On December 31, 2006, I wrote my quarterly commentary with the title “Complacency and Volatility” (you can read it on my web site). You will recall that the world economies and markets were doing very well and optimism was everywhere. Speculation and take-overs abounded, and crazy credit deals were common. Volatility was at record-low levels and complacency was prevalent among industry, finance and the public. Back then I worried that investors weren’t paying attention to the fact that excessive debt and shaky credit structures were being overlooked amongst the optimism and calm, and that at some point complacency would be replaced by more violent volatility.
In the ensuing six years we have seen an epic, debt-fuelled crisis unfold. At their worst, some stock indices were off about 50%, volatility indices exploded from 10 to almost 60, and bond yields plunged.
Understandably, investors are now fearful and shunning ‘risky’ assets like stocks for the ‘safety’ of bonds and cash. Complacency and low volatility have been replaced by fear.
Markets are an extension of human emotion and as such are prone to mood swings, sometimes excessive. Six years ago things were too optimistic; today, I think they are too pessimistic.
As we all know, aggressive central bank money-printing has saved the financial system and things have normalized somewhat. A lot of restructuring and deleveraging has taken place, and there is much more ahead for sure. Excess debts remain in many areas, especially in developed western nations, and slower growth ahead is likely as this deleveraging continues. Some social benefits will need to be cut, bloated governments reduced and, in some places, taxes raised. To keep economies moving forward, aggressive monetary policy will likely continue.
Europe’s problems continue, as do the negotiations on how to keep the euro intact and help the over-indebted nations. While the outlook there looks ugly, progress is being made. In the U.S. there is much discussion about ‘the fiscal cliff,’ and in typical fashion the press is making a spectacle of it. Like many European countries with high and growing debts and deficits, the U.S. needs to reform spending and taxes. There are obviously big ideological differences in the U.S. on what the government should provide and who should pay.
These differences in ideology created this ‘crisis’ 10 years ago because the only way to agree then was to enact laws with an expiry date – December 31, 2012. Many U.S. politicians vowed publically to never raise taxes, which helped create the current problem. A ‘deal’ will be made, but due to the lack of consensus in the U.S., it will be a more temporary fix than a permanent one, but the markets will be relieved.
Countries like Australia and Canada weathered the financial crisis well due to sound banks, good government and an abundance of commodities.
These strengths will continue to bode them well, but the demographic trends that helped create the mess in Europe and the U.S. are similar and pre-emptive government action will be required to prevent similar fates in the years ahead.
China appears to have slowed their economy and inflation as planned, and the desired soft economic landing looks likely now. Similarly, other emerging markets are coping and growing in spite of the reduced demand from Europe and the U.S.
Interest rates remain near record low levels. The U.S. Federal Reserve has implemented ‘QE3’ in which they are buying U.S. bonds and debt to keep rates low in an effort to restart economic growth and inflation. Their resolve is clear – they will do whatever it takes for as long as it takes to do this. They are being helped in this task from the fearful investors that I referred to earlier who are happy to park money in cash or buy bonds to avoid the volatility of stocks. Further, a lot of European money has flowed to New York and is hiding from the storm in U.S. bonds. However, with most bonds paying less than today’s inflation, let alone future inflation, this is actually a risky strategy. The aggressive strategy that the U.S. Fed is using is artificial and temporary. Signs of an improving U.S. and global economy, higher inflation, or some unseen event is bound to cause rates to rise to a more normal level at some point – perhaps very quickly. The U.S. Fed is holding rates down like a beach ball underwater – when they lose their grip they will pop up. I think that the ‘safe’ bond market, with its artificial buying by the government and resulting stability and low volatility, is actually the risky asset today. At some point, rates will pop up creating large losses on some bonds and income securities.
Equity markets in North America are almost back to where they were six years ago. Much of the gains have been driven by gains in higher dividend paying stocks, which has been nice in this income-starved world. Meanwhile, returns from lower yielding stocks with more growth potential have been far less. When rates move up, many high yield stocks will be priced as bond proxies and lag in returns or fall in value. This bears watching. Stocks compared to bonds haven’t been as inexpensive as they are in years. The historical premium that investors receive from owning stocks over bonds is 4%. Currently it is estimated to be at 8%.
The ‘crowd’ is fearful – the public have been large sellers of stocks for the past five years and large buyers of bonds. A survey of investment strategists recently showed the recommended stock allocation is the lowest since the survey began 27 years ago. As a contrarian, this piques my interest. Central banks are intent on printing money and achieving targeted economic growth rather than inflation. The housing sector in the U.S. looks to have bottomed and is improving. Auto sales in the U.S. are improving and the outlook is positive. Consumer confidence there is picking up. Finally, and importantly, the shale oil and gas boom in North America is delivering an advantage here for manufacturing and consumers, which will provide significant advantages in the years ahead.
Governments are printing money and intent on creating growth and inflation. If they are successful, stocks offer far better protection than bonds. I think that artificial government policies and fear have created an environment where bonds are overpriced and many stocks underpriced. Yes, there remain risks globally, but I think these are likely priced in.
As always, I will do my best to protect your interests.
Tony Pringle, CFA December 31, 2012
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