First Quarter 2012 PerspectiveMarch 2012
THIS RECOVERY HAS LEGS
Why amid hand wringing over Europe, China, the U.S. deficit, tepid job growth and the prospect of higher taxes did U.S. stocks shoot up by 24% from their October 3 low (CHART 1)?
Analysts Are More Optimistic about 2012 Earnings
Early last year as analysts and investors peered ahead into 2012, they concluded that a second recession was the likely outcome as Europe imploded and China fought to curb inflation and real estate excesses. These together would likely push the lumbering U.S. recovery into reverse. Analysts consequently spent 2011 marking down their estimates for this year’s earnings for each of the first three 2012 quarters. In the fourth quarter, however, their pessimism abated as they calibrated the impact of compromise and flexibility among the EU leaders and progress toward blunting inflation within the emerging economies. In this light, the strong worldwide equity rally makes sense.
Deleveraging, while Painful Now, Is a Long-Term Positive
Deleveraging in the U.S. is impressive, with household debt as a percentage of GDP down from 130.1% at the beginning of the recession in 2009 to 114.2% as of the end of September, the latest reading. Of course, the massive liquidation of mortgage debt is responsible, and the price has been elevated joblessness. Despite Americans’ progress, it has been shown that the level of debt, whether taken on by government, by businesses or by households, no longer adds to economic growth in much of the world As the chart suggests, nations with debt levels trending above 250% have a bleak outlook (CHART 2). The U.S. is in an enviable position-as long as we make progress in reducing debt and deficits.
Despite Earnings Optimism, Global Deleveraging May Mean Continued Bumps in the Road
What does the rising optimism about earnings confronted by the harsh policy imperatives of global deleveraging mean for investors? First, as a general conclusion, the presidential campaign, despite whatever the daily news cycle bellows, is all about resolving the gloomy slow-growth, low job-growth outlook. The outcome on November 6 will demonstrate whether the political will exists to implement policies to support an increasingly older and less-productive population while investing for long-term growth. Higher taxes, either directly imposed or the result of eliminating "sacred" benefits such as the mortgage interest deduction, are highly likely. Our investment view is that the months ahead will be volatile as the many facets of this core question are debated.
If the Jobs Pendulum Continues To Swing Our Way, We Believe the Domestic Outlook Is Quite Good
We believe that the U.S. occupies a strong position to navigate through this uncertainty. The dynamism of U.S. business supported by law and custom is the envy of the world. As strong growth continues in the emerging world, the cost of labor has risen, challenging the relative attractiveness of the low-cost manufacturing and exporting model. The result is that high-paying manufacturing jobs are returning to the U.S., and rising shipping expense further accelerates the trend.
An important development is the rising supply of domestically sourced energy. As shale gas production increases, the relative cost of manufacturing in the U.S. will likely decline. This has obvious positive implications for heavy industries such as petrochemicals, metals and machinery manufacturing. Already, the Chicago Fed reports rising employment in its district, especially among energy producers (CHART 3). Our individual equity and industry sector selections are emphasizing these trends.
The domestic outlook is quite good in our view if the U.S. can return the large number of un- and under-employed workers to paying jobs and retrain the poorly educated to participate in this important global shift.
Inflation: The Markets—So Far—Do Not See It Accelerating
Investors are asking questions: will inflation accelerate, when, how quickly, and where is the threshold beyond which a broad-based rise in prices no longer boosts profits but instead distorts behavior? Today bond futures prices benignly suggest inflation will be at just 1.9% in five years.1
Indeed, while we watch for this tipping point, parts of the U.S. economy are benefitting from the global bias toward deflation. Many important costs—of financing and many raw materials—remain subdued, which helps profits as sales rise.
This unsustainable but happy state of low inflation and a recovering economy cannot last in our view, as the relative upward shift in labor costs in the emerging economies signals. We worry that the Fed will overstay its zero interest rate policy, now extended through 2014, as did the Greenspan Fed through the early 2000s. Signs of the changing more inflation-prone economic landscape are the rising velocity of money, following a prolonged post-Lehman decline, and growing commercial and industrial loans (CHART 4).
Investing through an Environment Where Deflation Gives Way to Inflation
The combination of rising money circulation (velocity), a liberal supply of new money from the Fed’s liquidity initiatives, the "QEs" and resurgence of bank lending, suggest accelerating economic growth. This, without doubt, is a happy event and consistent with our outlook for further upside surprises in economic reports. Dr. Bernanke, however, will have to be supremely deft or lead a Fed that repeats the mistakes of the past. We are concerned. This highly simplified diagram showing in broad terms the choices investors face in the four stages of inflation is useful for thinking about the likely future (CHART 5).
