Fourth Quarter, 2010
This year 2010 ended on a very strong note as reflected in the substantial increase in client portfolio returns compared to account performance through the third quarter of 2010. Some of the items which have influenced our thinking regarding tactical revisions to client portfolios are presented in the bullet point below.
Looking over this abbreviated list of factors affecting your asset allocation illustrates the need to continuously juggle many pieces of information with the significance of each varying over time and with new considerations constantly entering the equation. Old issues occasionally re-flare up, and then eventually subside. Investors react differently to similar information at different times. It got us to thinking that effective portfolio management can be likened to juggling different sized and weighted balls in the air while skating across a frozen lake heading in the direction of increasingly thin ice (being our deficit time bomb).
In order to effectively manage your portfolio, we engage in a process of constant re-evaluation of economic indicators and the markets' reactions to these indicators. Fortunately, there are a growing number of investment-type indicators that track and therefore give signals about various risks associated with all stock, bond and commodity markets.
At the end of the day, we use judgment to determine your asset mix, based upon our familiarity with your personal situation. As the fourth quarter progressed, factors such as the gathering strength of the U.S. recovery coupled with low interest rates, low CPI inflation, increasing growth rates in emerging markets, and increasing strength in commodities markets have led to an increase in your equity exposure.
Because the negative risks to the economy remain significant, we haven't thrown all caution to the wind. That's why your equities remain below the high end of your agreed-upon range. One of the top areas of concern remains our high unemployment rates. We present below a study by BCA Research of the trends in unemployment from past recessions. The chart clearly illustrates three points. First, employment recovery times have grown steadily longer during the past forty years after each recession. Second, the impact of our most recent recession, having a financial crisis at its heart, has been more severe than any other since the Great Depression years. Finally, the current employment cycle has passed through its low point and has now entered a slow but steady recovery period.
Net job creation plans are looking up in virtually all industries with the present exception of construction. Even this lagging area, however, may generate some surprising improvement in the second or third quarters given the powerful rise in the Architecture Billing Index, now at its highest level since 2007. Improvement in this index precedes improvements in construction industry employment.
Various investment themes which we used as a basis for portfolio decision making during 2010 bore fruit during the fourth quarter and have continued in the new year. Particularly gratifying was our decision to focus on industries that would benefit from supply shortages as the U.S. and other developed countries began growing again in unison with emerging markets. Demand for many products today is such that shortages exist or are expected to exist across a wide spectrum – grains, base metals (such as copper, aluminum, tin, and lead), oil, rare earth metals, water, and fertilizers, to name a few.
The point at which creditors begin to lose confidence in a country's debt servicing capability varies from country to country. For the U.S., there will clearly be some threshold level when panic sets in, but because the dollar is the world's major reserve currency, the point at which confidence collapses may entail a much higher level of leverage than that of other countries. It also helps a lot when the world is enjoying a period of economic growth coupled with low levels of inflation.
We are of the opinion that our improving economy will temporarily reduce investor concern regarding the U.S. federal debt level. This is likely to be a relatively short term reprieve as our economy continues to strengthen. Longer term (i.e., 3-5 years from now) we are considerably less sanguine. Politicians today are only focusing on the 15% portion of the budget which involves discretionary spending while ignoring (still) the 85% which is at the heart of a non-functioning spending discipline. According to the Wall Street Journal, more than $2 trillion of this year's $3.5 trillion federal budget consists of mandatory spending. Medicare, Social Security, and interest on the federal debt will be what eventually break the country. So far, the President and Congress continue to sidestep serious debate on these issues.
When the Greek financial crisis first hit the panic stage, the European Central Bank (ECB) and the members of the euro zone (those countries using the Euro for their currency) came through with the cash to quell the riot. More recently, when confidence in the Irish banks collapsed, the ECB came through again with the needed cash to restore liquidity in that government bond market. Portugal is widely believed to be the next country in need of a bailout when their bond market reaches the riot stage. Adequate funding for aiding Portugal is available as well.
A clear pattern has emerged in Europe since the recent Greek crisis began. European leaders squabble and fuss while local sovereign markets simmer just below the boiling point and then unite when the pot starts to boil over. There are practical reasons underlying this high stakes gamesmanship on the part of the ECB and country politicians.
First, all European leaders believe saving the Euro is of unquestionable importance. The economic power of the euro zone is not trivial. All countries using the common currency recognize they are better off in the euro zone than outside of it. Second, the local populations of the stronger economic countries hate these bailouts so their leaders are loathe to act until their backs are to the wall and they have no other choice to preserve the union. Third, it is in the interest of each member country to support the euro zone because the euro is a more stable currency than the former currencies of each of the individual countries. That is why other European countries continue to jump through hoops, even at present, in their efforts to become euro zone members.
