Investors continued to pull money out of stock and bond funds in December, although advisors for the most part are optimistic. In a time for counting your blessings, market-watchers point to strong company profits in Europe, a thorough report from the U.S. budget-deficit commission, and better-than-expected U.S. retail sales. After a spell of spending, Americans may need to ratchet down “Great Expectations,” says Timothy Barron at Rogerscasey. But don’t bet on the end of productivity growth, he says: the U.S. economy has averaged 1.8% gains for more than a century.
Dorsey D. Farr, French, Wolf and Farr Investment Advisors
The U.S. labor market appears to have finally bottomed out. Bond prices continued to rally, despite low yields at the start of the year. And equities are poised to record double- digit gains in the United States and the developing world.
To be sure, things haven’t been so pretty throughout the year. In fact, all of the gain in equity prices has occurred since the end of August. What changed? Fed Chairman Bernanke announced that the lender of last resort would continue to fight off deflation by serving as the Treasury bond buyer of last resort. The mid-term elections changed the balance of power in Washington. The Grinch who had threatened to steal the recovery experienced a metamorphosis in November, and recovery-killing tax increases have now been postponed for at least two years. Investors responded to these developments with a speculative enthusiasm that transformed a dismal year into a success story for many equity markets. Interestingly, what didn’t fare so well in the equity world seems to offer the greatest future promise.
The story behind high quality domestic stocks is well known. If fact, it is so common to hear folks talk about the opportunities in this area, that more than the normal dose of skepticism is in order. Of course, quality, like beauty, is defined by the eyes of the beholder. A room full of investors touting the opportunity in quality could be filled with differences of opinion.
Differences aside, one popular proxy for quality stocks (which includes household names such as WalMart, Pepsi, ExxonMobil, Cisco, Microsoft, Johnson & Johnson, Procter & Gamble, Pfizer, and Merck) lagged the S&P 500 by almost 800 basis points during the first 11 months of the year. Those who are nervously grateful about the recent performance of their equity portfolio might find it an opportune time to implement a quality bias. While quality certainly gets its due measure of praise, the other major area of opportunity in the global equity arena is rarely mentioned. After posting dismal results in 2010, conventional wisdom on Europe is decidedly negative. Europe does have problems. The region’s poor demographics, high government debt levels, and high unemployment are all cause for concern. But such problems often result in opportunity being overlooked. These same problems plague much of the developed world, and European equity markets seem to be the U.S. market’s whipping boy. In fact, the United States is in worse shape than Europe when gauged by some of these metrics. While talking heads remind us daily about impressive profit growth in the United States, many investors do not realize that European profits are surging.
According to Bloomberg, European profits are expected to grow by nearly 80% in 2010, and earnings growth for the Europe Stoxx 600 index is expected to outpace the S&P 500 in 2011. A recent report from Richard Bernstein Advisors (see Figure 2) highlights that positive earnings surprises in Europe recently hit 63%, exceeding the level for small cap stocks in the U.S. (56%) and emerging markets (46%). On top of that, revenue growth has also been impressive. Positive revenue surprises in Europe (69%) surpass both the U.S and emerging markets. While profits and revenue have been gaining, debt levels have been on the decline as European companies – like their U.S. counterparts –have been deleveraging their balance sheets.
In the near term, the wildcard is the euro. Favorable equity returns can be wiped out by unfavorable currency movements. Currency movements are notoriously difficult to forecast, but we have already witnessed numerous false alarms about the impending demise of the euro. Our view is that the current europhobia will prove to be overblown. Widespread fear about a breakup of the currency union and sovereign debt contagion spreading across the continent recently prompted Deutsche Bank CEO Josef Ackermann to comment that anyone who thinks they need to build a position betting on the demise of Europe and the euro will “need to pay a price.”
For those who cannot get over the currency fears, there is always Switzerland, home of private banking, low sovereign debt, modest unemployment, the Franc, the world’s largest luxury goods maker, Europe’s largest chemicals manufacturer, household names like Nestle, and, of course, Davos, where the world’s elites will gather again in a few weeks time to contemplate the world’s problems. Until then, we wish you a Quality Christmas. Joyeux Noel. Frohe Weihnachten. Buon Natale. Feliz Navidad.
Jason D. Pride, Glenmede MONTHLY INSIGHTS, December 2010
2011 Outlook: Avoiding a Groundhog Year “Well, what if there is no tomorrow? There wasn't one today.” -Phil Connors (Bill Murray) in Groundhog Day, 1993
In formulating the 2011 economic and market outlook, I was startled to recognize the similarities that exist between now and this time last year. This thought process led me to remember the above quote from the 1993 movie Groundhog Day. In the film, Bill Murray plays an egocentric weatherman who, during a hated assignment covering the annual Punxsutawney Groundhog Day event, finds himself repeatedly awaking to the same day. While the repetition is initially fun – life with no permanent consequences – it becomes desperately dull, leading the character to employ numerous schemes in order to break free of the monotony.
