2012, Quarter 1
January 6, 2012
2011: Volatility Reigned
2011 was a choppy year in the financial markets as investors judged the impact of real and potential calamities. Interest rates in the U.S. and other perceived safe havens were pushed to rock bottom levels, while equities began a period of wild swings during the summer as Europe stood on the precipice of a catastrophic currency breakup and bank meltdown. The S&P 500 ended the year up 2.1% (dividends included), while the MSCI World Index was down 6.9% and the MSCI Emerging Market Index fell 18.4%. 2011 was one of the few years of the last decade when emerging markets underperformed the S&P 500. Our predictions of higher interest rates haven’t been fulfilled yet, but we continue to believe rates will rise sooner or later, and when they do long duration bonds will underperform.
The first disaster of 2011 occurred in March, when a tidal wave struck Japan and killed thousands. The Nikkei index fell 16% in the days after the disaster. The destruction of the nuclear reactor at Fukushima took months to control, and impacted the global economy as trade with Japan was disrupted. Interestingly, the yen rallied after the disaster, as investors bet the Japanese government would repatriate foreign assets to pay for reconstruction. The disaster is no longer impacting global economic growth much, if at all, since trade flows have normalized and government spending in Japan has boosted demand. The human cost of the disaster, of course, was horrendous and tragic.
The next potential disaster, this one entirely man-made, began in July. The risk of default in peripheral European countries had been known for some time, but a tipping point was finally reached in the summer as yields on Greek bonds reached unsustainable levels. European leaders dithered, seemingly hoping for a miracle that would allow them to avoid making difficult decisions. They eventually enacted a series of reforms in an attempt to calm markets, most of which proved inadequate. After each announcement risky assets would rally, only to fall soon after. For some time it looked as if Greece might actually leave the eurozone, either by expulsion or its own choice, though Greek polls consistently showed that a majority of Greeks wished to stay with the euro and stomach painful reforms. A deal was finally struck in October to give holders of Greek bonds a 50% haircut. The deal proved a lawyer’s dream as negotiators did verbal contortions to avoid the legal definition of “default”, which would trigger the payment of CDS’s (credit default swaps) on Greek debt. This, of course, would likely have bankrupted some European banks and might have crippled Europe’s entire financial system. Greek leaders have pledged far-reaching reforms but clearly Greece will need help from stronger eurozone countries for years as the country attempts to lift itself out of its present hole and onto a sustainable path.
The next stop for the eurozone crisis was Italy. Italy actually ran a small primary budget surplus in 2011 but its overall debt level (almost 120% of GDP) made the country vulnerable to changing moods in the bond markets. Yields on Italian debt began rising over the summer and in the fall reached 7.0%, making a rollover of debt without assistance impossible over the medium and long term. This finally forced the reluctant hand of German chancellor Angela Merkel, while the ascent of technocrat economist Mario Monti as Italian prime minister made a broader deal politically acceptable for leaders in the eurozone’s core. Italy, like Greece, is pushing through tough economic reforms as a prerequisite toward getting continued assistance from the rest of the eurozone and from the European Central Bank (ECB). The new head of the ECB, Mario Draghi, has promised not to monetize debt in eurozone’s troubled periphery, but the ECB has continued to purchase sovereign bonds of troubled countries anyway. As 2012 begins there is renewed hope that a broader political solution will be found. Any solution, however, will demand years of austerity in many countries.
Prospects for Europe
News out of Europe drove the global bond and equity markets for much of 2011. We continue to believe that eurozone leaders will be forced to continue on the path toward a stronger fiscal union, and that the euro will survive. There are a few reasons to believe this, but the most important is that a collapse of the currency would simply be devastating to all of Europe, as well as to the global economy, and is too costly to be allowed.
