2013 Telemus Capital First Quarter Market Update

The domestic stock market has demonstrated an uncanny resiliency and resolve of late.  The S&P 500 was up 10.6% in the first quarter, closing within 0.5% of its all-time high.  This, despite numerous headwinds including a sluggish economy (Q4 GDP growth was an anemic 0.4%), the implementation of the automatic spending cuts which could further weaken economic growth, the still unresolved debt ceiling debate, declining consumer confidence, an Italian electorate that is revolting against Europe’s austerity measures, and the demise of the little island of Cypress which has bank depositors throughout Europe wondering if their savings are at risk of a government-imposed tax.  Most of the information flow is signaling caution yet the market surges ahead—what’s up with that?

 

We think what’s up is that we are in the early stages of a major re-allocation shift among institutional and individual investors.  The rise in equity valuations and the decline in bond prices are not due to some newfound euphoria over future economic growth—if that were the case we would expect to see emerging markets leading the pack (down 2% for the quarter), commodities in general (up 0.5%) and particularly economically sensitive commodities such as copper (down 7%) also showing significant gains.  Instead, we are seeing the more defensive, higher dividend yielding sectors of the market leading the charge—the Dow Jones Utility Index (4% yield) was up more than 13% for the quarter, the Alerian MLP Infrastructure Index (5.3% yield) was up nearly 20%, and the Bloomberg Mortgage REIT Index (12% yield) was up almost 18%.  What’s up is a widespread rotation from bonds to stocks as investors seek out higher yielding assets.  The transition makes sense for income dependent investors—intermediate tax exempt bonds are yielding 1.2% and intermediate investment grade corporate bonds are yielding less than 2%.

 

Our clients’ portfolios performed quite well, on both an absolute and relative basis, in this environment as we have been touting many of these non-traditional higher yielding asset classes for some time now.  The global equity portion of clients’ portfolios benefitted from an underweighting in developed international stocks and an overweighting in domestic small- and mid-cap stocks.  The returns for both our taxable and tax-exempt bond portfolios were greatly enhanced by their exposure to lower rated high yield bonds.  Our holdings of gold and silver as a deflation/inflation hedge, which we were reducing throughout the quarter, was the biggest drag on portfolio returns as precious metals were down more than 5% for the quarter.

 

With the equity market fast approaching its historic highs it would be tempting to become more defensive.  While we wouldn’t be surprised with a modest correction along the way, we believe the overriding upward trend remains intact.  Investor asset class rotations, as we are witnessing now, are typically long in duration—they don’t get completed in a few months or quarters, it usually takes a couple years.  The headwinds remain but they are also known.  Based on the market’s recent performance in the face of some unanticipated shocks (Italian elections and Cypress come to mind), it will take quite a bit to derail this train.

 

Not to worry, we remain committed to our mandate to build the least risky portfolios necessary for our clients to achieve their financial goals.

2013 Global Outlook

U.S. Overview

Economy

The delay in resolution of the Fiscal Cliff certainly had a negative impact on consumer spending in the fourth quarter and will likely have an adverse effect on Q1 2013 GDP growth as many corporations postponed initiatives awaiting the outcome.  Even though the first leg of the Fiscal Cliff resolution preserved the Bush-era tax cuts for all but the wealthiest Americans, everyone will be paying higher taxes than a year ago as the temporary payroll tax holiday expired.  The next leg of the Fiscal Cliff debate could be even uglier and more dysfunctional than the first as spending cuts and an extension of the debt ceiling will be on the table.  While we are confident a compromise will eventually be reached between Republicans and Democrats, we suspect the bickering and haggling between now and then could further erode consumer and corporate confidence.  In short, we see a politician-induced difficult economic environment over the first half of 2013; but, once the politics are behind us we expect an improving economy over the second half of the year.

Inflation

At its last Federal Open Market Committee meeting of 2012 the Federal Reserve tied its accommodative monetary policy to the unemployment rate.  Specifically, the committee agreed to maintain its asset purchase programs and 0% Federal Funds rate policies until such time as the unemployment rate falls below 6.5%.  The Fed wants higher inflation.  For those of us who were raised in this business on the adage “don’t fight the Fed”, we believe the Fed will eventually get its way—lower unemployment but higher inflation.

