EXECUTIVE SUMMARY
So Far, 2012 Is Producing Mostly Positive Economic Signs
Global equity markets are off to one of their best starts in recent history. In our year-end 2011 report, we mentioned that equities were set up for a potentially strong year in 2012 if policymakers in Europe could get ahead of the credit crisis. Our support for this view was that U.S. corporate operating earnings were up 15 percent in 2011, and equities were flat for the year, thus making stock valuations more attractive.
At the end of 2011, equity valuations were in the lowest quartile over the past 20 years, and equities were the cheapest relative to bonds in the past 30 years. Eventually, money typically flows into the more attractively valued asset class. After four straight years of record flows into bond funds and out of equity funds, a massive imbalance was beginning to unfold. We may now be in the early stages of a large rebalancing trade, where portfolio managers and investors begin to sell their bonds and re-allocate the proceeds into equities.
Bond investors are getting a taste of the dangers in the bond market as we are coming off record low interest rates. The thinking is that if bond investors continue to see losses on their investments as rates rise, they will begin to sell their bond positions and re-allocate some of the proceeds into equities and other assets that protect against rising inflation.
We see three major factors supporting the potential view that a reflationary situation may now be at hand. This may indicate a great re-allocation trade.
U.S. employment markets are strengthening
New claims for unemployment are coming in at four-year lows, while new hires are trending up and job openings are at five-year highs. At 285,000, we now have more openings for manufacturing jobs than in the past five years. The problem? Companies cannot find workers with the skills to fill these positions. Thus, it looks as though much of the unemployment dilemma could be resolved through the training and education of those who are out of work.
The bond market is watching the labor market closely, and that is one of the primary reasons why the 10-year treasury yield has moved from 1.92 percent three weeks ago to 2.38 percent as of this publication. The bond market is beginning to price in a recovering U.S. economy and a stronger employment picture.
If employment continues on its current path, it could have a significant impact on the two biggest issues facing the U.S. economy today: housing and the federal deficit. Stronger employment markets are truly the answer to get U.S. housing back into recovery mode, as it will increase the demand for new and existing homes. Rising employment may also dramatically effect the projected budget deficits in Washington, because the more people who are working, the more tax revenue the government collects. In addition, a robust labor market reduces the pressure on entitlement programs.
Source: All data from Bureau of Labor Statistics. ©2012 Ned Davis Research, Inc.
Source: ©2012 Ned Davis Research, Inc.
Source: ©2012 Ned Davis Research, Inc.
Central bank liquidity in the United States and Europe, and accommodative central banks in Japan, China, India, and Brazil
Seasoned equity strategists know that one of the primary influences of the capital markets to follow and respect is central bank monetary policy. “Don’t fight the Fed” is a common investment quote following this principle. Most great asset reflation cycles have been driven by the influence of monetary policy. We are currently witnessing the greatest reflationary effort by central banks in the history of the world. Both the U.S. Federal Reserve and the European Central Bank have expanded their balance sheets by more than $2.5 trillion each. The Bank of Japan is believed to be on the verge of expanding its balance sheet as well, while India, Brazil, and China are now beginning to become more accommodative with their policies after nearly two years of tightening. This massive coordinated easing is starting to flood the system with liquidity, which is finally beginning to circulate into the overall economy through increased bank lending.
The combination of excess liquidity in the system with an increase in confidence at the consumer level due to stronger employment, could provide the foundation for positive feedback loops within the economy. This could drive up asset prices, further shore up confidence, and boost consumption. As consumption goes up, inflation starts to rise, which will nudge interest rates upward. Central bank policy around the world is currently attempting to kick start the global economy in hopes it will push these positive feedback loops into action.
Source: Haver Analytics. ©2012 Ned Davis Research, Inc.
Source: ©2012 Ned Davis Research, Inc.
Source: ©2012 Ned Davis Research, Inc.