From the evidence, we are gradually moving from the lower-right into the upper-right quadrant. For over a year, our portfolio allocations have been adjusting with this trend in mind. Today, innovative companies with pricing power remain attractive to us, and U.S. companies are in an especially good position as noted earlier.
We have been, and continue to be, wary of bonds, particularly those with long maturities. This has been costly as global deflationary fears swept through financial markets pushing bond prices up and their yields down. This fear drove investors into U.S. government debt as Europe’s outlook waffled between crisis and muddle-along, reviving predictions of acute deflation (lower-left quadrant). The demand for U.S. Treasuries was also abetted by yield-seekers naively disregarding the price risk we see in long bonds.
We Are Optimistic about Opportunities in the Equity Markets
In conclusion, we continue to be optimistic that earnings will validate market prices, suggesting equities will offer greater reward than bonds. Selected equities also have dividend yields above those available from investment grade bonds. In many instances these dividends are supported by growing earnings, raising the likelihood of their increase.
- United States. The U.S. continues to offer a relative haven in our view, with its improving fundamentals validated by rising retail sales, jobs, bank lending and a gradual clearing of unsold houses.
- Europe. The muddle-through outlook for Europe appears in place after the recent European Central Bank (ECB) commitment to ensure banks’ liquidity. How long, however, the debt liquidation goes on and how long will Greeks, Portuguese, Spanish and Italians put up severe economic pain is unknown.
- China. The fears of a hard landing following China’s massive post-Lehmann stimulus have abated as the government took steps to relax credit in order to head off real estate bankruptcies. China, the continuing engine of global growth, now looks poised to accelerate in our view. The implication of China’s active participation in resolution of the Eurozone sovereign debt discussions is also encouraging and suggests that the economic threat of a Chinese banking/financial crisis has abated, giving room to expand its global reach.
An Improving Global Economy, but Not Without Risks
The global economy and markets are improving and we have sought to position portfolios to benefit. Real and imagined risks abound, led today by plausible military action in the Gulf to take out Iran’s nuclear ambitions. Oil traders have noticed and the Brent crude price is up 21% from the October 4 low. No one can foresee if an attack will happen or the long-term impact on world growth if it takes place. It is wise to keep some cash available in our view. Also, after such a sharp recovery from early October, equity traders may not need much excuse to lock in profit. We do not, however, anticipate a pronounced correction in the months ahead.
1. Cited by Ned Davis Research.
2. Bank for International Settlements; The Real Effects of Debt, Stephen Cecchetti et. al.
FIXED INCOME PERSPECTIVEA Changing Attitude Toward Risk Presents Opportunities Beyond Treasuries
Over the past quarter we have seen a substantial recovery in financial markets, essentially reversing some of the declines that we experienced during the latter part of 2011. Although major challenges remain in the world economies, positive developments have shifted investors’ focus from persistent headline news fixated on the public sector back to the private sector. Risk aversion and the recurring flight to quality created elevated risk premiums that have begun to abate as investors’ view toward taking on risk is becoming more balanced.
The Disconnect Between Rates and Data Is Correcting
The market recovery early in the quarter was across the board with the notable exception of the U.S. Treasury market. The 10-year Treasury yield remained below the 2% level, despite tangible progress in Europe, recovery in financial markets and the avoidance of a double-dip recession. Since mid-fourth quarter 2011, we saw signs of a developing disconnect between macro fundamentals and the yield level of U.S. Treasury notes. The hotly debated reason for that disconnect became academic as Treasury prices posted a sharp, four-day sell-off in mid-March. This came on the back of a seemingly begrudging Fed upgrade of the U.S. economy, dramatically reducing the probability of a third round of quantitative easing.
Interest Rates Remain Artificially Influenced
In addition to growth and inflation expectations, the Treasury market is highly influenced by myriad fundamental and technical factors. Three years after the credit crisis, the interest rate environment still remains artificially impacted by these factors. The Federal Reserve’s various policies and programs have been designed to push inflation-adjusted interest rates below zero (CHART 1).
We Expect Yields to Hold Steady in the Near Term
Even after the mid-March backup, we believe the greatest influence affecting U.S. Treasury rates is the overwhelmingly positive technical position of the market. The Federal Reserve and foreigners have dramatically increased their holdings of U.S. Government debt. This central bank intervention has resulted in demand continuing to outpace supply, even after a period of unprecedented Treasury issuance. The outright supply of global debt that investors perceive to be risk free is clearly shrinking.
Our View Remains Cautious on Municipal Bonds
We continue to find the tax-free nature of munis appealing, and we are finding value in short-intermediate maturity high coupon callable bonds, short maturity higher-quality healthcare bonds and essential service revenue bonds. That said, our view on the asset class remains cautious as the low absolute level of rates has led to diminished relative value. And in spite of improvements in tax revenues in many states, overall tax collections are still not back to pre-recession levels and credit downgrades continue to exceed upgrades.
