October 2012 Investment Commentary
The third quarter was a risk-on period with U.S. large-cap stocks gaining 6%, while core investment-grade bonds returned 1.5%. Going back to the stock market low on June 1, 2012, large-cap stocks are up 10.7% versus 1.6% for core bonds. European stocks also rose dramatically, up nearly 9% in the quarter and 17% from the June low. Emerging-markets stocks gained 6.5% in the third quarter and are also posting double-digit gains from the June low.
While there are always many factors that affect financial markets in the short run, it seems pretty clear that a key driver of the rally in stocks and other riskier assets over the past few months has been global central bank monetary policy, with markets reacting positively to policymakers’ signals—and ultimately the announcements—of additional liquidity and market support by the European Central Bank and the Federal Reserve.
With the exception of the U.S. housing market, which is finally showing signs of improvement, the bulk of the economic news was not positive during the quarter, highlighted by disappointing U.S. employment numbers. However, the stock market’s mindset seemed to be: bad news is actually good news because it means the Fed will step in with even more aggressive intervention, which will be a further boost for risk-taking. And the market was right (at least in the short term).
Similarly, while European stocks did even better than U.S. stocks in the third quarter, Europe’s economic fundamentals did not improve, and the eurozone growth outlook remains pretty bleak over the next few years at least.
Now let’s dig a bit deeper into the details of the recent ECB and Fed policy announcements and also discuss what it means for our current investment outlook and portfolio positioning.
The ECB: ‘OMT! OMG!’
Throughout July and August, Draghi, with the support of other eurozone political leaders, communicated that the ECB was preparing to take strong action in an effort to eliminate the risk of a eurozone break-up and financial crisis. For example, on July 26, 2012, Draghi said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This policy signaling culminated in the ECB’s announcement on September 6, 2012, of a major new policy dubbed “outright monetary transactions,” or OMTs. On the same date, Draghi also declared, “The euro is irreversible,” meaning it would never be allowed to break apart.
Under the OMT program, the ECB committed to potentially unlimited purchases of distressed eurozone government bonds (e.g., from Spain or Italy) with maturities of up to three years. However, it also said such purchases would be conditional on the target country’s government formally requesting assistance and also committing to additional fiscal controls (austerity) and structural economic reforms, under external oversight. That is, the government must agree to give up some sovereignty. The ECB also said it could stop its bond purchases if the target country breaks its commitments. Finally, the ECB said it will “sterilize” its bond purchases by removing an equivalent amount of liquidity from the financial system. This provision was likely included in order to preempt criticism that the OMTs are monetizing the bad debt, i.e., “printing money,” which raises fears in some camps of a repeat of a Weimar Republic–like hyperinflation period.
OMTs are significant because it is the first time the ECB has made an open-ended commitment—in terms of both the amount of government bonds it might buy on the secondary markets and the time frame over which the policy will be active. The ECB’s words and actions had the desired effect of sharply reducing yields on Spanish and Italian government debt. A week after the OMT announcement, the Spanish Treasury sold 10-year bonds at an average yield of 5.67%, about a percentage point less than its borrowing cost at its previous 10-year bond auction in early August. Shorter-term Spanish government bond yields—the direct target of the OMTs—dropped even more dramatically, from 6.5% to 3%.
The OMTs appear to have reduced the perceived and actual risk of a systemic debt crisis in the eurozone, at least over the nearer-term. But there remain many unanswered questions and unknowns with regard to the actual implementation of the OMTs (let alone their longer-term effectiveness), not the least of which is whether and when Spain will actually ask for formal assistance and agree to the necessary conditions. (Toward the end of September, rising political tensions and anti-austerity protests in Spain pushed 10-year bond yields back above 6%.)
Moreover, the credibility of the ECB’s commitment to enforcing conditionality under the OMT program is questionable. We think a recent Financial Times editorial put it well:
This commitment, while welcome, does not eliminate the risk of moral hazard. Mr. Draghi may claim that the ECB will stop buying the bonds of countries which are not compliant with their agreed programmes. But doing so after the central bank has stuffed itself with a country’s bonds is like putting a gun to one’s own head and threatening to pull the trigger.
