Investment Review and Outlook
Winter 2013
Stocks shrugged off numerous worries to log a very good year in 2012. The riskiest areas were the most profitable. Europe gained over 21% in 2012. Emerging-markets stocks earned 19%. In the U.S., small-cap value stocks earned 18%.
The bond side also saw riskier asset classes beating traditionally safer fixed income market sectors. Emerging-markets local-currency bonds notably gained 17%. Domestically, high-yield bonds returned 15%, while investment-grade bonds returned 4%.
Our actively-managed bond funds performed well relative to their benchmarks, and added significant value versus the core bond benchmark over the last year.
A key risk going forward is how our politicians deal with the problem of growing public sector debt. The last- minute fiscal cliff compromise buys politicians a little time to address the more important longer-term fiscal issues, but does little to resolve them.
Investment Review and Outlook
For several years, we have said the most likely outcome for the developed world economy would be years of slow growth. This view was based on our assessment that excessive debt levels in the United States and around the developed world had to be reduced, and that this lengthy period of deleveraging would suppress spending and be a major drag on economic growth.
Benchmark Returns
| Benchmark Funds | Q4 2012 | 12 Months Ending 12/31/2012 |
| U.S. Large Cap Vanguard 500 Index Fund |
-0.4% | +15.8% |
| U.S. Large Cap Value iShares Russell 1000 Value Index |
+1.5% | +17.3% |
| U.S. Small Cap iShares Russell 2000 Index |
+1.8% | +16.4% |
| U.S. Small Cap Value iShares Russell 2000 Value Index |
+3.2% | +17.9% |
| International Vanguard Total International Stock Index Fund |
+6.7% | +18.1% |
| Emerging Markets Vanguard MSCI Emerging Markets ETF |
+6.8% | +18.8% |
| U.S. REITs Vanguard REIT ETF |
+2.5% | +17.7% |
| Investment-Grade Bonds iShares Core Total U.S. Bond Market ETF |
+.02% | +4.0% |
While clear progress has been made, the deleveraging process is not close to being complete. The risk of another crisis has declined, but it remains possible and should not be dismissed. Reducing the growth of debt at the right pace and in the right way is necessary, but not easily achieved. This will be an important year, as politicians are charged with putting in place a viable longer-term plan. If this is not done in 2013, the risk is that it won’t be done until after the next presidential election, unless a crisis comes first. The lost time may mean we will face even greater consequences.
Europe
As challenging as the politics are in the United States, the challenges are even greater in Europe, where countries with different cultures and economic characteristics are being asked to give up some of their economic sovereignty. Solving these problems will take a long time and along the way they could trigger more serious social unrest. As in the United States, Europe’s problems are all about debt-related economic headwinds and the threat of political mishandling of a fragile economy.
Europe also made progress in 2012 by reducing borrowing costs and thereby lessening the “tail risk” of an imminent eurozone breakup. There has been some improvement in the peripheral countries as most seem likely to have current account surpluses in 2013; capital flight appears to have stopped, and there are signs that the push for austerity may soften a bit.
It remains an open question whether European governments will be able to make the right decisions with respect to growth policies, debt relief, and the fiscal and banking integration that is needed to hold together the single currency over the long run.
The Optimistic Scenario
We recognize a variety of bullish factors that could drive stocks to strong returns over the next five years. These factors are listed below.
- As we move further along in the deleveraging process, expected returns for stocks have improved.
- An enormous amount of “froth” has been taken out of stock prices. The stock market, as measured by the S&P 500, is at a level first reached 13 years ago and multiples are much more reasonable than they were.
- Relative valuations driven by the Fed’s low interest- rate policies could continue to play a big role in stock returns going forward. Stock valuations are in a fair-value range on many absolute measures.
- The risk of another financial crisis that leads to deflation has declined. Some deleveraging has occurred, and over time, this should impact investor risk-taking, especially if this trend continues.
- If politicians can agree on a credible plan for long-term deficit reduction, that could go a long way toward mitigating concerns about future debt build-up and related policy errors.
- In the United States, the corporate sector is sitting on a lot of cash that could be used for capital investment and hiring, as some of the uncertainty recedes.
- The global economy has experienced some encouraging macro developments. In the United States, housing is now a driver rather than a drag on growth. Credit markets also continue to improve with easier lending standards, and the labor market is slowly healing, though it remains historically weak. Outside the United States, the growth slowdown in the emerging markets may have ended and there are numerous signs that China’s economy is picking up (though not to previous growth levels). Even Europe, currently in a recession, could start growing again in the second half of 2013.
Weighing on the positive factors listed above is the growing debt level. There is no easy road out of the debt bind. The only straightforward path would be robust growth, but this is unlikely in a deleveraging global economy. In this environment, corporate earnings will be challenged as growth through cost cutting has largely played out.
Global Markets
The developed world continues to face significant debt-related challenges. The solutions are not easy and there are no quick fixes. Failure could play out in various ways, from another financial crisis to sharply higher inflation several years down the road. A brighter spot is that developing countries are generally less indebted and growing faster. However, growth has slowed there as well, partly due to the impact of reduced demand from the heavily indebted developed countries
How This Impacts Portfolio Positioning
We expect that in all but the most pessimistic scenarios, stocks should significantly outperform bonds over the next five years. Decent fixed-income opportunities exist outside of the investment-grade bond market, including parts of the mortgage market, short-term high-yield bonds, and emerging-markets local-currency bonds. Alternative strategies, such as flexible fixed-income strategies, can help investors capture higher returns than bonds.
During 2012, our actively-managed fixed-income positions added enormous value to our client portfolios. Most of the bond funds we hold pay much higher yields than the bond index and have less interest-rate risk. The lower-interest-rate risk is a function of lower duration and more credit exposure, which is likely to perform better in a rising interest-rate environment. However, yields have come down and this means lower potential returns than what we were able to capture in 2012 and over the past several years.
Looking Ahead
The weight of the evidence suggests global deleveraging will create an environment that may mute returns and carry outsized risks in the short term.
Our client portfolios are positioned to be globally diversified and not excessively cautious. Cash needs in the near-term (i.e. five years) should not be invested in the stock market. We hold some niche assets that we believe offer the potential to add value relative to our benchmarks.
While investing in this environment can be frustrating at times, successful investing requires the patience to wait for opportunities.
