2012, Quarter 2
April 5, 2012
Equities rallied in the first quarter and Treasuries fell as investors were encouraged by stronger economic growth in the US, falling inflation in the major emerging economies, and renewed optimism that Europe’s leaders will find a way out of the eurozone’s political and financial crisis. The S&P 500 rose 12.6% in the quarter and the MSCI Emerging Market index was up 14.0%, while the yield of the 10-year Treasury rose to 2.21% from 1.88% at the start of the year. The flood of money into Treasuries during the financial crisis of 2008-2009 began to reverse in the first quarter but rates are still very low across the yield curve. We expect more money to flow out of fixed income and into more risky assets, driving interest rates higher, as economic growth ramps up and investors regain appetite for risk in the months ahead. Equities are threatened in the short run by the possibility of slower growth in the emerging markets and the possibility of a political shock — such as a military conflict with Iran. Even with these risks equities are reasonably priced and are still very attractive vis-à-vis fixed income. The breakeven inflation rate on 10-year Treasuries is 2.29%, which is above the nominal rate. In other words, the real return on 10-year Treasuries is negative. The MSCI AC World Index trades at 12.7 times forward earnings, while the MSCI Emerging Market Index trades at 10.7 times earnings, both very reasonable valuations.
Emerging market stocks faced headwinds last year as policymakers worked to pull inflation down from uncomfortably high levels. Central banks in Brazil, Chile, and Indonesia raised rates, and Chinese leaders put new restrictions on the real estate market in an attempt to limit speculative investing and to prevent the Chinese economy from overheating. Those policies worked and inflation is down considerably in China, Brazil, and most emerging economies.
Policymakers have changed their focus and are now working to ensure that robust economic growth is maintained, which should provide a tailwind for emerging market stocks during the next few quarters. Many central banks in the emerging economies have recently loosened monetary policy, as they now fear diminished demand from Europe and continued tepid demand from the United States.
The main driver of emerging market growth is China, which continues to demand copious amounts of commodities needed for the development of its industrial base and transportation system. Growth in China has slowed somewhat during the last year, and Premier Wen Jiabao recently said he expects GDP growth in China to be 7.5% this year, slower than the 8-10% the country has usually achieved during the last decade. Given the very cautious character of China’s leadership, it’s possible that Premier Wen was trying to control expectations in case growth slows, and that actual growth will be faster than 7.5%. If China’s growth rate does slow to 7.5%, that figure is still high enough to lead to continued fast growth in other emerging economies that depend on Chinese demand for commodities (this includes virtually all of Latin America, much of southeast Asia, and parts of Africa).
It’s important to note that China’s leaders have uncommon control over their country’s banking system, due to the quasi-public nature of Chinese banks. This allows them powerful tools to enact countercyclical policies to encourage growth when needed. China’s leadership has staked its political legitimacy on fast economic growth and restrained inflation. Inflation is under control so the focus now will turn to maintaining growth.
We predicted last summer and fall that European leaders would be forced to find a political solution to the eurozone’s problems, and that the common currency would survive. Our voice was a lonely one during some trying days in September and October, but our prediction has proven correct. Greece and Italy have agreed to and are implementing austerity measures, German leaders have pledged that their country will stay with the euro, and, critically, European Central Bank President Mario Draghi has eased the pressure on the continent’s banking system by pledging loans to European banks at rock bottom interest rates for three years. Draghi’s program has been an unqualified success and banks have taken advantage of this carry trade to buy European sovereign debt, bringing yields down to much more comfortable levels. Surely this was one of Draghi’s principal goals, though he could never say so since it would infuriate German politicians who are dead set against any form of “quantitative easing”.
Critics contend that the fundamental causes of the Eurozone’s current crisis – profligate and unsustainable spending in the periphery combined with weak centralized control – have not been adequately addressed. This is certainly true, but German Chancellor Merkel has done an excellent job of setting the stage for these difficult but necessary reforms. Greece and other peripheral economies might eventually decide that austerity is too painful and that they must leave the eurozone, but a sudden and unexpected exit, which could tear the eurozone’s core apart, is now out of the question.
The next step on the road to reform will be to continue strengthening centralized fiscal control in the eurozone. We believe this is likely to be successful given Chancellor Merkel’s adroit handling of events up to now. We would like to see Merkel and her European compatriots focus somewhat more on growth instead of their laser-like focus on austerity, since fiscal tightening in Italy and elsewhere has pushed Europe into a mild recession. We expect the Eurozone as a whole will grow 1% in 2012. That’s the bad news. The good news is that the continent’s banking system has been saved, disaster has been avoided, and the eurozone is on much better footing than it was six months ago.
There are various signs that the US economy is improving. During the last few months manufacturing data have been better than expected, as have retail sales data, and consumer confidence is higher than it was six months ago. The housing sector is still depressed but there is significant evidence that the market has begun to turn. Some of the worst-hit cities have seen house prices rise, while mortgage rates remain at rock bottom levels and rental rates are still expensive. Initial jobless claims have been better than expected, and it’s clear that the economy is adding jobs. We’re forecasting a continuation of the modest recovery the US economy has been experiencing during the last year. The economy should grow 2.5% this year, and we anticipate that growth will accelerate later in the year.
Oil prices have risen significantly during the last three years and WTI (West Texas Intermediate) crude is currently trading at $102 a barrel. The rise is due primarily to increasing demand in China, India, Brazil, and, increasingly, the Middle East. There are also worries about a possible supply shock in the Persian Gulf. Iran has already cut off oil shipments to some European countries as a preemptive move (the Europeans were preparing to cut off Iranian shipments themselves), and the US is pressuring all countries to stop importing Iranian oil. Iran is a major oil producer and these developments have resulted in a tightening of the oil markets.
