We are at the NYC Green Festival this weekend, talking to visitors about Socially Responsible Investing. Stop by and visit up at booth 321, Javits North.
Dear Clients & Friends,
As the New Year begins, we’d like to wish you and your family a wonderful 2013.
2012 was quite an eventful year for the global economy. The Federal Reserve maintained exceptionally low rates, which prompted a number of reactions from investors and consumers alike. Home mortgage rates remained near historic lows, boosting the number of homes sold. That said, much of country still carries excess inventory and new home construction is a mere shadow of its 2006 peak. Household formation – the biggest driver of housing demand – remains low as unemployment in much of the country is still at recessionary levels.
The employment picture improved over 2012, with new unemployment claims down to 350,000 per week in December, a level consistent with moderate growth. However, a substantial number of workers remain unemployed or under-employed and many have been out of work for an extended period of time, making workforce reintegration more challenging. On a positive note, various factors are prompting resurgence in US manufacturing. Concerns about intellectual property theft, rising energy costs, the brittle nature of global supply chains, and higher labor costs in Asia have combined to force many industries to consider opening factories in the US. Employment expectations will have to be tempered as any new manufacturing facilities in the developed world shall be highly automated and employ far fewer workers than older facilities. In addition, workers will require higher level training as new factories will be more complex than past assembly lines.
Despite strong headwinds, most equity markets globally enjoyed double-digit returns in 2012. The S&P 500 rose 13.4% on the year, and when dividends are factored in, the total return was 16%. Some foreign markets have done even better, despite relatively uneven news over the course of the year.
The US economy has seen 4 years of unbroken growth since Q1 2009. This makes the expansion comparatively long in the tooth since the average post-war expansion has lasted only 14 quarters. 2013 will pose a series of difficult questions for markets, many of them political in nature. The stalemate surrounding the 2001/2002 tax cuts has been resolved with rates staying level for all except the highest earners. However, a number of confrontations between Congress and the President over the debt ceiling, defense spending and troop withdrawals loom in the coming months. The US continues to run a deficit and by February, the Treasury will be unable to meet its monthly expenditure unless Congress raises the debt ceiling. The market is increasingly losing confidence in Congress’s ability to put aside ideology and act in the national interest. The wide ideological divide between very active right wing elements in the Republican party, and center-left elements in the Democratic party who believe not much was gained from compromise during the first Obama administration, guarantees the next couple of years will make for continuing political drama. To a large degree, this situation is an outcome of the US election in 2012. The election was expected to be a referendum on the Obama administration’s policies and a clear majority of voters opted to have the president continue to implement his policies.
Over in Europe, a similar dynamic is playing out. The political establishment is in stalemate while the broader European economy struggles towards a recovery. The French election this year has led to a Socialist far-left government of Francois Hollande possibly over-reaching by raising income tax rates to staggeringly high levels (over 75%) and inserting itself rather visibly into disputes with industry. Southern Europe continues to flounder, with Mario Morsi resigning as prime minister in Italy. Spain and Greece continue to be racked with widespread protests over austerity measures. Portugal and Ireland, meanwhile, seem to resigned to draconian austerity with characteristic acceptance of hardship. Perhaps most troubling of all is the suggestion amongst some circles that the United Kingdom may opt to withdraw from the political union while trying to maintain certain trading privileges. We do not expect any resolution to the European crisis till after the German elections in 2013.
In Asia, the Chinese economy continues to sputter, new car sales have dropped, along with energy demand and home prices in most cities. The politburo standing committee transition occurred in November after the US elections with an apparent loss for the Jiang Zemin faction that was closely associated with party elites. Meanwhile in India, it appears the Congress government faces a very difficult legislative session as the economy slows, inflation picks up and various necessary reforms are held up. The one bright spot in the East, surprisingly, is Japan. Japanese voters handed the LDP a resounding victory in the recent elections. The newly (re)elected government of Shinzo Abe seems to intend to use its super-majority to the fullest extent. It has been surprisingly assertive in demanding the Japanese Central Bank set an inflation target of 2%. The broader market has turned positive on Japan, perhaps relieved to finally see political will in action. We remain wary of investments in China, are more positive on India and relatively bullish on Japan.
