Stocks at home and abroad posted strong gains in 2012 in the face of numerous macro risks. Europe gained over 21% in 2012. Emerging-markets stocks earned 19%. In the U.S., mid- and small-cap stocks slightly outpaced large-cap stocks, 17% to 16%. The bond side also saw riskier asset classes do better. Emerging-markets local-currency bonds gained 17%. Domestically, high-yield bonds and leveraged loans returned 15% and nearly 10%, respectively, while investment-grade bonds returned 4%. Despite a conservative bias, our strategies performed well relative to their benchmarks over the past year, as our active bond funds, in particular, added significant value versus the core bond index.

We have been talking about the big-picture risks for several years, and our expectation that too much debt across the developed world will lead to subpar growth in the years ahead. And yet, we’ve just come off a year in which returns were not only decent, but downright good. Were we wrong?

Actually, our assessment in recent years about economic headwinds has been right on. Growth has been slower than any other recovery since World War II, and the risk in the financial system, particularly Europe, has led to major volatility. While we’re now four plus years into a period of reducing debt, we still have a long way to go—probably at least another four to five years—before we can expect to resume a historically normal growth track. Meanwhile, though the risk has come down, we still face the possibility of a major shock to the financial system. This could happen if, among other possibilities, Europe is unable to manage their ongoing crisis involving massive government debt, or if the U.S. is unable to make sufficient progress getting its fiscal house in order. The clock is ticking for both.

With respect to why we’ve seen good market returns despite macro problems and slow growth: one way to look at this is in the context of borrowing from the future. Here in the U.S. and in other developed countries we have delayed addressing the troubling fiscal problems for fear of triggering another recession and possible deflation, which could become a downward feedback loop that makes escaping our debt troubles even more difficult. The least painful way to reduce debt is through growth (as opposed to default or inflation), and that has been the overriding policy focus. But the fiscal and monetary action to stimulate growth comes at the cost of ballooning deficits that we’ll have to pay for later. That stimulus, including ultra low interest rates, has successfully encouraged risk taking—such as investing in stocks—and is part of the reason returns have been good. But there too we are in effect borrowing from future returns, and as we face the music and begin addressing our fiscal problems, we expect the negative impact on the economy will slow corporate earnings and affect stock returns.

There’s another significant cost that comes from pulling out all the monetary stops to keep the economy moving forward. The ultra low interest rates engineered by the Federal Reserve not only sap income that many boomers and their parents rely on for living expenses (which reduces spending), they also raise the risk of damaging losses in bonds once rates start to rise. Since it is conservative investors who have the largest allocations to bonds, the damage will be felt most by those who can least tolerate it. Admittedly, we’re not talking stock market level damage here. But as investors go out to longer and longer dated bonds in search of yield, the risk of loss goes up as well. A bond (or bond fund) with a 10-year duration would (generally speaking) lose 10% of value for each 1% rise in rates because bond prices fall predictably as rates rise (and vice versa). That magnitude of interest rise is well within the realm of possibility.

Our portfolio positioning seeks to take into account the likelihood of below-average returns and higher risk for stocks as well as the low yields and high interest-rate risk for core investment-grade bonds. We don’t want to be fully invested in stocks, but core bonds aren’t a great alternative, so we’ve allocated away from both areas in favor of areas that we think can generate acceptable returns with less market risk than stocks and less interest-rate risk than core bonds. On the bond side, these multi-sector positions give us a slightly higher current yield and much lower interest rate risk than the traditional core bond index. But there’s never a free lunch, and the “cost” of this positioning is that if we do see a sharp drop in stock markets such as from a big downturn in the economy or some other global shock, we’ll get less protection than we would with a full position in core bonds, due to the perceived credit quality risk. We are willing to accept this tradeoff because we are highly confident we will earn better returns over our full five-year window, even if we do have a bad period along the way, than we would owning more core bonds with their paltry yields and limited opportunities for price gains. Meanwhile, multi-sector bond funds have much less downside risk than stocks in a market downturn scenario.

Generally speaking, our largest multi-sector strategy is Osterweis Strategic Income, which primarily invests in short-term high yield bonds. If we do experience a downturn in stocks, which if pressed to guess we’d say is more likely than not over our five-year window, we expect to take advantage of more attractive valuations and return prospects by reducing this allocation in favor of stocks. We continue to analyze the longterm prospects for stocks and, when the time comes to increase risk, we believe emerging markets may be more appealing than domestic equities, given our longer-term outlook.

All in all, while we aren’t exactly excited about the cards in the deck, we are happy with how we’re playing our hand and appreciate your taking the time to let us walk you through what we’re doing and why.

We welcome any questions you may have, and want to convey that all of us at Storey & Associates appreciate your confidence.

Best regards,

Harlan G. Storey, JD, CFP®