January 16, 2013
December 31 has come and gone, U.S. politicians have slapped some patches on the U.S. fiscal plan, and global financial markets have been following the path of economic growth and monetary policy. Congress made permanent most of the Bush-era tax rates, while increasing rates on high-income taxpayers. As we had expected, this patchwork deal left much work still ahead — including raising the debt ceiling, dealing with mandated spending cuts (sequestration) and continuing to fund the government. The next round of discussions promises to be even more difficult, with the Republicans unlikely to approve new taxes while the Democrats may balk on entitlement reform. While we expect financial markets to handle these negotiations with an increase in market volatility, our risk case is that the markets will view the next agreement as anti-growth if it's too reliant on revenue increases and provides insufficient long-term spending control.
We enter 2013 with a new headwind to U.S. growth, courtesy of fiscal cliff tax increases of about $200 billion (or 1.3% of gross domestic product). Hopefully, the momentum displayed in the global economy as we exited 2012 will provide some backstop to growth. Global manufacturing new orders rose each month during the fourth quarter, and employment and output followed suit. Emerging-market and U.S. economies showed strength, while Europe and Japan remained laggards.
Even though growth is showing some momentum, inflation remains dormant in the developed world, while picking up slightly in developing economies. We still see this environment as one in which monetary policy remains highly accommodative, with investors gradually beginning to question the duration of the extremely low interest rate policy during the next year. While uncertainty around U.S. fiscal policy should remain high, we continue to favor risk-taking in this environment. We see slow but steady economic growth and low yields across investment-grade fixed income, leading investors increasingly to seek income and capital appreciation through risk assets such as stocks.
- Equity funds have seen significant net outflows during the past five
- We believe the stage is
set for a rotation back
Investor concerns about volatility and fiscal policy have driven significant equity fund outflows. Despite this, the S&P 500 outperformed other asset classes with a 16% return in 2012. With earnings and market volatility subsiding with distance from the credit crisis, and as international concerns either failed to materialize or have been addressed by policy response, we believe the stage is set for a rotation back into equities after years of outflows. Equity valuations are attractive relative to history, and when low valuations are combined with record-low interest rates, the equity risk premium is at its highest level in more than 25 years. Finally, in the current low interest rate environment, equities are also a source of yield for income-oriented investors.Europe & Asia-Pacific Equity
- Promises of economic reform in Japan provided a boost to equity prices.
- Skepticism remains over the efficacy of programs given structural headwinds.
Building on second-half momentum generated by the European Central Bank's pledge to "do whatever it takes to save the euro," Japan's newly reappointed prime minister, Shinzo Abe, has pledged to do whatever it takes to reform Japanese economic policy. Policy initiatives pursued thus far include both fiscal and monetary, with Abe pushing a $116 billion stimulus package and pressuring the Bank of Japan to target a 2% inflation rate — not an easy task considering that Japan's year-over-year consumer price index has remained mostly negative since the Great Recession. Stock markets have responded positively to Abe's aims, but we remain skeptical — talk of economic reform emerges in Japan much more often than action, and structural headwinds in both Japan and Europe continue.Emerging-Market Equity
- Emerging-market stocks spring back to life.
- Keep an eye on developing Asia as a barometer for emerging-market growth.
After lackluster performance through much of 2012, emerging-market stocks caught fire late in the year and managed to outperform world markets for the full year. We have been citing improving Asian trade data as an early sign of improvement, and Chinese export and import strength in December corroborates this trend. While Brazil, Russia, India and China receive most of the attention, the cumulative size of China, Korea and Taiwan is just as large, and developing Asia collectively represents 60% of the MSCI Emerging Market Index. Monetary policy across emerging markets has become more supportive during the last year as inflation has slowed, but this cycle should start to turn as growth accelerates. We believe recent increases in China's wholesale food prices are likely transitory, however, and shouldn't present a roadblock to improving Chinese growth trends in 2013.U.S. Fixed Income
- The Barclays U.S. Corporate Index returned nearly 10% in 2012.
- Positive fundamentals and above-average spreads support high-grade bonds.
Despite corporations issuing a record amount of debt in 2012, their balance sheets remain in excellent condition. The uncertain political and economic environment is causing corporations to hold more cash and remain cautious investing in their businesses. Corporate credit spreads to Treasuries also remain much higher than normal, despite having tightened measurably in 2012. Investors can receive double the yield today by investing in corporate bonds vs. U.S. Treasuries. As such, we retain a positive outlook on this sector predicated on our outlook for continued slow economic growth in the United States and reaccelerating growth in emerging-market economies. Despite our positive outlook, investors should expect lower returns for this asset class in 2013 in light of the exceptionally low level of current interest rates.U.S. High Yield
- Revenue and earnings growth has been slowing during the past four quarters.
- The high yield coupon provides a cushion that's not found in other asset classes.