In other words, doing so would cause yields to spike back up and hasten a eurozone debt crisis. On the other hand, if the ECB continued to buy bonds after a country failed to hold up its end of the conditionality bargain, it would almost surely intensify opposition to the program by Germany—whose central bank was the one dissenting vote against the OMTs—and others. This would potentially lead to renewed fears of euro “reversibility”—precisely what the OMTs are meant to prevent.
So the OMTs buy some more time for eurozone political leaders to try to work toward a long-lasting solution. It may be more meaningful than the previous kicking-the-can-down-the-road actions of the ECB, but obviously, it still does not “solve” the structural problems threatening the existence of the eurozone, which include:
- competitive imbalances between the Northern Europe and Southern Europe economies;
- unsustainable debt/deficit issues facing Southern Europe;
- the necessity of further political, fiscal, and regulatory integration among the eurozone countries in order to create the conditions necessary for a sustainable monetary union; and
- huge challenges to achieving such integration given the conflicting incentives and the significant economic/cultural/political differences across eurozone member countries.
We agree with Martin Wolfe, the respected economics columnist for the Financial Times, who wrote:
The ECB has done what it can, given the politics. . . . But the risks of a breakup cannot be eliminated. For these to disappear, citizens of debtor countries must see a credible path to growth, while citizens of creditor countries must believe they are not throwing money down a bottomless pit. What the ECB has done is win some time. It has not won the game.
Our view remains that there is significant likelihood that the eurozone will not survive this crisis intact, and a lesser, but still material, probability that the breakup is not orderly (i.e., reasonably well planned and orchestrated), but is instead disorderly (implying a major shock to the global financial system and markets). Of course, even if there is a eurozone breakup, the timing remains highly uncertain. The OMTs appear to have at least extended the potential time frame before a breakup, if not substantially reduced the risk of that ultimate outcome. As things stand now, the OMTs do not materially change our assessment of the range of potential outcomes and risks related to a potential crisis in Europe over the next five years. As such, it hasn’t impacted our portfolio allocations or asset class risk/return assessments. However, depending on further developments in the eurozone, that could (and at some point will) certainly change.
The Fed: ‘QE Infinity and Beyond!’
After foreshadowing further action several weeks earlier, Fed chairman Ben Bernanke made yet another major monetary policy announcement on September 13, 2012:
- The Fed initiated a new program of quantitative easing, or QE3, saying it would buy $40 billion per month of government agency mortgage-backed securities. An important distinction compared to QE1 and QE2 is that QE3 is open-ended (similar to OMTs), with no predefined end-point in terms of its duration or magnitude (this led some commentators to refer to it as “QE Infinity” or “QEternity”).
- The Fed said it would continue its Operation Twist program through year-end, buying $45 billion per month of longer-term Treasury bonds and selling shorter-term Treasury securities. This program has been in place since September 2011.
- The Fed emphasized that QE3 would be tied to conditions in the labor market—the unemployment rate in particular. It also said if there isn’t substantial improvement in unemployment, it would take additional actions beyond buying mortgage-backed securities. Specifically, the Fed stated, “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
- The Fed attempted to further influence market expectations regarding its commitment to reflation, and perhaps marked the initiation of a new inflationary monetary regime, stating: “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens [emphasis is ours].”
- The Fed also said it expects to keep the federal funds rate at exceptionally low levels (0%–0.25%) at least through mid-2015. Previously their expectation was through the end of 2014.
These are significant changes to Fed policy (economist David Rosenberg called them “nothing short of radical.”). There is already plenty of liquidity in the U.S. banking system, with $1.5 trillion in excess bank reserves sitting idle at the Federal Reserve, the result of the previous two QEs. U.S. corporations are also flush with more than $1.7 trillion in cash on their balance sheets. In other words, there is plenty of credit potentially available if lenders are willing to lend and borrowers want to borrow. So, the recent Fed moves are clearly not needed for liquidity reasons.
