Nobody likes a party pooper, especially when the party pooper also happens to be the life of the party.
Over the past two years, the financial markets have grown accustomed to Federal Reserve Chairman Ben Bernanke and his magic punch bowl of extraordinary monetary policy to provide liquid courage to the U.S. economy and financial markets.
Although rational investors knew that it couldn’t last forever, and that too much monetary punch can lead to nasty side effects and dependency, there was still the irrational hope that perhaps this might all go on a while longer.
And so, in May when Ben Bernanke looked at his watch and remarked “Well, I really must be going soon,” the financial markets went into a temporary tizzy. Interest rates around the world rose and stocks, bonds and commodities fell.
The greatest turmoil and damage occurred in the bond market where investors immediately started to discount the prospect of rising interest rates as the Federal Reserve Bank (aka “The Fed”) scales back its bond purchase programs. The interest rate on the 10 year U.S. treasury bond rose over 1% in a mere 64 days, sending traditionally conservative bond portfolios and bond funds into negative territory for the quarter and year to date. Foreign bonds, commodities and precious metals also took a drubbing.
Investors are right to be concerned. Extraordinary monetary policy has had a large impact on the U.S. economy and financial markets in recent years, artificially depressing interest rates and the Dollar, boosting asset prices, and allowing parts of the U.S. economy to heal and grow stronger.
The markets have become accustomed, if not addicted to its presence. And to some extent, quantitative easing has led to meaningful distortions in asset prices relative to their intrinsic value, as well as a false sense of confidence among investors that the Federal Reserve has got the market’s back no matter what. For these reasons, the eventual discontinuation of extraordinary monetary policy is no trivial matter for the economy, asset prices and investor psychology.
At the same time, it is also important to consider the state of the Fed and U.S. economy in relation to other major central banks and economies in the world. The Chinese economy is slowing as the Chinese Government attempts to put the brakes on a shadow banking system gone wild and engineer a transformation from an export to consumption-driven economy. Meanwhile the Japanese Central Bank has gone “all in” with its own massive quantitative easing program to boost asset prices and foment growth and inflation. In Europe, the European Central Bank says that it remains poised to do “whatever is needed for as long as it takes” to maintain order and stability and stimulate economic growth.
And so there are massive and extraordinary monetary cross-currents at work around the world with the two largest economies, the U.S. and China, moving towards tighter monetary policy, while Japan and Europe try their luck with easier money.
It is therefore no wonder that asset prices are in a state of flux as they seek to reflect a complex new reality.
But we also think that investors have overreacted in some cases, thereby creating significant distortions and disconnects between asset prices, asset classes, and their inherent risk relative to potential return.
Diversification is one of the cardinal rules of investing. Investments and asset classes go through a continuous cycle of outperformance and underperformance. This year’s biggest winners often become next year’s biggest losers and visa versa. So you want to have your investment eggs in multiple baskets to spread your bets and risks, reduce volatility and increase your odds of long-term success.
Chart 1 above shows this principle at work, ranking the annual return of 11 different asset classes from 2004 through June 30th of this year, along with an Allocated Portfolio that includes a representative sample of each asset class consistent with a moderate risk and return objective. As the old saying implies, past performance is typically a poor, if not contrary predictor of future performance. Asset classes tend to jump around from year to year, especially at the extremes and especially with respect to top performing asset classes. The chart exemplifies this by showing the cumulative return of a portfolio comprised of the prior year’s top or bottom performing asset class. While picking last year’s worst performer still resulted in a respectable 72.4% cumulative return, picking the prior year’s best performer resulted in a -0.3% cumulative return over the last 10 years; worse than buying and holding any other single asset class.
Meanwhile, the diversified Allocated Portfolio produced a very good 92% cumulative return, handily beating the S&P 500, and with considerably less volatility.
By contrast, this year, conventional asset allocation and diversification has been a remarkably losing strategy. In fact, the trends that we wrote about in the first quarter were only further exacerbated in the second quarter.
Chart II above shows the performance of major asset classes for the first half of this year, (shown in green if positive and red if negative) as well as their ten year average return (shown in blue).
As in Chart I, we can see that while over the span of a decade, all of the major asset classes produced a positive return, this year, U.S. stocks were the only major asset class to produce a return that was higher than its 10-year average.
Non U.S. developed economy stocks as measured by the MSCI EAFE index (Which includes Europe and Japan) turned in a positive 4.2% return, but well below its historical average, and driven primarily by the strength of the Japanese stock market.
More remarkably, every other major asset class is down for the year.
Emerging market equities fell almost 10%, commodities fell 10% and precious metals fell a whopping 30% respectively.
Most notably, bonds, the asset class of capital preservation and income took a beating across the board, especially in corporate, global and emerging markets.
Considering Charts I and II together, we note that it is unusual to have such an unbalanced distribution of returns among asset classes, other than in a crisis year like 2008. (And in such cases, bonds and precious metals are typically up and stocks and commodities are typically down.)
We can understand why returns are as they are, given concerns about rising bond yields in the U.S. and slowing economic growth elsewhere, as well as the tendency for investors to chase recent performance.
But we also know that investors and markets are not entirely rational and tend to overestimate and extrapolate both good news and bad, with a bias towards overestimating bad news.
For the time being, these performance disparities may continue to grow. Trends tend to take on a life of their own and extend farther than they rationally should. Recent returns may encourage more investors to undiversify their portfolios, moving out of bonds and commodities, precious metals, and emerging market equities and areas of recent underperformance, and into U.S. and Japanese stocks, or else into cash.
