The end of 2012 produced some major media-induced worries with November’s Election, December’s Mayan end-of-the-world prediction and the Fiscal Cliff. And yet, despite all those looming disasters, we’ve just come through a year in which stock returns were not only decent, but downright good. Looking back it’s amazing how little these “events” actually impacted the markets. Odds are that the Debt Ceiling crisis will pass just as well.
In 2012, the riskiest areas were the most profitable. Emerging-markets stocks earned 19% and U.S. large-cap stocks returned 16%, while the steadier, dividend paying stocks of the Dow Jones Index returned 10%. The bond side also saw riskier asset classes out-earning traditionally safer fixed income sectors. High-yield bonds returned 15% compared to investment-grade bonds which returned 4%. Professional and active managed portfolios added significant value versus all those indexes in 2012.
Our expectation of slow economic growth has largely been right-on over the past four years. Though there has been progress with deleveraging, the process is not nearly complete. And, while the risk of another crisis has declined, it remains possible and cannot be easily dismissed. A real long-term risk to our economic security is how our politicians deal with the problem of growing public sector debt. The last-minute fiscal cliff compromise did nothing to address the more important longer-term fiscal issues. Europe also made some progress in 2012, but most of that was in the form of buying time by reducing borrowing costs.
Our big-picture expectations are that too much debt across the developed world will lead to subpar growth in the years ahead. The developed world continues to face significant debt-related challenges. The solutions are not easy and there are no quick fixes. Failure could play out in various ways, from another financial crisis to sharply higher inflation several years down the road. A brighter spot is that developing countries are generally less indebted and growing faster. However, growth has slowed there as well, partly due to the impact of reduced demand from the heavily indebted developed world like the U.S. and Europe.
We recognize that there are a variety of bullish factors that should drive stocks to decent returns over the next five years. The odds of a strong economic recovery in the U.S. and Europe are low, and it is more likely that we will see a slow-growth environment with a continuation of risk aversion. Given the continued risks and moderate return expectations for most asset classes, portfolios should be positioned in a cautiously optimistic way. In this current interest rate environment, most bonds are fully valued. We think allocating modestly away from them in favor of several low volatility investments, such as structured notes, and Triple Net Lease funds can generate good returns with less interest-rate risk than bonds. These strategies did well in 2012, providing nice returns and lowering volatility. We believe they will continue to add good value in the years ahead.