t we just see this cartoon?

Year Review and Outlook:

Meanwhile, in the real world, the economy and financial markets actually had a reasonably good year; much better year than you would think by listening to the news or talking to people (Chart I).

Chart 1

Despite low expectations and the looming prospects of the election and fiscal cliff, almost all asset classes produced strong returns in 2012, in sharp contrast to 2011, when only gold and bonds did well.

In the U.S., the bellwether S&P 500 ended the year up 16%. More notably, both the MSCI Emerging Markets Index and EFA (Europe, Australasia & Far East) index performed even better, especially after a very weak 2011. Bonds and gold also delivered solid returns. Commodities were the only weak spot, down 5%-10% for the year.

It is hard to know how much of this performance is a reflection of underlying economic fundamentals, how much is a reflection of monetary policy on the part of the world’s major central banks and how much is a result of investor psychology. The cross-currents are formidable in their scope and complexity.

With respect to economic fundamentals, the U.S. economy continues to muddle along with slow to moderate growth. Europe remains in a recession but we see some near-term signs of economic improvement. Meanwhile Asia is showing signs of a rebound.

(CHART II) shows Industrial Pro-duction by each major economic zone.

Chart 2

In the U.S. we did see some slowing in overall economic activity towards year-end, and a divergence between business and consumer sentiment and spending. We think that businesses were more guarded about the Fiscal Cliff as well as the overall outlook for the global economy, and therefore put discretionary spending and hiring decisions on hold.

Still, corporations reported solid profit growth in 2012, and corporate balance sheets are in the best shape in years. Growth may be slow, but businesses are healthy and have a lot of potential to invest, expand, make strategic acquisitions, repurchase stock or even return capital to shareholders.

Consumers were more resilient and perhaps blissfully ignorant of The Cliff; at least until after the election, when the news media turned their full attention to it. As Chart III shows, consumer spending growth was tepid but fairly constant through year-end. Car sales were an area of particular strength. The U.S. auto industry is back.

Chart 3

Housing also continued to recover (Chart IV). This trend should endure as housing represents a compelling value on both an absolute basis and relative to renting. Home inventory levels are low. Financing is also very attractive if you can get it. If bank lending standards eased, the recovery in housing would become much stronger.

Chart 4

Employment growth in the U.S. is slow but persistent. We may endure a higher than average level of structural unemployment for an extended period of time, especially in the area of unskilled labor. The U.S. still has significant excess productive capacity and many jobs and industries have been disrupted by innovation and competition.

Inflation in the U.S. remains benign. Higher food prices have been offset by lower energy costs. There is a growing expectation that at some point, all of the monetary stimulus will work its way into higher prices. But, for now, a lot of this created money is laying dormant: sitting on bank balance sheets and held in reserves. Until the money starts flowing through the economy, we do not think inflation will be a major problem.

In the mean time, the U.S. is benefitting from an energy boom that could have enormously positive implications for our economy. The combination of new drilling technologies and the discovery of vast amounts of natural gas creates the potential for the U.S. to become energy self-sufficient in the coming decade. Having access to inexpensive, abundant and relatively clean energy would be a significant competitive advantage for the U.S. relative to the rest of the World.

Europe:

European markets were up strongly last year, reflecting the anticipation of a recovery.

Europe has been stabilized, at least for the time being, by the pledge of unlimited monetary support for the Eurozone by the European Central Bank, and the implicit commitment by Germany to back this pledge. This is an essential precondition for recovery, but it does little to address the longer-term challenges of excessive debt, taxation and regulation; anemic economic growth; and large structural imbalances between and among countries.

Human talent and economic capital continue to leave the area in favor of the U.S. and Asia. This makes it ever harder for Europe to dig itself out of its own hole. Things may have stopped getting worse, but recovery will be long and difficult.

For this reason, we prefer to focus our investment activities on the part of the world that is growing.

Which takes us to China.

The fate of the emerging/developing economies and markets is dominated by China - the World’s second largest economy - followed by India and Brazil. Despite worries about a “hard landing” for China last year, it looks like the Chinese economy grew somewhere between 5% and 7%, depending on how much you want to discount their government statistics. This compares favorably with India and the rest of the emerging economies that grew around 4%. Late last year, China transitioned power to a new generation of leaders, led by Xi Jinping. Mr. Xi has signaled a commitment to ongoing economic and social reform as well as increased investment to restimulate economic growth. The most recent data out of China suggest a rebound in economic activity.

We expect more bumps in the road ahead for the emerging/developing markets as they evolve from manufacturing and export-driven growth to consumption-driven growth. But these economies are growing faster than the developed world, are in better financial health, are investing for the future, and can make difficult political decisions quickly. They will generate the majority of the world’s GDP growth in the coming years and we believe it is important to have a meaningful portion of portfolio assets positioned to benefit from this growth. Most importantly, these markets are cheap on an absolute and relative basis.

