A Review of 2010 and Macro Economic Considerations for the Future.

                                                              Mark Sladkus

Reflections on the Past Year

Global equity markets continued their rebound in 2010, providing handsome returns.  But as is often the case, patience was required.  By the end of August the S&P 500 was down 4.62%, and the economic signs did not provide much to cheer about.  Yet in the remainder of the year, stock prices surged and the S&P 500 ended the year up 15.06%.  The S&P has now recouped all of its losses since the collapse of Lehman Brothers on September 15, 2008 ^[1].  Of the 45 developed and emerging market countries tracked by MSCI, 37 had positive results in both dollars and local currency. 

Fixed income returns were positive, despite predictions that bond prices were in dangerous “bubble” territory. Despite continued weakness in residential housing and commercial property, real estate securities around the world outperformed the broad equity market  

“The pessimist sees difficulty in every opportunity.  The optimist sees opportunity in every difficulty.”

Sir Winston Churchill

The World Stock Market Performance chart, below, offers a snapshot of global stock market performance, as measured by the MSCI All Country World Index. Actual headlines from publications around the world are featured. These headlines illustrate the difficulty of staying disciplined when bombarded by the media.

Throughout the year, investors could find a host of reasons to sit on the sidelines waiting for more positive news. As these select headlines suggest, determining the right time to invest is a difficult task since the market anticipates news and quickly factors in new information.

2010 Themes

In retrospect, it was a good year for globally diversified investors. But if investors had shaped their market expectations and decisions according to economic news or the opinions of pundits, they likely would not have expected positive returns.  As is often the case, acting on predictions or emotions can be risky. The following are a few of last year’s themes:

Mixed Economic Signals

Economic reports were mixed, with some measures showing improvement and others offering evidence that the economy remains vulnerable. Favorable news included moderate economic expansion in the US, Euro zone, and Australia; rising factory orders and manufacturing activity; rebounding auto sales and automaker profits; slowing growth in US bankruptcies; declining home foreclosures; and an improving financial services sector.

Negative news included continuing high unemployment in the US and other developed markets (US unemployment began the year at 9.7% and dipped to 9.5% in July but climbed to 9.8% in November); increasing personal bankruptcies in the US; bank failures in 2010 culminating in the worst year since 1992, during the savings and loan crisis; and personal bankruptcies in the US increased 9%, reaching their highest level since 2005.  This negative news caused some investors to sit on the sideline, missing the stock markets’ continued rebound.  Investors should consider that by the time they learn of news, good or bad, it is likely to already be reflected in the price of stocks and bonds.

Housing and Real Estate

The global property decline that helped trigger the 2008 financial crisis improved in 2010. Home prices increased in the UK but remained weak in the US, with monthly sales of new homes falling at one point to the lowest level since tracking was initiated in 1963. Foreclosures increased in the first half of 2010 before improving in the last quarter. Investors worried about the continuing weakness in housing and commercial real estate would have missed out on Real Estate Investment Trusts (REITs.)  Despite dire predictions by some pundits, 2010 was an outstanding year for US and non US REITs.

Quantitative Easing and Fiscal Stimulus

Governments and central banks took additional actions to stimulate economies and shore up financial markets. The most direct support came as central banks supported government bond markets in the US and Europe. The Federal Reserve’s November announcement of a second round of quantitative easing (known as “QE2”) sparked concern that additional monetary stimulus would stoke inflation and cause the US Dollar to collapse.  Yet despite all the stimulus, interest rates did not shoot up and bond prices didn’t collapse as many predicted.

Sovereign Debt Worries

During the year, the weakening finances of some European states, including Portugal, Ireland, Italy, Greece, and Spain, raised concerns that the financial crisis had moved from private-sector banks to public-sector balance sheets. These concerns led to the downgrading of certain government debt and widening of bond yield spreads. The Euro zone countries and International Monetary Fund responded with loans that were conditional on some sovereign borrowers taking drastic austerity measures.   Despite the widespread belief that US bonds would do poorly in 2010 the sovereign debt crisis helped to ignite a US bond rally. 

Investor Confidence

In the wake of the financial crisis, many investors became risk averse.  These investors, who accepted the tenets of a “new normal” in the economy and markets, chose to remain in fixed income assets. Bond funds in the US received a massive net inflow of money in the past two years, suggesting that many investors who fled stocks may have missed out on much of the rebound in equities. 

2010 Investment Perspective

After a difficult first half for stocks, most markets ended the year with positive results. Thirty-seven of the forty-five developed and emerging countries that MSCI tracks advanced in both local currency and US dollar terms.

In the last few months of the year, the highest returns were generally experienced by countries whose economies are dominated by oil and commodity exports—for example, Canada, Norway, Russia, and South Africa.  China, despite its continued high profile and news of economic growth, was one of the lowest-performing emerging markets.

The US dollar lost ground against the Canadian dollar and most Pacific Rim currencies, which helped dollar-denominated equity returns from those countries. The US dollar gained against the euro and British pound.