We Are Seeking Incremental Yield in Investment-Grade and High-Yield Corporate Bonds
We are seeking to add incremental yield to portfolios with select corporate bonds issued by companies that have strong fundamentals and solid credit profiles. Yields on intermediate-term investment-grade corporate bonds are attractive relative to Treasuries. We expect continued improvements in the economy to further strengthen corporate balance sheets as well as increase investor appetite for increased risk, benefiting the corporate bond asset class.
STRATEGIC ASSET ALLOCATION
Increased Equity Allocations Support Our More Optimistic Outlook
- Our tactical allocation recommendation is approaching our long-term strategic target, reflecting our generally more optimistic outlook.
- We are seeking to increase exposure to U.S. multi-national firms that have strong fundamentals, a history of dividend increases and above-market yields.
- Our emerging market allocation is in line with our strategic target, as we expect relatively faster growth in these markets.
- The 2012 GDP growth rate is forecast to be 5.4% for emerging markets versus 0.8% for the developed world. The U.S., however, is expected to grow at approximately 1.9%.1
- Our fixed income recommendation remains below our long-term target due to the continued low rate environment.
- We expect Treasury yields to hold steady in the near term as strong demand for risk-free assets continues alongside the Federal Reserve’s commitment to keep rates low.
- We are seeking to add incremental yield to portfolios with select investment-grade and high-yield corporate bonds issued by companies that have strong fundamentals and solid credit profiles.
- We have been selectively redeploying cash into carefully chosen, high-quality U.S. and emerging market stocks as opportunities present themselves.
FIDUCIARY TRUST FORUM
Perspective on Emerging Markets: A Gradual Shift from Low Cost Exporters to Consumer-Driven Economies
A long-term positive theme for emerging markets is their gradual transition from low cost exporters to consumer-driven economic models. Our Fiduciary Trust Forum members discuss the growth opportunities related to this transition, and share insights on the investment potential they see within the emerging markets.
Q. Emerging stock markets were among the worst performers in 2011 but have rallied so far in 2012. Do you see this positive momentum continuing?
Bibi: Stock markets in the developing world significantly underperformed last year despite their favorable economic fundamentals and reasonable valuations. They were penalized by a risk-averse sentiment as investors chose to stay close to home due to concerns about the slowing global economy and the European debt crisis.
Xavier: So far in 2012, emerging markets have already outperformed the U.S. by a wide margin--as of February, the MSCI Emerging Markets Index advanced by 17.7% in comparison with a gain of 8.5% for the S&P 500. And the 12-month P/E ratio forward outlook is relatively low, at 9 times (as of December 2011). This is very appealing to us considering that prices were 7 times earnings at the November 2008 low, and 28 times earnings at the peak in May of 1988.
Karen: The GDP growth rates in the highly-populous BRIC countries (Brazil, Russia, India and China) have slowed to some extent. However, the growth rate for emerging markets as a whole is expected to be 5.4% in 2012, well in excess of the 0.8% GDP growth rate forecast for the developed world. And, many of the emerging market economies are fiscally sounder. For example, China's debt ratio stands at just 17% versus 100% or more on average for the U.S. and Europe.
Bibi: As the middle class populations of the developing countries expand, their economies are evolving from an export-driven economic model to one which will be influenced to a greater degree by personal consumption going forward—a positive long-term trend.
Q. Would a recession in Europe change your outlook for emerging markets?
Xavier: We believe that in the near-term a European recession would pose a risk. Many of the emerging markets are heavily export driven, and the largest market for export for many of these countries is Europe. In fact, slower growth in Europe has already impacted exports--in 2006 18% of emerging market exports was going to Europe; by 2010 this figure dropped to about 13%.
Karen: We expect that concerns over the European debt situation and lower-trending worldwide economic growth may cause some volatility in the short-term. However, we believe that over the long run, the slowdown in the developed markets should be mitigated by relatively increasing emerging market growth, including consumer demand growth from the new and growing middle class and the need for basic infrastructure development.
Q. What is your perspective on the threat of inflation?
Wayne: Inflation is a very serious challenge in emerging market countries. In the U.S., primary drivers of inflation are salaries and wages. But outside the U.S. rising commodity prices, food prices and energy prices in particular are typically subsidized and are therefore burdensome for emerging market governments, impeding capital spending.
