A Mid-Year Letter to Clients: A Positive Outlook on America

In late May, the U.S. stock market reached all-time highs; from the start of the year, U.S. and global markets were up high double-digits. Then, at a press conference on May 22, Federal Reserve Board Chair Ben Bernanke made a low-key suggestion that a stronger outlook for U.S. economic growth would lead to a gradual reduction in bond purchases that had helped keep interest rates low. The prospect of an end to the record-low interest rates shocked markets, leading to declines in the next six weeks of 4% in the U.S. and 8% in global markets elsewhere.

Here’s what performance looked like before and after Bernanke’s announcement:

Source: MSCI, returns include dividends, all returns in local currency

Some things worth noting about performance in the first half of 2013:

1. Even with the declines after Ben Bernanke’s announcement, for the first half of the year the U.S. is still up 14% for the year and global markets outside the U.S. are up 10%. If you’d suggested these results at the beginning of the year, everyone would have been thrilled.
2. The strength in the U.S. is a continuation of the trend of the past three years and a half years. Since the beginning of 2010, the U.S. market is up 32%, compared to 14% for global markets outside the U.S.
3. In spite of continuing headlines about Cyprus, Greece and Portugal, European stock markets had a solid gain in the first half, as some of the worst case scenarios built into stock prices failed to materialize. While smaller countries got the headlines, the large bulk of Europe’s economic performance will continue to be driven by the larger economies.

Will America pick up the global growth baton?

With Europe’s economies facing continuing challenges and slowing growth in China and other emerging markets, the U.S. is once again being looked to as the driver of global growth.

That’s why it’s important to step back and look critically at prospects for the American economy. The spotlight on the U.S. is nothing new – the opening quote for this letter was drawn from a book by 19th century French historian Alexis de Toqueville, written after travelling across America. His insights on America’s resiliency and can-do spirit caused a stir among European politicians, many of whom still saw the U.S. as an uncivilized outpost.

Like every other country today, the United States faces serious issues. A Wall Street Journalarticle by Harvard economist Niall Ferguson made the bear case for the U.S., focusing on political dysfunction, burdensome regulation and slipping competitiveness.

Sometimes taking a step back provides useful perspective. The Globe and Mail is Canada’s leading national newspaper and ranked in the top 20 global newspapers. A recent Globe and Mailarticle, titled The Star Spangled recovery, pointed to a laundry list of positives for the U.S., among them:

• Improvement in the budget situation
• Growth in housing and auto sales
• Stronger job growth, fuelled in part by the return of manufacturing from overseas
• The positive impact of small- and mid-sized businesses and America’s hyper-competitive culture, positioning it for success in global trade.

Another positive perspective comes from The Economist magazine; published in London, The Economist is broadly respected for its objective analysis of global trends. In April, The Economist published a special report on American competitiveness. The Economist’s take wasn’t entirely positive, as it drew a distinction between political dysfunction in Washington and what’s happening in the rest of the country.

Here’s an excerpt from their comments about political leadership in Washington:

This is the America that China’s leaders laugh at, and the rest of the democratic world despairs of. Its debt is rising, its population is ageing in a budget-threatening way, its schools are mediocre by international standards, its infrastructure rickety, its regulations dense, its tax code Byzantine, its immigration system hare-brained—and it has fallen from first position in the World Economic Forum’s competitiveness rankings to seventh in just four years

Offsetting those issues, The Economist urged readers to look outside of Washington to the progress being made across the country:

• The shale oil and gas revolution is changing the dynamics of the energy industry and provides America with the prospect of energy self-sufficiency.
• Sweeping reforms are taking place at the state and municipal level to create accountability and greater focus on results in the public education system.
• America’s innovation engine is once more operating at full speed – research and development as a percent of the economy has matched the previous record set during the space race.
• In a world where technology is playing a growing role, the U.S. is home to 27 out of the world’s top 30 universities for scientific research.

Earlier this year, Warren Buffett addressed the uncertainty that preoccupies many members of the media and which has dampened the willingness of American business to invest. He pointed out that uncertainty has been a constant in the U.S. since 1776; the only difference has been whether people ignore the uncertainty (which typically happens in boom times) or fixate on it. Buffett continues to express confidence in the resiliency of American business, just as he did in his famous New York Times article in the fall of 2008 titled “ Buy American I Am” that appeared close to stock market bottoms during the uncertainty in the aftermath of the global financial crisis.

What this means for your portfolio

In my email at the end of last year, I outlined some guiding principles in my approach to building client portfolios, three of which I repeat here. I’d be pleased to discuss these guidelines at our next meeting.

1. Time to rebalance: Adhering to your plan

   In light of stock valuations and the risk in bonds, early last year we recommended that clients increase equity weights to the upper end of their range. Given strong stock performance since the mid-point of last year, that has worked out well and we continue to advise that clients hold their maximum equity weight.

   But strong performance by stocks means that in April and May, some clients were above the top of their equity allocation. In those cases, we have been recommending reducing equity weighting to bring portfolios back within their guidelines. Regardless of what happens to markets in the short term, barring a significant change in your circumstances, you should stick to your investment parameters.

2. Diversifying portfolios

   When building equity portfolios, I’ve always advocated strong diversification. While the benefits diversified portfolios have not always been evident over short periods of time, the proper approach to asset allocation has paid off generously over the long term.

   It is impossible to predict the direction of markets or of interest rates, at least over the short term. Likewise, historical data have proven that economic growth has not correlated with market performance; the fastest-growing regions or countries have not been the best-performers, and vice versa. For these reasons, we advocate broad exposure geographically and across asset classes.

3. Focus on dividends and cash flow

   The final principle relates to the role of cash flow from investments. Amid the uncertainty surrounding economic growth and equity returns, I continue to place priority on the cash yield from investments. While the headlines talked about U.S. markets hitting new highs in May, investors who reinvested their dividends saw their account values exceed the 2007 peak significantly earlier.

   Dividends on stocks in selective sectors continue to make these stocks attractive. When it comes to equities, we do have to be increasingly discerning, however; in some traditional high-dividend sectors stocks that pay steady income are expensive by historical standards and show signs of stretched valuations.

I hope you found this overview helpful. Should you have questions about anything in this note or about any other issue, please feel free to give me or one of the members of my team a call.

And as always, thank you for the opportunity to serve as your financial advisor.

conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written and video commentaries, go to www.clientinsights.ca. Use A555A for the rep and dealer code to register for website access.

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