With this anecdote in mind, I introduce our 2011 Outlook and Investment Strategy Themes: 2011 Outlook
• The global economy, still recovering from the recession, looks ready to begin expanding in 2011. This provides a supportive backdrop for the financial markets.
• However, the global economy still faces multiple headwinds (deleveraging, deficit reduction, etc.), inhibiting a more robust expansion.
• U.S. political leaders continue to kick the can down the road, buying more time for the economy to improve and congressional leaders to resolve longer-term issues.
• Momentum to reduce long-term government spending is building. Progress toward a longer-term deficit reduction plan will be a top priority in 2011.
• Currencies of developed nations are likely to remain under pressure relative to those of merging market nations.
2011: A Groundhog Day Year?
If we revert to the events of December 2009, we would find the economy running at the not-so-breakneck pace of roughly 3%, and unemployment nearing 10%. It was during this period that short-term interest rates were near 0% and the U.S economy was being “juiced” by quantitative easing and a near $800 billion fiscal stimulus plan. Total U.S non-financial debt exceeded 240% of GDP, with U.S government debt representing nearly 70% of this mix. Simultaneously, debt balances of many developed economies (Portugal, Ireland, Italy, Greece, and Spain) were running dangerously high.
The similarity of current circumstances to the start of last year leaves an eerie feeling of repetition. At the time of this commentary's writing, the economy, although it grew throughout 2010, has not grown enough to reach higher ground. Therefore, we again put forth an outlook calling for continued recovery and a transition to expansion.
Often, economists and market observers seek to determine if the economy’s self-feeding cycle is self-sustaining — functioning and capable of continuing without external influence (i.e., stimulus). While government spending and/or stimulus often fuel the initial stage of an economic recovery, long-term expansion requires that a certain pattern of economic factors work together in progression. If initial stimulus efforts boost national or global sales, overall corporate profits increase, leading companies to eventually step up production. The lift in production typically leads to capital expenditures and new hiring. This new spending or increased hiring typically further expands sales, thus completing the loop.
The Economy and 30-Year-Old Automobile Engines
This economic loop can be in disrepair, much like an older automobile engine. While it might still work, it could take quite a bit more grit to get it up and running. One of my neighbors has a car that fits this category. It’s a 1970s-era Porsche 911 Carrera, and I’m sure it has some serious get-up-and-go. He doesn’t take it out much (and has never invited me for a drive – maybe he will see this?), so when he does decide to drive it, he often has to let it run and warm up for a while. Occasionally, when he lets it go too long between drives, it takes more than a warm-up to get the motor going. The current economy has, deservedly, received many tune-ups (economic stimulus packages) over the past few years and is now in a rather long warm-up period. A key link in the economic loop described above, unemployment, provides the best evidence of this extended warm-up period.
Avoiding a Groundhog Year
In Groundhog Day, Phil (Bill Murray) eventually endeavors to make the best of his circumstances, at first by helping the townspeople and eventually by learning to play piano, ice sculpt, and speak French. He discovers that despite his curmudgeonly ways, he is able to befriend the townspeople and even create a genuine relationship with his news producer, Rita (Andie MacDowell). With his reform, he is finally able to break the time loop, awakening from the cycle a much different, less self-centered person than he was on Feb 1.
In order to break free of this groundhog year, maybe we too need to seek the same high level of reform. Perhaps progress toward longer-term economic responsibility will afford us the chance of a renewed start. While the economy’s performance in 2010 was disappointing, not all was lost. Maybe 2010 was a year well allocated to the search for economic responsibility. European nations were brought back to fiscal responsibility by their brethren as austerity plans were introduced throughout the continent. In the U.S., the newly dubbed Tea Party rode in on a wave of fiscal-responsibility-focused sentiment, and like a cherry atop an ice-cream sundae, the U.S. budget-deficit commission produced a surprisingly thorough recommendation of spending cuts and policy and tax reforms. Theoretically, these proposals could reduce the deficit to 1.4% of GDP by 2020, limiting debt to nearly 60% of GDP versus the projected 87% based on current policy. We believe this plan, despite having not received the needed 14 of 18 commission votes, provides a roadmap for future policy development. While significant opposition to portions of the plan exists, the growing momentum within political circles implies a compromise may still be on the horizon. The public, apparently further along in its thought process, is the driving force behind this movement.
