Despite some positive economic signs and fiscal cliff resolution, we remain concerned about the impact that still-high levels of global debt will have on economic growth and corporate profits. In our base-case subpar economic recovery scenario, working through the huge debt overhang is a significant drag on growth. In a worst-case scenario, we could see the eurozone deteriorate and spark another financial crisis (though this risk has declined).
Looking specifically at the U.S., the stock market shrugged off automatic government spending cuts (sequestration) without much drama in the first quarter. However, we believe the impact of the $85 billion in government spending cuts (estimated to shave 0.6% from GDP growth in 2013) is small compared to the debt and fiscal policy challenges that still confront the nation. How—and when—we deal with the issue of our growing deficit remains a major unknown. What we do know is that these challenges cannot be resolved without significant impact to the economy—it is a certainty that spending less and/or taxing more will detract from growth.
On the monetary-policy side, however, we can at least be clear the Fed has no plans to tighten its stimulative policies, which currently involve purchasing $85 billion per month of Treasury bonds and mortgage-backed securities and holding the federal funds policy rate near zero percent. However, there is significant uncertainty as to the medium- to longer-term consequences of these policies and whether the Fed’s ultimate exit plan will be executed successfully.
Against this backdrop, our twelve to twenty-four month outlook for stocks has not improved. We believe the upside return potential of the stock market remains insufficient to compensate for the downside risks in our base case and negative scenarios. That said, we also believe there is an unusually wide range of possible outcomes for the economy, including scenarios more positive than we expect, which is why we are ready to increase stock exposure should we experience a market pullback or see signs of sustainable economic growth, not driven by Federal Reserve intervention. Even in our base-case subpar economic recovery, stock returns will likely be better than what we expect from bonds. In other words, there is no clear and compelling case to further reduce exposure to stocks, in our view.
Turning to the bond markets, since year-end there has not been much change in how we view risk and return potential. With bond yields very low, particularly for the highest-quality sectors, we are quite confident that returns will be very low over our twelve to twenty-four month investment horizon. Further, we expect to see rising interest rates at some point, which would drive bond prices lower.
Core bond funds are generally more sensitive to changes in interest rates than multi-sector bond funds. Based on our expectation of rising interest rates, our portfolios remain underweighted to core bond funds. In their place, we have larger allocations to multi-sector bond funds. These non-core bond positions have contributed significantly to our relative returns in recent quarters, and we expect this to continue to be the case over the long term. That said, our bond positioning will underperform during any shorter periods in which investors run from risk.
In an environment such as the one we’ve seen—where stocks have rallied strongly in the face of very visible risks—two questions are most common. One is why we aren’t adding to stocks, and the other is why we aren’t reducing them. What we can say is that our current positioning reflects our best judgment about balancing the tradeoffs between risk and return over the next twelve to twenty-four months. We aren’t willing to make big bets given the wide range of possible outcomes, but we are willing to make longer-term bets where our confidence is high—such as in alternatives to core bonds.
It’s worth a reminder that patience is a critical element of our investment success, and is always the most difficult to maintain. It demands the discipline to resist the temptation to jump into “what’s working” in order to allow longer-term themes—which can be analyzed with far greater confidence—time to play out. Patience also lets investors be selective and position themselves to take advantage of the kinds of highly compelling opportunities that come along infrequently.
We appreciate your confidence and trust, and as always will continue to work our hardest to earn it.
Harlan G. Storey, JD, CFP®