A discussion of how a collapse of the euro would affect Europe is a useful exercise. The first domino to fall in a breakup would be the big European banks, as their holdings of sovereign debt would collapse in value. This would trigger a similar situation to what happened in the fall of 2008 when Lehman Brothers failed. Libor would jump and nationalization of most if not all major European banks would be inevitable. Banks in the US and Asia would be affected, since they also have exposure to European sovereign debt, and money market funds in the U.S. would “break the buck”, as they did in 2008, prompting even more bailouts. Europe and the U.S. are too fragile to absorb blows like this so soon after the calamitous events of 2008-2009, and both would be pushed back into deep recession. This is the scenario confronting Europe’s leaders as they negotiate the path forward, and is the alternative to continued cooperation. It does much to explain why the EU’s recent deal to enact treaty changes and move toward what German chancellor Merkel calls “fiscal union” was almost unanimous (only Britain voted no).
Another reason the euro is likely to survive is that its demise would devastate the European Union, and might destroy the project of European integration itself. Decades of negotiations and treaties would be thrown away and Europe would face the challenges of the 21st century – terrorism, environmental degradation, and rising economic and military competitors in Asia and elsewhere – divided and from a position of weakness. This would be a bitter pill for Europe’s people and leaders, and there is much to be gained by its avoidance.
A lasting solution to Europe’s problems must include significant help from the European Central Bank, though this has been loudly protested by German politicians. German leaders argue against quantitative easing (printing money to buy debt) by pointing out that it could lead to hyperinflation. Germany has a history of this, of course, and its hyperinflation in the 1920’s contributed to the Nazis taking power and, eventually, to World War II. Inflation is clearly a major concern, but couldn’t a breakup of the eurozone and subsequent financial breakdown also lead to future conflict? The answer is yes, of course, and is an issue that has certainly been carefully considered by Angela Merkel.
The head of the ECB, Mario Draghi, has hinted that the central bank may purchase more sovereign debt of troubled eurozone countries if they continue reforms and fiscal union is strengthened. Draghi is an orthodox economist and will fight inflation, but without more central bank assistance deflation and deep recession are much bigger fears. Inflation in Europe is under control, and the argument that more must be done to prevent deflation is gaining strength. This points a way out of the crisis.
For these reasons it is likely that the euro will survive in something near its present form, with much greater fiscal union. Some peripheral economies — Greece and Portugal come to mind — might eventually be removed from the currency block, but a disorderly breakup looks increasingly unlikely. All but Britain agreed to the reform package in December, and that included conservative as well as leftist governments, and countries from outside the eurozone. The fundamental question of whether the euro will survive in the short run has been firmly decided — it will. The negotiations will continue as leaders decide how fiscal union will be instituted. We expect financial markets to show lower volatility in 2012 as Europe’s path from the brink takes shape.
Emerging Markets
Inflation in the emerging economies was uncomfortably high in the first half of 2011, so central banks raised rates and governments tried to slow capital inflows. These policies have largely worked, and have been aided by the European currency crisis. Investors sold off “risky” assets around the globe in 2011 whenever troubling news came out of Europe, and the market still views emerging market currencies as risky. Since the end of July the Brazilian real and Indian rupee have both dropped 17% against the U.S. dollar, for example. Commodities, especially economically-sensitive metals such as copper and silver, also fell, resulting in slower growth in the emerging markets.
Economic growth in 2012 is likely to be slower than growth in 2011 for many emerging economies, but prospects for financial assets — currencies and stocks, especially — are bright. Inflation is now broadly under control and governments are beginning to implement fiscal stimulus as leaders fear low demand from Europe. Central banks are also easing monetary policy. Valuations are compelling, with the MSCI emerging market equity index trading at 9.4 times 2012 earnings, a 22% discount to the S&P 500, despite much better long-term earnings growth prospects. Demographics are excellent in most emerging economies, and most governments now follow orthodox economic policies and have strong balance sheets. There are problems, of course, including corruption, which is especially insidious in certain countries, but the negatives are already factored into the price of emerging market securities, and the prospects for growth are not.
