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Among those choices, credit-sensitive, fixed-income instruments would seem to offer better returns with reasonable security. Opportunities also present themselves in the equity markets. In the developed markets, North America seems to offer the best risk/reward balance. Though stock valuations are better in Europe and Japan, the former still needs to deal with its debt crisis and the likelihood of recession, while the latter faces the very fundamental matter of severely aging demographics, as well as the immediate adverse impact of an expensive currency. Emerging markets, however, offer a reasonably bright outlook. Though they are not likely to generate anything near their former growth and return records, their economies still indicate much more impressive rates of expansion than those in the developed world and, given the rather attractive valuations in these emerging markets, equity returns there may be much improved. Here, then, is a brief analysis of the situation in each area and the associated investment prospects.
The Safe Havens Look Risky
The turmoil and uncertainty that have plagued markets since 2008 have driven many individual and institutional investors into the usual safe havens. Yields on U.S. Treasury bonds—the quintessential refuge in uncertain times—have fallen accordingly to touch record lows, as have German and other favored government securities. Gold prices, though uneven of late, have soared.
Meanwhile, the U.S. Federal Reserve’s monetary easing has driven down all short-term, dollar-based rates to fractions of a percent, as has the Bank of England to sterling-based rates. The Bank of Japan did the same to yen-based short rates a while ago. The European Central Bank (ECB) had bucked the trend, but the demands of the sovereign debt crisis forced a reversal of that policy, so that by late 2011, eurozone short-rate targets had fallen as well.
Matters have gone so far that these havens now offer ridiculously low returns. Earlier this year, for example, German government yields actually dipped into negative territory. Investors, in other words, paid Berlin for the privilege of lending it money. Ten-year Treasury bonds in the United States, with yields less than 2%, still pay a positive nominal return, but after accounting for even modest rates of inflation, they leave investors with a real loss, effectively paying the U.S. Treasury in real terms for the privilege of lending it money too. Short rates in all seemingly safe, developed markets, whether on government debt or deposits, remain so low that any funds left in them lose in real terms with each passing day.
Investors offered such low returns seem likely to look for better deals elsewhere with the slightest improvement in economic or financial conditions. Even a modest abatement in the pattern of European panic, for instance, or an improvement in the U.S. economy, or even signs of stability in the emerging economies, could draw funds out of government bonds, raise their yields, and impose capital losses on their holders, as well as on those investing in gold. Easing tensions in the Middle East could have a similar effect. Meanwhile, it is hard to see what would cause these safe-haven yields to move much lower. Investments in these areas, then, look generally unattractive, offering a continuation of inadequate yields at best or capital losses on the least improvement anywhere.
In such a situation, it would seem better, then, to lean toward lesser-quality,more credit-sensitive, fixed-income instruments. These carry yields much higher than most government bonds and other seemingly safe investments. In the event that matters remain as worrisome as at present, yields should at least offer a positive real return, and in the event that there is the slightest improvement on any front, they should protect against the capital losses likely in U.S. Treasuries and other, stronger government bonds, even if they do not necessarily offer capital gains.
Of course, not all lesser credits are equal. Bonds issued by Europe’s endangered periphery, for example, may require more intestinal fortitude than most investors may be willing to exhibit. But in the United States, for instance, high-yield bonds offer yields some 600–700 basis points (bps) above Treasuries—a gap of 150 bps above their long-term averages. Intermediate-grade corporate issues offer similarly attractive, if less dramatic, yield spreads. Since default experiences have actually improved, the picture is one of an attractive risk/reward trade-off. For many U.S. taxpayers, municipal bonds, even after their very good performance in 2011, offer an even more attractive investment picture for much the same reasons.
Europe Remains a Fountain of Bad News
While the stock losses engendered by Europe’s sovereign debt crisis have given European stocks some of the most attractive valuations in the world, their prospects still look dubious. The crisis will remain for a long time to come, and Europe this year faces the strong likelihood of at least a mild recession. At some future date, attractive valuations will make European equities a generally good investment choice. But it would be premature now to make a general move into European equities.
