Executive Summary
Though the stock market ended 2011 roughly where it began the year, the ride for investors has been anything but flat. The immense volatility in the markets over the past year gave rise to the “Risk On” or “Risk Off” characterizations, which seemed to change back and forth on a daily basis. At the heart of this immense market volatility and high correlations among stocks has been a heightened sensitivity to each bit of news (e.g., Europe) and each new piece of macroeconomic data. Many investors have become so preoccupied with the short-term and trying to predict whether today will be a “Risk On” or “Risk Off” day, that they have lost sight of the fundamentals that drive stock performance over the long run. We address this challenging market environment in this month’s Feature Article, A Case for Long-Term Investing in a “Risk On, Risk Off” Market.
We saw a continued streak of market turbulence in December as the European debt crisis remained on the front page. Geopolitical turmoil in the Middle East and North Africa heightened as Iran has plowed ahead with its nuclear program, and there are intensifying concerns that the program is developing nuclear weapons. Iran’s nuclear ambition is a real threat to the region and the idea that Israel is near an attack is a very real worry and threat. The U.S. drone shot down over Iran in December has escalated these worries.
The developed market economies look to be mid-cycle to late cycle, though decelerating and leaving the sub-par growth environment intact. Global growth is slowing and we do not expect a significant amount of sustainable improvement from here given that the global debt load has only been moved to sovereign balance sheets, creating a larger appetite for fiscal austerity and subsequently limiting developed market growth in the near-term. In the emerging markets, the tightening cycle has largely hit its peak, although a few countries did increase rates recently. We have started to see more wholesale easing via both rate cuts and non-conventional measures. A growth deceleration will continue as a carry-over from past tightening, though the new easier policy stance should begin to work through these developing economies in 2012. Global Economic Overview »
This month, we modestly reduced our recommended exposure to equities, though we remain overweight. This change was brought about as a result of deteriorating economic indicators in the developed international markets – specifically Europe. Valuations in the developed markets remain very attractive, so we are comfortable maintaining a slight overweight despite the changes in our economic indicators. The Economic Clock moved backward slightly to 8:30 this month, continuing to suggest that we are late in the economic cycle. Although there are economic risks in the current environment, we believe that current valuations and sentiment are attractive enough to recommend maintaining an overweight equity allocation. In fact, we increased our U.S. Large Cap and U.S. Mid Cap exposure as we continue to see signs of stability in the U.S. market, and valuations in the U.S. Mid Cap space have improved. We also slightly increased our recommended exposure to Emerging Markets (though still slightly underweight), as indicators for these regions became more favorable. In the fixed income space, we believe that high yield bonds offer solid opportunities, but investors should exercise caution when selecting specific issues within that market. Investment grade credit spreads continue to present opportunities, even more so than earlier in the year. Top-Down Asset Allocation Recommendations »
We have chosen to revisit the United Kingdom this month for our Country in Focus. Similar to other developed countries around the world, the United Kingdom (UK) has many favorable attributes, but many noteworthy headwinds as well (including a high government debt burden). From a political standpoint, the UK faces many serious and intertwined domestic and international issues, with perhaps the most prominent one being tensions between the UK government and the European Union at the recent Euro Summit in December. In general, the UK economy continues to gradually heal from the financial crisis in 2008/2009. However, the de-leveraging process remains painful and long. The government has made a noticeable effort to reduce its deficit and debt load, implementing an aggressive program to cut costs and raise taxes. However, the effects of these austerity measures are being felt across the economy, with the potential for a recession in 2012 looking more likely. UK unemployment is rising again, and with negative disposable income growth, the consumer remains generally weak. In the business sector, sentiment remains at historically low levels and investment spending has been decelerating. With the goal of boosting broad money growth and encouraging private spending, the Bank of England has maintained accommodative monetary policy and implemented two quantitative easing (QE) programs. If conditions deteriorate further, there is the chance that the central bank could act again with more QE in an effort to support the economy. Meanwhile, inflation has remained stubbornly high, mainly the result of higher taxes and commodity prices. The UK stock market is one of the cheapest on both an absolute and relative basis, which could be creating opportunities at attractive valuations. Country in Focus »