Investors have reason for enthusiasm as stock markets around the world have delivered strong gains to start the year. During the first quarter, the DJIA was up 8.1%, the S&P 500 was up 12.6% and the MSCI World Index delivered gains of 11.3%. Driving this rally was the abatement of immediate liquidity issues surrounding the European banking crisis, allowing investors to focus on the positive U.S. economic news of persistent improvement in both housing starts and headline unemployment numbers.
Encouragingly, home building activity in the U.S. seems to have troughed and is slowly on the mend. Having peaked in 2005 at over 2 million units, new housing starts collapsed to about 550,000 units in 2009 and remained under 600,000 units through 2011. However, for the past seven months, there’s been consistent incremental improvement, and new housing starts are expected to be almost 750,000 units in 2012. Growth in this sector of the economy is important not only because it reflects some fundamental improvement in housing but also because the home building industry is a ‘job creating’ industry, as a result of the additional jobs (i.e. realtors, appliances, home furnishings, etc.) supported by a strong housing market.
The U.S. jobs picture has also provided reason for optimism. The unemployment rate dropped to 8.2% while the broader U6 under-employment rate dropped from over 17% to 14.5%. While there’s much debate regarding how precise these figures are, with labor force participation rates down and many workers simply not being counted any longer as they’ve given up looking for work, the fact remains that jobs are being created (an average of 246,000 per month during Q1 2012) and that’s a net positive for the economy.
In response to these economic improvements, bond markets began 2012 with some trepidation as investors questioned whether the nascent U.S. economic recovery would force the Fed to skip additional liquidity measures (i.e. QE3) and, instead, be pressured to raise interest rates earlier than their stated intent of 2014. These worries pressured the bond market, driving the yield on 10 year U.S. Treasuries from just under 2.0% at the start of the year to almost 2.4% mid-quarter before settling down and ending the first quarter around 2.2%.
Confidence in the global economic recovery remains understandably fragile. In the first few weeks of April, stocks have begun to give back some of their earlier gains. Earnings growth has not yet kept pace with the sharp gains in the stock market and near-record high profit margins remain threatened by rising commodity prices and incrementally higher labor costs. In April, gains in housing and employment also seemed to stall, which, when combined with renewed concerns over Spain, Italy & France, have spooked investors and led to questions on the sustainability of the recovery. This led to a rush to the relatively safety of U.S. Treasuries, bringing the 10 year yield back under 2.0%.
So what’s happening?
At a broad macro level, we remain in the early stages of a massive global de-leveraging that will likely take years to fully unwind. As we’ve previously written, the popping of the housing bubble in 2008 marked the end of an almost three decade long period of easy credit where consumers, home owners, business, and governments all gorged on cheap and readily available credit. Many of the excesses created during this time remain on balance sheets as the unwinding of this credit bubble has not yet finished.
Businesses are clearly the furthest along as they were the first to cut costs, largely through employee layoffs, and have aggressively refinanced into less expensive debt. With the economy stabilizing, many U.S. businesses are in better shape than they ever have been with rock solid balance sheets and record cash levels. U.S. homeowners and, more broadly, consumers in general have also taken steps to reduce spending and pare back debt. With record low interest rates, consumer debt service levels as a percentage of disposable income have fallen to their lowest levels since the early 1990’s. While some of this has been the result of debt discharged through foreclosure, the net effect is a stronger consumer with a greater ability to spend and stimulate the economy.
Governments, on the other hand, are clearly struggling under the weight of their debt as some of the private debt problems (most notably those of the banking systems) have been shifted to public debt for tax payers to deal with. While the massive liquidity efforts, most notably by the U.S. Fed and European Central Bank, have smoothed over crisis liquidity issues, they have not really solved the fundamental problem of excessive debt and, in fact, have exacerbated some of the problems and limited options for the future.
In Europe, much of the problem is structural and there simply isn’t any easy solution. While investors became comfortable with the seemingly manageable size of the problems of a tertiary country like Greece, increasingly it is becoming apparent that the much larger countries of Spain, Italy and France have similarly intractable problems. There is simply no way to grow their way out of the economic malaise. Looming elections, especially in France, threaten to further tilt the political system towards a Socialist solution, which many economists already blame for some of the current problems.
The U.S. faces its own structural issues and political gridlock suggests little progress will be made on the ballooning budget deficit, which continues to widen as projected spending grows as a percent of GDP to reach record highs on ballooning entitlement spending. With the looming U.S. Presidential election, it’s unlikely that any meaningful progress will be made between now and November, which will leave Congress roughly 29 working days to steer the budget discussions away from what is being called the “fiscal cliff”.
