Investors are no doubt weary of hearing about all of the geo-political and economic risks in the world. The last five years have been exhausting, filled with unprecedented volatility, global turmoil and uncertainty. Unfortunately, the world is unlikely to simplify anytime soon.
Israel and Iran continue to edge closer to conflict, the European debt crisis remains unresolved, China’s growth is slowing and near zero US interest rates are punishing savers as the Fed has pulled out all of the stops in an attempt to restart the economy. In the US, we are facing a transformative election ahead of a self-imposed fiscal cliff that could subtract, by some estimates, as much as 5% from U.S. GDP growth under the worst case scenario.
Regardless of what your personal political leanings are, most can probably agree that compromise will be the key to avoiding the negative drag that higher taxes and sequestration could cause. We can also agree that compromise might be a bridge too far for most politicians these days. While the scale of the economic drag these spending cuts and tax increases will cause is uncertain, investors should expect to see headwinds to economic growth in 2013.
So, what is an investor to do? First, it is important to remember that despite how gloomy the current environment may feel, the last year has been a terrific year for global stock markets, particularly U.S. stocks. As of the end of September the S&P 500 is up over 30% in the past 12 months and over 16% year to date. While international & emerging market stocks have lagged the U.S., the MSCI All World (ex-U.S.) Index is up a solid 14.5% and 10.4% over the same time periods. Many bond markets have also had relatively strong returns as U.S. Treasury rates have fallen again this year.
From the current elevated levels in equity markets and with bond rates as low as they are, attractive investment opportunities by definition are harder to come by. However, that does not mean that they are nonexistent. We continue to see strong fundamentals in the U.S. housing market and have made several investments in the past year to take advantage of this opportunity. One of these opportunities is in mortgage debt, which has become even more attractive as the Fed announced its most recent easing program where it made an open-ended commitment to purchase mortgage bonds.
In addition to mortgage debt, we continue to favor gold, especially as these additional, unprecedented actions by the Fed place further pressure on the value of the dollar and suppress interest rates, which is traditionally bullish for gold. As long as the Fed continues to print and interest rates stay close to zero, gold will remain an attractive hedge against fiat currencies.
We have also identified several high quality equities providing strong growth characteristics that became available at attractive valuations and merited investment. The key to our investment decisions is staying disciplined so that we’re investing and holding only high quality securities that are trading at a discount to our conservative view of fair value. This strategy allows for strong participation in markets that are rallying as these securities appreciate towards fair value, but more importantly it minimizes the opportunity for losses in less favorable climates as the lower valuation and underlying strength of these high quality businesses typically act as a buffer to more volatile markets. Purchasing these stocks at a discount builds in an additional margin of safety and further insulates clients from volatility.
We also remain constructive on emerging market local currency debt, emerging market equities and floating-rate senior secured debt (i.e. bank loans). We have carefully considered most emerging market geographies and constructed a portfolio that focuses on what we consider to be the most attractive regions (i.e. Brazil) and minimize exposure to regions with less favorable fundamentals (i.e. China). As a result of this thoughtful asset allocation process we have been able to help protect client portfolios from the slowdown in China while maintaining exposure to the secular growth drivers of the emerging markets.
Further, our investment in differentiated asset classes such as floating-rate bank loans and emerging market local currency debt have enabled clients to enjoy yields on fixed income assets well beyond what is currently available in traditional fixed income markets while simultaneously protecting portfolios against the potential threat of rising rates. Bank loans are a particularly interesting asset class as they are currently one of the only fixed income asset classes that we track that is trading at a meaningful discount to par value. Also, they are floating rate instruments, a feature which insulates investors from the ravages of rising rates while allowing investors to participate in the increased yield environment that rising rates provide. To top it all off, these bonds sit at the top of a company’s capital structure and are generally secured by specific corporate assets, offering protection if credit quality deteriorates.
The world is not a simple place and investing in the current environment is extremely challenging; however, through disciplined investing, risk can be minimized and we stand ready to capitalize on opportunities presented to us through market volatility. It is highly likely that any one of the risks in the world will cause investment markets to pause and/or perhaps decline. We take some solace from this potential future from our careful consideration of these risks and the adjustments we have made to client portfolios, both in structure as well as our research analysis, to protect client portfolios should investors even temporarily lose faith. The mix of high quality stocks, mortgage debt, gold, bank loans and emerging market securities is specifically designed to provide clients with strong long term opportunities for growth and income so that portfolios may achieve the total return required to meet their investment goals.
The risks that fill the airwaves and newspapers are unlikely to ebb any time soon and it is crucial to invest with an appreciation of the potential negative consequences any one of these risks could have on investment markets. Even with our somewhat defensive posture in client portfolios, we are confident that we will continue to participate in the currently strong investment markets and have similar confidence that we are well positioned to protect portfolios for the volatility of a less favorable environment.