For the third quarter 2012, here’s a quick rundown of the biases we’ve built into our model portfolios. For a bit more color, read on below
- Global government bonds offer no value for longer-term investors. Instead we’re focused on mortgages, high-grade and high-yield corporates, and other credit-sensitive sectors.
- After benefiting from a bias towards growth for the past year, the time has come to begin favoring value over growth in our U.S. equity exposure. We’re tilting towards value throughout all market cap sectors.
- While holding our collective noses, we’re tip-toeing back into international value and small cap.
- Emerging markets remain a secular trend that we want to remain exposed to.
Economic growth is slowing rapidly within the vast majority of developed and emerging markets - even in the face of very, very accommodative global monetary policy. This speaks to the strength of structural deflationary trends that have been in place since the U.S. housing bubble burst in 2008.
Global government bond markets have ferreted out the renewed slowdown, and key interest rates have responded by dropping accordingly. Extremely low rates across the U.S. curve are troubling for at least three reasons. First, they’re being manipulated artificially lower by the monetary authorities – where would we be without intervention?
Second, even if rates stay where they are, returns from sovereign bonds are unlikely to keep up with inflation. Finally, even a small move up will translate into a formidable capital loss. If 10 year rates were to move from 1.6% to 1.85%, the value of a 10-year note would fall about 2.25%, wiping out about 17 months of income. There is simply no value in bonds except as a speculation that the economy slows down further.
Non-government income investments - such as corporate high-grade and high-yield bonds, mortgages, preferred stocks, oil & gas MLPs, etc. offer better yields for investors and in our opinion will ultimately prove more credit-worthy than their sovereign counterparts. Combining these assets should continue to out-perform treasuries, albeit at the cost of a bumpier ride, and where possible, our models are now firmly biased in this direction.
Over the past few years, the U.S. stock market has by-and-large been driven by the Federal Reserve’s continued printing. Fears of economic slowdown lead to expectations of further monetary stimulus, supporting stocks significantly above where they would otherwise trade in our opinion. All things come to an end, and monetary easing is no exception – market players have begun pricing this in. Since October when the Fed offered its latest support program, cyclical, small cap and emerging markets (which all typically lead the market) have all severely under-performed their large-cap and growthier brethren.
For the past few quarters our models have been overweight growth, to our benefit. Yet with differences in valuations now at extremes, we’re shifting course to take on more of a value tilt.
Europe makes up over 60% of the developed international markets and it’s a mess; a perfect example of how not to overcome a crisis! Our strong belief is that the continent unravels further and our instinct is to stay completely clear until it does. That said, valuations are very compelling in the more cyclical market sectors (banking, energy, natural resources) and liquidity starved small caps. With hesitation we’re tip-toeing in, although we expect most models will remain significantly under-weight international relative to comparable target-date funds.
Emerging markets remain a secular growth story that we remain biased towards. They too are being impacted by the global slowdown (no escaping it), so don’t look for a decoupling in performance here over the short term, but the story remains intact longer-term.
Ultimately the path to renewed sustainable growth involves writing off, or at least aggressively restructuring, a bunch of personal, corporate and sovereign debts. Someone will take losses – it’s just a question of when, and who. The longer it takes, the greater the likelihood losses will be “socialized”, or foisted on the general population, as opposed to incurred by those who took the risks in the first place.