In the final analysis, for much of the world, we return to the question of sovereign and household debt. This question is particularly acute for Japan, where total government debt is now over 200% of GDP. Meanwhile, in the US, consumers continue to pay down debt, deleveraging to a more sustainable level while the federal government will likely run deficits for another 2-3 years to compensate. We are now five years past the crisis of 2007, which was caused by a vast bubble in debt and spending. These cycles typically take seven years to resolve and we expect the current dynamic of restrained growth to continue for another two to three years, with significant risk of another recession in the near-term.
In terms of our 2013 investment outlook, we see a number of risks and opportunities. We believe bonds, particularly 20-30 year treasuries are ripe for a correction. Long-term bonds are priced for perfection and will face a severe sell-off when the market suspects the Fed is about to raise interest rates or end its QE program. This could present an opportunity for investors to increase medium-term bond holdings (3-5 years) and longer-dated bonds over time. We see value in international and emerging market equities and would look to add to positions over the course of the year. Portions of the US equity markets potentially look quite attractive if there is a significant correction (we believe a number of political and economic factors could trigger this). We think alternative energy and network-driven businesses would present a particularly interesting buying opportunity during a correction. These and other topics are explored in more detail in our Top Ten Themes for 2013.
Louis Berger Subir Grewal
2013 Themes: Snakes and Ladders
- Europe lingers: The full-blown European crisis has been with us now for almost 4 years. It appears to morph into a different shape every few months. We believe political action and inaction in Europe will continue to drive global markets this year. Two important events will occur in 2013, a German election, and possibly a referendum in the UK on its relationship with Europe. In our view, the European Union will have to provide financial assistance to one or more peripheral countries in 2013, we believe this may be delayed till after the German elections to limit the impact on the Merkel government.
- Asia slowdown: The biggest Asian economy is showing some growing pains. 2013 may be the year when China backs away from a policy of growth at any cost and its institutions embrace a more holistic view of economic advance that includes environmental regulation and some liberalization of speech and rights. Though in the short term this might well lead to upheaval and a growth-shock, in the longer term, it will strengthen Chinese consumption. We believe China will underperform other emerging markets over the next year.
- Equities: Global Stocks are almost four years into an expansion that began in March 2009. On average, since the great depression, stocks have risen for just under four years before seeing a correction. We have been skeptical of economic growth driven by monetary stimulus virtually since the beginning, and our view has not changed. We believe the prolonged monetary stimulus has built up imbalances in the system and as policy-makers remove the stimulus, there is a strong probability that stocks will be in for a very rough ride. Many companies have learned a lesson from the credit crisis and we believe stocks with strong balance sheets, robust business models and high-quality earnings will outperform.
- The myth of hyper-inflation: Certain observers have been trumpeting the risk of high inflation as a result of Fed easing. We do not believe this is a likely scenario. Whilst implementing staggering amounts of quantitative easing, the Federal Reserve has bought over two trillion dollars in Treasury and MBS debt over the past four years. This huge balance sheet gives the Fed an enormous arsenal to combat inflation. When it begins to sell its bond holdings, vast amounts will be taken out of the money supply, putting a damper on any inflation. This is why we find inflation protected bonds relatively unattractive.
- A rude awakening for bonds: The Fed has been providing price support for long-dated bonds with its large purchase program and low interest rates. When that price support stops and the market has to stand on its own, we expect bond prices to collapse and rates to rise. There is a chance the Fed halts its QE program and raises rates in 2013 if headline unemployment reaches 6.5%, which is within the realm of possibility given the current trends in jobless claims. As a result, we find long-dated bonds extremely risky and prefer floating rate, short-duration and international bonds.
