EXECUTIVE SUMMARY

Watching Europe: The View Is Not Improving

The European debt crisis continues to be the single biggest risk to the global economy and capital markets. It seems that policymakers in Europe are taking one step forward and two steps back with their initiatives to date. We have witnessed interest rates in Greece, Spain, and Italy approaching new crisis highs, European equities moving toward new lows, and economic activity indicating a potentially deep recession throughout Europe. Policy intended to stop the slide is implemented, only to find later that it did not target the issue at hand.

Clearly, the Europeans are dealing with an issue of solvency, not liquidity. Banks in Europe are on average twice as leveraged as their U.S. counterparts, leaving much less room for error before they become insolvent. To overcome this leverage, European banks are required to hold much higher levels of government bonds. In a normalized marketplace, this would stabilize the banking system’s balance sheet. Unfortunately, these are not normal times. Much of the toxic debt on the balance sheet of banks is the government bonds of profligate countries, such as Spain, Greece, Italy, and Portugal. The declining value of government debt, in addition to deteriorating real estate loans, continues to pressure the European banking system.

European policymakers have attempted to kick the debt issue down the road through the expansion of the European Central Bank (ECB) balance sheet, which has provided liquidity to the banking system through the Long-Term Refinancing Operation (LTRO) mechanism. But LTRO is nothing more than short-term loans to the banking system that provide liquidity but do not assist with solvency problems. In addition, these policies do nothing to improve the trade imbalances of southern European countries. Sovereign balance sheets throughout Europe continue to deteriorate, as evidenced by the rating downgrades of their debt over the past two years.

Unsustainable liabilities

There are simply too many European countries with unsustainable liabilities. Governments find themselves with too much debt, along with too many entitlement programs, such as pensions, welfare, and nationalized health care. The eurozone experiment appears to be running out of runway. Germany is the one balance sheet that, if it were to guarantee the debt of other countries, could push the European showdown far into the future. But so far, Germany has been unwilling to take that step; leaders seem to have no interest in bailing out their debt-ridden neighbors.

Source: Bloomberg

In our opinion, the majority of sovereign governments in the advanced world find themselves with too much debt (Japan, Europe, United Kingdom, and United States) The problems facing these governments won’t be resolved until excess debt is either:

• Reduced through debt repayment (highly unlikely)
• Restructured (likely)
• Defaulted and forgiven (highly likely)

We do not condone the last two choices, but we see very little opportunity for these governments to honor their obligations in their current form. At some point in the near-to-intermediate future, we will likely see a cleansing of debt, which will require a reset for the capital markets and the global economy. When this process is complete, we believe the global economy can move back into a very powerful growth phase. It is also likely that we will not get to the other side of the process without massive policy reform on spending and taxation, or without restructuring debt and long-term liabilities, such as Social Security, Medicare, and other entitlement programs.

The math is simple: living beyond your means through debt works, at least until it doesn’t. There is an end game to this approach, and it is growing close. With the debt-to-Gross Domestic Product (GDP) ratios in Japan, Europe, and the United States at historically high levels (see debt-to-GDP charts), we believe we are in the ending stages of a deflationary debt de-leveraging cycle. Most likely, it will result in low inflation and deflation, low wage growth, high unemployment, low interest rates, and low returns on risk assets.

Source: Haver Analytics ©2012 Ned Davis Research, Inc.

Here’s what the numbers tell us

We have witnessed a negative trend in the economic reports out of Europe, Asia (China), and the United States. Following are some data points indicating that a synchronized global slowdown is at hand. Do policymakers still have what it takes to stem a global recession this year? We know there are fewer tools than at any time in history, and the ones they have aren’t likely to produce the same impact as prior stimulus efforts.

In addition, the United States faces a fiscal cliff created by the expiration of Bush-era tax cuts, the 2 percent payroll tax holiday, and the surtax on investment income. If not addressed, it could negatively impact GDP by 3 percent, according to leading economists.

Source: ©2012 Ned Davis Research, Inc.

Source: ©2012 Ned Davis Research, Inc.

Source: ©2012 Ned Davis Research, Inc.

Source: Economic Cycle Research Institute ©2012 Ned Davis Research, Inc.

Source: Haver Analytics, HSBC ©2012 Ned Davis Research, Inc.

Source: Haver Analytics, China National Bureau of Statistics ©2012 Ned Davis Research, Inc.

Source: Advisor Perspectives

Source: ©2012 Ned Davis Research, Inc.

Source: ©2012 Ned Davis Research, Inc.

Sentiment

Source: ©2012 Ned Davis Research, Inc.

Valuation

Source: Standard & Poor’s ©2012 Ned Davis Research, Inc.

