Market Comment Q1 2012
Following the strong performance of global stock markets since last fall, markets have entered a more vulnerable phase. In the first week of April, this vulnerability was shown by the first weekly decline in the S&P 500 since last year. The recent series of strong employment reports in the U.S. ended with the March report, which revealed a slowdown. For the first time in a while, earnings are not expected to grow much this quarter, with consensus expectations for growth of 3-5%. Europe appears to be in or on the verge of recession. Even China has officially downgraded its growth target for the year, albeit to an enviable 7.5%.
These cyclical developments are taking place within the context of longer-term secular constraints on economic growth. A multi-year period of public and private debt liquidation is likely to continue to weigh on economic growth for several more years. The available policy responses to tepid growth—monetary stimulus and fiscal restraint—seem to provoke as much investor anxiety as the underlying conditions.
The offsets to these headwinds are that the risk of a financial meltdown in Europe appears to have been reduced, corporate balance sheets are in fine shape, and equity valuations are reasonable enough to be judged to have incorporated the bulk of foreseeable consequences. The key to navigating this market is to pay attention to asset allocation. A sufficiently long-term investment horizon favors equities, even if a market correction seems plausible. At the same time, near-term expected cash needs should be secured.
In an interview with ABC news anchor Diane Sawyer a few weeks ago, Fed Chair Ben Bernanke said, “… we haven’t quite yet got to the point where we can be completely confident that we’re on a track to full recovery.” In particular he worried about employment. The fall in the jobless rate to 8.3 percent in February may reflect “a reversal of the unusually large layoffs that occurred during late 2008 and over 2009.” Significant further improvement in reducing unemployment will probably require faster growth, he said. In the March payroll report, released earlier this month, his concern appears to have been substantiated. The Labor Department reported that nonfarm payrolls rose 120,000 in March, about half the level of gains posted in the preceding three months and less than expected. While it is dangerous to draw conclusions from monthly reports, the stock market appeared to do so anyway, dropping 2.5% in the next two trading days.
Employment gains this year have been one of the clearest indicators of economic recovery. Even though these gains have not been as strong as might have been hoped following the recession, they have nonetheless provided some comfort that our economic woes are on the mend.
It may be difficult to discern the employment disappointment in the chart above. It goes to show how sensitive the market is to any change in perceived economic conditions. In each of the past two years, the market has been disappointed by weakness in the labor market. Investors are thus highly sensitive to even a hint that we might see this pattern replayed this year. If this trend persists, especially in this election year, we are likely to see calls for further fiscal or monetary action to address the employment situation.
The financial crisis exposed the soft underbelly of the developed world’s recent economic performance:
It was reliant on debt expansion to stimulate demand. Debt expansion was enormously profitable to financial institutions, whose profits rose substantially as a percentage of GDP. The chart above shows financial profits rose from less than 0.5% of GDP in 1980 to over 2.5% two decades later. Meanwhile, total debt as a percentage of GDP rose to troubling heights.
In the U.S., consumption spending composes about 70% of GDP. The financial condition of consumers, therefore, is of paramount importance to the economy’s health. Many factors contribute to consumers’ financial condition, including income, indebtedness, housing wealth and overall net worth. Most of these factors were under pressure during the recession. In the chart below, it is easy to see the recent pattern: Households are deleveraging. The percentage of household debt to personal income has fallen from a peak near 115% in 2008 to about 100% today, with considerable room to fall further. A good portion of this decline, unfortunately, comes from reduced mortgage debt, which is extinguished in foreclosure. The good news is that personal income has grown since the recession. What has restrained economic and employment growth is that a good share of that income has been used to liquidate debt instead of for consumption.
How much debt households will be comfortable carrying is a matter of speculation. Among other things, it depends on the outlook for jobs, housing prices and general economic activity. It is prudent to conclude, therefore, that indebtedness will be seen as anathema for a good while longer.
The secular backdrop of debt liquidation exacerbates the current cyclical fragility. Investors are keenly interested in marginal changes in employment and other measures of economic activity. Meanwhile, corporate earnings growth in 2012 is expected to slow to 8%, largely because the recovery has simply aged. Recently, however, estimates have been downgraded on the European recession, oil prices and perhaps Chinese growth.
The good news is that equity prices, though up in the past six months, are still reasonable compared with expected earnings and still offer the prospect of attractive long-term returns. Investors should be prepared, however, for renewed volatility, especially if oil prices were to continue to rise or European weakness were to affect the U.S. more than is currently anticipated.
In our most recent client letter, we wrote that owning bonds in your investment portfolio is a good hedge against adverse economic or geopolitical developments. This is true despite the fact that bond yields are now only slightly higher than the generational lows reached last fall. Given low yields, investors are often tempted to take more risk in bonds in order to improve returns. While some additional risk may be appropriate, we caution against large-scale investment in longer-term or below investment grade bonds. After all, it doesn’t make sense to take too much risk in an asset class whose primary investment attribute is relative safety.
Bonds are contracts that pay investors a fixed or floating rate of interest until maturity, when the investors’ capital is returned. The two main sources of risk that investors face today are that interest rates will rise, causing a decline in the value of the bond, or that the bond issuer will not pay the interest or repay the principal.
Interest rate risk is measured by a statistic called duration. Duration is the weighted average maturity of each coupon and principal payment of a bond, or of a portfolio of bonds. The weighting factor is the present value of each payment, calculated using current interest rates. A 10-year Treasury bond, for example, currently has a duration of about 9 years. If interest rates rise across the board by 1%, say, the Treasury bond with duration of 9 will decline in value by 9%. Similarly, if rates fell by 1%, the bond’s value would increase by 9%.
To control interest rate risk, HeadInvest generally seeks to invest fixed income funds in a “ladder”, where maturities are spaced out over the next one to ten years. The duration of a ten-year ladder is about 4 years. We generally do not purchase bonds that have maturities greater than 10 years. This is because the duration of a thirty-year Treasury bond is currently 19 years—implying a potential 19% decline if rates move up 1%.
Credit risk is measured by credit ratings, which are assigned by Moodys, S&P and other rating agencies. Though these agencies clearly failed when assessing the risk in collateralized mortgage obligations, and do so occasionally with individual corporate bonds (eg, Enron and WorldCom), they are the most widely accepted arbiters of credit risk. Bonds rated investment grade and above form the core of clients’ portfolios, though as a matter of policy, HeadInvest generally seeks bonds rated slightly higher within the investment grade category. Short-term bond funds may invest up to 30% of assets in investment grade bonds below our usual quality criteria. Because of the diversification they achieve by holding hundreds or even thousands of individual bonds, we believe they are good vehicles through which to accept some additional credit risk.
In today’s low yield environment, investors in bonds are incentivized to take more risk. We say, be careful. To manage both interest rate risk and credit risk, we focus on both short duration and high credit quality.
After twenty-three years at HeadInvest, Don Head founder, has left the firm to enjoy retirement. “It has been my privilege to work closely with many of you,” Don writes, “and to have been intimately involved in matters of such significance in peoples’ lives. Thank you for your confidence and trust.”
The Board of Directors appointed Carl G. Gercke Managing Director of HeadInvest as of March 31, 2012. Carl joined the firm as director of research in 1999 and has led the investment process since that time.
HeadInvest will continue to apply the investment principles upon which the firm was founded. We wish Don and his wife Caron all the best.
The average price of gasoline could surpass $4 per gallon nationwide as early as this week. It’s already $3.93 per gallon, a record for this time of year. Since 2000, pump prices have risen every year between early February and late May. The annual increase has boosted prices by 27 percent on average, according to the National Association of Convenience Stores.
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