Market update — marking time

William F. (Ted) Truscott, Chief Investment Officer
Oct. 20, 2009

A look back

The most appropriate word to describe the emotions of last fall and the fateful week of Sept. 15, 2008 would probably be panic. As has been well-documented in The Wall Street Journal, Vanity Fair, The New Yorker and many other publications, the events of last fall are truly disturbing to revisit. Many of the United States' seemingly soundest financial institutions were on the verge of collapse.

Not since the late 1920s and early 1930s had so many questions about financial safety and soundness been asked. Confidence in the financial system vanished as trust in most financial institutions evaporated. Cold hard cash and government debt seemed to be the only safe place to store wealth and with no wonder based on what was going on. When no one knows who to trust, a financial system cannot function properly. Thankfully, those panic-filled days appear to be gone. However, we must remember the lessons of 2008 and I am somewhat fearful that complacency has begun to find its way back into the markets.

Almost 12 months ago, on Nov. 5, 2008, I wrote a market update that outlined two possible scenarios for the economy and financial markets. A 30% probability was assigned to the "Disinflation/Deflation" scenario where a powerful deflationary force that the government could not stop would be unleashed on the economy. It was not a rosy scenario and had it played out, could have looked very much like a revisit of the Great Depression. A 70% probability was assigned to the "Reflation" scenario and below is an excerpt from that scenario:

The government continues its strong intervention in the economy. It continues taking equity stakes in banks and extends that policy to insurance companies and other components of the financial system, including automobile financing companies such as GMAC. Bernanke and the Federal Reserve introduce "quantitative easing" where interest rates are taken down close to zero in order to ward off deflation. The government enacts another fiscal stimulus package that passes with ease thanks to the Democrats' control of both the White House and Congress. These policies err on the side of reigniting inflation deliberately because the Fed knows how to fight inflation. Deflation is avoided at all costs as the remedies are mostly theories in text books. The economy contracts according to chief economist Dan Laufenberg's [now retired] forecast in the first half of 2009 but the bond and stock markets sense that government policy is working and will continue to work. Despite increased bond defaults, higher unemployment and continued consumer retrenchment, investors flock to bargains in the stock and bond markets. World markets also benefit from policies enacted by European and Asian governments. Emerging markets get an additional boost to already-solid growth rates.

I am happy to report that much of the reflation scenario has played out. A powerful stock market rally off the lows of March 6, 2009 has ensued, while corporate and high-yield bond spreads have contracted in the face of an equally powerful bond market rally. Exceptionally low interest rates and other creative policies instituted by the Federal Reserve and other government agencies have pushed investors off the sidelines. Demand for cash has fallen as market participants no longer shun risk. As a result, stock and bond markets are beginning to function normally. A functioning credit market is critical — an economy simply cannot grow without the free flow of credit between borrowers and lenders.

The chart below shows the significant narrowing of corporate bond spreads since the peak of the crisis in late 2008. Narrowing bond spreads indicate that investors are demanding less compensation for the risks undertaken. Note that the average 6% spread over treasuries at the peak of the crisis is the highest level ever seen. Those levels suggested that the bond market was predicting a depression that thankfully never occurred. High-yield bond and bank loan spreads were even wider. Investment-grade spreads have now returned to a level we last saw during the WorldCom/Enron crisis of late 2002.

What's next?

A financial disaster has clearly been averted and while everyone is relieved, this naturally begs the question, "What happens next?" Below are three scenarios and associated probabilities that will hopefully serve as a guide to investors for the next year. Each case contains suggestions as to the financial instruments that may perform well under each scenario. Please note that the suggested allocation among various instruments is for a short-term period of only one year.

Clients should consult their financial advisor as to the appropriate mix of assets and financial products as each client's needs and appetite for risk are different. Reconciling short- and long-term investing is always a difficult exercise. As such, it may be appropriate for advisors and their clients to use the suggestions below only as a guide to tilting a portfolio toward a particular mix but not changing it completely. Other possibilities include using advice-embedded products that perform ongoing asset allocation. Individual risk tolerance, tax considerations, mix of the existing portfolio and other factors would also influence the degree to which these suggestions are utilized, if at all.

Economy snaps back (30% probability)

In the rosiest of all possible scenarios, the late Milton Friedman and current macroeconomic expert Jim Grant are right and the economy is set to grow much faster than anyone expects in 2010. Friedman, a Nobel Prize winning U.S. economist, believed that the deeper the downturn, the more powerful the economy snaps back. In true contrarian fashion, Jim Grant, founder of Grant's Interest Rate Observer, echoed this sentiment in a recent newsletter and The Wall Street Journal article.

Growth rates are 5% or higher and this allows earnings to grow at a faster rate than expected. The unemployment rate falls. Financial markets stage an even more powerful rally on the back of this largely unexpected result. The Fed is able to withdraw monetary stimulus and allow interest rates to rise as a result of strong economic growth. Inflation risks moderate as a result of higher rates. Higher rates are a drag on Treasury and municipal bond returns, but high-yield and corporate bonds perform well as the outlook for defaults moderates. Small-cap stocks, always the beneficiary of strong economic growth, perform strongly. The dollar strengthens making international equities somewhat less attractive than U.S. assets for dollar investors. Emerging market equities provide good returns on the back of world economic growth, strong commodity exports and the peg of many emerging currencies to the dollar.

