2012 Q4 Letter

Dear Clients & Friends,

As the New Year begins, we’d like to wish you and your family a wonderful 2013.

2012 was quite an eventful year for the global economy. The Federal Reserve maintained exceptionally low rates, which prompted a number of reactions from investors and consumers alike. Home mortgage rates remained near historic lows, boosting the number of homes sold. That said, much of country still carries excess inventory and new home construction is a mere shadow of its 2006 peak. Household formation – the biggest driver of housing demand – remains low as unemployment in much of the country is still at recessionary levels.

The employment picture improved over 2012, with new unemployment claims down to 350,000 per week in December, a level consistent with moderate growth. However, a substantial number of workers remain unemployed or under-employed and many have been out of work for an extended period of time, making workforce reintegration more challenging. On a positive note, various factors are prompting resurgence in US manufacturing. Concerns about intellectual property theft, rising energy costs, the brittle nature of global supply chains, and higher labor costs in Asia have combined to force many industries to consider opening factories in the US. Employment expectations will have to be tempered as any new manufacturing facilities in the developed world shall be highly automated and employ far fewer workers than older facilities. In addition, workers will require higher level training as new factories will be more complex than past assembly lines.

Despite strong headwinds, most equity markets globally enjoyed double-digit returns in 2012.  The S&P 500 rose 13.4% on the year, and when dividends are factored in, the total return was 16%. Some foreign markets have done even better, despite relatively uneven news over the course of the year.

The US economy has seen 4 years of unbroken growth since Q1 2009. This makes the expansion comparatively long in the tooth since the average post-war expansion has lasted only 14 quarters. 2013 will pose a series of difficult questions for markets, many of them political in nature. The stalemate surrounding the 2001/2002 tax cuts has been resolved with rates staying level for all except the highest earners. However, a number of confrontations between Congress and the President over the debt ceiling, defense spending and troop withdrawals loom in the coming months. The US continues to run a deficit and by February, the Treasury will be unable to meet its monthly expenditure unless Congress raises the debt ceiling. The market is increasingly losing confidence in Congress’s ability to put aside ideology and act in the national interest. The wide ideological divide between very active right wing elements in the Republican party, and center-left elements in the Democratic party who believe not much was gained from compromise during the first Obama administration, guarantees the next couple of years will make for continuing political drama. To a large degree, this situation is an outcome of the US election in 2012. The election was expected to be a referendum on the Obama administration’s policies and a clear majority of voters opted to have the president continue to implement his policies.

Over in Europe, a similar dynamic is playing out. The political establishment is in stalemate while the broader European economy struggles towards a recovery. The French election this year has led to a Socialist far-left government of Francois Hollande possibly over-reaching by raising income tax rates to staggeringly high levels (over 75%) and inserting itself rather visibly into disputes with industry. Southern Europe continues to flounder, with Mario Morsi resigning as prime minister in Italy. Spain and Greece continue to be racked with widespread protests over austerity measures. Portugal and Ireland, meanwhile, seem to resigned to draconian austerity with characteristic acceptance of hardship. Perhaps most troubling of all is the suggestion amongst some circles that the United Kingdom may opt to withdraw from the political union while trying to maintain certain trading privileges. We do not expect any resolution to the European crisis till after the German elections in 2013.

In Asia, the Chinese economy continues to sputter, new car sales have dropped, along with energy demand and home prices in most cities. The politburo standing committee transition occurred in November after the US elections with an apparent loss for the Jiang Zemin faction that was closely associated with party elites. Meanwhile in India, it appears the Congress government faces a very difficult legislative session as the economy slows, inflation picks up and various necessary reforms are held up. The one bright spot in the East, surprisingly, is Japan. Japanese voters handed the LDP a resounding victory in the recent elections. The newly (re)elected government of Shinzo Abe seems to intend to use its super-majority to the fullest extent. It has been surprisingly assertive in demanding the Japanese Central Bank set an inflation target of 2%. The broader market has turned positive on Japan, perhaps relieved to finally see political will in action. We remain wary of investments in China, are more positive on India and relatively bullish on Japan.

In the final analysis, for much of the world, we return to the question of sovereign and household debt. This question is particularly acute for Japan, where total government debt is now over 200% of GDP. Meanwhile, in the US, consumers continue to pay down debt, deleveraging to a more sustainable level while the federal government will likely run deficits for another 2-3 years to compensate. We are now five years past the crisis of 2007, which was caused by a vast bubble in debt and spending. These cycles typically take seven years to resolve and we expect the current dynamic of restrained growth to continue for another two to three years, with significant risk of another recession in the near-term.

In terms of our 2013 investment outlook, we see a number of risks and opportunities. We believe bonds, particularly 20-30 year treasuries are ripe for a correction. Long-term bonds are priced for perfection and will face a severe sell-off when the market suspects the Fed is about to raise interest rates or end its QE program. This could present an opportunity for investors to increase medium-term bond holdings (3-5 years) and longer-dated bonds over time. We see value in international and emerging market equities and would look to add to positions over the course of the year. Portions of the US equity markets potentially look quite attractive if there is a significant correction (we believe a number of political and economic factors could trigger this). We think alternative energy and network-driven businesses would present a particularly interesting buying opportunity during a correction. These and other topics are explored in more detail in our Top Ten Themes for 2013.

Regards,

Louis Berger   Subir Grewal