So goes comedian Louis CK’s bit about hitting middle age. “Not old enough for anyone to care that you’re old. Not young enough for anyone to be proud of you or impressed.” And as we head into the backstretch of this economic cycle, that same cynicism and resignation seems to be settling right in. The glory days of riding the upward slope when almost everything was screamingly cheap in 2009 are behind us. The thrill of uncovering pockets of assets still unloved and mispriced seems to be about wrung dry. The fun of being on the other side of all-time sentiment lows is fading into memory. Now, like scarred ligaments from that middle school soccer injury or nerve damage from that college bike accident, the aftermath of past transgressions is coming home to roost. The force of repeated QE, the tardiness of the ECB, the pace of emerging market fixed investment on credit – the long-term consequences of those short-term remedies are making themselves felt. What seemed to have healed over at the time is now calling for a knee replacement.
“Yeah. That starts to happen.”
Perhaps not the most reassuring answer, but an honest one when it comes time for a mid-cycle check-up. The halfway point of the year is a good time to look back at our thoughts for 2013 as discussed in our December newsletter. Overall our focus on bond risks, equity markets’ tendency to climb a wall of worry, and the influence of the Fed masking asset price risks have been on point.
- Unemployment is likely to decline below the consensus 7.5%. As of publication, unemployment is already down to 7.6%.
- But the number detached workers and underemployed is likely to remain high. The number of underemployed and discouraged workers have increased by over 1 million persons over the last 12 months.
- The Fed is masking risk since it is not permitted to be priced. The skittish moves in equity markets and the plunge in bond prices in the second quarter after hints from the Fed at the reduction of QE show the influence of monetary policy on prices, and associated volatility of re-establishing pricing mechanisms.
- Equity markets are likely to climb a wall of worry. The US was particularly strong in the first 6 months of the year and overall global equity markets were positive but more subdued.
- Investors shun frontier markets at their peril. While emerging markets and especially BRICs have suffered in 2013, frontier markets have shown positive performance.
- The longer the bond bubble persists, the more dangerous it becomes. As DoubleLine bond manager Luz Padilla says, bonds reward slowly but punish quickly. The sharp 4% decline of the Barclays Aggregate over the course of the last two months of the quarter is the proof. Long dated bonds could easily experience double-digit declines.
- Duration management is a high priority. Galway’s focus on duration hedges, credit, currency, and country management, and niche opportunities led to positive bond performance in 2013 despite the overall market decline.
“Just take Aleve. Don’t worry about the dosage.”
We are pleased that many of our thoughts for the year have so far not been far from the mark. But there are areas that are giving us pause and prompting us to be more cautious as we head into the summer.
Speed is one concern. Our base case S&P 500 target for the year was struck within 5 months. This leaves a lot less room for positive surprises on earnings to propel the market upward. It has been very difficult for the market to sustain a rise above a forward P/E of 14, and it was not surprising that a correction started in June when it hit 14.3. The rapid market rise has also led to increased investor bullishness. As we discussed in Investor Complacency Makes Us Nervous (February 2013), when the herd gets too positive, risks are ignored and allowed to grow. The essentially unobstructed correlation between asset prices and QE is also masking risk. True prices can’t be known when the Fed is interfering with the normal pricing mechanism, namely the risk-free asset.
Cracks in the BRIC veneer are another concern. Continued frontier market strength despite emerging market weakness is a good sign for the long-term emerging market middle class thesis. It shows that while the liquidity from QE is impacting prices in the more heavily invested emerging markets, the continued forward march in frontier markets is a good indicator that the fundamental thesis is intact. However, our expectation that the five-year plan in China was likely to be on track in 2013 has been revised. Increased debt has led to stabilization of Chinese GDP, but not higher growth. Capacity appears to have been expanded beyond the ability for it to be currently utilized. It is likely to be more a question of timing than a hard landing, but 2013 is looking less positive than we anticipated. Similar challenges have faced Brazil.
Don't get us wrong, we’re glad to find that significant elements of our forecast have been on point. But there are market health complaints for which we wish there were an easy fix. Most investors will feel some aches and pains in their portfolios. The challenge is deciding for which ones to pop another Aleve and tough it out, and when to visit the doctor for a more serious procedure.
“You’re not an athlete. So ‘no’ to whatever else you were about to say.”
There is no ‘take two and see me in the morning’ for any economic cycle. The utopia of perpetual, sustainable growth without any recessions is as elusive as the unicorn ( Beta the One-Trick Unicorn, October 2012). However, middle age is still too early to throw in the towel. Grinding slow growth continues. Pockets of strength – US manufacturing and a resurgence in construction, the developing world consumer – may be looking tired, but they’re still hanging in there. This cycle may be half dead, but that means we’re still half alive, and we intend to make the most of it.
As always, we are proud to be your partners in regular check-ups and stewardship without compromise.
Liam Molloy, CFA
Bethany Carlson, CFA
1Quotes taken from Louis CK’s 2008 comedy special, “Chewed Up”.
© Galway Investment Strategy