- The Sun also rises in Japan: Japan has been mired in deflationary malaise for over 25 years. An entire generation of investors has lived through successive mirages of Japanese recovery. We have begun to believe that this time is different. The enormous growth in Japan’s Asian neighbors and its own robust legal institutions make it an attractive destination for investment, tourism and business partnership. Japanese businesses are taking advantage of these opportunities, and though China still possesses a cost advantage, the gap is closing as wages rise in China. We see Japan’s demographics stabilizing and a generational change underway in Japanese business creating an entrepreneurial surge. We believe this presents an attractive opportunity for equity investors.
- Gold: Our regular readers know that we are not enamored of gold. Fiat money has served the world relatively well and provides policy makers with some flexibility. Competing fiat currencies and the opportunity to invest in both real enterprises (via stocks) and geographic communities (via government bonds) provide the modern investors with a variety of options to store wealth. We continue to hold that the price of gold is elevated beyond fundamentals and not sustainable. We see demographic changes that are steadily eroding Asian demand for gold, removing this long ranged support. We expect gold prices to drop in 2013.
- The death of the PC has been greatly exaggerated: 2012 was the year when smartphones and tablets decisively pushed desktop computers from their perch as the primary electronic devices in most homes. Relatively low prices, accessible touch-screen interfaces, wireless internet access and rich functionality are making small devices the desirable option for more consumers. Despite being overshadowed by its cooler, touch-sensitive cousins, the traditional computer remains the one device capable of performing the whole range of computing functions. It will remain an essential business tool for years to come. We think it’s a little too early to call the death of the computer, and that certain PC-related stocks will outperform in 2013.
- Network everything: Though wide access to the Internet is well into its second decade, connected devices have yet to reach their ultimate potential. Over the course of the next decade, we expect to see more devices linked to the broader Internet for specialized and general function. This will include cars and household appliances, opening up new use cases and opportunities for businesses positioned to produce the right set of products and services. We believe the technology sector in general, and Internet infrastructure firms in particular, offer attractive growth potential over the next decade.
- Alternative Energy: Alternative energy businesses have suffered significant losses since 2009 due to a variety of reasons. In the three years since, a couple of trends have converged to make their future look much brighter. Alternative energy at utility scale is approaching cost parity with conventional energy generation, and a nascent environmental movement is developing in the emerging world. These two trends are changing the equation for alternative energy and 2013 should see an increase in investment flows towards non-conventional sources of energy. We think prices are relatively depressed and the sector offers attractive value for long-term investors.
2012 Themes: The More Things Change.
Since we’ve now closed the chapter on 2012, we’d like to review our “10 economic themes for 2012” from last January to see how well our ideas performed.
We’ve graded ourselves using these symbols: ? Right, X Wrong, ? Not Exactly.
- ? Steady as she goes: We think it unlikely the Fed will raise rates in 2012, largely due to the presidential election… We were largely right here. The Fed held rates steady ahead of the presidential election. We will admit to being surprised at the robust extension of QE as we did not expect the Fed to make as controversial a decision only a few months ahead of an election.
- X Risk Off: We believe risk assets (stock, real-estate, long-dated and high-yield bonds) will have a difficult 2012. Stocks have benefited from a sharp rebound after the credit crisis and are now back to the higher end of the historical range. Bonds meanwhile, are trading at yields that are lower than any seen in two generations. During the course of 2012, we would expect both to correct towards the mean. This should provide some interesting buying opportunities, especially for dollar-based investors. We were flat out wrong here. Both stocks and bonds performed well in 2012. Stocks did well as vast amounts of monetary support helped lift demand from depressed levels. Bond prices were supported by the Fed’s steady purchases over the course of the year, and investors’ rediscovery of the appeals of fixed income.
- ? Break-Up or Make-Up, Brussels is good for both: 2012 should be the denouement for the European sovereign debt crisis… We believe a Greek default is extremely likely this year. Even if there is a pre-negotiated haircut with some lenders, the market will treat it with the seriousness that the first default by a “developed” economy in a generation should. In either case, Greek bondholders should be prepared for losses on the order of 60% of par value. We are giving ourselves a half point here. Greece did not default, even though private Greek bondholders will have to settle for 50 cents on the dollar. However, by strong-arming creditors to accept the most draconian restructuring in recent history, Greece has managed to avoid the imprimatur of default. Greece continues to struggle and there is a another restructuring possible in 2013.