Instead, Bernanke and the Fed are trying to signal even more strongly that they have no intention of pulling back on their aggressively accommodative monetary policy and that they view unemployment as a significantly greater risk than inflation. (The Fed has a so-called dual mandate to promote maximum employment, along with stable prices.) As Bernanke stated with the prior two QEs, the goal is to depress interest rates even more in order to encourage (or push) investors further out on the risk spectrum, causing increased inflation in asset prices, such as the stock market and housing, with the hope that the positive “wealth effect” will stimulate consumer spending and ultimately business investment and job creation. That’s the theory. Whether it will actually lead to any significant real economic impact is questionable and the subject of debate among economists.
But there may be more significance to the policy than just an attempt to create a wealth-effect stimulus. Mohamed El-Erian, CEO and co-CIO of PIMCO, recently wrote that the United States might now be experiencing “a ‘reverse Volcker moment’ in which low and stable inflation gets subordinated to other economic objectives.” In other words, this may be the beginning of central bank policy regime change that reverses the expectations that have been in place since the early 1980s when Fed chairman Paul Volcker crushed inflation and reset inflation expectations by raising interest rates even as the economy experienced a severe recession (the federal funds rate peaked at 19% in 1981). El-Erian also notes, as many others and we have, that given the U.S. debt burden and sluggish growth prospects, it is tempting for governments to resort to “somewhat higher” inflation as a means to help deleverage. New York Times Op-Ed columnist Paul Krugman, among others, has said he believes this was an explicit (and salutary) aim of the new policy. As it turned out, market-based measures of inflation expectations did spike higher after the Fed announcement.
Changing Gears: What About the U.S. Elections?
Moving away from central bank policy, a question we frequently get from clients every two or four years is: What is Litman Gregory’s take on the U.S. elections and how is it impacting your investment outlook? Our answer to this question hasn’t changed much over the years. First, to the extent a particular election result is widely expected, the financial markets will have already discounted this outcome, i.e., current asset prices will reflect the market consensus. In order for us to believe there is a tactical investment opportunity stemming from a particular election outcome, we’d need to believe we have an edge in assessing the outcome better than the market overall, and our view would also have to be materially different from the consensus view. That is highly unlikely to ever be the case.
In general, there is too much uncertainty and too many “non-election” variables that impact longer-term investment outcomes for us to see any value in positioning our portfolio for a particular election result. This would be true even if we had a high degree of certainty about who the winner will be, which we don’t in this presidential election (although the odds on www.intrade.com currently heavily favor President Obama). The current climate of partisan political polarization and congressional gridlock creates significant additional policy uncertainty, e.g., with regard to when and how the near-term fiscal cliff will be dealt with, let alone the country’s longer-term debt problem. Even if one assumes, say, that President Obama is the winner, the actual policies that will be implemented in 2013 (assuming something gets implemented) are still quite uncertain. Moreover, even if we had a higher degree of certainty as to who would be elected and what policies would be implemented, the ultimate economic effects and outcomes of those policies would still be highly uncertain. Macroeconomics is far from being a hard science, and there are a multitude of other factors and variables that impact economic outcomes beyond U.S. fiscal and monetary policy.
We aren’t saying the result of this election is meaningless to the path of the economy and financial markets over the next four years. We do believe that different fiscal and monetary policies are likely to be implemented depending on who is president and which party controls the Senate. But we are saying that 1) we are not willing to bet on a particular election result; 2) there is a wide range of potential macro outcomes around either election result, stemming from the uncertainty related to policy implementation and ultimate effectiveness in achieving desired results; and 3) there are a multitude of other variables and factors unrelated to the election results that are out of U.S. politicians’ control that are likely to have at least as meaningful an impact on the course of the global economy and financial markets over the next five years.
How Are Our Portfolios Currently Positioned?
