The second quarter of 2012 was largely defined by rekindled concerns of slow economic growth and European credit issues. The effect of these concerns was as we’ve come to expect - global stock markets sold off (the U.S. less than others), while bond markets continued to find buyers seeking “safety” at ever lower yields. The total returns for major asset classes are below.
||MSCI All Country Index
||Barclays Aggregate Bond
Fears receded late in the quarter and markets recovered some of their losses. This marks a continuation of the “two steps forward, one step back” progress we have made over the last several years, which is well illustrated in the chart below.
Given the fragility of global markets (and the alarmist nature of the news cycle) I’d like to use the rest of the commentary to address, in a Q&A style, several issues that are top of mind lately.
What’s going on in Europe?
The European Union – a confederation of 21 European countries, 17 of which use the Euro as a common currency – finds itself in a tragedy of its own making. The monetary union was designed to provide uniformity, efficiency, and stability to the countries that swapped their local currencies for the Euro. The story plays out in three chapters.
Chapter 1: The adoption of a single currency, lowered interest rates across Europe, allowing less developed, less disciplined and less productive countries (like Greece and Spain) to borrow at interest rates similar to Germany and France. This was deemed a success.
Chapter 2: However, access to cheap credit and little accountability (the European Union seemed more interested in enforcing standards on the size of cucumbers, than enforcing fiscal discipline on its member countries) led to ballooning deficits and unsustainable levels of debt for many countries. The financial crisis only exacerbated the problem.
As lenders rationalized the differences between Eurozone borrowers, interest rates for the countries in question reversed course, making the situation more difficult.
Chapter 3: In most situations, countries with large fiscal imbalances, force an involuntary haircut upon their citizens and bond holders in the form of currency devaluation. When a currency is devalued, the economy contracts but eventually settles into a new equilibrium, albeit at a lower level, and moves on from there.
Unfortunately, the monetary union takes this option off the table for the countries that need it most, so Europe has been in negations for much of the past three years over which voluntary haircuts must be taken – austerity for the citizenry, and pennies on the dollar for bond holders. And that is where we find ourselves now.
Why is this important?
Well, in some ways it isn’t. Countries of all shapes and sizes have gone through similar restructurings (i.e. Sweden in the early 90’s; Argentina in 2001). In isolation, these events have little or no effect on the wider global economy.
However, one thing we’ve learned recently is that in today’s financial markets, events don’t happen in isolation. This is why the problems in Europe weigh so heavily on investors’ minds. There is legitimate fear that an unruly Greek default (or similar disruption) could lead to problems in French, German, and Spanish banks, which could lead to problems in banks here at home, etc.
What if they don’t fix it?
European debt levels are unsustainable. By definition, things that are unsustainable can’t continue indefinitely, so fix it they must. The question is not if, but when and how.
Unlike in 2008, when the interconnectivity of the financial system was still cloaked in mystery, today counterparties, regulators, and policy makers have their “eyes wide open.” They are busy in Europe finding solutions while the stock and bond markets act as a real time score card against which the results are judged.
Given the risks, why invest outside the U.S.?
It is true that Europe’s problems have been a drag on international stock markets and any diversification outside of large U.S. stocks has been a detractor from performance of late. However, this has not always been the case.
Looking back over the past fifteen calendar years, the S&P 500 (when compared to five other major equity assets class exposures) has been the top performer exactly two times. In contrast:
• U.S. real estate (DFREX) took the top spot three times
• Emerging market stocks (DFEMX) had four first place finishes
• U.S. small company stocks (DFSVX) finished first three times
• International small company stocks (DISVX) had three first place finishes
Equity markets are not like professional sports, where a few major franchises dominate the championships year after year. In investing, the first place trophy gets passed around quite a bit, and since we can’t predict which asset class will be the winner in any given year, we will continue to commit to owning all of them. (It is worth noting that often the winning asset class is one that performed quite poorly in the recent past. This could bode well for international equity markets in general and European stocks in particular.)
What’s the bottom line?
All over the world, countries are working off the excesses of the last several decades. In Europe, it is one story. In America, it is another.
Every ounce of progress made in paying down debt, increasing savings, eliminating excess – all good things in the long run – are drags on the economy in the short run. Massive fiscal and monetary stimuli are used to bridge the gap, but the net result still leaves us bumping along with sub-par economic growth.
In the meantime, investors (like generals) are preparing to fight the last war. They are embracing the perceived safety of bonds over the perceived risk of equities. We think this mentality is short-term safe and long-term risky.
Are we making any changes?
In the current environment, global equity markets are susceptible to selloffs at the mere hint of trouble, and there is always the chance that bigger selloffs could occur. At the same time, we know there is real underlying value in the companies we own through public markets, and that value doesn’t disappear when their stock prices fall.
Bonds – the traditional buffer to the ups and downs of the stock market – are currently so expensive, they introduce a new set of risks into a diversified portfolio.
Looking at the situation, we have reached the following conclusions about how to best manage investments in the current environment.
• Bonds still play a role in diversifying the volatility of stocks, therefore, we will continue to allocate to bonds, although in reduced amounts. We will, however, focus our exposure to segments of the bond market that are true diversifiers – high quality, investment grade bonds – and manage exposure to interest rate risks by limiting durations and relying on managers with track records of effectively navigating rising interest rate environments. Translation: if we want to own bonds for safety, own safe bonds.
• We will continue to look for, and implement, alternative strategies that can act as bond or stock surrogates. To be effective, they must meet the criteria of truly diversifying the portfolio, while having an inherent economic return expectation equal to or greater than the fixed income and equity positions they are complimenting.
• As long-term investors, we will embrace the long-term value proposition equities offer, knowing that with that comes the very real likelihood of short-term volatility.
In conclusion, we will continue to do what we know works, while trying to avoid obviously avoidable risks. We will not sacrifice long-term value for short-term safety, but will instead make sure each investment portfolio meets the financial planning needs of each client. These are the principles that we trust will lead to a successful investment experience for all involved.