Still Room for More Good Performance
During the first quarter of 2011, a number of US equity
market sectors surpassed their October 2007 peaks and a few
more have a total return (including dividends) which is now
positive. Small- and mid-cap stocks are now at new highs,
though large cap value (Russell 1000) and large cap blend
(S&P 500) indices, with heavy weighting in financial services,
are still below their previous peak. Is there cause for concern
that the markets have come too far, too fast? As we discuss
below, we don’t think so.
Source: Russell Investment Group, Standard & Poors, J.P. Morgan Asset Management
For investors looking for reasons to be optimistic, the first
quarter started off well. The US economy seemed to have
finally put the financial crisis into the past and Europe’s
sovereign-debt crisis seemed less acute. Investors responded
by moving out of money market funds and into equities.
Their primary concern was that emerging economies would
grow too quickly, pushing up commodity prices and allowing
inflation to take hold in their domestic economies.
What a difference a month can make. First, social unrest in
North Africa put oil markets on edge. Then an earthquake,
tsunami, and a nuclear accident deeply wounded the world’s
third-largest economy. Finally, a series of setbacks in the
European financial system – Ireland uncovered a capital
shortfall in a round of “stress tests” on top banks, Portugal
reported that it missed its 2010 budget deficit goal and has
now just admitted it needs to be bailed-out – led to ratings
downgrades and more fears about sovereign default risk.
In response to social unrest throughout North Africa (which
provides around 35% of the world’s oil), the price of a barrel
of Brent crude oil has increased from around $96 in January to
$115 as of this writing (April 12). The fighting in Libya, which
itself produces 1.7m of the world’s 88m barrels a day, continues.
But so far prices have not been pushed up by actual disruptions
to supply. Oil hit a peak even before news emerged that some
foreign oil firms operating in Libya would cut production
and that the country’s ports had temporarily closed. Further,
oil is more global than it was during previous crises. In the
1970s, production was concentrated around the Persian
Gulf. Since then, the supply of non-OPEC oil has hit markets
from fields in Latin America, West Africa, and beyond. Russia
overtook Saudi Arabia as the world’s biggest crude supplier
in 2009; OPEC’s share of production has gone from around
51% in the mid-1970s to just over 40% now. The impact of
a deeper crisis would depend on how much oil production
was lost and for how long, but in the longer term, stable,
democratic regimes may improve productivity and reduce the
influence of terror groups. There is a rosy potential outcome.
Concerns regarding the potential impact of the earthquake
on Japan’s economy and the knock-on effects to the US and
global economies took hold in US markets after a muted
reaction immediately following the earthquake. While the
full extent and duration of the earthquake’s effect on Japan’s
economy isn’t yet clear, our initial impression is that the
impact to growth in the US and the world will be limited.
US exports of goods and services to Japan represent roughly
4.4% of total goods exports (exports were 12.7% of GDP
in Q4), equivalent to roughly 0.4% of GDP. Including
services exports brings overall exports to Japan to 0.7% of
GDP. It would take a very significant disruption to domestic
demand in Japan to have a meaningful effect on US exports.
The disruption in the global supply chain is more problematic,
especially for the US auto industry. Some Japanese suppliers,
it is now apparent, are critical suppliers of raw materials. For
example, the Economist reports that two firms, Mitsubishi
Gas Chemical and Hitachi Chemical, control about 90%
of the market for a specialty resin used to bond parts of
microchips that go in to smartphones and other devices. Both
firms’ plants were damaged. The compact battery in Apple’s
iPods relies on a polymer made by Kureha, which holds
70% of the market, and whose factory was also damaged.
It seems clear that industrial firms, having spent years
becoming ever leaner in their production techniques
(in the process, making themselves more vulnerable to
supply shocks), will now have to make adjustments, likely
giving up some efficiency gains to become more robust.
The challenges facing the Eurozone as the result of issues in
Greece, Ireland, Portugal and Spain are too numerous and
complicated to review here. But the threat of sovereign
default and/or the need for a massive bailout is real, and the
implications of a collapse of the Spanish financial system are
On the other hand, the European Central Bank, preparing
for a policy meeting shortly after this writing, is expected
to become the first central bank among the world’s large,
developed economies to raise interest rates since 2008 (China
recently increased rates for the fourth time in less than six
months). Higher interest rates could punish Europe’s fragile
economies in the short run and a stronger euro could hurt
German exports by making them more expensive on world
markets, but the ECB is betting that a rate increase now will
prove its willingness to fight inflation and help it avoid more
significant increases in interest rates in the future.
Across a range of likely scenarios with the three issue areas
above, the implications are clear. Unrest and uncertainty in
oil producing regions will put upward pressure on oil prices,
regardless of the actual impact on production. With the ECB
moving toward tighter policy and the US Federal Reserve
standing pat, the US dollar would likely continue to decline as
investors seek higher-returning bond investments elsewhere.
The dollar is down 3% against a broad basket of currencies
since the beginning of the year and down 24% from a decade
ago, though it has been even weaker in the past – July 2008
and in the early 1990s, according to Fed data.
Many Aspiriant portfolios include commodities, through
the publicly-available exchange traded note GSC (which we
worked with Goldman Sachs to create), as a hedge against an
oil crisis. That vehicle has been very effective.
Source: Bloomberg. Total returns include the reinvestment of dividends and GSC reflects
the management fee of Goldman Sachs (the issuer of GSC) while GSCI does not.
Aspiriant portfolios are also well-diversified globally, with
currency exposure generally unhedged. So our investments in
real estate and public equity markets around the world will
benefit from, and act as a hedge against, a weakening dollar.
In summary, we do not believe that the equity markets have
come too far, too fast, and anyway think that is the wrong
question. The right question is whether, from here, global
capital markets offer an attractive future return given the
risks. We think so. Our thoughts are more fully spelled out in
our March 2011 Market Viewpoint, which is available on our
Jason Thomas, PhD, CFA
Chief Investment Officer, Principal