Fourth Quarter, 2009
As we begin 2010, an increasing number of U.S. and global economic indicators continue to point towards a strengthening global recovery with the most promising growth potential being generated in emerging markets around the world. Recently, for example, both the World Bank and the International Monetary Fund increased their estimates of the global growth rate for 2010. Client portfolio’s have reaped the benefits of this improving economic outlook as we continue to emphasize equities relative to bonds and cash. As the recovery continues to advance at home and abroad, rising demand for industrial and agricultural commodities has already begun to fuel new asset price speculation which may eventually result in new financial bubbles1 in the world’s strongest growth regions - primarily throughout Asia.
There’s not much chance of any near term speculative bubble behavior germinating in the U.S. however. High unemployment, retrenching consumers, falling home prices and banks that are deleveraging their loan portfolios present an overwhelming barrier to home-grown speculative behavior. Our economic recovery so far has been weak and the Fed has stated repeatedly that the risks of deflation and negative economic growth at home are greater than the risk of inflation, and their intention remains to hold interest rates at very low levels for an extended period of time. As we have stated in past letters, this Fed policy, coupled with low inflation, presents a favorable climate for stocks.
Fed-engineered low interest rates do have their negative side, as speculators are once again bulking up on low interest rate loans in the U.S. and investing the proceeds internationally in the high growth areas mentioned above. Countries experiencing rapid asset price appreciation at this time, particularly in real estate, include South Korea, Taiwan, Singapore, Hong Kong and certain areas in China. The Fed has acknowledged that our current low interest rate levels may be causing excessive risk-taking in certain markets. Fed spokespersons have now taken the position that if low interest rates at home are fostering speculative behavior in fast growing regions abroad, then dealing with the consequences is their problem, not ours.
Secular vs. Cyclical Trends
In the literature of finance, a secular period is one of great length – typically spanning many years or perhaps decades. Cyclical periods, on the other hand, generally pertain to shorter time periods even though occasionally they may also extend out for some number of years. Trends in the economy from growth through recession and back to recovery are considered to be cyclical.
Recently, fears associated with the downside economic consequences of certain secular trends such as the economic impact of aging baby boomers, rising government deficits, and rising air and water pollution, among others, have been clashing with the positive cyclical consequences of a generally improving global economic recovery. Stock and bond markets have been celebrating a gradual move back towards a period of more typical economic growth which may continue for as long as the next couple of years. What we have been witnessing since March, 2009 is the markets’ collective belief that cyclical factors are trumping secular concerns.
Again, for the present, governments’ collective actions have been focused on economic stimulus to fight the recent cyclical downturn. As was clearly demonstrated at the recent Copenhagen summit, long term concerns about the possible negative consequences of CO2 production and man-made global warming proved to be of secondary importance to fighting recession and preventing further job losses among both developed and emerging market nations. Given that we are still at the early stages of a global economic recovery, momentum has been on the side of the bulls and global stock markets have continued to move higher.
Resistant vs. Resilient
U.S. treasury securities are rated Aaa by the well known bond rating services such as Moody’s, Standard & Poors and Fitch. We have long enjoyed this exalted position among nations whose credit is in the top credit tier together with Germany, France, Canada, Switzerland, the UK and New Zealand. Now, for the first time, Moody’s rating service has begun to differentiate among Aaa rated sovereign (country) debt as many countries have been ratcheting up their total debt as a percent of GDP. Moody’s explains their position as follows: “The U.S. and the U.K. may test the Aaa boundaries because their public finances are worsening in the wake of the global financial crises.”
Moody’s now considers that the U.S. and the U.K. have resilient Aaa ratings, which they define as “countries whose public finances are deteriorating considerably but which display, in Moody’s opinion, an adequate reaction capacity to rise to the challenge and rebound.” In other words, finances are starting to look shaky but there is still time to address the situation before our Aaa rating is in jeopardy. Moody’s further describes the present U.S. and U. K. situations as “losing altitude” within the Aaa rating category.
By contrast a Aaa resistant country (Canada, Germany, France) does not have a debt-to GDP ratio which is concerning from a credit rating standpoint.
This is a serious matter for the U.S. as declining credit quality is almost always accompanied by rising financing costs. Should our country’s financing costs begin to increase due to the rising probability of a rating downgrade, the odds of a double dip recession will also increase. Politically the U.S. is now in a very difficult situation. Growing deficits and a rise in the public-debt-to-GDP ratio may force borrowing costs to rise at some point if our credit rating begins to suffer. However, the Fed, Congress and the Administration are loathe to cut back on stimulus support by cutting deficit spending at this still fragile stage of recovery for fear of causing a relapse back into the recent recession. The Congressional Budget Office analysis of the Obama Administration budget proposal to Congress anticipates 10 years of potential trillion dollar deficits. A long term counterbalance is that increasing deficits should cause declines in stocks and bonds that may force change upon politically-driven, possibly reckless economic behavior.
Tweaking our Strategy
We believe clashing cyclical and secular forces as described in this letter may create a period of intense market volatility in 2010. Investors are attempting to sort out cyclical vs. secular trends; global growth patterns vs. country-specific deteriorating debt concerns; inflationary vs. deflationary forces, etc. In sum, we are in the midst of a period of great uncertainty that may make it very uncomfortable for clients to watch their portfolios on a day-to-day or week-to-week basis this year.