Interest Rates

As noted above, short-term interest rates will remain low for some time.  Prior to this last FOMC meeting, the Federal Reserve had committed to keeping them low until at least 2015.  Longer term interest rates will benefit from the Fed’s asset purchase programs but will face more upward pressure from the aforementioned inflation outlook.  Moreover, bond investors are not comforted by fiscal irresponsibility—an extension of the Bush-era tax cuts for all but the wealthiest without an accompanying expense reduction plan will not be well received by bondholders.

Domestic Equity Markets

Ultimately stock prices track corporate earnings—we believe the corporate earnings environment remains positive even as the overall economic environment remains fragile.  That, coupled with an accommodative monetary policy, makes domestic equities attractive.  Dividend and long-term capital gains tax rates were bumped modestly for the wealthiest Americans, but not as much as many feared (back to the ordinary income tax rate).  On an after-tax basis, even for those paying the highest rates, the 2.2% dividend yield of the S&P 500 is much higher than the 1.75% yield on the investment grade corporate bond market or the 1.25% yield on the intermediate municipal bond market.

Domestic Bond Market

We expect short-term interest rates to remain low for some time; but, as we noted above, we do expect the Fed to ultimately win its fight to reduce the unemployment rate and increase the inflation rate—that isn’t a good scenario for longer-term bonds.  Corporate bond yield spreads relative to US Treasury debt remain attractive particularly when one considers the increasing supply of US Treasury debt relative to corporate debt.  In our tax-exempt portfolios we continue to emphasize higher quality issuers as declining property values and tax bases are having an adverse effect on many state and local municipalities.  Non-traditional fixed income securities such as senior bank loans, convertible bonds and preferred stocks continue to provide the most attractive risk/reward characteristics.

 

International Overview

Economy

Europe is in a recession, but there are signs of little green shoots popping up—we believe the worst may be behind the European Union.  Likewise, the newly elected Japanese Premier Shinzo Abe is putting pressure on the Bank of Japan to pursue the same accommodative policies as our own Federal Reserve Bank to stimulate growth in that country.  The emerging market economies are showing signs of renewed strength, as evidenced by the fact Macau saw gambling revenues balloon 20% this past December.  Longer term we still expect the emerging economies and the emerging middle classes within those economies to fuel significant growth over the coming decades.

Inflation

Since most of the world’s major central banks are pursuing inflationary policies similar to our own Federal Reserve Bank we would expect inflationary pressures to increase in most major economies.  Europe could be an exception to this as the austerity measures pursued there probably pose a greater risk for deflation than inflation.

Interest Rates

As with the domestic market, we expect global short-term interest rates to remain low; but, due to inflationary pressures we would expect some upward pressure on longer-term interest rates.  Again, the exception is probably the European rate environment where longer-term rates probably still have room to fall, particularly in some of the periphery states.

Currencies

The dollar remains the unquestioned global reserve currency but oddly enough, since last summer the Euro has been the world’s strongest currency.  This is largely due to Europe’s austerity measures as opposed to our inflationary monetary stimulus policies.  Japan is now also pursuing those same policies, which has led to a10% devaluation in the yen versus the US dollar.  We would expect the dollar/euro relationship to stabilize, but we expect further declines in the yen.

Natural Resources

Global central banks’ inflationary policies will be positive for natural resource prices.   Renewed economic growth in the emerging markets will be a huge positive for natural resource prices.  Longer-term, increased global demand without a comparable increase in supply will keep natural resource prices on their upward sloping trajectory.

Global Equity Markets

We’ve become much more constructive with regard to developed and emerging international markets.  At present we have a neutral weighting but the next move is likely to be an overweight.  Valuations in developed international markets remain attractive; and, emerging and frontier market valuations are attractive relative to their high growth rates.

Global Bond Markets

While we remain concerned about the seemingly never-ending sovereign debt crisis in Europe, we believe current yield levels offered by some of the periphery states compensate investors for those risks.  Longer term we believe developed foreign government bonds will outperform U.S. Treasury bonds due to their higher yields and less inflationary central bank policies.  We would underweight emerging market debt as we believe those yields no longer compensate investors for the inherent inflation and credit risks.

Jim Robinson

CIO

 

Disclaimer and Disclosures
This report is provided for informational purposes only, and does not constitute any offer or solicitation to buy or sell any security discussed herein. All opinions expressed and data provided herein are subject to change without notice. All investments involve different degrees of risk. You should be aware of your risk tolerance level and financial situations at all times. Past performance does not guarantee future results.