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.

Social Unrest

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.

Japan

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.

Europe

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 significant.

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.

Implications

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 website.

Jason Thomas, PhD, CFA
Chief Investment Officer, Principal

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