The stock and corporate bond markets’ initial period of optimism resulting from a turn from deepening recession to budding economic recovery has, we believe, run its course. The easy money has been made. Stock P/E ratios and other measures of valuation have now returned to levels in line with long term averages. Stock markets around the world are now, we believe, reasonably priced. Our current view is that future gains in stock prices may become more selective. Under this scenario, companies will need to generate meaningful revenue and earnings growth if they are to enjoy further stock price appreciation during the next few years.
Our strategy during this period of anticipated turbulence is to replace under-performing companies in your portfolio with companies that are experiencing strong earnings growth at the present time and share an expectation of strong earnings growth over at least the next few years. We continue to believe that the world will experience growing shortages of key industrial and agricultural commodities over the new few years as long as we don’t experience a double dip recession later this year. Therefore, we continue to emphasize natural resource companies in your portfolio.
Since the beginning of December, 2009, inflation expectations have begun to move higher. In similar fashion, interest rates for all but the shortest dated government securities have also begun to move higher. It is too soon to tell if a new inflationary trend is taking hold or if this new development is nothing more than a blip within a longer-term deflationary trend. When interest rates move higher, bond prices fall and consequently, returns suffer. Out of an abundance of caution we have taken note of this early change concerning inflation expectations and interest rates and have begun modifying the fixed income portion of client portfolios as further described below.
Representative performance of different investment market segments are presented below:
12 months ending
4th Qtr. December 31, 2020
Money Market Fund Proxy 0% .2%
Russell 3000 Index (US stocks) 5.9% 28.4%
MSCI EAFE Index (foreign stocks) 2.2% 31.8%
MSCI Emerging Market Index 8.5% 78.5%
Lehman Aggregate Bond Market -.4% 3.0%
MSCI REIT Index
(Real Estate Investment Trusts) 8.9% 27.9%
Gold (Commodity) 8.8% 24.4%
Philadelphia Gold/Silver Mining Cos. 1.9% 36.6%
Commodity Research Bureau
(broad commodity markets) 9.2% 23.5%
CPI Inflation (12 months) .8% 2.7%
Stocks
Stock markets around the world hit bottom during the first week of March, 2009. Subsequently, they reversed course and thereafter generated one of the most explosive rallies of the past seventy years. The market rally cooled off considerably during the fourth quarter as stocks returned to long-term average valuations, prompting a modest change in our equity strategy as described above.
Emerging markets remained the global winner for the fourth quarter and for the year. It’s easy to see why investors have gravitated to this investment area during the past nine months. We believe the boom in emerging markets is not over as global infrastructure spending is still increasing and asset bubbles are at early stages of development. Our strategy continues to emphasize stocks in client accounts with a belief that emerging markets present the strongest growth potential.
Fixed Income
Treasury bonds had a very bad year in 2009.
Investment grade corporate bonds had a good year.
High-risk junk bonds had a great year.
Our bond market was influenced by two primary factors during 2009: 1) rising treasury interest rates throughout the year and 2) improving corporate credit quality as the recovery began to take hold across the economy. Treasury securities’ returns are determined by their coupon interest rate and more importantly, by the change in interest rates during the time period being measured. For 2009, the increase in rates was significant for all treasury securities having maturities of 6 years or longer. Shorter-term treasuries were effective controlled by the Fed. For example, the 10-year treasury saw its yield increase by 73%, from a January 2nd low of 2.2% to a December 31st high of 3.8%. As a result of this interest rate change the 10-20 year maturity treasury bond ETF for example, had a 2009 total return of -9.1%.
Investment grade corporate bonds experienced yield declines (price increases) during the year as fear of economic catastrophe gradually gave way to a growing belief in recovery. Junk bonds experienced huge price increases as yield declines ranged from 5.5 percentage points to as much as 7 percentage points depending upon term to maturity and credit rating.
The bond portion of client portfolios contained investment grade corporate and junk bonds (mostly convertibles), or funds which owned these types of bonds. We did not have any meaningful position in treasury securities in client portfolios during 2009.
Recently we began reducing exposure to longer term investment grade corporate bonds or bond funds in favor of relatively short term bond investments as we continue to monitor the rising trend in inflation expectations.
Other Assets
REITS and commodity-type holdings – primarily gold related – both enjoyed strong market returns during 2009. As we noted in a previous letter, gold was most heavily influenced by changes in the value of the dollar, which itself is a reflection of confidence (or lack thereof) in our government’s economic policies. We also noted in our past letters that gold price movements do not correlate well with either inflationary or deflationary trends.
The overall REIT market did surprisingly well considering the poor performance of residential and commercial properties. Real estate markets remain in deep financial difficulty considering the damage this sector has done to banks’ financial stability. Investors are looking across a long valley when envisioning brighter future days for this industry. Nevertheless, a growing optimism is being evidenced in the REIT sector.
In sum, our present view is that global equities remain the most attractive asset class compared to the alternatives being; a) short-term bond investments which currently offer no return and b) longer-term bond investments which are negatively impacted by rising interest rates or expectations of same. Furthermore, we believe the time has not yet arrived when secular trends will cause a return to a bear market investment mentality.
Sincerely,
Sheffield Investment Management, Inc.