The U.S. economy faces this “fiscal cliff” on the first day of 2013. That is when the Bush tax cuts expire, dividends and capital gains start to be taxed as ordinary income, and the payroll tax cuts and extended unemployment benefits end. In addition, mandatory government spending cuts, agreed to during the melodrama of the 2011 debt ceiling debate, are set to go into effect in 2013. Unless legislation is changed prior to year-end, the agreed upon spending cuts automatically take effect. According to the Congressional Budget Office, the pending tax increases and abrupt spending cuts are estimated to shave at least 1.5% from U.S. GDP next year. This is not a particularly rosy scenario with GDP currently growing about 2.5%.
The Consequences of De-Leveraging
We do not have a high degree of conviction in any specific outcome of the ongoing deleveraging process and we’d argue that neither do many of the politicians that are driving the debate. In fact, with governments and politicians playing such an important role in “managing” the process, we suggest that many of the “solutions” will continue to be made for reasons other than the most economically rational ones and therefore present greater risks of potentially unfavorable and unintended outcomes. While we believe specific outcomes are unknowable, we are confident that ongoing debt reconciliation (or reducing credit in the economic system) will provide a headwind for economic growth as credit is constrained and spending/investment funds are redirected to pay down debt (or losses are finally realized).
Generally slower economic growth will lead to generally lower economic return opportunities for businesses and persistently higher unemployment (both in the U.S. and globally) as slower growth will retard the economy’s ability to absorb the natural expansion of the work force (i.e. immigration, high school & college grads) let alone reverse some of the approximately 8 million job losses since the 2008 recession. The global consulting firm McKinsey & Co. estimates that the U.S. will need to create 21 million jobs over the next decade to get us back to “full employment”. While an average of 2.1 million job additions per year over the next 10 years seems unfathomable given the past few years, there’s reason for optimism. McKinsey also reports that, with the exception of the 2000-2010 decade, this was the average pace of job creation over the past 40 years!
Slack in the global labor markets along with excess productive capacity are deflationary forces and will no doubt continue to provide partial cover to the printing presses of the U.S. Fed and the European Central Banks, in particular. While broad inflationary forces will likely continue to be kept at bay given this slack, accelerating inflation remains a potential problem that we would rather avoid as investors.
How We’re Managing Portfolios
As noted above, the role of governments and politicians in the current investment markets heightens risks and makes our always cloudy crystal ball that much hazier. As a result, the need for global diversification to strategically position portfolios for both opportunities as well as uncertainty is especially important today. We believe it is necessary to expand investment opportunities beyond the U.S. and developed economies and broaden the mix of stocks, bonds and currencies to take advantage of ongoing growth opportunities and reduce overall portfolio risk.
As an example, many investors are understandably concerned about the ongoing slowdown of the Chinese economy, which, together with the slowing growth of the world’s developed economies, has created concerns over the cyclical growth of the broader “emerging markets.” We believe that this has created longer-term investment opportunity. The ‘balance sheets’ of many emerging market countries are far healthier than developed market countries and with economic growth generally supported by strong fundamentals (i.e. natural resources, expanding middle class consumers), economic returns in emerging markets are much stronger than those in developed economies. At the same time, emerging market stocks continue to trade at a healthy discount to developed markets despite their stronger growth and economic return profile.
We continue to believe that “income” from our investments (interest and/or dividends) will play an important role in what we believe will likely be a lower return environment in the years ahead. Though absolute yields are low, bonds still play an important role in portfolios. Municipal bonds continue to offer relative value. We have been expanding on our core corporate/municipal portfolios by ensuring that senior-secured floating rate debt, emerging market debt, Master Limited Partnerships and, most recently, mortgage debt are all well represented in our portfolios. We believe these asset classes will significantly boost yield and total return opportunities for portfolios.
We also continue to target growth investments that generate strong free cash flow, which often leads to higher dividends or stock buy backs, enhancing our returns when top line revenue growth is more challenged. Though we are optimistic about the improving economic environment, we are under no illusion that the recovery will be without speed bumps. We continue to incorporate fairly conservative views into our analysis of future growth opportunities. In general, we anticipate slower revenue growth, weaker profit margins and lower valuations versus Wall Street consensus expectations. We want to make sure that our investments will not disappoint should others prove too optimistic about the pace of the global recovery.
Finally, we are striving to make the ongoing portfolio volatility work to the advantage of clients by remaining disciplined in our investment analysis and proactively managing portfolios to mitigate risk. We have been aggressively selling investments that are no longer supported by valuation, managing position sizes of new and existing investments and, much to our own frustration some times, we remain willing to hold cash and be patient for new opportunities.
We are prudently managing portfolios this way with the idea that one of the few “knowable” things is that the volatility that has so far been mostly benign will surely make a return appearance before too long. Even without all the unresolved significant economic challenges, the soon-to-be prime-time main event of Obama vs. Romney means that politicians will again grab center stage, bringing further fireworks and political theater to the still fragile economic stage.