Mark Luschini, Janney Montgomery Scott
A pick up in confidence here, a little better than expected economy there, throw in some talk of tax cut extensions (which President Obama signed into law on Friday), and before you know it, the consumer is dressing as Santa Claus. The latest reports on retail sales show strong gains in apparel and general merchandise purchased through malls and online vendors. According to the Commerce Department, sales during the last three months have risen at a 14.6% annual rate! Given the well-documented headwinds of a sluggish labor market, soft housing, increasing personal savings and less than accommodative credit conditions, one might have thought consumer spending this holiday season would be decent but hardly terrific.
And yet, like many other recent economic data points, readings have been stronger than expected. In all, this has contributed to buttressing the conviction among a growing list of pundits that expect equity prices to advance through 2011, on the back of improving economic conditions. While we are among them, we also recognize that risks loom which could make the market’s performance erratic even if directionally positive on a year-over-year basis. The few trading sessions left before the ball drops in Times Square will be largely quiet but not void of news that could push markets around, particularly in the absence of many investors who have already “taken a knee” for the year. The Dow Jones Industrial Average managed to finish with its third consecutive week of gains, rising 82 points, or 0.7%, to finish at 11,492. Bond prices, after having come under some intense pressure in the last month, closed Friday basically unchanged from the week before. While the 10-year Treasury bond yield of 3.32% is roughly 0.8% higher than just a couple months ago, a move substantially higher is unlikely for now. In fact, readings on inflation, such as the Consumer Price Index which reported a 0.1% increase in November and is up 1.1% from a year ago, pose no immediate threat. We do expect that a byproduct of a quickening pace of economic growth, if what has been evident of late is sustained, will ultimately press rates higher later in 2011. If that is the case, then investors will want to triage their investment holdings to ensure they are invested in assets that can participate in capital growth, and alternative income sources, as a complement to bonds and bond mutual funds.
Timothy R. Barron, Rogerscasey
DICKENS IN DECEMBER OF 2010
When writing their often tedious pieces regarding economic times, many macro strategists seem to enjoy beginning with the famous Charles Dickens’ quotation: “It was the best of times, it was the worst of times.” Of late, however, it seems they are dropping the first phrase and only thinking of the Hard Times. The good Mr. Dickens might well be flattered that his opening line garnered such widespread usage, but I think he would be amused by its misuse relative to his meaning. It occurred to me that if he were writing in these complicated times (yes, and surely life in those days was so simple), perhaps the titles of some of his best known works would have been different. Let’s see…..
OVER A CHRISTMAS BARREL
It certainly does not seem as though we are entering this holiday season with visions of sugar plums dancing around our cranial cavities or a song in our auricles or ventricles. This is the time of planning for the coming year, budgeting for assets under management and for human resources, and positioning the portfolio for the future. For some this could include considering tax consequences and making changes accordingly. In any case, the industry is focused on putting the finishing touches on strategies and plans by December 15th in order to enjoy the winding down of the year with family and friends, secure in the knowledge that after your favorite team wins the big game, you can begin 2011 ready to “hit the new year running.”
Instead, next year appears to be one of continuing uncertainty and potential risk. Are QE I and QE II going to cause the economy to grow without inflationary pressure? Will the Chinese play ball economically and let the rest of the world participate in their sustained growth? Does the new environment in Washington result in compromise or calamity? What will tax rates be next year, and on what, and from which governmental body? Is this the best time to buy bonds or to sell them? All in all, the Christmas carol feels more like we are over a barrel.
MARY (AS IN SHAPIRO) TWIST
Start with a period of deregulation, or perhaps misregulation, followed by reregulation with a midterm change in control of the House, add in a handful of Dodd-Frank, a pinch of fraud, and a dash of interagency fighting, bake slowly over a bed of expensive Wall Street lawyers, and you have everyone’s favorite industrial revolution meal – MUSH. Charlie would have been right at home with this story. Plenty of room for character development, intrigue, heroes, and villains. This is best seller material. A classic in the making. Mary, we are waiting anxiously for your surveys and studies and regs and pronouncements. We have really missed reading those 247 page documents meant to explain how to describe fees. We have longed for proposed interim final interpretations of hedge fund registration rules. Mostly, however, we have been just plain heartbroken that many of our friends in the legal community have been idle for so long. Ah, as we wait with bated breath for the upcoming torrent, one can easily predict that the regulatory environment in 2011 will be reminiscent of that old Beatles song: “Twist and Shout.” Or is that scream?
