The S&P 500 was up nearly 11% in the first quarter of 2013 even while the looming sequestration threatened to shave up to 0.5% off GDP, North Korea threatened war, the situation in Cyprus deteriorated, and U.S. companies reduced guidance in the face of a less certain economic landscape. Equity returns and global tensions seem to be wildly dislocated, however looking at other parts of the world reveals that strong returns are a uniquely U.S. phenomenon. Emerging markets, gold, international developed markets, commodities and broad fixed income benchmarks have all struggled, leaving investors to wonder what to do in the face of radically divergent indicators.
If this situation seems familiar, that’s because it is. Last year at this time, U.S. equity markets were up nearly 13% with essentially the same set of problems we have today. Excessive government debt, fanatical rulers threatening war, and overall weakness and uncertainty made investing as challenging then as it is now. The only difference between then and now is that the U.S. stock market is almost 15% higher, making valuations more stretched given slower earnings growth.
While finding attractive investments is difficult in the current environment, many of our existing holdings continue to perform well and remain attractive. We have focused our investment of client assets in the portions of the economy that are showing the most vibrant signs of life and, as a result, we remain encouraged by the performance and opportunity for these assets. The recovering housing market, firming insurance fundamentals, industry-leading & high quality stocks, emerging markets, and differentiated income producing assets all remain appealing.
In late 2011 and early 2012 our thesis on an improving US housing market began to become evident in the economic data. Now, over a year later, the improvement is easy to see. In some regions, houses are selling at or above asking prices after being on the market for only a few days while businesses and assets that are connected to this improving housing market are rising.
Our housing thesis has influenced investment ideas beyond individual equities as well. In early 2012 we allocated a substantial portion of client portfolios to mortgage backed securities based on an attractive yield and valuation backed by improving home prices, the biggest driver of mortgage bond prices. While we have already benefited from these securities, we remain attracted to the asset class and expect mortgage bonds to continue to be a meaningful contributor to client performance.
Other differentiated fixed income asset classes like emerging market local currency debt and bank loans have also aided client portfolios. Emerging market local currency debt provides a nice yield while diversifying client portfolios away from the USD, which is subject to ongoing and significant risk of debasement due to the Fed’s $85bn/month quantitative easing program.
Bank loans, while dollar denominated, also offer an attractive yield and have the added benefit of being very short duration, which will allow them to outperform longer duration fixed income securities in a rising interest rate environment.
Other assets classes, such as emerging market equities and gold, have struggled this year; however we remain attracted to the potential for these holdings over the longer term. Emerging markets offer much stronger growth potential than developed markets, driven by the burgeoning middle class in these geographies boosting domestic consumption in economies that have traditionally been based on exports. In addition to the attractive growth, the equities in these geographies are trading at a discount to developed markets and pay a stronger dividend yield. We have chosen to take on exposure to these geographies based on our longer-term view that they will continue to experience greater economic growth versus developed markets, but we have kept the allocation relatively small versus U.S. equities and fixed income to account for the likelihood of continued volatility. While the near term may remain volatile, we believe that these drivers will result in superior long-term returns from a diversified portfolio.
In addition to position size management, we have allocated our emerging markets exposure to higher quality dividend paying equities, which have proven to be less volatile through an economic cycle. We have also chosen to barbell this portion of the portfolio in the same manner we do in other areas, balancing the weights of more economically sensitive securities with more defenses securities to further dampen potential volatility.
Finally, our exposure to gold has been a laggard in portfolios over the last year; however, we have maintained an allocation as a hedge against risk in general. Gold remains the ultimate reserve currency in the minds of many and should benefit in times of heightened volatility and macro-economic risk. With the U.S., Japan and Europe engaging in unprecedented bouts of quantitative easing, the allure of gold remains strong. Debasement of fiat currencies is a very real concern for investors and gold is hedge against that risk.
Clients should be aware that many of the assets in their portfolios, beyond gold, will protect them against the threat of a weakening dollar. Obviously, gold, emerging market equities, and emerging market local currency debt will serve as portfolio ballast, but several other portfolio holdings will perform well should the recent strength in the U.S. dollar wane. Individual equities with hard assets, international exposure or strong global brands should also perform well. Hard asset producers will be able to sell commodities at inflated dollar denominated prices which will protect the real value of cash flows.
Similarly, businesses with foreign exposure will benefit from the diversification of its business away from the U.S. and will have positive exchange rate gains when profits are brought back to the U.S. Strong domestic brands that have pricing power will also be able to raise U.S. prices as purchasing power parity to the rest of the world erodes.
The world remains full of risks and these risks are not likely to lessen any time soon. Because of these risks we have allocated client portfolios in a manner that should maximize exposure to sources of growth while also protecting against the most probable sources of trouble going forward. The overall economic environment may not be ideal, but prudent investors focusing on the most encouraging areas of growth should be well positioned for the risks and opportunities still ahead.