Investment themes

 

Income-producing securities

We like income-producing securities and believe they are in a bull market. With approximately 10,000 Baby Boomers turning 65 in the United States each day, the demand for sustainable retirement income is at an all-time high. This record demand is being met with the lowest interest rates in U.S. history on traditional government-guaranteed fixed income instruments, such as certificates of deposit, treasuries, money markets, and mortgages. Boomers are being forced to seek alternative forms of income-producing instruments, such as investment grade/high yield corporate and municipal bonds, preferred stocks, and closed-end funds. With that goal in mind, investment companies are creating publicly traded alternative investment vehicles, such as mortgage real estate investment trusts (REITs) and master limited partnership (MLP) funds.

The CliftonLarsonAllen Wealth Advisors portfolio solutions group oversees a broad array of portfolios that seek to produce solid and sustainable income streams from these asset classes.

Real estate

We believe there is a secular shift taking place in the housing market that’s being driven by credit, demographics, and psychology. The housing bear market has had a significant impact on 20 to 30 year olds. Credit is now much more restrictive, making it difficult for young people to finance a home. In addition, they have a pessimistic view toward housing because they’ve witnessed the recent negative experiences in owning a home. Another demographic that is driving real estate is the swelling number of Baby Boomers surpassing 65 years of age. Both of these age groups are driving the demand for rental apartments.

Commercial real estate witnessed a 41 percent correction over the past few years, which has created potential opportunity in the office, hotel, and medical real estate markets. We are still somewhat skeptical of retail space as online shopping continues to take away market share from sticks and brick retailers.

 

Hedged, income, and U.S. equity

At this level of the market, we prefer hedged equity to pure long-only equities. We also favor higher-yielding equity vehicles, as the income will most likely provide support in corrective markets. We are inclined to choose U.S. equities over developed international equities due to the view that the United States is the cleanest dirty shirt in the clothes hamper.

 

Gold and gold miners

Gold and gold miners in a portfolio provide insurance against the continual devaluation of fiat currencies due to central bank policies (money printing). Gold is viewed as “real money” in a world of “paper money.”

Absolute return strategies
These are typically strategies that try to achieve a positive return in any given calendar year. They generally deploy risk management techniques that attempt to limit downside risk. Many different, often complicated, techniques are used in an attempt to achieve the desired returns, and they also may be available to investors through fund shares created by investment companies or exchange-traded funds (ETFs).

It is more critical to focus on absolute return investing in times of secular bear markets. Relative returns don’t typically buy much in a secular bear market. For example, the Japanese Nikkei Index peaked in 1989 at about 39,000. Today, the Nikkei is at 8,735, down 65 percent over the past 22 years. Thus, an investor attempting to benchmark against major stock indices during Japan’s 22-year secular bear market was defeated. But can it be considered success if the investor was down just 50 percent over the past 22 years and still beat the Nikkei?

Here in the United States, we find ourselves in a somewhat similar situation. An investor in the S&P 500 over the past 12 years has seen negative returns. We expect U.S. investors will eventually learn that beating the S&P 500 should not be their goal in a secular bear market. Instead, investors should focus on knocking out singles and doubles year after year, and attempting to avoid the big washout. Losses are the number one destroyer of the powerful forces created by compounding.

It is important for every family to perform an asset/liability report during times like the current range-bound secular stock market to figure out what return is needed to meet future liabilities. We recommend investing in a portfolio that provides a high probability of achieving those future goals. If you can get your assets to meet your liabilities, you can consider that a “success.”

We believe these strategies can provide our clients with a much higher probability of achieving goals in what has been, and will continue to be, a very challenging and volatile investment environment. Our advice: run your own race. Create your own personal benchmark based on your family’s goals and then invest in strategies that increase the probability of your assets meeting your liabilities.

View as PDF.

 

 

---

Tony Hallada, CEO
CliftonLarsonAllen Wealth Advisors, LLC
tony.hallada@cliftonlarsonallen.com 
612-376-4529

CliftonLarsonAllen Wealth Advisors, LLC (“CLA Wealth Advisors”)
The purpose of this publication is purely educational and informational. It is not intended to promote any product or service and should not be relied on for accounting, legal, tax, or investment advice. The views expressed are those of CLA Wealth Advisors. They are subject to change at any time. Past performance does not imply or guarantee future results. Investing entails risks, including possible loss of principal. Diversification cannot assure a profit or guarantee against a loss. Investing involves other forms of risk that are not described here. For that reason, you should contact an investment professional before acting on any information in this publication.

Financial information is from third party sources. Such information is believed to be reliable but is not verified or guaranteed. Performances from any indices in this report are presented without factoring fees or charges, and are provided for reference and competitive purposes only. Any fees, charges, or holdings different than the indices will effect individual results. Indexes are unmanaged; one cannot invest directly into an index. Investment Advisory Services offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC Registered Investment Advisor.

Prior approval is required for further distribution of this material.