December 31, 2011 Market Commentary and Outlook
“Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies.”
Groucho Marx
Politics as Usual
The S&P 500 index, which tracks the stocks of large US companies, ended a rollercoaster year almost exactly where it started: 2010 ended at 1257.60 and 2011 ended at 1257.64. But investor in the S&P 500 actually earned 2.11% for 2011 because of the dividends paid by the companies in the index. For the fourth quarter, stocks returned 11.82%, bouncing back from the correction of late summer and early fall. Bonds, as measured by the Barclays Capital Aggregate Bond Index, earned 7.84% for the year and 1.12% for the quarter.
In our last quarterly market commentary, we highlighted the lack of certainty in markets and that this uneasiness could lead to more volatility until several issues reach resolution. Unusually high levels of uncertainty still exist on both sides of the Atlantic these days, and investors are closely watching whether elected officials are able to enact the right policies. In the case of the bi-partisan Supercommittee, investors were watching to see if there would be any policy enacted. But the failure to agree on what taxes to increase and what portions of the budget to cut instead served as a testament to the quality of America’s elected officials on both sides of the aisles (recall that the Supercommittee was created because of the previous inability of lawmakers to forge an agreement). Much politicking is occurring overseas, as well, as the European Union continues to hold a succession of summits that seem to temporarily calm markets, only to be followed by more summits and large market movements.
Europe
Over the very short term horizon, we continue to expect equity markets to fluctuate based on progress—or lack thereof—in improving the fiscal situation of several key nations in the European Union. The intensive deal-making involved with nearly any decision in Europe is a headwind for European leaders, when compared to the ability of those in the US to make seemingly easy decisions, in contrast. While the European Union has a Central Bank and common monetary policy as a result, there is no common fiscal policy between the relatively independent member nations. Any short-term progress is based directly on the political abilities of Europe’s leaders.
Much of the problem is that the Euro was purposely designed, as one columnist cleverly described, like a “Roach Motel” of currencies—countries can enter, but they can never leave. In the past, when developed countries have faced economic challenges, those countries have been able to devalue their currency and pay back their bonds in the devalued currency—effectively a default without as much hullabaloo. Instead, European bailout recipients such as Greece must enact large spending cuts, balance their budgets, and endure severe recessions instead of relying on a devalued currency to meet their obligations.
Over the quarter, the European Central Bank (ECB) saw the installation of a new Chairman, an Italian, while Greece and Italy elected new Prime Ministers, both economists by training. It will be an uphill battle for the new Prime Ministers to convince constituents back home that continued government budget cuts and possible tax increases during recessions are positive steps, especially when many fellow economists are publicly skeptical about the approach and social unrest already looms large in their home countries. Convincing a populace to make sacrifices for what is perceived as the common good has traditionally required very strong leadership, a trait that will be tested in the new leaders perhaps the same way it was tested in their ousted predecessors.
Fiscal integration of the region will be the goal for many EU leaders in 2012 and there will be no shortage of summits to prove it, as fiscally-troubled nations enact budget cuts at home in exchange for bailout packages from stronger Northern European countries like Germany. Some of the largest market movements in 2011—a more volatile year than most—took place in anticipation of the 9 European summits of 2011. The summit of December 9 was especially important and resulted in a plan that improves the ability of the collective body to influence member nations’ budgets, including the possibility of mandatory constitutional balanced budget amendments for member nations and automatic sanctions for nations that have annual deficits in excess of 3%. Many believe that the December 9 summit averted a crisis and saved the currency. The next summit will be on January 30.
Time will tell whether the bailout recipients or the financiers will tire of the arrangement first, or whether the EU will continue with fewer members, split into two tiers or continue unscathed. Markets were on edge throughout 2011 before the major summit meetings, and more meetings will take place in 2012. For this reason alone, one might expect another year with more volatility than usual.
United States
Although issues in Europe are driving short-term market movements, developments in the United States could gain prominence as 2012 progresses. In less than 12 months, voters will decide who will be President—at least for the next four years—and there will be certainty around which party will control the House, Senate or both. To a lesser extent, additional uncertainty surrounds the $400B Jobs Bill and healthcare legislation (will large employers have any uncertainty around what it might cost to hire due to health benefits?). And then there is the question about possible tax increases on the wealthy.
Some of the traditional short-term relationships in markets are continuing to hold. That is, when volatility increases in foreign markets, global investors—so far— have still sought refuge in bonds backed by the US government. This “flight to safety” even happened despite Standard and Poors’ downgrade of US bonds in August. Ironically, S&P cited the political environment and its effect on controlling spending as the reason for the downgrade; but investors bought (not sold) treasuries as a result, pushing prices up and yields down, in effect making it less expensive for the country to borrow.
Green Shoots or an Economic Headfake?
Politics aside, the Fourth Quarter of 2011 was one with several positive economic surprises. Estimated third quarter GDP growth, initial unemployment claims, and new residential construction were all better than anticipated. This led to relatively strong stock performance, especially in October. Some might point out that consumers do not actually spend consumer confidence or initial unemployment claims—consumers spend incomes! And incomes are still down, with a consumer that is intent on paying off debt instead of borrowing to spend. We hope that the trajectory of the recent economic data releases continues, but in the meantime we maintain a healthy level of skepticism until a clear trend emerges.
A Time to Reflect (What Worked and What Didn’t)
During 2011 we predicted that a number of themes were likely to add outperformance to investors’ portfolios. Let’s take a moment to see how these themes played out.
Theme #1: Focus on quality, large cap dividend‐paying companies
Large caps, measured by the S&P 500, returned 2.11% compared to small caps which lost -4.18%. High quality and dividend paying companies (as measured by S&P’s High Quality and Dividend Aristocrats indices) returned 6.6% and 7.6% respectively. In 2011, many of our clients had two large cap managers who focused heavily on these themes and outperformed large cap stocks for the year.