Corporate balance sheets are flush with cash
During the worst of the credit crisis in 2008, many corporations were shut out of the money markets, and their bank lines were being reeled in. After the crisis had passed, they did not want to experience another liquidity squeeze, so they began stockpiling cash. Fears are now beginning to ebb, and management is feeling pressure from shareholders to do something with this abundance of liquid assets.
Four things can be done in these situations. Corporations can pay back shareholders in the form of dividends; they can buy their own stock and retire shares; they can make capital investments in their business; or they can acquire other companies. All of these activities stimulate the equity markets or the economy. We have witnessed significant announcements on this topic in recent weeks, which we believe may be the beginning of a trend. Apple announced that it will begin to put some of the more than $90 billion it has in cash on its balance sheet to work in the form of a dividend to shareholders. It will also buy back stock. JP Morgan announced that it will buy back up to $15 billion in stock and increase its annual dividend by 20 percent. The cash on balance sheets should place some wind at the back of the equity markets.
European crisis update
For some time, we have discussed that, in our estimation, the European debt crisis is the single biggest risk facing the global economy. We have witnessed substantial change in Europe over the past few months to address these issues. Leaders have implemented massive policy shifts, regime changes, and austerity measures in an attempt to reduce the stress in the European credit markets and banking system. The hope is that this will buy time to allow each country to get its budget balanced, and the banks time to repair their balance sheets. The positive is that the Italian bond market, which is the third largest sovereign debt market in the world, has seen its 10-year bond yield drop from a November 2011 peak of more than 7 percent, back to more normalized levels of 4.9 percent today.
Europe’s sovereign problems are far from resolved. Leaders have bought time in hopes that an improving global economy can help them grow their way out of their lingering problems. The positive is Germany, which is by far the strongest country in terms of its balance sheet and its strong export economy.
Valuations
Source: ©2012 Ned Davis Research, Inc.
Technical Indicators
Source: ©Stockcharts.com
Sentiment
Source: ICI, Bloomberg
Source: ©2012 Ned Davis Research, Inc.
Investment strategy and conclusion
It would be unwise to dismiss the risks to the current global economic recovery. Sovereign deficits around the world top the list of reasons. However, the U.S. economy is still dominant throughout the world, and it is now entering its fifth year since the beginning of the 2007 credit crisis and real estate bust. Employment is recovering and central bankers everywhere have their foot on the gas attempting to reflate the global economy.
Historically, this has resulted in higher prices for risk assets, which in turn results in positive feedback loops and increasing global economic activity. We have positioned our portfolios to hedge the risk of interest rates rising as we expect a stronger employment market in 2012. With interest rates at 30-year lows and the U.S. economy recovering, this is a potentially dangerous time for bond investors who are not well diversified across various fixed income spectrums.
We believe there is a tremendous opportunity to add value to a traditional high quality, buy-and-hold bond portfolio by introducing income vehicles that are less sensitive to interest rates. Within our equity portfolios, we are neutral to our strategic targets, with a small allocation to alternative investments as a hedge against continuing sovereign debt issues and money-printing risks.
We do like select opportunities within the commercial real estate market. Banks are unloading nonperforming assets in large volumes. This reminds us of a similar situation during the last commercial real estate bust in the early 1990s. The Resolution Trust Corporation liquidated nonperforming loans off the balance sheets of failed savings and loans. We believe the current opportunities in commercial real estate dwarf that of 1990. In the 1990 commercial real estate bust, the space corrected 24 percent over a 45-month period, with $200 billion worth of assets being liquidated by the banking industry over a four-year period. The current commercial real estate correction witnessed a 41 percent correction over a 22-month period, resulting in an estimated $2 trillion of potential bank dispositions. Thus, the current correction is more severe and is resulting in a far larger opportunity set for sophisticated commercial real estate investors. We are working closely with experienced commercial real estate professionals to expose certain clients to what we see as an unprecedented opportunity.
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Tony Hallada, CEO
CliftonLarsonAllen Wealth Advisors, LLC
tony.hallada@cliftonlarsonallen.com
612-376-452
CliftonLarsonAllen Wealth Advisors, LLC (“CLA Wealth Advisors”)
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