Feedback from recent commentary can
largely be boiled down to the following: “We get it. Developed market growth
will continue to redefine mediocrity; emerging market leaders cannot decide
whether to institute steps to limit hot
money inflows or raise interest rates to mitigate the more recent outflows;
and financial markets at all points of the compass are distorted thanks to the
tidal wave of artificial money seeking marginally respectable returns.” These
comments are immediately followed by the query: “So what am I to do?” Fair
enough. After harping on the
aforementioned risks to the global economy and investment portfolios, it is
easy to resemble the annoying sports fan at the corner of the bar complaining
about every play without offering up a rational alternative. Since there is no
Ph.D. in economics hanging on my wall, I’ll skip over policy and instead
concentrate on how one should deploy capital in such an uncharted environment.
So this entry is about asset allocation, the granddaddy of generating
investment returns. The concern here is not with market activity this week or
this month, but rather how to construct a portfolio able to meet one’s financial
obligations in the globalized 21st century economy and the eventual
unwinding….or unintended consequences…of extraordinary monetary policy,
whichever comes first.
The Landscape
Although the most expensive words
in the English language may be “but this
time it’s different,” this time, it really is. The sources of the recent
economic crises have been developed, not developing, countries. There has never been a broader range of
financial markets and asset classes in which to invest, not only for sophisticated
institutions, but increasingly for the main street crowd. And as alluded to
above, it is anyone’s guess how the removal of central bank support will affect
investor psychology, much less the real economy. If someone comes along
pitching the standard portfolio of domestic equities, bonds and cash, don’t
laugh or slam the door in his face. Just politely take his card and store it on
the shelf next to the floppy discs, flip phone and Seattle Supersonics jersey. Instead, rather than being the domain of
investors with a high risk tolerance, these new markets and new vehicles should
find a place in the portfolios of any
judicious market participant as a means to capture returns and diversify risk,
in other words: to expand the efficient frontier.
So what does this landscape look
like? The S&P 500 nailed yet another record high this past week and at 1,691.7
is up 18.6% for the year and 150% since the crisis nadir four years ago.
Despite massive Fed purchases, the benchmark 10-Year U.S. Treasury has seen its
yield rise 98 basis points since May 2nd. All this must mean the
economy is rip-roaring. Not exactly. Over the past five quarters, America’s GDP
has averaged 1.72%. Immediate prospects are equally grim with yet another sub
2% print for Q2 2013 expected. This has been the same story across developed
markets in the post crisis era. As seen in the IMF data below, the U.S. may
once again crest the 3% threshold for both 2014 and 2015, with other advanced
economies eventually following suit. This number was doubtlessly arrived at by
complex economic modeling…and perhaps a coin tossed into a fountain.
Continued tepid advanced market
growth and a contraction in the pace of emerging market expansion, which carried
the global economy on its back during the lean years, have been reflected in other
financial market indicators. The MSCI Emerging Market Index is down 11% from
its 2013 high and over 20% below its January 2011 level. Similarly, another
putatively favored destination for yield-starved investors, commodities, is
6.3% off its 2013 high as measured by the S&P GSCI broad commodities index.
Either these asset classes reflect a more cautious view of growth than those
imbedded in U.S. equities, or investors are simply jockeying for position in
advance of the Fed eventually withdrawing its multi-trillion dollar supportive
hand. This talk has become acute of late
with the expectation that the bank’s current $85 billion monthly purchases may
be curtailed towards the end of this year. Frightening thought that markets are
jittery, not because the Fed is selling off its gargantuan bond portfolio or
planning on raising interest rates, but simply due to the fact that it will be
it will be expanding its balance sheet at
a slower pace. When markets emit such
conflicting signals, especially with the presence of QE distortions,
investors must weigh the costs and benefits of major asset classes and adjust
his/her allocation accordingly.
U.S. Equities
The United States is home to the
deepest, most liquid pools of equities anywhere in the world. Stringent
reporting requirements ensure transparency and solid corporate governance when
compared to other markets, including advanced economies. As a brilliant mind
told me years ago when discussing the ascendency of Asia, the U.S. still
maintains the competitive advantage of freedom,
flexibility and innovation. Also
most domestic investors plan on having their retirement funded in dollars,
unless they expect to spend their golden years in San Miguel Allende or
Mauritius.
But what of America’s recent lousy
track record of economic growth? That is offset by yet another differentiating
factor for U.S. firms: investors are not only gaining access to U.S. growth,
but to global markets as well. As seen
below, nearly 50% of sales by S&P 500 member firms are generated abroad.
That’s a nice hedge to have.
Despite record highs being set just
this past week, valuations are arguably still within the realm of plausibility.