Finally, ECB officials are moving in the direction of creating global financing alternatives including special purpose "facilities" with global borrowing capacity as a source of funds for the benefit of financially stressed member countries. One such facility is the European Financial Stability Facility, created in May, 2010, that has at its disposal up to 750 billion of euro backing¹. Its first bonds were sold on January 25, 2020 for the benefit of Ireland's present financial needs. Investor demand from around the world for these AAA rated securities was nine times greater than available supply. Faith in the long-term viability of the euro zone persists!
Your portfolio's 2010 full-year performance can be compared against the frames of reference presented below:
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Money Market Fund Proxy
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0.0%
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0.0%
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Russell 3000 Index (US stocks)
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11.6%
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16.9%
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MSCI EAFE Index (foreign stocks)
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6.7%
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8.4%
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MSCI Emerging Market Index
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7.3%
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18.9%
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Aggregate Bond Market Index
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-1.3%
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6.5%
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MSCI REIT Index
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7.3%
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28.4%
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Gold (Commodity)
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8.6%
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29.5%
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CRB Commodity Index
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16.1%
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17.4%
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CPI Inflation (12 months-Sept)
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1.5%
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Cash
Cash returns, either through money market funds or treasury bills, remained near zero during the fourth quarter and for the year as a whole. Presently, the Fed continues to take the position that the economic recovery is still too weak to allow short term rates to rise to a more natural level reflective of today's actual economic performance. By holding short term rates near zero, the Fed continues to force investors to take investment risk in pursuit of any level of return.
Equities
While emerging markets once again generated the strongest equity returns for the year, the middle of the fourth quarter saw U.S. stocks start to outperform the rest of the world. Perceptions appear to be shifting back to the U.S. as an engine for global growth for perhaps the next couple of years. We believe this is a promising development for 2011 stock market performance. A plethora of favorable economic statistics coupled with generally reasonable market valuations has led us to begin increasing client equity exposure during the fourth quarter. Given the generally favorable global growth prospects at this time, we would view any stock market pullbacks as opportunities to add to client equity positions.
Fixed Income
The fourth quarter dealt the U.S. bond markets a setback as inflation expectations and longer term interest rates began to rise after Fed Chairman Bernanke announced his second program of monetary easing (QE2). During the quarter we reduced client bond fund holdings coincident with the rise in inflation expectations and began purchasing, in all but the smallest accounts, individual investment grade corporate bonds with maturities in the 2-5 year range.
¹ For some perspective on this sum, according to BCA Research, the entire outstanding debt of Greece, Ireland and Portugal combined is 620 billion euro, equal to 6.8% of euro area GDP.
We also sold virtually all client municipal bond fund holdings, as this segment of the fixed income market began to experience what appears to be indiscriminate panic selling by investors.
Certain segments of the bond market have continued to perform well during the fourth quarter, including junk bonds and variable rate bank loan funds. We continue to maintain investment in these areas because both continue to benefit from the improving economic environment.
Other
Our strongest asset class returns for the fourth quarter and for the year have come from our commodity fund investments. While gold (GLD) outperformed our other commodity funds for the year, a clear change in performance leadership occurred in the fourth quarter. Extreme weather patterns around the world, "quantitative easing" by the Fed (QE2) and positive economic surprises here in the U.S. resulted in sharply rising agricultural and base metals commodities prices during the fourth quarter. Thus, the theme of economic growth has now trumped the theme of precious metals for protection against economic collapse.
We believe gold has peaked for now and we have reduced (but not eliminated) client holdings accordingly. Our reasoning is based on certain recent trends: 1) rising real (after inflation) interest rates present new profit opportunities in fixed income markets; 2) growing global economic vigor enhances the attractiveness of investments which create the potential for economic gain; and 3) the European countries, now assisted by Japan and China, are demonstrating an increasing willingness to lend money to the financially stressed European countries. Japan and China's willingness to come to the financial aid of Greece, Ireland, Portugal, etc., is a shrewd move on their part and an important milestone, in our opinion. We continue to monitor this situation.
Federated Money Market Funds
Due to the extraordinarily low returns on short term commercial paper, UMB Bank decided to terminate their in-house money market funds – the Scout Funds. In lieu thereof, clients of the bank's trust department will have all available cash balances in their account(s) swept daily into a Federated money market account.
This decision was based on economics from UMB's standpoint, as expenses incurred operating the Scout Funds exceeded revenues generated from the investment portfolio. Your sweep money market account will soon be with Federated Investors, whose money market funds are much larger than the Scout Funds, enabling them to spread operating costs over a larger investor base.
Other than a name change for your money market account this transfer is of no material consequence to you. It is not necessary for you to contact UMB Bank regarding this transaction. The bank estimates that this change will be effective around the end of February.
We look forward to discussing your thoughts regarding this quarterly letter.
Sincerely,
Sheffield Investment Management, Inc.