Read Between the (Head)Lines
By: Trevor Callan
The elephant in the room right now is fiscal austerity, and not just for the U.S. As U.S. policy makers grapple with impending tax hikes and budget cuts, European leaders are scrambling to save the Euro. Headline-driven investor behavior is nothing new, but cooler heads will look past the panic-laced headlines as they position their investment portfolios for the remainder of 2012 and 2013.
As we anticipated in our prior updates, the U.S. economy has continued to experience tepid growth and has managed to avoid a recession in 2012. Our nation?s economy marked its 12th consecutive quarter of growth but expanded at a slower pace. Housing shows signs of improving, with the Case Shiller, FHFA Purchase Only and Average Existing Home indexes all moving higher. As of June 30th we have added 4.3 million jobs since the great recession, but the growth in payrolls has been a disappointment and not strong enough to move unemployment down in a meaningful way.
As usual, plenty of risks need to be addressed in the design of our portfolios. If no action is taken in Washington to extend current law (Bush era tax cuts), 2013 will begin with a $400 billion tax increase and a $100 billion per year spending cut, which could send us into another recession. As we approach this well-anticipated fiscal cliff, the U.S. economy is growing slowly at 1.5%-2.0%. Both sides of the political aisle are flexing their muscles as we head into the election, signaling gridlock. We feel neither party will ultimately want to take responsibility for a fiscal cliff dive and that this will lead to a compromise, providing relief to investor fear and reduce some of the uncertainty in the financial markets.
Europe continues to fight to save their monetary union. Greece is struggling to satisfy the troika on budget cuts and other reforms promised as part of their bailout arrangement. The process of saving the Euro has proven to be and will continue to be slow and uneven. Jose Manuel Barroso, the head of the European Commission, recently warned Antonis Samaras, the Greek prime minister, that Greece has only a couple of weeks to persuade its creditors that it can put economic reforms back on track. Mario Monti, Italy?s prime minister, noted serious concerns about the possibility that Sicily would default. In the face of this uncertainty, the Europeans have shifted their rhetoric towards creating a fiscal union in addition to their monetary union, which is what is needed to solve the crisis. Mario Draghis, president of the European Central Bank, pledged last week to do whatever is necessary to save the euro, saying, ?And believe me, it will be enough.? This statement is important because it speaks to the little known fact that despite the rhetoric and the messy political process, the ECB controls the printing press and theoretically has access to unlimited Euro Dollars.
Although the European region will continue to be a source of uncertainty and volatility, we favor the region?s equity markets for long term investors. Our European equity position, which includes over 400 of the world?s largest companies, provides a dividend yield of more than 4% and is trading at deep discounts to historical averages. Europe has been and will continue to be a case of three steps forward, two steps back, but the overall fear should slowly dissipate, reversing some of the pressure on the financial markets.
Stocks and bonds continue to trade at valuations that, in some cases, resemble those not seen since the 1950?s. This is clearly reflected in the Price Earnings Multiple (a valuation measure for stocks) of the U.S. Stock Market, which is trading at a lower multiple than what has been typical in past recessions. This is extraordinary given the fact that we have experienced 12 consecutive quarters of economic growth. Investors are so fearful of the unknown that many are actually purchasing 10 year U.S. treasury bonds with a negative real yield (net of inflation). If we use the earnings yield as a valuation measure (earnings divided by price), the stock market is cheaper today than the week following the Lehman Brothers bankruptcy, September 11th, the stock market crash in 1987 and the Cuban Missile Crisis. This leads us to believe that the remainder of 2012 will be directed more by emotions and headlines and less on fundamentals. This creates an enormous opportunity for investors with a longer term time horizon. As an example, when Mario Draghi pledged to defend the euro this week, investors exhaled and stock markets around the world skyrocketed in euphoria. This begs the question of how much bad news could be priced into the financial markets. If the news is slightly less dire, we should see relief and a move toward more normal valuations, creating a headwind for bonds and support for stocks and residential real estate.
Our antidote during these uncertain times is to focus on diversification and dividends. We continue to focus on yield across our fixed income and equity portfolio, which has proven to be a good strategy in 2012. Standard and Poors expects dividends to set a record this year as companies distribute their record cash surpluses. We expect to continue to see companies repurchase their stock, increase dividends and make acquisitions which provide support for equities. We feel interest rates will eventually rise as central banks reverse their bond purchase programs and fear subsides, creating a headwind for fixed income. With this in mind, we continue to position our fixed income portfolios defensively against interest rate exposure.