- ? Euro Trash: We expect the Euro to bear much of the burden of the European sovereign crisis, and the currency to weaken significantly against the dollar. When we discussed a Euro break-up last year, it seemed like an outlier scenario. We have been amazed at the speed with which events have moved and a potential Euro-exit for one or more peripheral economies is now being openly discussed. We were wrong here. The Euro did indeed weaken by 10% over the summer, but by the end of the year it had made up the loss.
- ? Blue States/Red States: This is a two part theme. The presidential election cycle should be the major story in the US in 2012. In our view though, the more critical issue is the associated discussion about the US and individual state debt burdens. The charmed baby-boomer generation will have to decide how much of a cut in benefits is acceptable to ensure the burden of their entitlement programs in coming years does not doom the economic future of their children and grandchildren… Surprisingly the presidential election did not settle these issues. The topic remains hotly debated in Washington and the prime driver of US bond markets. Rating agencies continue to scrutinize every move in Congress with an eye towards the country’s AAA rating.
- ? Chinese Math: At the 18th Communist party congress, we expect power to be transferred to a new generation of Chinese political leaders. We have no doubt that the enormous state apparatus will be fully utilized to ensure economic stability during the transfer. However, we believe these efforts will ultimately be for naught. The structural shift required in China as it moves from an investment driven economy to a consumption driven one will make for a tumultuous year in Chinese markets. The stock market has been depressed for almost five years, and we expect Chinese real-estate is beginning to make the first moves in an unavoidable decline towards more reasonable levels. We give ourselves a qualified right on this one. There are signs that the Chinese economy is faltering, and real-estate prices have begun to fall. But none of these has occurred to the extent we had anticipated.
- X Revolutionary Times: …We expect to see more political turmoil in Europe and the Middle East in 2012. This coupled with major elections and power-transfers in the US and China make for a very uncertain 2012 politically speaking. In our view, this will make for very jittery markets throughout the year. No doubt, 2012 was full of political upheaval and this was reflected in the markets with many sectors seeing large swings over the course of the year.
- ? Oil Slicks: The events in the middle-east will of course have an impact on energy prices. We expect political tensions to keep oil prices artificially inflated in 2012, but longer-term we think $100 oil is unsustainable as alternative energy sources approach cost-parity with conventional sources… Oil had a tough time rising despite extreme uncertainty in the Middle-East, it is still around $100. We give ourselves a draw on this one.
- ? Smart Homes: The past decade has seen the widespread adoption of computing and telecommunications technology touch virtually every aspect of human activity. We expect the markets to be enamored with a couple of very high-profile IPOs expected in 2012/2013 (Facebook and Twitter). We believe some of the higher profile IPOs of 2011 will perform poorly (GroupOn for instance)… We were largely right here, with some of the more questionable business models (like GroupOn) falling out of favor with investors. The most significant Internet IPO of the past five years (Facebook), was overpriced at issue and dropped significantly in the first few months.
- ? Housing: Still a buyer’s market: We expect the overall US housing market to remain stagnant in 2012 with pockets of strength, particularly in major urban areas (NYC, DC, San Francisco) and some suburban and rural areas that did not overbuild in the run-up to the credit crisis… We were largely right here, the US housing market continues to languish at low levels of activity with prices not far from the lows in most markets.
An article in the New York Time today reminds us all how important it is to have our financial act in order before a life-changing event occurs. We always advise clients to prepare a will, health care proxy and medical directive as part of our initial conversations with them. We’ve worked with numerous legal and estate professionals to tackle these tasks for clients. Without these documents, families can find themselves facing a morass of complex legal issues at the worst possible time.
In most cases, for young families, term life insurance and good disability insurance are cost-effective ways to ease the financial stresses of losing an income. We always evaluate these options as part of our comprehensive financial planning process with each client. Our regularly updated financial plan also contains a consolidated balance sheet to provide a view of all your financial assets and accounts in a single place. Such an accounting can make re-organzing your finances after a disaster much easier.