Systemic Risk in Europe, Relative Strength in the US, and the Benefits of Diversification

January 9, 2012

Summary

Our goal is to understand world economic events not to make predictions but to evaluate potential outcomes and recognize extremes in investment markets. We continue to think fear has driven defensive investments like US Treasurys and several high dividend-paying global stocks to uncomfortably high prices. In contrast, US stocks, corporate bonds, and other areas like high yield and some emerging markets, appear relatively more attractive.

Regarding the global economy, 2012 will further highlight the tug-of-war between policy decisions and economic recovery. Until Europe makes convincing moves toward containing its debt crisis and generating growth, austerity measures will likely mean recession on the continent. Echoing in the background is China’s own debt issues as local governments cope with falling real estate values. Encouragingly, we are finally seeing Europe make some progress, with opportunity this spring to solidify it. For the US, healthier credit markets and balance sheets should help it weather reasonable storms, and growth in 2012 may end up better than expected, although policy missteps in Europe admittedly present risk.

As always, bonds, stocks, and other investments all play a role to support your near-term and long-term goals. Portfolio diversification is the right investment approach as global issues unfold. We continue to keep fixed income maturities short to protect against what we think is inevitable inflation over time, although nearer term deflationary forces appear more likely. We have found high yield bonds becoming more attractive for appropriate portfolios and feel that US stocks offer balanced risk/reward.

Full Commentary

In the financial media, we hear two passionate but opposing arguments about investment strategy over the next few years: one says (to paraphrase) you should stay very defensive because the European debt crisis will shock credit markets and launch deflation, while the other side claims that growth (and inflation) will be higher than expected because recession and credit challenges are well known and can be contained to Europe. Which one is it?

Either prediction could materialize, yielding unattractive investment results if you guess incorrectly. The best answer is to build a portfolio of diversified investments which should behave differently in various economic environments. That framework is what should guide you, particularly in times of stress, so that you don’t react to the financial headlines, jump around investments, and destroy value.

Speaking of Stress, Stocks Have Done Poorly for the Past Decade!

As 2011 closed, the S&P 500 was up only 2% after another volatile year. Long term US bonds were the best asset class, up a whopping 23%. And last year merely echoed the trend of the past decade (see figure at right).

Appetite for stocks (particularly those of developed countries) remains low on concerns about volatility, aging baby boomers, and downside protection. Consider that since the credit crisis, two-thirds of all investments have gone to bonds. We’ve been waiting for people to warm to stocks, but except for a brief surge in late 2010 (near the market peak, no less!) it hasn’t happened.

We’ll save a detailed assessment for another day but will make three quick points:

• These returns do illustrate our opening point above—the importance of diversified portfolios across multiple, liquid asset classes. The past decade witnessed two asset bubbles (tech and real estate), which launched deflationary forces that benefited bonds and hurt stocks. A diversified portfolio would have done better than the S&P in almost all cases, but only in hindsight would you know to avoid stocks.
• Even considering long periods of limited net gains (the 1970s/early ‘80s, the 1930s/‘40s, and early 1900s), invariably stocks have offered some of the best risk/reward and therefore belong in a portfolio. Economic growth drives value creation, which is well captured by equity ownership. Without stocks (alongside hard assets and commodities), inflation could erode value.
• On a relative basis, after the bond rally of the past ten years, stocks appear more attractive than bonds when comparing earnings yields.

But for stocks to work broadly in the coming decade, we need economic growth. When will we get it? Which brings us to…

What’s Next for Europe?

After nearly 18 months of rescue packages, it is clear that Europe lacks a convincing solution to the sovereign debt and banking crisis.

Markets know this. Bond yields (see figure below) are at or near all-time highs for Greece, Portugal and Italy, despite targeted rescue efforts. By comparison, yields on perceived-to-be-healthy sovereign nations like Germany, the UK, the Netherlands, and even France remain in good territory.

European stock markets also show extreme concern, generally down 10% to 30% in 2011. Greece was down over 50%. Most economists say recession is inevitable.

Why the skepticism? As we outlined last September (see our report Update on the European Sovereign Debt Crisis), problems won’t be solved until Europe develops a centralized, credible funding mechanism to contain the damage. Until then, several countries will have to go through painful debt restructuring and economies will contract under austerity measures. The longer it takes, the more painful it could be as debt increases. This is already happening for Greece, Ireland, Spain, Portugal and Italy (see figure below), which is why their cost of debt is trending higher.