Instead of trying to handicap election results, we stick to our longer-term analytical framework, in which we consider and weigh multiple potential macro scenarios and assess the potential risks and returns across asset classes in each scenario. Given the highly uncertain global economic and political environment, we continue to structure our portfolios to perform at least reasonably well across a wide range of outcomes, any one of which we think is at least reasonably likely to happen. Moreover, should investor “herd behavior” cause markets to drop sharply over the shorter term, our tactical asset allocation discipline should enable us to take advantage by identifying and investing in compelling longer-term investment opportunities and/or reducing our exposure to overvalued asset classes.
To briefly recap our key five-year scenarios:
- Our base-case scenario continues to be one of subpar economic and earnings growth due to headwinds resulting from the aftermath of the 2008 financial crisis and the effects of ongoing deleveraging. In this scenario, we estimate low single-digit annualized returns to the S&P 500 stock index and essentially zero return to the core U.S. bond index over the next five years.
- Our worst-case scenario incorporates the possibility of a debt-deleveraging spiral and financial crisis playing out. Obviously, portfolio risk management is especially critical in this type of scenario as shorter-term returns would likely be sharply negative for stocks and other risk assets. While core bonds would outperform stocks in this scenario over the full five-year time frame, bond returns would still be very low—less than 2% annualized in our estimation.
- On the optimistic side, we also consider a reflationary scenario where policy is effective, a U.S. or global economic recovery gains traction and, as a result, riskier assets perform very well, e.g., U.S. stocks would generate a low double-digit annualized return. We don’t assign a high probability to this optimistic scenario, but our portfolios are still positioned to capture significant upside should our base-case scenario assumptions turn out to be too pessimistic.
This chart depicts our current five-year return expectations for the asset classes and strategies in our portfolios. It shows both the magnitude and the wide range of potential returns for stocks across our scenarios, as well as the extremely low potential returns for investment-grade bonds in all scenarios. This is a key reason for our underweight to core bonds in favor of flexible and absolute-return-oriented fixed-income strategies. Note that the absolute-return-oriented fixed-income and arbitrage strategies included in the chart represent unique investment strategies rather than a homogeneous asset class. As such, these strategies can’t be represented by a standard market index (such as the S&P 500 or the Barclays Aggregate Bond Index). The return ranges on the chart for those strategies are our estimates based on the specific funds in which we are currently invested.
Strategy and Conclusion
We continue to structure our balanced portfolios for a range of potential macro outcomes. Rather than focus on a particular investment style, we are invested across several different investment approaches and styles. These include managers who 1) focus on high-quality, consistently growing and stable businesses who are willing to pay up for such companies; 2) have a very long time horizon, focus on companies selling at a large discount to intrinsic value and therefore may have larger exposures to out-of-favor cyclically sensitive businesses right now; 3) focus on fast-growing businesses with short-term catalysts or secular growth tailwinds; and 4) other variations.
Our expectation is that over the long term our managers will generate returns better than the market indexes. They will take different paths in getting there—that is the point of diversifying across managers and investment styles—and inevitably some of them will experience periods of outperformance and underperformance. In the course of our ongoing due diligence, our research team is continually reassessing our thesis for investing with each manager and the basis for our conviction that they will outperform over the long term. We will intensify and accelerate this process when we feel it necessary, whether due to a run of particularly poor performance or non-performance-related issues (e.g., team turnover).
In addition to our ongoing, existing manager due diligence, we are also doing work on several new equity managers as well as other asset classes and strategies that we believe have the potential to add to our portfolios’ long-term performance, particularly in the context of the challenging and volatile environment we anticipate over the next several years.
As always, we will continue to challenge the assumptions that underlie our views, consider new information as it becomes available, and stay intellectually honest in making well-reasoned investment decisions for our clients. We appreciate your continued confidence and trust.
~ Pacifica Wealth Advisors
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter (article), will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this report serves as the receipt of, or as a substitute for, personalized investment advice from Pacifica Wealth Advisors, Inc.
Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings do or will correspond directly to any comparative indices.
Please remember to contact Pacifica Wealth Advisors, Inc. if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of our current written disclosure statement discussing our advisory services and fees continues to remain available for your review upon request.
About the Independent Financial Advisor
Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.