Investment Review and Outlook
Global markets experienced an up and down first quarter, and ended mostly positive. In the first three months of the year, we saw: Russia’s annexation of Crimea; further evidence that China’s growth is slowing amidst government efforts to manage a potential credit bubble; the changeover in Federal Reserve leadership; and a general continuation of the slow economic recovery in the United States and Europe.
In the U.S., economic growth was complicated by severe winter weather that likely depressed some of the short-term indicators of the economy’s health. Overall, the picture remains one of modest but steady economic growth, driven by a rebound in housing and dampened by persistently slow-to-recover employment.
Investment Review & Outlook
U.S. stocks cooled from last year’s pace but posted gains for the quarter. Developed international stocks were flat, largely due to a sizeable decline in Japan, where a new sales tax is the latest uncertainty. Amidst slow growth but still-high unemployment and very low inflation (and deflation fears), many European markets rose. Emerging markets have been beset by ongoing concerns about economic growth alongside macroeconomic instability in countries such as Ukraine and Turkey. These issues have been a headwind over the past year and led to a small first quarter loss for emerging-markets stocks.
Core bonds were among the quarter’s stronger performers, reinforcing the important role they play in a diversified portfolio. Municipal bonds were another bright spot amidst improving economic health for states and municipalities.
|Benchmark Funds||Q1 2014||12 Months
|U.S. Large Cap
Vanguard 500 Index Fund
|U.S. Large Cap Value
iShares Russell 1000 Value Index
|U.S. Small Cap
iShares Russell 2000 Index
|U.S. Small Cap Value
iShares Russell 2000 Value Index
Vanguard Total International Stock Index Fund
Vanguard MSCI Emerging Markets ETF
Vanguard REIT ETF
iShares Core Total U.S. Bond Market ETF
In prior newsletters we’ve noted the significant improvement in household balance sheets (total net worth), driven by both a strong rebound in housing prices and a surging stock market. We have also noted many other improvements in the U.S. economy and the broader macro environment over the past year. Specific conclusions include the following:
- The deleveraging process is still ongoing; this is good news for the economy.
- While median incomes have not gone anywhere in real (inflation-adjusted) terms, the key to any smooth deleveraging is that nominal incomes do not decline. On that front, the stimulative monetary and fiscal policies since the financial crisis have worked well, so far. Should the economic recovery continue, we would expect improvement in household income growth. Personal balance sheets have improved significantly as the housing and stock markets have risen, and household net worth is now above pre-crisis highs.
- Largely due to the Federal Reserve’s quantitative easing (QE) policies which make holding cash (a safe asset with very low yield) extremely painful, investors have not been as risk averse as would be expected during a deleveraging process. The Fed has committed to gradually tapering QE and keeping rates low until unemployment and inflation reach levels they believe reflect a healthy economy.
The Economy is Not Back to “Normal”
In investing, there is always something to worry about. While we are optimistic about the economy and the markets, we are living in a period without historical precedent. We are still in the midst of a monetary policy “experiment,” which has resulted in the Fed having a huge balance sheet. How that unwinds, or whether or not it will even fully unwind, and how the Fed will normalize interest rates such that lenders once again have an incentive to lend are big unknowns, and they introduce considerable uncertainty. The Fed’s monetary policy (in the form of QE) thus far has fortunately led to a benign deleveraging process. Of course, the steps taken to make the deleveraging process less painful may have unintended consequences that the Fed cannot fully understand or anticipate.
Can the Fed unwind its huge balance sheet and normalize interest rates without major disruptions in the markets? The majority of investors see it as a huge uncertainty and an unknowable risk. A smaller group offers a benign view, reasoning the Fed has the tools to accomplish its goals without a major impact on the markets or the real economy.
Much of the private sector deleveraging has been accomplished by shifting debt from the private to the public sector. As such, overall U.S. debt levels remain uncomfortably high. There are a few reasons why it may not be as concerning as private sector indebtedness—at least not in the near term. First, the United States, through its privilege of being the world’s reserve currency, is still a preferred destination for the world’s savings, which are in excess supply. This gives the United States greater flexibility to manage its deleveraging and to grow out of its indebtedness. Second, the fiscal deficit has decreased, and debt is no longer growing faster than nominal GDP growth. However, with the U.S. public sector deleveraging already underway, a sharp increase in interest rates is a big risk to the economy, and to housing in particular.
International Economic Update
Outside of the United States, China has a massive credit and infrastructure bubble. In recent months, we have seen defaults from Chinese entities unable to generate sufficient cash flow to service their debt. This may be the beginning of a credit-bubble unwind that would be disruptive for global markets. In Europe, countries continue to flirt with deflation and a credit crunch. Structural imbalances between creditor and debtor countries are still unresolved, and there remains a meaningful risk of a debt crisis stemming from the weaker peripheral eurozone countries. The banking system is undercapitalized and in need of a credible backstop such as a region-wide banking union.
In the past year, some emerging market countries have had to raise interest rates at the wrong time, when their economies were slowing. While overall, rates haven’t risen a lot, there is a risk that poor investor sentiment leads to capital outflows, which in turn forces emerging markets into policy decisions that contaminate their fundamentals. Despite the increase in the size of local corporate bond markets, liquidity remains relatively poor and most emerging-markets companies continue to tap foreign-currency debt, exposing themselves to currency fluctuations.
Five years after the worst financial crisis since the Great Depression, we feel fortunate to be where we are. There are still many economic problems and uncertainties. The question all investors should ask is how material are these risks? And, what’s the likelihood of them playing out?
Our goal is to give our clients the returns of the global markets while mitigating downside risk. Interest rates will eventually normalize: even if we don’t know precisely when, we still have to prepare our client portfolios for the possibility of what will happen when rates do rise. Moreover, in the current period of extremely low bond yields where there isn’t a lot of cushion against a recession or an economic shock, the need to insure against downside risks is greater than when yields were higher. Ultimately, portfolio asset class weightings are determined by each client’s expectation of return, tolerance for risk, and time horizon. These factors are our foremost considerations as we manage portfolios to help our clients achieve their goals.