From the Desk of Bill Hornbarger. . .
The conventional wisdom asserts: equity market advances occurring against the backdrop of a ‘wall of worry’ indicate that investors are confident that the issues will be resolved at some point in the future. If that is the case, 2012’s performance should generate a high degree of confidence that the looming debt ceiling debate, higher taxes, and below-trend forecasted economic growth are temporary bumps in the road.
Last year investors and the markets faced a myriad of challenges: a bruising election season, concerns over the “fiscal cliff”, Europe slipping back into recession and China decelerating. There were also geopolitical risks related to the Middle East. Consumer and business confidence reflected these concerns, remaining relatively tepid before falling sharply at the end of the year, particularly the gauges of future expectations. Despite these and other concerns, equities (as measured by the S&P 500) were up 16 percent (including dividends), well in excess of long-term average returns.
With a successful 2012 for the equity markets in the books, the focus shifts to what will 2013 bring in terms of the investment backdrop? I would argue that very little has changed regarding the economic and investing climate. The so-called fiscal cliff was averted and tax rates for certain higher-earning Americans permanently reverted to the levels seen before the second Bush’s presidency. However, several other difficult and potentially contentious debt and spending debates loom large in the first half of 2013. The debt ceiling will have to be raised sometime prior to March 1, and the automatic budget cuts (called ‘sequestration’) that were enacted as part of the 2011 debt ceiling debate are scheduled to take effect in March unless a deal is reached to avoid them.
What about the financial markets? The bond market remains captive to the Fed and the ultra-easy monetary policy currently in place. At its December 2012 meeting, the Fed reaffirmed its commitment to quantitative easing, and was much more explicit about what issues would bring about a reevaluation of current policy. Based on current Fed central tendency forecasts on growth, employment and inflation, it would appear that the “exceptionally low range” for the Fed funds rate will be in place past 2014. While the yield on the benchmark 10-year Treasury has risen 10 basis point for the year—and almost half a percent from last summer’s lows—yields are still “low” by almost any definition. They are likely to remain that way until the Fed reverses quantitative easing and begins increasing the target Fed funds rate from the current zero percent. This will likely keep nominal bond yields low for an extended period and real yields negative-to-flat for the same time frame.
Equity valuations remain at what can best be characterized as fair, relative to current conditions. The S&P 500 dividend yield remains higher than the benchmark Treasury yield, and equities are trading at almost 15 times current earnings, lower than the long-term average. However, using the cyclically adjusted price/earnings ratio (CAPE) tells a slightly different story. The CAPE, developed by Professor Robert Shiller of Yale University, looks at the inflation adjusted 10-year average earnings number divided by the current price. The current cyclically adjusted PE is 22 times—about 30 percent—above its long-term average.
Whether fairly valued or slightly overvalued, the lifeblood of sustained equity market gains is earnings growth. Expectations of earnings growth have been scaled back slightly, but with an estimated one-year forward PE ratio of 13.25 times earnings (according to Bloomberg estimates), the constituents of the S&P 500 are expected to earn something close to $110 over the next four quarters, an increase of approximately 10 percent over 2012. With healthy and lean balance sheets, high productivity and extraordinarily low borrowing costs, even in a slow-growth economy, companies, in aggregate, should be able to realize positive earnings growth in 2013.
During last year, many investors were positioned defensively because of the aforementioned concerns. Cash and fixed income remain safe havens from market volatility, but at great cost in the form of low nominal and negative real returns. The greatly feared ‘worst case scenario’ did not materialize last year, and 2013 could potentially be better for the economy both here and abroad. Global policymakers have been aggressive, having taken steps in 2012 to boost growth this year, and many of the most feared events (such as the fiscal cliff and a European banking crisis) were avoided. Investors also appear to be slightly less risk averse this year as evidenced by positive flows into equity mutual funds in very recent periods and the performance of more cyclically sensitive sectors of the equity markets.
We are still of the opinion that the zero percent interest rate policy is one of the biggest—if not the biggest—influence on the financial markets. Financial repression (loosely defined as a policy or set of policies that result in a period of consistent negative real interest rates) has distorted risk premiums across markets, contributed to increased correlations across multiple asset classes, and is almost forcing investors into riskier asset classes in order to generate returns in excess of inflation. While every investor’s risk/reward tolerance and investment goals are different, following are a few universal investment thoughts for the current climate:
- Based on current valuations, stocks will very likely do better than bonds for the foreseeable future. Starting yields and low nominal rates leave little room for appreciation or returns in excess of the starting yield. With rates this low, even a small uptick in yields can wipe out the yield return. We would recommend being at one’s minimum comfort level for fixed income weightings.
- Fixed income risk premiums and nominal yields in the credit portions of the bond market are also very low. Historically, this has not been an advantageous time to reach for yield.
- Correlations across many asset classes (commodities, real estate, and all sectors of the equity markets) remain elevated. Strategy-based investments, with the ability to use both long and short positions, are one of the few ways to find diversification in the current environment. These strategies typically employ more active risk management and, in this uncertain environment, that has resulted in low (but generally) positive returns.
- Low interest rates influence returns across many asset classes and strategies. Hedge fund returns, for example, are closely tied to bond yields. Equity returns are also dependent on the interest rate environment. Stable-to-falling yields often correspond with multiple expansion, while higher yields can have the opposite effect. We think earnings growth and dividend yields will be bigger drivers of equity returns than multiple expansion in the current environment.
- Extraordinarily low interest rates and rampant liquidity are supportive of “risk” assets. The longer one thinks the current stance of financial repression will persist, the more one should lean into risk assets. While the history is limited, studies show that past episodes of financial repression have lasted on average for 22 years!
- In addition to market risk and credit risk, investors need to be conscious of the impact inflation has on their portfolio and planning process. Bond yields at or below the rate of inflation for an extended period will impact lifestyles for investors with heavy allocations to fixed income if negative real rates persist.
Many investors remain (rightfully) concerned about the future of the United States as it prepares to tackle the question of debt in a slow growing economy with above-trend unemployment. None of us know what will happen in this environment or how markets will perform in the future, but here are a couple of final thoughts to consider in relation to the financial markets.
- First, markets are most vulnerable when valuations are extended, the news is all positive, and no one thinks it will change. Think about the conditions in place just prior to the Tech Wreck and the Credit Crisis. Today’s ‘bad’ news is in every newspaper and nonstop on CNBC. When we are bombarded with it, the news is known and reflected in the market.
- Second, there are certainly times when the markets and economy decouple. I don’t think I would characterize 2012 as an above average year for the economy, yet that is what the equity markets returned: better than average. It is important to keep this in mind when one is constantly bombarded about the dysfunction in Washington.
- Finally, the bond market is probably riskier now than it has ever been. Using the 10-year Treasury as a benchmark, a very slight increase in yields (one quarter of one percent) from current levels over the next 12 months would result in a negative total return. That is a risk that most investors are conscious of.
But another risk lurks and that is that rates stay at current levels for an extended period of time (the Japanese experience). There is still definitely a role for fixed income in a portfolio, but we have to be conscious of becoming too conservative (too much fixed income) in the current environment.