A portfolio designed to take advantage of this scenario is suggested below:

• U.S. small-cap stocks – 15%
• U.S. mid-cap stocks – 15%
• U.S. large-cap stocks – 25%
• International stocks – 15%
• Emerging markets equities – 5%
• High-yield bonds – 15%
• Investment-grade corporate bonds – 10%

Marking time (50% probability)

In the following scenario, which I believe is the most likely to occur, the burst debt bubble does more damage than expected and like other countries that have experienced banking crises, the United States experiences sub-par economic growth on the order of 2% to 2.5% in 2010 (note the official Ameriprise forecast is 2.4% growth for all of 2010). This growth rate is insufficient to reduce the output gap and the unemployment rate remains high but falls from its peak. Consumers remain cautious in the wake of high unemployment and the savings rate continues to rise. Further savings are necessary as house prices, while forming a bottom, no longer appreciate at a rate that supplies consumers with additional income for spending. Bonds provide competitive returns vs. stocks, especially when adjusting for risk. The dollar remains weak as the Fed keeps interest rates low making international equities more attractive.

The economy suffered a horrific shock in late 2008 and early 2009. Credit markets did not function normally for close to six months while global trade collapsed for almost the same time period. While government intervention has revived credit markets and trade, I am highly skeptical that we can recover from such an enormous shock in such a short time period. Indeed the Bank Credit Analyst (BCA) quotes International Monetary Fund studies that recoveries after financial crises are weaker than recoveries after more classic recessions.¹

This environment would result in positive returns for the stock and bond markets but in the mid-to low-single digits. Bond coupons and stock dividends would provide a significant component of the return as price appreciation in the latter half of this year reduces the possibility of additional significant capital gains in 2010. The "Marking Time" scenario is not horrible but it is different from the past and suggests a longer period of recovery for portfolios damaged by the downturn.

A suggested portfolio for this environment is:

• U.S. mid-cap stocks – 5%
• U.S. large-cap stocks (especially dividend paying stocks) – 20%
• International stocks – 25%
• Emerging markets equities – 5%
• High-yield bonds – 10%
• Investment-grade corporate bonds – 20%
• Municipal bonds – 10%
• Cash – 5%

Japan redux (20% probability)

In our most pessimistic scenario, exceptionally low interest rates are unable to overcome the waning effects of the U.S. government's $780 billion stimulus package. The economy slips back into recession or grows at a very anemic pace of less than 1%. There is pressure to enact another stimulus package but the government cannot afford it due to large existing deficits. The Fed's 0% interest rate policy remains in effect for all of 2010 and the dollar weakens further in the face of a sluggish economy and low interest rates. Corporate restructuring continues as companies adjust to anemic revenue growth through further cost cutting. The unemployment rate is stuck at 10%. Consumers continue to save and are reluctant to spend. Stock markets trade sideways as hoped-for revenue and earnings growth never materialize. As such, stocks provide for minimal gains, mostly through dividends. High-yield bond defaults grow in the face of a weak economy and credit growth remains constrained.

While the economy would not exactly resemble Japan, forecasters and commentators would in fact compare the state of the economy to Japan's lost decade in the 1990s — itself the result of a burst debt bubble. Emerging market equities remain one of the few areas of optimism as there is significant enough domestic demand to provide some growth.

A suggested portfolio for a moderate investor in this environment is:

• U.S. and International stocks with low levels of debt and high dividends – 20%
• Emerging markets equities – 5%
• U.S. Treasury notes/bonds and or municipal bonds (10 to 30 years) – 30%
• Global government bonds – 25%
• U.S. investment-grade corporate bonds – 10%
• Cash – 10%

A quick word on inflation

Inflation remains a risk given the large sums of money used to combat the financial crisis and yet it is clearly absent from any of our scenarios. Why? Inflation risk seems to be a few years away given the sluggish growth in credit, large output gap in major world economies and high unemployment rates. We will keep a close eye on this risk as the emergence of a credible inflation threat would create significantly different portfolio allocations and would likely include the use of TIPS, gold and other hard assets to combat inflation's destructive and distorting effect on financial assets.

Conclusion

In just one year's time, U.S. and global economies have avoided an economic disaster that could have rivaled the Great Depression. The creative policies of the Federal Reserve and other government agencies were largely responsible for containing the fallout after the collapse of Lehman Brothers — although luck no doubt played a role as well.

We remain wary of complacency creeping back into the financial system. It is not credible or even believable to move from a state of panic to one of aggressive risk-taking in just 13 months. Risk and return are directly related and we must remain vigilant and aware of risks building in the system again, especially since short-term interest rates remain near zero. Remember, it was low interest rates, aggressive lending and the burst housing bubble that set off last year's panic in the first place.

As 2009 draws to an end, now may be the perfect time for you to sit down with your financial advisor to discuss these potential scenarios and how your own portfolio could be affected by each. Ensuring that your financial plan is keeping up with the changing economic and market conditions can be crucial in helping you prepare your investment strategy to allow you to reach both your short- and long-term financial goals.