The oil markets are most worried, however, that the conflict with Iran will escalate to military action. It’s unclear how Iran would respond to a military attack on its nuclear facilities, though it would almost surely launch missiles at Israel and could release mines in the Persian Gulf in an attempt to close the Strait of Hormuz. In the aftermath of any strike against Iran the price of oil is very likely to spike – how high is unclear, but it would likely rise to $150 a barrel or higher immediately, which would be a major strain on the global economy. If high prices were sustained it could push the global economy into recession. We’re not predicting such a dire outcome, but the possibility of a spike in energy prices is one of the biggest risks to economic growth this year.
The composite return of the DBF Diversified Core portfolios was 12.81% in the first quarter, 79 basis points above its benchmark the MSCI All Country World Index, which rose 12.02%. During the last 7 years the DBF Diversified Core composite is up 6.39% annualized, while the MSCI ACWI has risen 5.18% on an annualized basis.
We have significant exposure to emerging market stocks, as we believe emerging economies will experience much faster growth in the coming years than the US, Europe, and Japan. We own Brazilian plane maker Embraer, Colombian bank Bancolombia, and Chilean companies Enersis and Sociedad Quimica y Minera de Chile, among other emerging market names. We are always very careful about the operating environments of the companies we invest in, and avoid stocks from countries with elevated risk of political instability.
Our portfolios hold oil producers Rosetta Resources, Berry Petroleum, and pipe maker Tenaris. We increased exposure to financials in the first quarter, and decreased exposure to Brazilian stocks. Compared to our benchmark the MSCI AC World Index, our equity portfolios are underweight EAFE stocks and neutral US equities.
Equity prices in Brazil are fairly priced, while the Chinese stock market looks cheap at 9.6 times forward earnings. We favor Chilean and Colombian stocks among Latin American names, while within Asia we favor companies from Malaysia and Indonesia. Vietnam is another country with interesting prospects over the longer term, though it faces hurdles in the short-term. Still, opportunities exist there.
US Treasury yields finally broke out of their four month trading range in March on upbeat US economic data, as well as the structured default in Greece that coincided with €130 billion in additional financing for the struggling country. The US Treasury yield curve steepened significantly with the 10-year yield up 24 basis points to finish at 2.21%, while the 2-year yield rose 3.5 basis points to end the quarter at 0.33%.
Treasury bonds suffered their worst quarter in over a year during the first three months of 2012, returning -1.00%. Long-term maturities fared especially poorly, down 5.80% for the quarter as a result of the steeper curve. Corporate bonds fell 0.97% in March. The corporate sector is still up 2.08% for the year as an improving economic picture has continued to tighten credit spreads. Mortgage-backed securities had a good month relative to the other investment grade sectors due to their shorter average duration. They returned 0.06% in March and are up 0.57% for the year.
As we have stated in prior letters, we continue to view US Treasuries as dangerous, especially the longer maturities (5+ years). The Federal Reserve is scheduled to wrap up “Operation Twist” in June and we don’t expect further monetary easing, which sets the stage for rising interest rates as the year progresses. We expect the 10-year US Treasury yield to rise to 2.75% by year-end, and the 2-year yield to hit 0.50%.
In his speech last week at the National Association for Business Economics, US Federal Reserve Chairman Ben Bernanke reiterated his concerns regarding structural unemployment in the U.S. economy. In other words, the dramatic shift away from housing and construction in the U.S. has left entire swaths of would-be workers unemployed and without the skill sets to compete in the current economic environment. In addition, he noted that the recent improvement in the labor market doesn’t seem consistent with the moderate pace of US GDP growth over the same period. Typically GDP growth is significantly higher than its long term trend as unemployment drops following recessions. Unemployment has dropped from a high of 10% in October of 2009, to 8.3% currently. However, year-over-year US GDP growth has remained below its long-term trend rate of 3% for most of that time frame. Bernanke reiterated the need for low rates in the near term in order to maintain the pace of recovery and reduce unemployment further. We expect the US economy to continue its moderate pace of recovery and we expect the Fed to keep the Fed Funds rate in the range of 0% – .25% through the end of 2012. If economic growth and inflation pick up significantly, the Fed may have to back off on their promise to maintain the rate in that range through the end of 2013.
Our clients’ Intermediate Duration Govt/Agency portfolios outperformed the Barclays Capital US Aggregate Index during March by 40 basis points (-0.15% versus -0.55%). Our allocation to mortgage-backed securities, along with our relatively short duration TIPS (Treasury Inflation Protected Securities) both contributed to portfolio performance. Inflation expectations dropped in March for the TIPS maturities we hold in client portfolios, so we took the opportunity to increase the allocation and increase the average maturity of the TIPS held. With corporate credit spreads at their tightest levels since 2007, there is reduced likelihood of continued strong outperformance by corporate bonds. With Treasury yields likely to rise over the next 12 months we are very optimistic about our clients’ opportunities for relative outperformance given our duration positioning and TIPS allocation.
Our clients’ short duration portfolios also significantly outperformed their benchmark. Our Short Duration Govt/Agency composite returned 0.18% versus -0.06% for the Merrill Lynch 1-3 Year Treasury Index. The mortgage-backed securities in the portfolio did well during March due to their short duration and negative convexity characteristics. They were also helped by bond market investors looking to invest in short bonds as the yield curve steepened. Portfolio duration is slightly shorter than the index at 1.6 years and we expect continued outperformance in this product vis-à-vis other high quality short-term fixed income instruments.
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