TALE OF TWO CITIES
Yes, Charles doesn’t need to change this title at all. Beijing and Washington. One seemingly on the way up and the other, well, at least up in terms of housing prices and employment. Let’s start with the latter. A Republican White House that expands government, followed by a Democratic President who didn’t make it half way through a first term before the boo birds were out in force. The Audacity of Hope probably will sell more than his predecessor’s, “No, I am Not a Dope,” but Mr. Obama has to be feeling a little humbler these days. Democrats in the Congress passed Health Care Reform Bill, but couldn’t manage immigration or jobs or hardly anything else, and with November’s party (think tea), the odds of constructive change don’t appear any better. We need a government that understands that it is supposed to be of, for, and by the people.
Enter the People’s Republic where they seem to be doing things right. High GDP growth, second largest economy on the planet – trying hard to be number one -massive reserves, controlled currency – what’s not to like? Growing middle class, improving education system plus a common sense of direction and focus (made much easier if you can jail dissidents and control the media). But, they can’t hide from the openness of the Internet; the exodus from the countryside to the city is largely unmanageable; industrialization without environmental controls creates a global problem; and entering the world stage means they will have to begin to play by the rules on trade and human rights.
As we ponder this tale, it is difficult to predict if these two ships of state steam independently, but cooperatively, with the occasional wake-caused turbulence, or collide when either or both is too proud to veer off of an intersecting course. A forecast? The ships sail around in circles, warily watching each other, but not colliding.
Ultimately, however, the wakes continue to build until the harmonic effects create a large enough disturbance that potential disaster looms. This journey, to a new world order of the two, and perhaps many cities, will not be easy or smooth. Expect that the storms from a newly-nuclear Iran, a starving (literally and for attention) North Korea, and a conflicted Taiwan will also roil the waters.
LOWERING GREAT EXPECTATIONS
Everyone knows, well at least they did, that stocks over the long run will earn investors between 9% and 10%. Everyone knows, well at least they thought they did, that international diversification will enable the asset owner to earn that return with lessened volatility due to lower correlations. Other common wisdom included: private equity is a form of leveraged equity with the downside protected by being an appraised asset class; real estate goes up most of the time and is a hybrid of debt and quity; bonds provide an anchor to windward for an otherwise risky portfolio; and hedge funds are largely uncorrelated to other asset classes. All of these well- accepted facts (and as we are told in Mr. Dickens’ Hard Times: “Facts alone are wanted in life. Plant nothing else and root out everything else.”) seem to have been toppled by one little old Global Financial Crisis. All of a sudden, we all have to lower our great expectations. Public pensions, which were the envy of nearly everyone else, are now being vilified as exemplary of government waste. Retirement in general is a promise that will have to be indefinitely put on hold as people must reboot their investment programs and hunker down for many more years of contributions. The dream of home ownership may be just that for the future generation and only folks who don’t need to borrow seem to be able to do so. In short, we will all simply have to lower our great expectations for the returns we can generate in our various investment programs and, in many cases, change the basic notion that one generation should have a progressively higher standard of living than the prior generation.
Shall we, however, take just a moment to examine some facts. There are booms and there are busts, particularly large booms often resulting in particularly large busts. Cycles always create an underlying skepticism about the future. We almost always extrapolate the most recent past to the most likely future. That is how one survives. “Oh, that stove is hot” shouldn’t be followed by “well I should touch it because it probably isn’t hot now.” That would get you burned, frequently.
Over the last 130 years or so, the average growth in real GDP per capita in the U.S. has been around 1.8% per year. That level of growth has been remarkably consistent (with the exception of the odd Depression or Financial Crisis) decade in and decade out. Now understandably, this growth rate is driven by increased human capital as the U.S. grew in population, and by improvements in both physical capital and technological knowledge. Nonetheless, it has been quite consistent. I would also note that each generation has at some point declared: “But we can’t really improve much further – technology has gone as far as it can.” Over the period from 2003 through 2010 (estimating the latest year), average growth in real per capital GDP was almost 2.8% -and that includes a down estimate for 2010 of -2.6%. We lived during a period of non-normal positive growth and extrapolated that as “normal,” and leveraged ourselves to maintain that normal. Now that we are paying the price, there are many claiming that the stove will always burn us.
I am not suggesting that we will automatically return to the long-term average just because it is the average. I am convinced, however, that we shouldn’t just listen to the naysayers either. Right now, they are playing to a crowd that is still feeling burnt. Has the world changed? Most certainly. Always does. Does the developed world have a set of problems that will be difficult to solve? And how. As usual. But, will productivity improvements cease? Unlikely. Is the western style capitalism that a few short years ago was being emulated as the envy of the world dead and buried? Don’t bet on it. You have to love pundits who quickly offer a quote designed to confuse or delight, but rarely if ever are right. It is Mr. Dickens, however, who should have the last word here. As he so rightly said: “Reflect upon your present blessings of which every man has many – not on your past misfortunes, of which all men have some.”
