ClearBridge Advisors - Market Commentary Q312
November 6, 2012
by Harry ?Hersh? Cohen
"Vibrant end demand is missing, as consumers have neither the wherewithal nor the will to spend as they did in prior periods."
Since the financial and housing collapses of 2007-2008, we repeatedly have discussed the headwinds facing the economy. In contrast to our view on the economy, we have felt that the stock market was made quite attractive by the declines suffered by so many good companies during the prior decade
The disconnect between an undervalued stock market and an economy stuck in neutral has been difficult for many observers to reconcile. There has been no shortage of things to worry about. Unemployment is stubborn and painful for too many people. Europe is mired in recession, as accumulated sovereign debt has collided with questionable fiscal “remedies” that make any recovery problematic. The Chinese economy, long an engine of growth for the rest of the world, has slowed markedly, adding to the woes of the countries whose exports have been impacted.
"The excellent returns of the past three years have been accompanied by widespread skepticism, which has kept markets from overheating."
Making it all more difficult is the issue we have flagged since August of 2011: the stultifying partisan enmity in our government. The inability to avoid a downgrade in the credit rating of the U.S. was merely a preview of what has occurred and what probably lies ahead. It has been given a name by Federal Reserve Chairman Ben Bernanke: the fiscal cliff.
If no budget agreements are reached by year-end, simultaneous tax increases and spending cuts will automatically occur. We have not been optimistic about the prospects for an agreement by an intransigent congress. Worse still, we are not sure that whatever agreement might be reached will be positive for the economy on a short-term basis.
For all the political posturing about whose fault the dismal economy is, the sad fact is that a weak recovery was in the cards all along. What we went though in 2007-2008 was not a classic post-World War II recession. It was an asset collapse in which housing, banks, stocks, and credit all got decimated. An asset collapse is deflationary. Assets get re-priced at substantially lower levels, and losses are severe. The unwinding of the debt buildup of the prior 20 years continues to be a huge headwind. Vibrant end demand is missing, as consumers have neither the wherewithal nor the will to spend as they did in prior periods.
The Federal Reserve, led by Bernanke, who is a scholar and expert on the Great Depression, helped stop the worst of the declines in 2009 by putting massive amounts of money into the system. A policy of quantitative easing1 (called QE1 and QE2) was designed to lower interest rates, thus providing banks with liquidity and helping stressed homeowners to refinance at much lower mortgage rates.
A byproduct of the Fed’s stimulus was a diminution of rates of return on very safe investments available to savers and retirees. In effect, the attempts by the Fed to save or invigorate banks and housing have forced people into riskier assets. We have been strong advocates of dividends, particularly because for the first time in over 50 years, stocks began to yield more than bonds. In addition, corporate balance sheets are generally flush with cash and dividends have room to grow, as indeed they have over the past three years.
The Fed’s latest move (QE3) leaves no doubt in our minds that it is trying to create some asset reflation. Flooding the system with credit and asset purchases has arrested the deflation, particularly in housing, which has shown signs of strengthening. Reflation, or the attempt to raise asset prices, has indeed helped the stock market. Ultra-low interest rates, coupled with absolute stock valuations that are reasonable, have made equities a vehicle of choice for many investors.
The excellent returns of the past three years have been accompanied by widespread skepticism, which has kept markets from overheating. Given the uncertainty over how the fiscal cliff will be resolved, we continue to believe that high quality companies will remain the best place to be for the next several years, but we are not averse to keeping some cash reserves on the sidelines to take advantage of any negative fallout from potential government mistakes. If the Fed is successful at reviving the economy, or if general price inflation returns, we believe stocks should be a good hedge. If not, the dividend growth should be of comfort.
What should I know before investing?
All investments involve risk, including possible loss of principal. Equity securities are subject to price fluctuation and possible loss of principal. Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls.
Mortgage-backed securities involve additional risk over more traditional fixed-income investments, including: interest rate risk, implied call and extension risks; and the possibility of premature return of principal due to mortgage prepayment, which can reduce expected yield and lead to price volatility.
Dividends and yields represent past performance and there is no guarantee they will continue to be paid.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. Typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.
IN THE UNITED STATES - INVESTMENT PRODUCTS: NOT FDIC INSURED | NO BANK GUARANTEE | MAY LOSE VALUE
Batterymarch • Brandywine Global • ClearBridge Advisors •
Legg Mason Capital Management • Legg Mason Global Equities Group
Permal • Private Capital Management • Royce & Associates • Western Asset Management
This document is for information only and does not constitute an invitation to the public to invest. You should be aware that the investment opportunities described should normally be regarded as longer term investments and they may not be suitable for everyone. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Past performance is no guide to future returns and may not be repeated. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. Please note that an investor cannot invest directly in an index. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data. Individual securities mentioned are intended as examples of portfolio holdings and are not intended as buy or sell recommendations. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors. The information in this document is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason nor any officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this document or its contents. This document may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this document may be restricted in certain jurisdictions. Any persons coming into possession of this document should seek advice for details of, and observe such restrictions (if any).
This document may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.
This material is only for distribution in the jurisdictions listed.
Investors in Europe:
Issued and approved by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Services Authority. Client Services +44 (0)207 070 7444. This document is for use by Professional Clients and Eligible Counterparties in EU and EEA countries. In Switzerland this document is only for use by Qualified Investors. It is not aimed at, or for use by, Retail Clients in any European jurisdictions.
Investors in Hong Kong, Korea, Taiwan and Singapore:
This document is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Korea, Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore and Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently. It is intended for distributors use only in respectively Hong Kong, Korea, Singapore and Taiwan. It is not intended for, nor should it be distributed to, any member of the public in Hong Kong, Korea, Singapore and Taiwan.
Investors in the Americas:
This document is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which may include Legg Mason International - Americas Offshore. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.
Investors in Canada:
This document is provided by Legg Mason Canada Inc. Address: 220 Bay Street, 4th Floor, Toronto, ON M5J 2W4. Legg Mason Canada Inc. is affiliated with the Legg Mason companies mentioned above through common control and ownership by Legg Mason, Inc.
Investors in Australia:
This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.
THIS MATERIAL IS NOT FOR PUBLIC DISTRIBUTION OUTSIDE THE UNITED STATES OF AMERICA.
Legg Mason Perspectives® is a registered trademark of Legg Mason Investor Services, LLC.
© 2012 Legg Mason Investor Services, LLC. Member FINRA, SIPC. ClearBridge Advisors, LLC, and Legg Mason Investor Services, LLC and all entities mentioned above are subsidiaries of Legg Mason, Inc.
407998 MIPX013990 10/12 FN1213314
1. Quantitative easing refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.