This may yield rewards over the short-term, but if history is any guide, it is not likely to be a good long term strategy. We still think a balanced approach, incorporating multiple asset classes and emphasizing areas of longer-term opportunity is the only sensible way to navigate an evermore challenging investment environment.
The current panic in the bond market about the Federal Reserve’s exit and rising interest rates is likely overstated.
The Fed is expressing a willingness to curtail its quantitative easing program largely because the U.S. economy is showing signs of improved health. Moreover, any reduction or “tapering” in its quantitative easing program will likely be gradual and well advertised.
As the financial markets come to terms with this new reality, we would expect to see interest rates start to stabilize.
Over the longer term, the path of interest rates is almost certainly higher, making bonds a challenging asset class in which to invest.
By contrast, stocks look like a far better alternative. They have the ability to capitalize on growth and innovation in the economy and increase in value, even in an environment of rising interest and inflation rates.
Real Estate also looks attractive relative to bonds. Governments may be able to print more money, but they can’t create new land so easily, especially in desirable locations.
But the investment merit of any investment asset is a function of its fundamentals and its price. Bonds can fall to a price where their yields become attractive and stocks and real estate can rise to a price where their risks outweigh their potential rewards.
Outlook and Strategy: As we look at the global economy and financial markets today, we think that the U.S. economy is growing and improving, Europe is still a mess but is getting slightly better, and that Emerging markets are slowing but still growing.
U.S. stocks are well positioned and reasonably valued for the long-term, but they are no longer cheap and expectations are fairly high. They may be vulnerable to a setback in the near-term as the Federal Reserve unwinds its Quantitative Easing program.
Chart III above shows the price of the S&P 500 as well as the size of the Federal Reserve’s balance sheet since the beginning of 2007. Superimposed on the chart are the three periods of Quantitative Easing. As the chart shows, the majority of the S&P 500’s return over the past five and a half years has occurred during periods of Quantitative Easing. Besides providing a sense of confidence to the markets, Quantitative Easing depresses borrowing rates and the dollar, both of which provide tail winds for U.S. companies that have debt and/or export their goods and services abroad. When you remove those tailwinds, financing costs and the dollar start to rise which puts a crimp in corporate profits. Companies are going to have to offset these higher costs with higher sales.
We remain optimistic that this is not only possible, but highly probable. The U.S. economy is dynamic, diverse and resilient. It has flourished over many years without the benefit of extraordinary monetary policy, and with much higher average interest rates than we have today.
American companies are very competitively positioned, and benefit from a skilled workforce, a large amount of entrepreneurial zeal, and an abundance of natural resources and cheap energy. U.S. energy costs are 30% to 40% of Europe and Asia.
Outside of the U.S., Europe still looks challenging to us, as does Japan. The European economies appear to be stabilizing as political leaders and the European Central Bank (ECB) are focusing more on growth and supportive monetary policy over austerity. But major structural imbalances and social tension remain.
In Japan, the massive monetary stimulus that the Japanese Central bank has embarked upon amounts to a Hail Mary pass. They really have no choice but to try something bold as the economy has been debt-laden and moribund for years. The immediate results have been mixed, boosting equities, but actually leading to an unintended increase in Japanese interest rates. Therein lies the rub. Japan has the highest level of debt to GDP of any developed or emerging nation. The nation is highly sensitive to even small increases in interest rates, and it is unclear how the government will ever be able to pay back the debt, let alone service it.
By and large the stocks of many European and Japanese companies are attractively valued, but their growth prospects remain cloudy. We have some exposure to both, but prefer to focus on the U.S., where there is more growth and clarity, and Emerging Markets where valuation levels and long term growth potential is more compelling.
Which leads us to Emerging Markets…
The slowdown in China has had a broad impact across emerging markets and resource-driven economies that sell into China, like Australia and Brazil.
China is going through the equivalent of economic puberty as it attempts to transition from a manufacturing and export-driven economy, to a more mature consumption-based economy like the U.S..
At the same time, China’s new leadership is also dealing with a significant credit crisis, largely at the local government level where trillions of dollars in questionable loans have been used to finance questionable projects. Many of these loans are up for refinancing at the same time that many of these projects are running into trouble. While the Central Government has the resources to bail out the problem, we think the problems have yet to be fully flushed out.
We still think that Emerging economies will account for the majority of Global GDP growth in the coming years, and that Emerging Market equities, debt and commodities are discounting an overly bearish and simplistic outlook. China, as well as the rest of the emerging and developing economies are not monolithic. They are diverse and multi-faceted and will continue to grow and flourish over time.
Although EM stocks may continue to underperform in the near term, at current prices they are cheap and offer attractive long-term potential for appreciation.
Given our guarded outlook for bonds, we have geared the bond portion of client portfolios towards a combination of “Total Return” managers who have broad flexibility to pursue opportunities anywhere in the global credit markets, and Multi-Asset Class investments that have defensive characteristics like bonds, but also have the ability to benefit from economic growth.
Finally, despite returns this year, we continue to believe in the importance of diversification. History, the laws of reversion to the mean and common sense suggest that returns next year will likely look quite different from this year. Perhaps surprisingly so. It therefore pays to have an appropriate balance of offensive, defensive and alternative assets aligned with a long-term investment outlook and approach.
As always, we welcome your questions and comments.
Jurika, Mills & Keifer, LLC