Through the noise of daily headlines, we must keep the broader picture in mind—not in order to predict the future (no one has done it consistently yet) but to better evaluate potential outcomes and recognize valuation extremes in investments. Those extremes continue to exist today, particularly for investment grade bonds, in our view.
The Bigger Picture
As we wrote two years ago, the underlying reality is that we are entering a new era in the relationship of debt and growth. For the past 20 years, unique circumstances fueled strong economies with historically cheap funding. The formula of easy money (low rates) arguably cannot drive growth indefinitely, especially as countries reach debt ceilings. Ultimately, higher borrowing costs should prevail, commensurate with increased risk. This is a natural balance, but predicting the shift is impossible.
Unwinding cheap debt will present new opportunities and risks for investors. While policy prescriptions and living standards may change, human emotion does not, and human emotion is always having an influence in asset prices and markets.
Accordingly, we continue to think fear has driven defensive investments like US Treasuries, corporate bonds, and the more popular high dividend-paying global stocks to uncomfortably high prices. On top of that, uncertainty about the economy, tax policy, and potential regulation has put a premium on cash for both individuals and corporations. In contrast, stocks in Europe and the US, high yield bonds, and some emerging markets, appear relatively more attractive, from a broad perspective. This isn’t to say those asset classes go straight up from here; in fact, they will likely move in fits and starts.
Has Europe Solved its Debt Problems?
Not yet. We continue to believe several managed defaults or restructurings are likely over the next few years. For some countries (Greece, Spain, Portugal), growth drivers of the past decade are fundamentally broken. We do not think they can generate enough growth to close deficits and repay creditors. Austerity without meaningful efforts to restructure labor markets and industries could make the situation worse. Spain’s recent struggles to meet deficit reduction targets illustrate this challenge.
Interbank lending markets are not yet healthy in Europe, but they have been given a reprieve. The $1.3 trillion in liquidity pumped into markets by the European Central Bank (ECB) in December helped European banks refinance sovereign debt on favorable terms. Hopefully, countries and banks will use this “grace period” to improve their economies, balance sheets, and capital ratios. If not, further refinancing will require intervention again by the ECB (but to what limit?) or by foreign creditors (but who?). So the long term situation remains cloudy.
Importantly, on the positive side, credit markets continue to separate the “have’s” from the “have not’s” in Europe. Countries with manageable deficits and stronger economies continue to receive favorable financing terms. Further progress by the ECB this spring toward more credible fiscal integration and centralized funding across the continent would help bring confidence to credit markets.
What about China’s Slowing Growth and Nuclear Tensions with Iran?
China’s economic growth appears to be slowing to 7%-8%. Arguably, this could crimp global growth at a time when we need it. But the real issue, in our view, is whether China can manage inflated real estate values and local government debt under slower growth. Local government banks provided much of the financing for the real estate boom, and it is difficult to assess how much bad debt could materialize on balance sheets. We do not have significant exposure to China, except in broad emerging markets equities, for certain clients. But developments in China can clearly affect global markets in general and commodity prices in particular.
Tensions over Iran’s nuclear program certainly present a wildcard in the markets. Oil sanctions on Iran by the US and European Union have restricted imports, driving oil prices incrementally higher. Continued supply constraints could threaten a global economic recovery. More saliently, tensions could escalate into broader conflict (including military action). Of course, we cannot predict how events unfold—diplomatic resolution would ease oil prices and help boost recovery, while heightened conflict could have a negative impact on growth and markets. Our answer to the uncertainty comes through asset allocation and diversification. Oil represents about 25%-50% of our commodities exposure and around 10% of equities, balanced by more stable fixed income investments. Volatility could create opportunity for long term investors through rebalancing.
As always, bonds, stocks, and other investments all play a role to support each investor’s near-term and long-term goals. Portfolio diversification is the right investment approach as global issues unfold. Volatility should be expected as the world works through its challenges, but the appropriate investment strategy should be able to balance risk/reward with fundamentals and probable outcomes to help investors meet their long term financial objectives in an uncertain time.