As 2012 begins it is important that investors look beyond Brazil, Russia, India, and China as they explore the emerging markets. There are other emerging countries with great prospects for growth, including Colombia, Malaysia, Indonesia, and Vietnam. Sub-Sahara Africa has bright spots, including Mozambique and Zambia. Portfolios must be diversified, but significant exposure to the emerging markets will be essential in the years ahead.
United States
The U.S. economy was lethargic in 2011, growing at a disappointing 2.0%, as the deleveraging of U.S. consumers dragged on. With all the negativity regarding the economy, there were some important positive developments at the end of the year, however. The unemployment rate has fallen to 8.6%, and new unemployment claims were below 400,000 for most of the last two months, indicating that jobs are being added in the economy. Holiday sales were up sharply over 2010 levels, and consumer confidence has improved. The housing sector is still depressed but house prices are bottoming out. Meanwhile, the Federal Reserve has promised to maintain interest rates at rock bottom levels until at least 2013, and there is little risk of policy shocks which could halt the recovery in 2012, since political deadlock in Washington is all but assured in a presidential election year. It’s not clear that this will finally be the strong recovery that some have been predicting for two years, but there is increasing evidence that a lasting recovery is beginning and that the worst is behind us.
Gold
Gold has been on a massive bull run during the past few years, as investors put faith in the yellow metal as a hedge against both economic collapse and runaway inflation. It is down 15% since the end of August, but is still up a whopping 150% since the start of 2007. The very popular exchange traded fund GLD, which tracks the price of gold, has undoubtedly helped the bull market along, since it offers investors an easy way to add exposure to gold without requiring physical possession.
Gold at these levels looks overpriced. Gold has very few actual uses other than as a store of value, and its price could quickly plummet if investor sentiment changes. An improving economy might cause gold to decline, as could less quantitative easing than the markets expect, which would make gold’s use as a hedge against inflation less valuable. A small exposure to gold is still warranted, but more economically sensitive metals such as silver and copper are likely to outperform gold in 2012.
Equity Markets
The “risk on — risk off” trade in the equity markets continued throughout the second half of 2011 as investors reacted to news out of Europe. The correlation of individual stocks increases in times of systematic volatility, and that is certainly what happened last year. In situations like these it is difficult for equity managers to demonstrate superior stock-picking ability. Emerging market stocks fell 18% for the year and EAFE (international stocks ex US and Canada) were off 12%, underperforming the S&P 500 significantly. Most of this underperformance can be explained by a flight to quality trade in the face of tough news out of Europe, which significantly boosted the U.S. dollar. Valuations of emerging market (EM) stocks are compelling, and EM stocks are trading at a very high discount to US stocks. When the potential for fast economic growth in the emerging economies is accounted for, the argument for EM stocks is stronger still.
Our equity portfolios have exposure to Chile, Colombia, Brazil, and India, and also hold a large allocation of U.S. stocks. We are avoiding stocks from countries with high levels of corruption and the potential for political instability, including Russia and Peru. EAFE also is cheap relative to the S&P 500 and we have significant exposure to developed economy international equities.
We recently added Bancolombia to the portfolios. The bank is the largest in Colombia, which is set to grow 5% in 2012. Colombia has good prospects for investors as its government has largely defeated the narco-terrorists that threatened stability in past years. The country has huge reserves of natural resources — gold, oil and gas, water — and the government is ramping up their exploitation.
We added another financial — Bank of Nova Scotia — to the portfolio. The bank is a leader in Canada and also has significant businesses in the emerging markets. We hold no large U.S. banks. We hold Sociedad Quimica y Minera de Chile, which supplies fertilizer to farmers around the globe, and has significant lithium reserves in the Atacama desert.
Small U.S. oil and gas exploration companies fell in December but we’re bullish on the sector and own Rosetta Resources, Newfield Exploration, and Berry Petroleum. Increasing demand and the risk of supply shocks has us bullish on oil. We also hold Caterpillar, Cummins, Eaton, and Paccar, all of which are well-managed companies.
