The Year Ahead: Annual Market...
Bad Moon Rising
Volatility returned to world asset markets in 2007 in a major way. The S&P 500 finished the year with a total return of 5.49% and risk (measured by standard deviation) of 9.66%. By comparison in 2006 the S&P 500 returned 15.79% with a bond-like risk level of 5.64%. Neither 2006 nor 2007 bear much resemblance to historical performance trends: for the period 1979 – 2007 the annual average return of the S&P 500 was 13.18% with standard deviation of 14.69%. As 2008 gets underway we see volatility continuing to be the contextual backdrop for a year potentially fraught with economic and political uncertainty.
Some years are good ones in which to outperform on a relative basis, while in others the primary goal is simply to make, not lose money. After all, outperformance doesn’t amount to much if it means “lost less money than the index”. While we do not necessarily think negative performance is the highest probability outcome for 2008 we think the risks are strongly oriented towards the downside. Our portfolios reflect a defensive bias against what we see as the major potential threats this year. In the following pages we discuss these in detail.
The US economy is edging close to recession territory and may turn negative for at least part of the year. The Wall Street Journal’s consensus estimate from 52 leading economists is for 2.0% real GDP growth for the full year but that same consensus sees a 42% chance of recession. We also think that below-trend but positive growth is the highest-probability outcome but see considerable volatility underlying that estimate, the main source of which volatility is US consumer spending.
That greater volatility is skewed to the downside as a sharp drop in consumer spending – which accounts for over 70% of US GDP – is more likely than an upside surprise. Global inflation has also been ticking up in recent months and that raises the possibility of stagflation, that 1970s-era combination of anemic growth and high inflation. Higher prices are clearly hitting consumers where it hurts them most – at the gas pump, the grocery check-out aisle and the doctor’s waiting room.
The twin beasts of credit market meltdown and housing market plunge cast a long shadow over the second half of 2007 and continue to stalk the landscape in the early weeks of this year. Bargain hunters are scarce and it could be some time before longer- term trends reassert themselves, with a reasonable possibility for further declines.
2008 is an election year in a number of hotspots including Russia and Pakistan – and oh, of course we have something here in the US as well. We don’t see much of a correlation between US market performance and the victory of any particular party or candidate – but election years create their own odd dynamics and the potential for ill-advised government policies coming out of ham-handed attempts to secure political positioning.
The US equity market is having a terrible decade. Historical comparisons and current valuation levels argue for an uptrend, but fundamental economic realities don’t paint as clear a picture. We think the likelihood is better than not that the broader US markets will not end the year in the red – but the real story this year is not expected return but the magnitude of deviation from expectations – which we think is very high.
Our views on style performance among US equity asset classes focus on the importance of capitalization relative to valuation: in other words, we think the most critical style decision to make this year is increased weighting among high-quality large and mega- cap names while we maintain a relatively neutral view on value versus growth.
In international equity markets the two main stories have been currency-driven outperformance by countries with free-floating currencies and the long, profitable run of emerged/emerging markets. The fundamentals don’t look much different today than a year ago – the dollar remains in a relative position of weakness and the secular 3-5 year outlook for emerging markets is robust – but in 2008 we could see a mini-cycle of reversal to the longer-term trend.
Fixed income markets reflect ongoing instability in the credit markets as the past year’s Summer of Subprime continues to cast its shadow. Quality spreads continue to widen though not as dramatically as was the case several months ago. The benefits of interest rate cuts will not fall anywhere near to equally across the different sectors of the credit markets. In our view flight to quality will be the central theme this year.
We have increased our exposure to alternative asset classes for low correlation benefits that we believe are of particular importance this year, with a favorable view towards commodities among high volatility alternatives and equity market neutral as a viable low volatility strategy.