Theme #2: Indirect access to emerging markets consumers
Emerging markets consumers represent about 2.9 billion people and emerging markets economies account for about 49% of the world’s GDP. Incomes in emerging markets, over time, are expected to rise and a new—and sizeable—middle class is expected to emerge. But stocks in these relatively young economies are highly volatile compared to those of the US. There are several managers that we focused on in 2011 who provided access to consumers in foreign and emerging markets via large multinationals that are listed on US stock exchanges, and on the stock exchanges of developed nations in Europe. Companies like Nestle and Coca Cola, according to these managers, provide significant access to emerging markets consumers. We utilized two managers who outperformed their benchmarks, in part due to their allocation to emerging markets in this manner.
Theme #3: A two speed global recovery
Within our fixed income portfolios, we anticipated that continued monetary easing by the Federal Reserve and other major developed nations would devalue—if moderately—the three major developed currencies. Japan, the US and the European Union, the logic goes, are borrowing more despite tepid economic growth rates. The result? A riskier borrower, in theory. As part of this observation, it stands to reason that countries with higher rates of economic growth and less debt in proportion to the size of their economies should see currency appreciation and declining bond yields to reflect the better economic position. South Africa, Denmark, Australia, and other currencies with more rapidly growing economies and less debt, should be attractive. When S&P downgraded the US Government and conditions in Europe deteriorated, much of this went ignored by investors and US Government bonds were viewed by many as a safe haven. We appeared to be right on this call for most of the year but in August and September one of our global bond managers, who was focused heavily on this theme, underperformed to finish the year slightly negative. Going forward, we believe allocating to global bonds makes sense within a diversified fixed income portfolio. That being said, we are looking at ways to reduce the volatility associated with the asset class for our investors.
Theme #4: Position for rising interest rates
Over the past few years we have allocated clients’ fixed income holdings to managers that would provide some protection in a rising interest rate environment (short duration). Historically, there have been periods where interest rates have risen rapidly and without expectation. Despite the Federal Reserve’s intention to keep short-term interest rates near zero through at least 2013, yields on the 10 year Treasury are painfully low and it remains hard to see how they might go lower. But they could, especially if a correction in stocks takes place, more problems in Europe continue to surface, or possibly if China’s economy experiences a “hard landing” and investors seek safe yield in the form of US Treasuries. However, with yields around 2%, there is some significant downside risk to the price of longer maturity bonds. Many investors do not have this kind of appetite for their bond portfolios. That being said, the short duration fixed income portfolios we have built for many of our clients’ were out of favor (on a relative basis) as longer-term US government securities had a tremendous year.
Conclusions
In 2012, a focus on large cap stocks with quality earnings and growing dividend yields should continue to be an investment theme that could help dampen the volatility of portfolios and maintain exposure to the stock market. In the year ahead, we foresee continued volatility as European countries and the EU work through several difficult and ongoing fiscal and structural issues. The gridlock in the US political environment and uncertainty around the looming elections could also lead to more volatility.
Despite the relatively-defensive positioning, there is always possibility for an upside surprise in equities because it is possible that investors have already “priced in” a healthy degree of pessimism. The stock market can make even the most seasoned prognosticators appear dead wrong (especially over short time periods). Only a handful of market commentators expect a year for stocks that might be considered “in-line” with longer-term averages for stock returns (say, in the 10% to 12% range). These commentators point to two factors that may bolster stocks. First, multinational corporations are holding significant amounts of cash relative to their historical levels, and they are in stronger positions than they may have ever been. It is possible that companies use this cash to increase dividends, buy back shares or acquire other companies. In addition, election years have historically been positive for stock investors. But much of this outlook should hinge on whether one views the upcoming elections and the current political environment in the US as “typical” or whether there is a degree of division and gridlock that may be more counterproductive than usual. Barring any breakthroughs, we gauge the political situation to be the latter for the time being.
It would not surprise us if 2012 ended up providing either double digit gains, or losses, for investors. The market currently appears to be a “coiled spring” waiting for a directional catalyst. If Europe threads the political needle, further economic stimulus takes place in the United States, or the recent economic data (including unemployment and housing) continue to improve, equity markets could move meaningfully higher.
Alternatively, there is the potential that one of the previously mentioned scenarios goes very wrong (e.g. the Euro collapses). In the long-term, markets are resilient and will survive the developments of 2012. In the short-term, however, the coiled spring would more than likely be pointing in the wrong direction and markets would be under pressure.
The majority of our clients prefer to mitigate downside participation during market corrections. As a result we currently remain relatively “defensive” (overweighting large caps, companies domiciled in the US, and fixed income). Please contact us if this allocation is inconsistent with how you would want your portfolio to be allocated going into 2012.
Within fixed income, yields on the US 10 year treasury are at record lows. Despite the Fed’s commitment to keep policy interest rates low for the foreseeable future, it is possible that longer maturities could see rapid decreases in value if investors begin to favor other assets or maturities. There have been times where long term rates have risen, but short term rates have remained low and investors in long maturities have lost significant principal value as a result. With yields at record lows, we still believe it is prudent to lean towards managers who allocate to short duration, very high quality bonds that stand to provide principal protection.
Henry Ford once said, “Coming together is a beginning. Keeping together is progress. Working together is success.” Let’s hope 2012 has more of the latter! Please do not hesitate to call (503-597-1600) or visit.
We appreciate your business,
Heintzberger | Payne Advisors
December 31, 2011
Past performance is no guarantee of future results. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Opinions are subject to change without notice. Northwest Capital Management, Inc. ©2011