Broker Check

Quarterly Newsletter April 2004

Quarterly Newsletter | April 2004

The powerful stock market rebound that started just over a year ago continued in the first quarter, though most of the gains occurred during the first few weeks of the year. Small-caps and foreign stocks were especially strong, and both outperformed the S&P 500. High-yield bonds managed to deliver good returns on the quarter, while investment-grade bonds did well as interest rates declined in January, February, and March. Foreign bonds also delivered positive returns in the first quarter. Far and away the biggest winner during the quarter was the REIT market, which moved higher in every month and even managed to make money in March when equities were generally negative.

What about Bonds?

Bonds are tricky. With interest rates at multi-decade lows, bonds, or more specifically, USinvestment grade bonds including treasuries, are not attractive investments. Our detailed search of fixed income opportunities worldwide yields only a few moderately attractive opportunities: Foreign bonds, including emerging markets, domestic high yield bonds and possibly TIPS (treasury inflation protection securities). We have incorporated these where appropriate in client portfolios. Multi-sector bond funds such as Loomis Sayles Institutional are useful in today’s climate. The manager, in this case Dan Fuss, is free to invest in almost any fixed income instrument in the world. It is also useful to remember that all mutual funds hold some cash. This in effect adds to our fixed income holdings.

The Investment Climate: Should We Be Cautiously Optimistic or Just Cautious?

For some time now my forward-looking view of the investment climate has been driven by several factors:

Valuations for U.S. equity-type asset classes are in a fair-value range. This means that over an extended time period it is unlikely (though not impossible) that these asset classes will return much more than their dividend yields plus their earnings growth. If true, this puts intermediate and long-term expected returns in a 5-7% range. Also important is the level of interest rates because this can have an impact on stock prices. As we all know, interest rates are exceptionally low. Using the 10-year Treasury as a reference point, if rates rise much above 5%, stock prices could be adversely affected, resulting in lower returns. The 5% level may seem like a long way away from today’s 4.0% yield, but from a historical frame of reference 5% is still a very low rate, and rates have the potential to spike up to that level in a matter of months. (In 2003, rates were as low as 3.1% in June and as high as 4.6% less than three months later.) In past bull markets, falling interest rates contributed a lot to returns: this is not likely now.

Structural risks continue to be an intermediate-to long-term risk factor. These risks include:

The current account deficit, which is mostly driven by the trade deficit. We import about 50% more than we export and as a result we need to “import” foreign capital to help us pay for it. The required foreign capital flows are huge and have most recently been provided by Asian central banks—mostly Japan’s and China’s. The risk is that a reduction in the flows of foreign capital to the U.S. could result in a larger, destabilizing decline in the dollar that could negatively impact the global economy.

Public and private debt levels. The question is whether the collective “we” that make up the net worth of the United States hold too much debt. Absolute debt levels are very high historically but low interest rates make the servicing of this manageable. A concern is what happens when rates rise? Will the rate of borrowing decline? If it does, the rate of spending growth is likely to decline since debt growth has been fuel for spending growth. This would dampen economic growth.

Inflation is another risk “down the road.” The substantial monetary stimulus provided by the Fed for some time now raises the risk of inflation. And China’s booming economy is another factor that adds to that risk. However, outside of commodity price inflation (which over the years has become a relatively small component of overall inflation), inflation remains muted at present. But, if the economy continues to improve it’s possible that inflation could move significantly higher (though I don’t expect 1970’s style out-of-control inflation) in coming years.

Geopolitical risks have not gone away. Terrorism risk impacts costs for governments and some companies, and terrorism-related economic shocks remain very much a wildcard.

The economic cycle is relatively early, which suggests that economic growth is likely to continue for several years before another recession. Though the early-cycle gains for stocks have already been strong, normally at this stage of the cycle equity-type investments would still have several more years of outperformance compared to defensive investments (on average—not necessarily every quarter or year). Stimulus remains strong, supporting this expectation. However, the labor market has not yet caught fire and this is the one worrisome aspect so far in this expansion. But, economic indicators suggest that the labor market is likely to strengthen in coming months. The non-farm payroll increase of 308,000 for March was certainly encouraging.

This environment had not changed significantly over the past 3 months. This potentially low-return period for U.S. stocks and bonds I’ve forecasted for some months now has led me to research many different asset-class options and funds as we’ve sought ways to add incremental value. Flexibility is crucial.

Boosting Returns in a Low Return Environment

During the course of the year, I attend many conferences and seminars on investing and other related topics. Last month I attended a seminar in Boston sponsored by PIMCO. Perhaps you're familiar with Bill Gross; he's their founder and major guru. Pimco manages primarily bonds and bond funds and is probably the best and biggest bond manager in the world. I can say that without blinking.

As you might expect the conference was well attended: about 200 people. Yes, that's a great turnout for a one day seminar like this in Boston. However, I was truly surprised: there were only two financial planners who cater to individuals: myself and one other person. All the rest were institutional money managers; for example, an investment manager from Boston University sat at my table. When I was invited to this seminar, I was really excited: an opportunity to get investment ideas from the best fixed income manager in the world. Pimco is unquestionably a first class research based organization.

So, what did they say, you ask. Well, let me give you the Agenda.

1. Asset Allocation in the Current Environment
2. The Importance of Reliable Equity Market Alpha
3. Maximizing Portfolio Return Potential: Benefiting from Reflation
4. Maximizing Portfolio Return Potential: Utilizing Higher Yielding Assets

Pimco presented a fair amount of historical data covering various time periods from twenty years to the last century. I won't in this space present all the details but rather will summarize. Returns will be lower than the recent past and inflation, and therefore interest rates, will be higher. Pimco presented very well researched and compelling data to support these conclusions. Not particularly earth shattering news? You're right.
I and others have been forecasting the same environment. But what investments and strategies does Pimco recommend?
In addition to a well managed equity portfolio, they suggest exposure to High Yield Bonds, Emerging Market Bonds, TIPS, Real Estate (commercial and industrial) and Commodities.
Now how you get exposure to these asset classes is important too. In all cases mutual funds are the preferred vehicle and in some cases, the funds utilize sophisticated active management techniques. 

Many of you know I already include these asset classes in most client portfolios: not because they may do well in the future but rather because they are doing well now. The main point here is to be flexible and consider all the world’s assets classes when constructing a portfolio.

I believe my ongoing analysis of over 50 worldwide asset classes for both risk and return will continue to reward us. And though there are no guarantees, I expect the equity funds we own to do better than the market averages. Please feel free to contact me if you want to discuss this further or if your investment objectives have changed.


Mike Durant, April 2004