Of course, European stocks would soar if the eurozone could resolve its debt crisis satisfactorily. Though 2012 does offer the prospect of some relief—now that the ECB seems to have decided to provide additional amounts of liquidity to support markets—that improvement will prove inadequate to the needs of the situation. The best the liquidity can do is blunt the market panic. It cannot address more fundamental issues. Even with a gratifyingly active ECB, an excess of debt will remain a fact. Concerns about the ability of Europe’s nations (both in the periphery and the core) to make fundamental fiscal reforms will continue to threaten European investments. Questions about the biases implicit in the basic structure of the euro will also weigh on markets. All of this, even with expected ECB help, will likely prevent European stocks from fully realizing their value.
Meanwhile, recessionary pressures will raise further concerns about European equities. Even if Europe’s policymakers could arrive at a promising plan today (something that is hardly likely), Europe would still face a legacy left from past troubles. Liquidity shortages that developed in 2010 and 2011 have created a great caution among businesses that will not lift quickly. The uncertainties engendered by the crisis also will take time to lift. European businesses, in the periphery certainly, but also across much of the Continent, will, consequently, remain reluctant to expand and to hire. The past reluctance of the ECB to ease the strains of the sovereign debt crisis will also leave the Continent struggling to overcome what amounts to two years of monetary restraint. Bank reserves have hardly grown at all, while money in circulation has expanded too slowly to support normal economic needs, much less those created by the debt crisis. Even now that the ECB seems ready to correct these past mistakes, it will take time for the policy change to have an economic effect. Still more, the fiscal austerity imposed on Europe’s periphery will restrain growth in these economies and, consequently, impair export growth prospects in Germany and other stronger European economies. Austerity efforts in these stronger economies, though less severe than in the periphery, will further restrain growth.
These recessionary forces have led optimists among European economists to anticipate zero real growth this year, while the pessimists look for declines in excess of 2.5%. Likelihoods fall somewhere in between. But even the best of those outlooks suggests little good about European earnings. As already indicated, over the longer-term period—after which Europe can lift the bulk of its sovereign debt burdens and work through the recessionary forces presently marshaled against it—the attractive valuations will tell, and European stocks will make very attractive investments, but that time will wait 18–24 months at least.
The United States Looks More Secure and More Attractive
Economic fundamentals in the United States, though far from robust, look better than those in Europe. Businesses have huge cash hoards and are showing signs of using them at last, including for stock repurchases, acquisitions, and hiring. Housing prices and buying activity seem to have stabilized. If housing is still far from an engine of growth, stability is a welcome relief from the near free fall of the past few years. In addition, other good news for the economy is that exports are booming as a consequence of the dollar’s long-term decline. And households also are beginning to spend again. Though consumers remain cautious, they have found relief from the worst aspects of real estate price declines and the most intense insecurities about their jobs. They also have done much to start the repair of their balance sheets. Households have raised the ongoing flow of savings from income to 4–5% of their outstanding liabilities, and thus they are in a position now to continue improving their finances without any need for further cutbacks. Circumstances hardly point to robust growth, however, but enough to advance the overall real economy between 2–2.5%, even in the face of a European recession.
If American stock valuations are not as depressed as those in Europe, they remain low enough to allow prices to more than keep up with the modest earnings expansion of about 10% that would likely accompany such an admittedly slow economic expansion. Price-to-earnings multiples, after all, remain far lower than their historical averages and, compared to bond yields, look more attractive than at any time since the early 1950s or even, by some metrics, the Great Depression of the 1930s. Attractive valuations show even more in dividend yields that, atypically, stand higher than bond yields. Though valuations and prices will face a headwind from continuing concerns over Washington’s lack of policy direction, fiscal matters promise to become no worse than the disarray to which investors have long since accustomed themselves. Certainly, both Congress and the White House were so chastened by the electorate’s response to the spectacle of the debt ceiling debate last summer that they will do most anything to avoid any rerun of that shamefully partisan episode. With fiscal concerns no worse than before and earnings continuing a modest expansion, there is every reason to expect attractive American equity returns even in a still slow-growing economy.
Japan Has Problems, but Looks Better Than Europe
Unlike Europe, Japan’s economy will likely grow, albeit modestly, in 2012. The country has room for some fiscal stimulus. Though the bulk of the recovery surge from last year’s earthquake and tsunami has already run its course, some positive rebuilding effects should persist. Still, both the pace of growth and the equity response will face constraints. Investors retain questions about any long-term prospects in the face of the population’s extreme aging trend. Further, Japan has not even begun the fundamental reforms that all—in business, academia, and government—acknowledge the country needs to implement in order for it to return dynamism and responsiveness to its economy. More immediately, Japan should feel the pinch its expensive yen imposes on its exports. The ill effects of the record yen values presented Japan, as 2011 closed, with, remarkably for Japan, a balance-of-payments deficit.