Revenue and earnings growth has been decelerating, but the smaller and more domestically focused companies found in the high yield market have outperformed their larger and more globally oriented counterparts. High yield issuers have been more insulated from weakness abroad, and they also have relatively less exposure to global input costs, which have been boosted by the depreciated dollar. Given current valuations and slowing growth, the coupon earned in the high yield market provides a cushion not found in other asset classes. Future returns in high yield, however, are likely capped by the current low interest rates. We see little prospect for further spread tightening, leaving total returns captive to the coupon payments received by investors.
- Futures-based commodity index returns were negative in 2012.
- Equity-based natural resources fared better given their equity risk premium exposure.
Futures-based commodities had a difficult time in 2012. Although spot prices increased 3.7% in aggregate during the course of the year, those increases (and then some) were priced into futures contracts, resulting in a negative overall return for the asset class. Some actively managed futures indexes, which take a more sophisticated approach to rolling forward futures contracts, provided positive returns for the year. Collateral yield, long a source of returns for commodity strategies, generated only 0.08% in income due to the low interest rate environment. An equity-based approach to commodity exposure, as measured by the Morningstar Global Upstream Natural Resources Index, generated a 9% return in 2012. The extra return is due, in part, to the equity risk premium attached to this method of commodity exposure, with the side effect being that it provides less diversification than its futures-based counterparts.Conclusion
We face a global economy today still constrained by the aftereffects of the financial crisis. We believe European growth in 2013 will continue to be hindered by austerity measures, while the drag on U.S. growth from increased taxes is a direct result of efforts to address budget deficits exacerbated by the financial crisis. Japan's policy outlook is the most interesting in years, but the promise of much easier monetary policy is too weak of a foundation to project a sustainable new growth trajectory. Emerging-market growth is showing signs of improvement, domestic demand has been relatively strong and exports are showing tentative signs of improvement. The ongoing deleveraging in the developed world, however, may cap the level of potential growth.
In this world of highly divergent economic conditions, we're focusing on those economies in which we have the strongest growth outlook. This leads us to favor emerging-market and U.S. equities at the expense of European and Japanese stocks. Fixed income investing has become only more challenging after another year of central bank balance sheet expansion, as real yields on quality sovereign debt are negative and credit spreads have continued to shrink. We continue to favor higher yielding assets, such as real estate and high yield, at the expense of investment-grade debt.
Our outlook considers both the downside and upside risk scenarios. Our downside risk cases include a near-term concern of anti-growth policies emerging from the next round of U.S. fiscal negotiations and an intermediate-term concern over how long global monetary policy can stay so easy. On the flip side, the private sector could surprise on the upside given the relative health of corporate balance sheets and early signs of cyclical improvement. As we assess the balance of risks, we think the outlook for risk assets during the next year remains constructive and we prefer them to investment-grade bonds.
Consumer Price Index a measure that examines the weighted average of prices of a fixed basket of consumer goods and services (such as food, transportation, shelter, utilities, and medical care), and is widely used as a cost-of-living benchmark.
Option-adjusted spread measures the yield spread between similar securities (typically bonds) with different options, such as prepayment or call options, which are very interest rate sensitive.
Yield-to-worst is the lowest potential bond yield received without the issuer defaulting, it assumes the worst-case scenario, or earliest redemption possible under terms of the bond.
The Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers that meet specified maturity, liquidity, and quality requirements.
The Dow Jones-UBS Commodity IndexesSM are composed of exchange-traded commodity futures contracts rather than physical commodities. By tracking commodity futures rather than commodity "spot" prices (meaning the prices quoted for immediate payment and delivery of physical commodities), the indexes are investable benchmarks, meaning they can generally be replicated using futures contracts.
Morningstar Global Upstream Natural Resources Index measures the performance of stocks issued by companies that have significant business operations in the ownership, management and/or production of natural resources in energy, agriculture, precious or industrial metals, timber and water resources sectors as defined by Morningstar's industry classification standards. Individual stock weights as well as category and regional exposure are capped to provide diversified exposure.
MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
The MSCI Europe Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe.
The MSCI Japan Index is a free-float adjusted market capitalization weighted index that is designed to track the equity market performance of Japanese securities listed on Tokyo Stock Exchange, Osaka Stock Exchange, JASDAQ and Nagoya Stock Exchange. The MSCI Japan Total Return Index takes into account both price performance and income from dividend payments. The MSCI Japan Index is constructed based on the MSCI Global Investable Market Indices Methodology, targeting a free-float market capitalization coverage of 85%.
The MSCI World ex USA Index captures large and mid cap representation across 23 of 24 Developed Markets DM countries — excluding the United States. With 1,006 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
S&P 500® Index is an unmanaged index consisting of 500 stocks and is a widely recognized common measure of the performance of the overall U.S. stock market.
It is not possible to invest directly in an index.