Monetary Policy:

The developed world is awash in monetary stimulus. Japan’s Central Bank was the most recent bank to throw in the towel and go “all-in.” So far, this extraordinary central bank intervention around the world has helped to stabilize the global economy: providing a backstop against systemic failure and deflationary forces; lowering Sovereign borrowing costs and inflating asset prices. It has done little to engender much in the way of economic and employment growth.

All of this monetary stimulus creates a world where interest rates are being artificially depressed and where investors are being forced into riskier assets to achieve an attractive real return.

And, while it can likely go on much longer than anyone thinks possible, extraordinary monetary stimulus is not sustainable. Each new dose produces diminishing returns and potentially nasty side-effects. At some point, economies will have to function under their own power. As Central Banks step away from the market as unconventional buyers of last resort, interest rates here and abroad should start a long and inevitable push higher.

Looking forward, the prospective combination of rising interest rates, inflation and currency devaluation creates an unfriendly environment for bonds and any other kind of fixed income/fixed value investment. It may not be a cake-walk for the stock market either, but in such an environment, productive and real assets such as stocks, commodities, and real estate have the greatest potential to work.

Sentiment:

One of the things that we find most encouraging is how pessimistic most investors seem to be. In the wake of the credit crisis here, the Sovereign Debt crisis in Europe, and the Looney Tunes in Washington, people have lost faith in financial and political institutions.

Despite rising 16% for the year, and over 120% from the March 2009 lows, the U.S. stock market has gained little respect. Since 2007, the vast majority of investment flows have been out of domestic stock funds and ETFs and into bonds and bond funds. There is an estimated $14 trillion of cash sitting on the sidelines, earning nothing, presumably waiting for the next big shoe to drop.

It is no wonder watching the news that investors are so dour and cautious. Turn on the news and the world is a bizarre and scary place. We have all become experts on the Fiscal Cliff, the Debt Ceiling, and nine out of every five things that can possibly go wrong.

While these are all important big-picture issues, we also know that 1) it is easier to see what is wrong than what is right and 2) the greatest risks are not usually the ones you focus on, but the ones you ignore.

And so while politicians carry on like cartoon characters in Washington, and while news reporters remind us of everything that can go wrong in the world, from Superstorms to Fiscal Cliffs to Mayan Apocalypses, there are good things happening too. There is innovation, growth and improvement. There is progress. American companies are more productive and better capitalized than ever, consumers have reduced their own debt load, and we may be entering a new era of low-cost energy and energy self-sufficiency.

It is true that the U.S. economy continues to operate below its potential. But it is remarkable how well it is doing in spite of our ineffective political leadership. Imagine how much better we might be doing if our leaders actually worked together to solve problems and inspire confidence in the future.

Current Strategy:

As we look out into the coming year, our overall investment strategy remains unchanged. We think the prevailing long-term trend will be inflationary rather than deflationary, and will not only favor but require the ownership of productive and real assets.

Overall, we think stocks offer reasonable value, especially relative to the dismal alternative of bonds and cash. We continue to favor technology and emerging markets.

But, after such a strong run for stocks in 2012, and with the next set of looming political uncertainties ahead, we would not be surprised to see a near-term pullback, combined with rising levels of market volatility around the daily headlines. We have therefore made a few tactical adjustments to reduce overall risk exposure in our client portfolios.

Companies will likely have a tougher time generating strong sales and profit growth this year than last. The easy cost cutting and productivity improvements are done. Profitability levels may have peaked. We expect solid results, but more cautious guidance for 2013.

But we remain optimistic about stocks for the longer term. Even in a slow growth environment there are still a lot of things companies can do to create value for shareholders: they can buy back their own stock, they can buy other companies, and they can increase their dividend.

That's All Folks?

Meanwhile, investors could decide to redeploy some of the trillions of dollars currently parked in bonds and money-market funds back into the stock market. Bonds and cash offer the illusion of safety, but are likely to offer a very poor real return on investment in the coming years, especially after the Federal Reserve indicates an end to its extraordinary monetary intervention.

A little confidence and a little less Looney Tunes could do wonders to rekindle growth and investment, and dispel the cloud of uncertainty and pessimism that currently hangs over the economy and financial markets.

As always, we welcome your questions and comments.

Jurika, Mills & Keifer LLC
January, 2013

Important Disclosures

Opinions expressed are those of Jurika, Mills & Keifer, LLC, and are subject to change.

Investments in securities involve the risk of loss. There can be no assurance that investment strategies referenced will be successful, or that investment objectives will be achieved. Past performance is no guarantee of future results.

This communication is neither an offer to sell nor the solicitation of an offer to buy a security or advisory services, which can only be made by the appropriate offering document.