Over the next six months, markets will be watching several key events (see figure on next page). We estimate around €200B in sovereign debt and perhaps €350B in debt and equity for banks will come to the market for funding. European credit markets remain in lock-down. These requirements could push the limits of its current funding mechanism (the EFSF), if banks or other investors don’t participate.

The Euro Summit in March will hopefully push politicians toward a more complete solution to the crisis, including moving beyond austerity measures to include pro-growth efforts, better fiscal policy integration, and granting the European Central Bank with more funding authority.

The risk to all this would be that weak funding results along the way could spread to other sovereigns or banks, causing a lack of confidence and multiple shortfalls. Also, there is potential for counterparty risk if off-balance sheet arrangements occur—i.e., a country guarantees a debt offering but then becomes insolvent themselves. This condition would have similar effects on credit markets that Lehman had in 2008, so it will be worth investigating.

Our Take on Investment Opportunities Today

As we’ve said, solving the European debt crisis will likely take years to complete, with several fits and starts. Markets will move up and down, perhaps dramatically at times, but the market is already pricing in an extremely rough ride.

• Currency (Euro and US Dollar): If the EU structure evolves as we expect, along with austerity programs and restructurings, we would expect pressure on the Euro. In contrast, the US Dollar has generally been weak but will likely remain a source of relative stability.

• US Treasurys: Yields remain at historic lows, implying Treasurys are already priced for recession, if not worse. We consider them expensive and are avoiding them under most circumstances, even though we expect them to remain in demand for much of 2012. Treasury Inflation Protection Securities (TIPS) are also expensive and investors holding these securities will earn a negative or zero real return for securities maturing in less than 10yrs.

• Inflation: Despite our view on unfavorable TIPS prices discussed above, we consider inflation a high probability over the next five to ten years. Accordingly, we prefer to keep fixed income maturities shorter, and favor real assets or broad commodities longer term.

• High Yield: After a period of unacceptably tight risk-spreads, they have widened over the past six months. They are back to levels seen during the initial Euro crisis (May 2010) and first leg of the recession (late 2007), creating opportunity for selected portfolios that accommodate the risk.

• Corporate and Agency Bonds: We are still reinvesting in corporate and agency bonds, but cash is starting to look more attractive given the low opportunity cost. Step-up bonds continue to make up an important part of the portfolio and so do BBB investment grade bonds.

• Equities: Domestic stocks currently trade at a very reasonable 12-times earnings for 2012. Defensive stocks (many multinationals with a large dividend, as well as utilities and staples) have been extensively profiled by Wall Street and are no longer cheap; our contrarian research ranks many of them as sells, favoring more cyclical sectors. But can corporate earnings stay strong if the recovery is weak? Cost-cutting can only go so far, so without top-line growth, we have some concern that earnings may be revised downward. In response, we have paid careful attention to gross margin trends and accruals accounting in our buy candidates. We also try to assess how much companies may need to borrow in a few years, should the credit markets freeze. We always maintain an allocation to stocks, in keeping with client risk parameters (and including broad international exposure, where appropriate) as they should generate attractive real returns over the long term.

• Municipal Bonds: State and municipal budget deficits should be manageable for most and have improved since 2009. Unfunded pensions are the bigger problem, requiring creative solutions over time. On the regulatory front, the Obama Administration’s proposed Jobs bill, now before Congress, contains some limits on tax deductions for wealthier individuals, which we will monitor. Our approach to muni bonds is to buy good quality across diversified issuers, to manage risk.

We continue to recommend that investors stay with their portfolio allocation and avoid taking extreme positions (going to all cash, or highly concentrated portfolios), even with complex events unfolding. Volatility should be expected as the world works through these issues, but the appropriate investment strategy should be able to guide investors to their financial goals. Adhering to a bearish or bullish prediction on the economy or markets misses the inevitable opportunities and risks that are unfolding in unpredictable ways, and leads to “market timing,” with its dismal record.  With our disciplined research and rebalancing, our goal is to balance risk/reward with fundamentals and probable outcomes to help our clients meet their long term financial objectives in an uncertain time.

See our commentaries and newsletters at www.cornercap.com for more detailed discussion of asset allocation strategies.

If you have any questions, please contact:

Cannon Carr, Chief Investment Officer, at (404) 870 0700

Paige Mitts, Director of Private Client Services, in Atlanta at (404) 870 0700

Larry Christ, Vice President and Portfolio Manager, in Charlotte at (704) 442 8457