Throughout 2011 we maintained about 30% of the DBF Diversified Core portfolio in emerging market stocks, a significantly larger weight than exists in the MSCI All Country World Index, our benchmark. EM stocks underperformed both EAFE and the S&P 500 yet, despite this, the DBF Diversified Core composite was down 7.4% in 2011, just below the MSCI AC World Index’s return of –6.9%. In other words, the portfolio held up well despite strong headwinds. We continue to think that emerging market stocks will outperform over the long-term, and have our portfolios positioned accordingly. The annualized return of the DBF Diversified Core portfolio during the last seven years is 4.4%, versus 3.4% for the MSCI AC World Index and 2.6% for the S&P 500. — Brandon Fitzpatrick
Fixed Income Markets
The bond market had a very good year in 2011 as U.S. interest rates fell to new all-time lows. The 10-year Treasury yield declined from 3.30% at the beginning of the year to 1.88%. The 30-year yield also declined dramatically from 4.34% to 2.90%. This resulted in exceptional returns of 17.18% and 35.60% for the 10-year and 30-year Treasury notes, respectively. For the month of December the broad bond market as measured by the Barclays Capital U.S. Aggregate returned 1.10%.
Corporate bonds also had a good year in 2011 despite the widening of credit spreads late in the year due to uncertainty surrounding the European sovereign debt crisis. Corporate paper returned 8.15% for 2011, with lower-rated investment grade bonds outperforming the highly-rated issues. Mortgage-backed securities trailed Treasuries and corporate bonds during the year, but still returned a respectable 6.23%. The lowest coupons outperformed due to the drop in interest rates, especially in the second half of the year.
Until the labor market shows significant improvement, the Federal Reserve is unlikely to raise the overnight Fed Funds rate from its current range of 0.00% – 0.25%. It has stated its intention to keep the rate in that range until at least the middle of 2013, which would make for an unprecedented 4-year stretch of Fed Funds near zero.
U.S. consumer price inflation has shown signs of abating in recent months. CPI growth was 3.4% year-over-year in November, which is down from 3.9% in September. Slowing economies in Europe and, to a lesser extent, China and Brazil have taken some of the pressure off of raw materials prices. The Commodity Research Bureau Index of industrial raw materials prices has declined over 18% since April, and the rise in prices of imported goods has slowed from 13.7% year-over-year in July to 9.9% in November. However, the risk of unexpectedly high inflation during the next 3-5 years remains significant given the unparalleled monetary policies undertaken by the Federal Reserve. While international demand for dollars has been strong recently due to the uncertainty in Europe, a world awash in dollars will begin to discount them as alternative mediums of exchange emerge. This could cause a sustained secular increase in the dollar price of all goods and services — the very definition of inflation.
During 2011 our clients’ intermediate duration portfolios trailed the Barclays U.S. Aggregate Index due primarily to the fact that government mortgage-backed securities (MBS) underperformed other sectors of the broad bond market. That typically occurs when interest rates fall dramatically, due to the negative convexity characteristics of MBS. On the other hand, our clients’ short duration portfolios outperformed their benchmark as we were able to harvest higher yields in the short-term bond market without additional interest rate risk. We continue to maintain a significant allocation to Treasury inflation-protected securities (TIPS) in both short and intermediate duration portfolios. We view TIPS as compelling vis-à-vis nominal Treasuries and believe it’s prudent to hedge against higher inflation given the risk going forward.
Developing an accurate forecast for U.S. interest rates is difficult given the risks to the global economy. The developed economies of the U.S. and Europe seem to be walking a fine line between a relapse into recession and possible deflation, and high inflation or even stagflation due to currency debasement. Navigating these two extremes will be an enormous challenge for central banks heading into 2012. However, given our expectation for ongoing improvement in the U.S. economy we expect rates to be higher 12 months from now. We expect the 10-year Treasury to increase toward 2.50% during 2012, with the 2-year moving to the 0.40% to 0.50% range. — Cody Barney
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