Along the market capitalization dimension, small caps outperformed large caps by substantial margins globally.  Value stocks underperformed growth stocks across all market capitalization segments in the US and had more mixed results in international developed and emerging markets.

Generally, fixed income performed well, particularly in the first 8 months, providing stability to the portfolio despite the predictions of many economists. Real estate securities had excellent returns, performing comparably to the equity asset classes.

Attached below is a summary of key benchmarks since the global crisis reached its nadir and for the year 2010.

Debt and Deficits:  Do They Affect Equity Returns?

What is the relationship between government debt and equity returns?

As government spending hits record levels in many countries, politicians and pundits are warning that rising indebtedness will reduce economic growth.  This issue has raised concern among investors who understandably assume that a government’s fiscal policy is closely linked to the country’s economic growth and market returns.

While historically high levels of debt are partially due to Governments’ efforts to stimulate economies out of the recent recession, serious structural issues are still looming.  Longer-term trends such as aging populations, expanding public pensions, and rising health care obligations are compounding the fiscal challenges of many heavily indebted countries.   The US is better off than many other developed countries in terms of both the demographics of the population and the health and pension obligations that have been promised.  So how does public debt affect economic growth and market returns?

The evidence might surprise you. Although rising levels of government debt create headwinds for economic growth, a country’s deficit and debt levels do not seem to adversely impact capital market returns.

Following are some questions that we often hear:

Do rising deficits increase interest rates?

Yes. As the supply of debt increases, governments must offer higher interest rates when issuing bonds.  This is simple supply and demand.  The public sector consumes savings and investment that may have otherwise been used in the private sector.

Consistent with this theory, analysis shows that current interest rates reflect expectations of future deficits^[2] but that current government deficits and debt do not predict future interest rates or bond returns.  So, long-term interest rates rise when the market expects future deficits to increase. Changes in expectations drive interest rate changes.  However, today’s interest rates already incorporate information about current government spending.

Do higher deficits retard economic growth?

It depends on a country’s debt level. High-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth. The combination of high debt and deficits can lessen economic expansion, but slower growth is not guaranteed.

So rising deficits can increase interest rates and potentially reduce growth.  But the impact on investment returns is less clear.

Does low economic growth imply lower equity returns?

No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. DFA conducted an analysis using all the developed countries in the MSCI universe, divided each year into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.  

Emerging market countries also showed similar results.  Looking at the MSCI emerging market countries, the return of the high-growth country portfolio averaged 19.77%, versus 24.62% for the low-growth portfolio (years: 2001 to 2008).  Vanguard too has published research, using data going back to 1900.  That research also failed to find a statistically significant correlation between a country’s GDP growth and stock market returns. High GDP growth does not correlate with high equity returns.  Please contact us if you wish to receive a copy of Vanguard’s research.

Complimentary Portfolio Checkup 

Is it time for a portfolio review?  Over time, individual investment decisions can compound to create a very inefficient portfolio.  At Red Lighthouse Investment Management, investment decisions are made in the context of clients’ total assets and investment objectives.  Readers, who are not clients, may benefit from a free “second opinion.”

Portfolio theory tells us that a given investment should not be judged in isolation but rather in the context of one’s entire portfolio.  For example an investment that is risky in isolation may in fact reduce the total risk of the overall portfolio if it has a low correlation with the other holdings.  Individual investors, however, can find themselves making purchases without properly considering how the incremental investment correlates with other holdings. 

As an example, during the late 1990’s, some investors purchased the best performing mutual funds.  Such investors may have believed that owning many different funds provided diversification.  Only when the markets retreated at the end of the decade did these investors come to realize that many of their funds were heavily weighted towards the same “high flying” stocks. 

Some common portfolio problems, grouped by category: 

Allocation

•              Inappropriate asset allocation relative to one’s risk profile/preferences.

•       Home country bias: Is the home country bias appropriate?

•             Recency: Being overly biased by recent performance.  It is difficult to try to buy low and sell high.  Attempting to do so requires knowledge of how asset classes have performed over extended periods.   People tend to overweight recent observations for example by becoming overly bullish after a period of above average performance.  Or vice versa.

•       Over concentration: a common example is having a high concentration of the stock of one’s employer. 

Implementation

•             Duration/Maturity Risk: Particularly in the current environment, a period when inflation risks seem high, long duration bonds  offer a poor risk/return tradeoff.

•           Fees: Investments in products with high and/or non-transparent fees.

•           High Turnover: Expensive and tax inefficient.

•           Poor choice of investment products: underperforming, high fees, high turnover, style drift.

Other

•           Discipline of rebalancing: Required to ensure asset allocation stays consistent with objectives.

•          Tax location: Inefficient placement of assets from a tax perspective.

 Please contact us if you, or someone whom you know, might benefit from such a comprehensive and non-binding review.  

Red Lighthouse Investment Management - 212.799.3532 - www.redlighthouseinvestment.com

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