According to S&P, the 12-month trailing P/E ratio is presently 16.99 based
on operating earnings, compared to a 25-year average of 17.8. Forward earnings
are an even more attractive 15.1. So what is not to like? For one, earnings
growth has been woeful of late, averaging under 1% between Q4 2011 and Q1 2013.
The expectation is that when all is said and done, Q2 will see a sizeable
uptick. Yet is that sufficient to justify recent highs? Hope springs eternal.
Just as telling, revenue gains are still stuck in low gear, having averaged low
single digits (4%) over the most recent fully-reported six quarters. A
troubling characteristic of this…ahem…recovery has been the ability of
executive teams to drive EPS growth by streamlining operations rather than
expanding the top-line. To borrow a phrase from our friends in the medical
profession, one can only cut so much fat until they start hacking into muscle
and bone. Also when looked at through another lens, valuations themselves
become suspect. When using the Shiller
P/E ratio based on 10-years of prior earnings, the S&P 500 is trading at a
slight premium (0.7%) to its recent average, compared to the 4.5% discount
based on operating earnings.
Bulls rationalize current prices by
positing that equities are pricing in the release of still-elusive pent-up
demand and that the economy will eventually start humming along at a 3%-plus
clip. But they have been playing this song during the entire run-up to new
market highs. Fool me once.
The
Verdict: Is there a lot to like about exposure to domestic stocks? Absolutely.
Just not at 1,691 in a sub 2% growth environment. Long-term exposure is clearly
a must for the aforementioned reasons. Adding to that exposure at current
valuations is likely an exercise in caveat emptor.
Bonds
Much conjecture has been made as to
whether the 30-year bull market in bonds has come to an end. How could it not
be? The epoch of low interest rates was a consequence of central banks, namely
the Fed under Paul Volcker, adhering to strict measures to break the back of persistent
inflation during the latter 1970s. That magic formula has sense been thrown out
the window as evidenced by advanced market zero-interest-rate-policy (ZIRP) and
massive bond purchases (QE). Even the inflation-paranoid Germans have been
cajoled by the ECB into going along (kicking and screaming) with loose monetary
policy. The Fed has already stated it intends to keep rates at present levels
until unemployment dips to 6.5% and that it is willing to tolerate inflation of
2.5%....above its previous comfort zone…in order ensure yet-to-be-seen jobs
gains become solidified. This tactic only adds fodder to the camp that believes
central banks tend to fall behind the curve when combatting incipient
inflation. On top of this concern in the reality that the Fed has become the
marginal buyer of Treasuries and mortgage-backed securities (MBS), and once
that support is removed, supply and demand must readjust…in perhaps a most
unsightly way….to find a new price equilibrium.
If one is an adherent to the
concept of mean reversion, today’s 2.6% yield on the 10-Year will eventually
drift back up towards its long-term average of 4%. In doing so, the bond’s
principle will take a significant hit and with yields at such miniscule levels,
only a slight drop in prices will wipe out gains attributed to coupon payments.
If inflation does eventually rear its head, the future value of bonds’ fixed
payments will be whittled away. Here equities, with their nominally-priced
dividends, have an advantage over fixed-income instruments as they can be
increased to keep up with (or ideally exceed) the pace of price growth. So a
little inflation…if it is a consequence of a healthy economy…is potentially a
positive for equities markets. Not so for bonds.
As seen above, during the credit
bubble, spreads of corporate bonds versus comparable risk-free benchmarks
reached laughably low levels. Now that the dust has settled in the crisis
aftermath, spreads have stabilized at levels slightly above their long-term
average. From an investor’s perspective, that may be an improvement over 2007,
but in absolute terms…with Treasuries at 2.5%, it pays very little to have
exposure to quality (or junk) corporate debt. And once again, once rates begin
to rise and new issuance offers juicier yields (if there is any firm left that
has yet to refinance at current low rates), securities already present in
portfolios will take a punch to the teeth.
The
Verdict on Bonds: Run. Run very fast and far away. Unless one is a manager of a
fund with mandated exposure to the fixed income space. In that case, harass
Washington about the generational theft that is occurring via its policy of
financial repression.
Commodities
The so-called commodities supercycle
has been on investors’ radar screens for nearly a decade. Rather than a fringe
component of a portfolio, included to diversify risk, commodities came to be
attractive as a source of returns. The reasons for this were twofold: the
supply of many key inputs were becoming more scarce, and demand, namely from
emerging markets was surging. Historically, an uptick in demand could be easily
met by the Saudis drilling another well or multinational miners dynamiting the
lid off of a previously pristine mountain. In a wicked twist of fate, the rapid
industrialization of the developing world has coincided with the depletion of
many of the most easily accessible (i.e. cheapest) sources of raw materials.
