A Tale of Two Markets - Commentary from Frank Haines, Chief Investment Officer
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity . . .”
It was all quite a change from what investors had learned to expect. Indeed, the period from the early 1980s through the mid 2000s was characterized by generally strong investment returns, a growing tolerance for risk, confidence in financial institutions and their regulators, and the belief that sophisticated mathematics could model financial risk. The long-term decline of inflation, as demonstrated by the Annual Change in CPI chart above, and the fall in interest rates from the mid-teens to low single-digits, as shown in the 10-Year Treasury Yield chart below, were powerful drivers of consistently strong portfolio gains. And the belief in the power of quantitative risk management encouraged the growing use of leverage in search of even stronger returns. This forgiving environment shaped the thinking of most of today’s investors, as it represents the only environment they knew.
The sharp financial market rebound during the second quarter of 2009 helped dispel much of the shock and apprehension that developed over prior quarters, when the global financial system was on the brink of collapse. It seemed at times during the quarter as if the good old days were back, and that the past year was nothing but a brutal pothole on the familiar road to prosperity. With markets buoyant once again, it is perhaps not surprising that many investors believe an economic recovery is underway, to be quickly followed by recovering home values and improving employment numbers.
Hard Times for Main Street
The global financial market is a complex system capable of favorable outcomes and this optimistic scenario may yet come to pass. However, there are also a number of compelling reasons why it may not. One frequently cited measure of the potential support for stock prices is the tremendous store of cash in money market funds, now earning next to no yield, which should return to the stock market at some point. Nevertheless, the Great Recession is not just a business cycle recession. It has two other serious aspects: the collapse of housing prices in an overbuilt market and the near-collapse of the global financial infrastructure.
Many consumers lived beyond their means for at least a decade, saving little and borrowing heavily, enjoying a financial levitation made possible by easy credit and inflated housing prices. Local, state and the federal government all mirrored this behavior, but without the corresponding need to balance the books, as individuals and companies must do when their financial condition deteriorates. Much of the recession’s pain over the past several quarters has resulted from consumers and businesses raising liquidity and attempting to reduce debt. This is difficult to achieve with layoffs and salary cuts confronting individuals and lower sales and profit margins hurting businesses, but the process is underway.
States must eventually trim their budgets too, but instead of making substantial cuts to spending that has grown well beyond supportable levels, and despite declines in tax revenues of 25% to 30% in 2009, they are now looking to the federal government’s stimulus to support continuation of discretionary programs. Of course, the federal government can simply print more money or issue debt, which it is doing at unprecedented levels, to offset declining revenue. This aggressive fiscal response to the economic malaise on Main Street may be contributing to the improvement in financial markets at mid-year. It may even produce a return to positive GDP growth by the end of 2009 and reasonably positive financial returns for the next several quarters. Yet it may well prove to be only temporary.
A number of severe structural challenges remain unsolved, and these may weigh on longer-term investment returns for some time to come. One challenge is the need for a global downsizing of production capacity to adjust to reduced consumption. Consumption is not likely to return to previous, elevated debt-fueled levels, nor is capital spending, as businesses face slower revenue growth. Moreover, the prospect of a significant rise in taxes will likely weigh on the outlook for profits and consumption and impair the most critical source of job creation, the growth of small businesses. Despite the understandable efforts by politicians to “save” or “create” jobs, there is little evidence that permanent jobs result from public works or that productive jobs result from government hiring. Government pays for such programs through taxation, and this simply reduces the capital that would otherwise be available for growth- and job-producing investment in the private sector.
Other major impediments to a strong global recovery include demographics, which reflect a trend toward fewer workers and more elderly, and the mismatch between rising demand and reduced supply of energy, which could further pressure corporate profits and household budgets. Inflation is not an immediate risk, as rising unemployment, depressed capacity utilization in manufacturing and slower global consumption are likely to offset the impact of massive government spending. Despite fiscal and monetary stimulus, new lending has fallen as most banks are still burdened by an overhang of bad loans while potential borrowers have little ability to take on more debt. Liquidity is still highly prized.
As a result of these considerations, investors’ expectations for longer-term equity and bond returns should be lowered from the strong results achieved during the 1980s through the mid-2000s, when conditions were often ideal. CBIS believes that annual returns averaging 4% to 8% for balanced portfolios, accompanied by substantial volatility, are more likely than the double-digit results of the past. We have shifted our asset class return assumptions moderately downward to reflect these reduced expectations. Economic conditions will certainly be more demanding over coming years, requiring a higher degree of individual financial responsibility than was evident in the recent past. Paradoxically, this may spur the self-reliance and drive to innovate which history has shown to be strong and resilient aspects of the American character. And this, in turn, may nourish the entrepreneurial energies that will drive investment returns back to higher levels when a lasting economic recovery takes hold.
Please contact your CBIS Investment Advisor if you would like to discuss these issues in more detail.
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