Investors had reasons to celebrate by the end of 2012. Despite somewhat tepid economic growth of only 2% during the first three quarters of 2012, which slowed into the 4th quarter, the S&P 500 was up 16% and the MSCI All World Index (ex-U.S.) was up almost 17% through the end of the year. While robust economic growth was lacking last year, investment markets had extraordinary assistance generating these gains as central banks around the world continued to pump money into the system. While this aggressive money printing raised asset prices and lessened the risk of economic collapse in still struggling economies, it also continues to set the stage for potential inflation and currency devaluation, highlighting some of the reasons we continue to hold gold in client portfolio. Investors should be pleased with the performance of nearly every asset class 2012; however, 2013 is likely to be a bit more challenging.
The compromise on taxes coming just after the ball dropped in Times Square to welcome the New Year provided at least some short-term resolution regarding the 12/31 fiscal cliff and an enthusiastic investor reaction to start the year. As a result of the compromise, most tax-payers will pay a bit more in federal taxes in 2013 with the wealthiest feeling the biggest pinch and higher payroll taxes ensuring that all wage-earners will pay a little more this year. Difficult discussions regarding the debt-ceiling and structural changes to entitlement programs and other government spending will surely cause additional political drama in the months ahead. Whatever the ultimate compromise turns out to be, we know that the mix of higher taxes and spending cuts will negatively impact GDP growth and serve as yet another headwind to business in 2013.
These headwinds are coming at a time when households remain strained and businesses are increasingly less able to pick up the slack in the economy. The 3rd quarter was extremely weak for S&P 500 constituents, with about 75% reducing guidance for Q4. This data came on the heels of only 40% of S&P 500 companies beating revenue expectation in the 3rd quarter and blended earnings growth coming at a very disappointing minus 3.1% for the quarter. We suspect that 4th quarter data will be similarly disappointing.
This bleak outlook from businesses is in addition to Washington’s woes, escalating conflict in the Middle East, a struggling Europe and the potential for a real estate market collapse in China – together enough to frighten even the most grizzled investors. However, as with any difficult market environment, there is still opportunity. The potential returns from the bright spots might not match the levels they provided last year, but near term returns from select asset classes may still provide a lift to investment portfolios.
Housing investments played a major role in client portfolios in 2012 and we believe that theme continues to be attractive as we look to 2013. Investing in this segment of the economy can take many forms. Many stocks offer exposure to trends in housing, the obvious ones being home builders. However, we have chosen to take a more differentiated approach by selecting stocks that are driven by an upturn in the housing market that may not be directly tied to the building of new homes. We have purchased a timber company, an appliance manufacturer, a title insurance provider and others that benefit from new home sales. These stocks experienced meaningful gains in 2012 and will likely continue to add to returns in 2013 as the housing market continues to gradually improve.
The stocks of select businesses are only one way to play this theme, however. We have also been active purchasers of mortgage backed securities, which are selling at a discount to their par value and offer a solid yield well in excess of what a fixed income investor could expect in almost any other sector of the bond market. This past year mortgage bonds provided a strong total return in addition to yield as these bonds crept closer to par value. Returns in 2013 are likely to not be as strong as the market is continually shrinking with the Fed buying $45bn of mortgage backed securities each month and more retail investors becoming attracted to the high yield available. This has put the inventory of mortgage bonds available to investors under constant pressure, slowly eroding this opportunity.
Other bright spots are much more evergreen. Emerging markets, for instance, continue to offer excellent long term growth profiles and are currently trading at attractive valuations versus historical averages. These economies and their investment markets are likely to be volatile; however disciplined investors can realize strong annualized returns when a modest allocation is taken in geographies that have strong balance sheets and stable political systems that will support the economy as it grows. Currently, we favor Brazil, as well as other Latin American economies, and India as we feel that these economies have the potential to produce a vibrant middle class that can drive GDP growth.
We steered clear of direct exposure to China in 2012 as we feared a slowing Chinese economy could result in cracks starting to show in the country’s fragile and overheated real estate market. Recent economic data has allayed some of those concerns, but we remain cautious. The Chinese market is trading at attractive valuation levels and we are continually monitoring China as a potential opportunity that could help investors grow assets in 2013.
As always, these asset allocation decisions are complemented by our focus on high quality U.S. equities. We continue to invest in businesses with strong returns that are trading at reasonable valuations and have a history of stable performance through changing economic cycles. These businesses are inherently less volatile and typically have more stable cash flows with an enduring competitive advantage that offers a wide “moat” to protect their business.
Given this backdrop, we believe investors should expect more modest returns going forward. 2013 is loaded with road blocks, but with thoughtful tactical asset allocation decisions that focus on the healthiest parts of the global economy, we are well positioned to benefit from attractive investment return opportunities. Higher starting valuations and slow GDP growth in the U.S. are headwinds to opportunity. However emerging markets, select fixed income investments and a continued focus on businesses with robust cash flow linked to stable parts of the economy offer the best chance for asset growth in 2013.