2012 Q1 Letter: Austere Growth and the Summer of Discontent
Before we begin our quarterly market commentary, we wanted to give you a few quick updates. Louis was recently profiled in the Wall Street Journal online where he discussed the mobile budgeting app we are developing. The genesis for the idea came from speaking to both clients and non-clients who have expressed a need for on-the-go assistance in tracking their spending habits. We’ll keep you posted on the app’s progress and let you know when it’s in beta.
Over at the WSQ Capital blog, Subir wrote a blog post examining the fundamental differences between Google and Yahoo in how they approach the internet. He wrote a second piece where he sites Pandora as a case study for how entrepreneurs can run into trouble if they sell too much equity to outside investors. And to complete the tech trifecta, he wrote a third piece looking at Facebook’s growth prospects just as the hype machine for the company’s IPO grinds into high gear. Meanwhile, Louis wrote a post that provides a primer for investors interested in learning what makes an investment socially responsible.
We look forward to speaking with you over course of the summer.
This has been an eventful quarter in the global markets. We now know that the UK has slipped into a double-dip recession with negative growth in the past two consecutive quarters. The jury is still out on whether this was driven by the relatively austere economic policies adopted by the Tory government and the Bank of England or the general weakness in broader Europe. Looking out east, we see a carefully choreographed political transition in China becoming unexpectedly messy. A very senior official, who was expected to join the nine-member Standing Committee of the Communist Party has been removed from his position in the Politburo and remains under house arrest amidst allegations of wire-tapping and murder. Meanwhile, the housing bubble in China continues to deflate.
Against this background, US stocks continued their upward trajectory. The S&P 500 index (a broad measure of large-cap US stocks) finished the quarter up over 150 points, closing at 1,408.47 – cracking the 1400 point threshold for the first time since 2008. This represented a quarterly gain of 12.59% (which, if annualized, would be 50.36%). These are gaudy returns and we don’t think it’s realistic for investors to expect stocks to continue performing at these levels for the remainder of 2012. So what’s been driving this rally? There has been a confluence of factors:
1. The primary explanation is extraordinary stimulus provided by the Federal Reserve over the past few years in an effort to stabilize the US economy. In addition to its 0% interest rate policy – intended to drive down mortgage rates, boost lending and encourage both investors and savers to flee cash and take on more risk – the Fed has played a direct, directional role in the bond markets via quantitative easing. So far, there have been two major rounds of quantitative easing (QE1 in 2008/09 & QE2 in 2010/11). Both rounds helped prop up equity markets as investors expected the Fed to be ready with its safety net protecting them against catastrophic losses.
In a variation on this theme, the Fed announced “Operation Twist” on Sept 21, 2011. It would sell $400 billion in short-term Treasuries to buy longer-dated bonds, driving down long-term rates. The policy took effect in October and is set to expire in June, 2012. At the time of its announcement, the stock market was mired in a summer slump with investors increasingly jittery about muted economic data and continued problems with the European debt crisis. Once Operation Twist took effect on Oct 1st, the US stock market began its renewed run upward to where we are today.
We recognize that these stimulus policies have been implemented to support the fragile US economy as it slowly emerges from the Great Recession. The catch, however, is that risk-taking investors have come to rely on the Fed’s intervention in the markets. Like clockwork, once these policies are set to expire, equity markets (and other risk assets) have sold off until a new iteration of the policy is announced. This is a dangerous precedent for the Fed to set. A constant cycle of interventionist policies skews market prices and encourages the type of herd-driven speculative behavior that caused the crisis in the first place.
2. In addition to continued Fed stimulus, the stock market has benefited from improving economic data (albeit from very low levels). Unemployment – while still stubbornly high – has continued to drift lower with recent monthly numbers beating expectations. Corporate earnings have beenstrong, especially for large-cap US conglomerates, which have continued to benefit from a weak dollar. Several of these companies have cut costs by reducing head-count and used the savings for share buy-backs and dividend distributions. With interest rates at historic lows, blue chip stocks with dependable dividends are attractive to conservative investors in search of income.
3. The equity rally has also been strengthened by the threat of inflation. The Fed’s policies have brought trillions of dollars of liquidity into the markets over the past few years. This liquidity has weakened the US dollar and driven up commodity prices. The consumer price index (CPI) – which measures changes in the price level of set basket of consumer goods and services purchased by households – has steadily crept upwards over the first three months of 2012. This trend suggests inflation could be closer on the horizon than expected, despite continued high unemployment levels and a stalled housing recovery. Since companies can adapt their strategy and pricing to changed conditions, stocks tend to be a better hedge against inflation than fixed income.
4. As the economy emerges from recession, an overheated economy becomes a very real concern. A majority of the board of governors in the Federal Reserve have stated that they expect interest rates to remain historically low through the end of 2014. However, this is not written in stone. If the economy does rebound and inflation picks up, the Federal Reserve will need to raise interest rates before 2014. Since the Fed can’t lower interest rates any further than where they are now, they will go up at some point. The question, of course is when. Once interest rates do start to rise, stocks will outperform bonds.
As the second quarter is now underway, we have seen a few of these drivers fading (which, not surprisingly, coincided with a selloff in stocks). The Federal Reserve has given no indication that another round of quantitative easing is imminent once Operation Twist expires in June. Corporate earnings continue to be strong, but US economic data, which was strong during the first quarter, has started to flag. If the macro-economy weakens materially, both inflation and the potential for an interest rate hike prior to 2014 become less of a concern and the Fed’s attention will turn back to unemployment. The monetary quiver though, is virtually empty, and there is not much we feel the Fed can do beyond keeping rates low.
So what does this mean for investors?
While we still view equities on the whole as over-valued, there are pockets of value in certain industries, and in individual stocks. We prefer large cap, blue chip stocks with strong balance sheets and dependable dividends. We favor short term, high quality bonds, with a preference for inflation protected or stepped coupon/variable rate securities. We continue to think that there will be an opportunity to buy stocks at an attractive level in the near future.
Louis Berger