The result? Elevated prices. Increased investor speculation…partly attributable
by the low-interest rate regime of the early 2000s…only fueled the price gains.
As seen in the top chart, 2013 has
not been kind to the commodities space. So much so that many have called an end
to the supercycle. It is true that as
in the past, industry has ramped up extraction activity to meet increased
demand, with the North American hydrocarbons revolution (see below) being a
prime example. But these new supplies generally require advanced engineering
techniques that had been avoidable during periods of flush supply. The result
is increased marginal costs. The next barrel of oil out of Canada or ton of
copper only make economic sense at the current elevated prices. Should those
fall, then firms simply curtail production, something already occurring in the
shale gas space. The end result is the same: prices across the commodities
space are not returning to their historically low levels…at least for any
sustained period.
On the demand side, despite the
much publicized slowdown in Chinese growth to the (gasp!) 7.5% neighborhood,
the appetite for raw materials…namely from the emerging world…will continue to
grow. And while the transfer of global manufacturing to Asia has largely run
its course, and the more recent frenzy in construction spending has begun to
cool, we are likely on the cusp of a third iteration of emerging market
commodities demand, this time from consumers seeking energy-sucking creature
comforts such as cars, and improved diets, which will tax the global food
supply chain. More on this in the following section.
The
Verdict on Commodities: this asset class should continue to be included in a
globally diversified portfolio seeking to capitalize on secular…that is
long-term….investment themes. Ironically, the potential exit of Fed support
from financial markets may chase away yield-seeking speculative money and cause
a reemergence of the historical attraction of commodities as an investment:
lack of correlation with other asset classes and a viable hedge against
inflation. Now that the supercycle has entered into a more mature phase,
industrial inputs (metals and energy) may become more attuned to the peaks and
valleys of the global business cycle, but consumer-specific resources such as
food stuffs will continue to benefit from elevated global demand.
Emerging Markets
Very much related to commodities
are themes surrounding the ascendency of emerging markets. And as with
commodities, 2013 has been less than kind with regard to investment returns.
Talk about an opportunity. If one believes markets got overheated on excess
liquidity, and he is a champion of the secular EM themes such as rising
consumer demand, then the upcoming post QE/stimulus shake-out period could be
rife with chances to gain cheap exposure to these rapidly growing regions. When
identifying tailwinds, favorable demographics are hard to beat. And
by-and-large population dispersion and urbanization trends greatly favor emerging
countries.
While these themes are attractive,
investment opportunities remain suspect. Unlike with the U.S., liquidity can be
wanting, transparency into numbers and corporate governance can be a sham, and
securities movements can be at the whim of macro-policy such as those governing
interest rates and currency regimes. That said, big-time investors yearn for
exposure and local EM business and government leaders yearn for these
investors’ dollars. This should….key
word….eventually lead to more sophisticated and higher quality financial market
regulations.
The
Verdict on Emerging Markets: Buy cheap access on the dips, utilizing the most
liquid and transparent vehicles possible. In some instances this may be U.S.
domiciled multinationals. In other cases it will be locally-denominated
government or corporate debt. This theme is not disappearing any time soon. Yet
remember that not all emerging countries are the same. Some are making great
inroads in developing the infrastructure and systems of an advance economy,
while others slip back into the historical pitfalls of corruption, cronyism and
the excessive meddling of state-driven industrial policy.
Wrapping it up:
It may be cliché and simplistic to wrap
this up by advising one to avoid asset classes facing significant hurdles
(bonds), and buy on the dips in areas tied into robust secular themes (emerging
markets and internationally-exposed U.S. equities). But these are the blocking
and tackling….i.e. the fundamentals…of investing. Unique to the current environment is the
eventual unwinding of exceptionally loose advanced market monetary policy. With
growth this lousy, it is hard to believe inflation will be a problem through
the mid-term. But then again, there are about three trillion good reasons why
it may be. Should it rear its ugly head, real assets…things you can touch… such
as commodities and real estate (not mentioned here)….may be attractive
defensive positions. It may be antithetical to say this with U.S. equity
volatility such low levels, but market riskiness can only go up. The purpose of
developing a thorough asset allocation is to plan for the long haul. But as
advanced market growth continues to convulse and with financial markets
possibly losing the supportive hand of the Fed, tactical adjustments to
portfolios will likely need to be made with greater frequency to account for
future developments. Such possible undulations also create shorter-term trading
possibilities for investors of that ilk. And with yields so hard to come by,
those are strategies many investors may plausibly come to consider.
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