Because Japan has equity valuations about as attractive as Europe’s, its markets should respond positively to even restrained rates of economic and, consequently, earnings growth. Especially since Japan faces nothing like Europe’s sovereign debt crisis, the country’s risk/reward trade-off looks better than Europe’s. Were it not for the fundamental structural and demographic problems facing Japan, its markets could probably outperform America’s. Japan, however, will likely lag because its deep concerns persist. The potential for a decline in the yen, as investors worry less about safe havens, will help Japanese exports, but only partially at first, and slowly. Meanwhile, such a currency correction would detract from the dollar- or euro-based returns on any yen-denominated investments.
Emerging Markets Likely Return to Their Promise
Prospects of gain have improved for emerging market equities, as many of the earlier concerns have began to ease. For the past year or so, these markets have suffered as inflation fears forced policy restraint from China to India to Brazil that in turn raised concerns about economic reverses—a “hard” landing in the jargon of financial commentary. Now with a marked easing on food prices (a major factor in emerging economies, and, hence, overall inflation concerns), these nations have begun to shift toward more expansive policy postures, lifting fears of recession and raising the chances for substantive growth in 2012. Of course, the residual effects of past restraint, among other things, preclude any return to the fabulous growth rates of earlier in this century. But the still-impressive development potentials in these economies should sustain growth rates that are far more robust than any in the developed economies, especially since most emerging countries have such good finances that they can readily capitalize on these opportunities. If, for instance, China ceases to grow at 10–12% a year, it should easily sustain 7–8%. Similar, if less dramatic, comparisons apply to India, Brazil, and other emerging economies.
There is reason to expect equity markets in these economies to reflect the positive policy and economic change, especially since the market reverses of the past year or two have created such good value. Problems remain, of course. China, for instance, must deal with a real estate bubble. But though a matter of concern, it would be a mistake to draw easy parallels, as too many have done, between this condition (or any other emerging economy’s excesses) and recent problems in the United States, for instance. Unlike America’s real estate market implosion, Chinese households are far from highly leveraged. By law, a Chinese homebuyer must put down 20% on a first home and 50% down on a second home. The leverage in China lies with the local governments, which, though a matter of concern, is much easier to deal with than widespread debt problems in households would be, as the American experience has shown. Also, because China and other emerging economies are growing so fast, their excesses represent less of a threat than they would in developed economies. China, for instance, has an ongoing flow of about one million people a month into its cities, making it much easier to correct its real estate inventory overhang than it is in the much slower-growing demographics in America.
Drawing the Threads Together
While the over- and underweightings implied by this analysis are apparent, it is another matter to draw a bead on a single allocation for individual and institutional investors. Whatever the indexes indicate and however important they are to professional portfolio managers, investors must ultimately remain focused on particular objectives and risk tolerances that have nothing to do with indexes. It would be better for investors, then, to draw up a neutral allocation of their own, which takes into account their particular investment criteria, and then apply under- and overweightings to that customized allocation—again, with an eye to their risk acceptance. With this approach in mind, assuming a relatively conservative investor, the portfolio weightings listed in Table 1 use this analysis to address such allocation considerations. Just for reference, the table also offers the weights of each equity region in the MSCI All Country World Index (ACWI).1
Bloomberg. Index data as of May 3, 2012.
Note: The table above is not an official Lord Abbett recommendation, but an approach based on the analysis provided in the story. Please note that this is only intended as an illustration of portfolio weightings and is not intended to be a recommendation. Investors should consult with their financial advisor to determine the best portfolio weightings based on their individual circumstances and risk tolerance before making any investment decisions.
To sum up, it appears that those seeking reasonable returns might do well to resist the impulse to rely too heavily on the traditional safe-haven investments, and look instead to the fixed-income and equity categories we’ve featured here. Amid the uncertainty enveloping economies, markets, and governments around the globe, the greatest risk for investors may be in not taking any.