Karen: Last year both Brazil and India were experiencing inflation and the governments implemented policies to raise interest rates. And China’s government took steps to relax credit in order to head off real estate bankruptcies. These government measures had a dampening effect on the equity markets, and on financial stocks in particular. We have seen this negative impact reversing, however, as inflation is perceived to have stabilized in certain countries. Central bankers worldwide are increasingly coordinated in their policies and actions.
Q. What are the most promising themes you see benefiting investors?
Bibi: We expect three big themes to present opportunities—consumers, commodities and infrastructure. These are largely driven by the population growth and the expansion of the middle class. The emerging market population is five times that of the developed world and has almost tripled since the 1950s, from approximately 2 billion to 6 billion, while that of the developed world remains flat at the 1 billion level.
Xavier: The consumer demand in emerging countries for what are considered basic items in the developed world has been staggering—consider that just 1% of rural Chinese households owned refrigerators in 1990 vs. 37% today; 9% owned washing machines vs. 53% today; and 0% owned computers vs. 7% today. And, because of the younger demographics in the developing world and the rising living standards of the middle class, we anticipate a long-term continuation of this trend.
Wayne: We expect emerging markets to be a major driver of our second theme, commodities, given the continued demand from growing economies as well as supply constraints globally. Commodities are needed to support the rapid infrastructure build out and population boom that is taking place, and demand is increasing for everything from precious and base metals, to grains, proteins and energy. In fact, China’s crude oil imports have increased from 36% of the world’s imports in 2005 to 47% in 2009.
Karen: Infrastructure demand in virtually every emerging markets country will drive demand for power generation, transportation, and the efficient use of resources, including water, for years to come. China already has the largest high speed rail system which is connecting major cities across the country. By high speed train, a trip to a city outside Shanghai which would have taken two hours by car now takes just 30 minutes.
Q. How are you achieving emerging market exposure in portfolios?
Wayne: In addition to individual securities, actively managed mutual funds and Exchange Traded Funds (ETFs) provide necessary diversification benefits for emerging market exposures. In our opinion, all emerging countries have unique characteristics. As such, their markets will react differently under various conditions, making diversification a very important aspect of investing in these markets.
One of the more interesting approaches we have been implementing is to incorporate select ETFs into portfolios for their ability to generate dividends. With the continued low interest rate environment, these vehicles can be an effective way to add an income component to an emerging market investment because they utilize a methodology that rewards emerging market companies that pay dividends. They have also tended to be less volatile investments because they typically have a value bias.
Karen: We use our extensive research capabilities across the firm to identify emerging market companies that we believe will be the benefactors of growth, especially in keeping with our consumer, commodity and infrastructure themes. In particular, we believe several automobile manufacturers and other durable goods manufacturers are well-poised for growth, as well as select consumer staples companies and makers of luxury items.
Bibi: In addition to the direct exposure to the emerging markets asset class, most leading multinational companies are now deriving a greater portion of their sales and earnings from the developing world. In fact, the emerging markets contribution to the earnings of large-cap multinational firms is now reaching nearly 20%, significantly higher than just a decade ago.
Wayne: We are also finding attractive emerging market opportunities in the Alternative Investments space. Hedge Fund managers have developed techniques that can reduce the volatility associated with the asset class, albeit while sacrificing robust upside returns.
The opportunity set has also expanded beyond traditional public market equities to include debt instruments, both sovereign and corporate debt, as well as private equity investment vehicles. Although these areas can be complex, we are finding select investment professionals in the alternative investment industry who are achieving attractive risk/reward characteristics.
Q. What is your outlook for emerging markets for 2012?
Wayne: We are cognizant that there are risks in these countries and within these companies—there are plenty of examples of this last year. We believe market volatility is likely to remain, and could even increase in the near term due to uncertainties, including economic conditions in Europe, China’s ability to achieve a soft landing and geopolitical concerns in the Middle East.
Bibi: On many levels the emerging markets are no longer emerging, but leading, as they are projected to be major drivers of global growth going forward. Barring the challenging environment experienced last year with the tsunami in Japan, the U.S. debt downgrade and the debt crisis in Europe, we expect emerging markets will continue to be an attractive asset class for investors. Given their historic volatility level, we are recommending a moderate but meaningful allocation.
FIDUCIARY TRUST FORUM MEMBERS: Bibi Conrad, Managing Director, New York; Karen Fang, Managing Director, New York; Xavier Martinez, Managing Director, Miami; Wayne Sprague, Managing Director, New York
This communication is intended solely to provide general information. The information and opinions stated are as of March 8, 2012, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.
Mackin Pulsifer, Vice Chairman and Chief Investment Officer
Ronald Sanchez, EVP and Director of Fixed Income Strategies
Bibi Conrad, Managing Director
Karen Fang, Managing Director
Xavier Martinez, Managing Director
Wayne Sprague, Managing Director
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