The first quarter of 2013 began with “Fiscal Cliff” concerns and a stalemate in Washington over the budgetary issues facing the United States.   The quarter is ending with concerns over sequestration, the debt ceiling, saber rattling in North Korea, the Cypriot Banking system failure, and the inability of leaders in Europe to manage the issues facing the European Union.  Underpinning all of this is the largest global expansion of Large Scale Asset Purchase Program (LSAPP) or Quantitative Easing (QE) in history causing the equity markets to chug ahead and keeping the fixed income markets flat.

As you know, markets never move up or down in a straight line.  The equity markets have had a pretty good run, so we would not be surprised to see them pullback at some point in the near future.  We believe a pullback in the equity markets would be healthy and give the markets the opportunity to pause and consolidate before providing a better base for further advances.  On the fixed income side, until we see some real improvement in the economy bonds will likely continue to move sideways.  However, bonds will likely come under pressure once we do begin to see signs of economic improvement.

The Economy

The U.S. economy continues to grow at a muddling pace.  Over the last 66 years, the average annual real growth rate (adjusted for inflation) of the U.S. economy has been 3.2%.  Following the 2008 recession, the average annual real growth rate has averaged 1.7%–or roughly half the norm.  This lack of growth is more clearly seen in the U.S. labor market.  For example, while we have seen improvement in the unemployment rate currently at 7.6%, the labor force participation rate, which measures the percentage of the working age population who are actually working, is at its lowest level since 1979 and still declining. In other words, much of the improvement in the unemployment rate is driven by people exiting the labor market and not because they are getting employed.

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If one looks to other developed economies around the globe the picture is even worse.  For example, the overall unemployment rate in Europe is at 11.9% and individual countries such as Spain and Greece are faced with an unemployment rate of more than 26%.

The unemployment issue is one of the primary reasons that the Federal Reserve and Central Banks around the globe continue to add money to their respective economies in hopes of stimulating economic growth and thereby reducing unemployment.  Until labor statistics normalize, the Federal Reserve and other Central Banks around the globe will continue to use various forms of Large Scale Asset Purchase Program (LSAPP) or Quantitative Easing (QE) (printing money to buy bonds) to try to spur economic growth.

To put the current round of QE in some context, let’s look at the magnitude of what the Federal Reserve is doing. The net increase for U.S. bonds outstanding in 2013 is estimated to be around $1,080 billion. The Federal Reserve is on track to purchase $1,020 billion worth of bonds ($85 billion a month x 12 months).  That is the equivalent of 94.4% of all net new issuance.  In 2012, it is estimated that natural buyers of bonds (Banks, Mutual Funds, Insurance Companies, Foreign Purchasers and reinvested interest) amounted to roughly $1,015 billion of demand.  As a result between the Federal Reserve and natural buyers, the demand for bonds could be nearly double the available net new supply.

This is not just an American phenomenon as the chart below illustrates.  European Central Banks, The Bank of Japan and the United States are all engaged in this experimentation.

While there will no doubt be long term negative ramifications to these programs, for now they are supportive of lower interest rates.  We are seeing this support of low interest rates play out in the housing, auto and equity markets.  In the housing market, we are beginning to see increases in home pricing across the country.  Home inventories are the lowest they have been in nearly ten years.  Auto sales are back above pre-recession levels.  The low interest rate environment is allowing corporations to buy back stock, increase their dividends, increase their capital expenditures and merge with or acquire other companies. Unfortunately, we have yet to see these programs translate into significant structural improvements in the labor market.

We believe that employment will remain under pressure for some time.  The Federal Reserve’s efforts to boost economic growth and employment have been countered by an environment of higher taxes and health care costs and an increase in regulations.  This has caused companies large and small to keep the brakes on hiring and/or look at alternative options for production such as automation and robotics.  Today, manufacturing in the United States is booming.  We are producing more goods than at any time in our history.  However, manufacturing employment is at the same level it was in 1945.  This same phenomenon can be seen clearly in the hiring trends across the country.  As a result, we believe the Federal Reserve may need to remain aggressive for some time yet.

Fixed Income

With all of this support for the fixed income markets coming from the Federal Reserve and other Central Banks, we think interest rates will likely remain low for some time. While having such a large purchaser of fixed income investments certainly creates a demand in the bond market, at some point the Federal Reserve will likely scale back and/or end its current QE program.  What would cause the Federal Reserve to end this policy? If the economy enters a period of self-sustaining growth with real improvements in the labor market, if we see a significant pickup in inflation and/or inflation expectations, or if there is a concern that the program is failing and its efficacy comes into question, the Federal Reserve may shift its current monetary policy.  For now, we believe the most likely outcome is for an improved economy. Regardless, at these low interest rates the long term risk for fixed-income investors will remain towards higher bond yields and lower prices.

To illustrate the risk to bond investors, the table below shows the impact in bond pricing should interest rates move up 0.50% or 1%.  You can see the effect on bond prices that small moves in interest rates can create.  This is especially unsettling given so many investors perception of their bond money being their “safe” money.

For our fixed income investors, we will continue to proactively work to provide you the best risk‐managed returns the markets can provide and continue to augment returns when we deem it reasonable. Over the last few years, we have augmented some of the traditional holdings to enhance returns and reduce risk. We have added corporate and international bond funds to enhance yield and we have purchased government bonds of resource‐rich nations with conservative fiscal policies and stable political systems. All of these positions are benefiting from actions of activist Central Banks. However, valuations throughout the fixed‐Income markets are extended. While we believe we are still in the bull market for bonds that began in 1982, the longer-term risk for bonds is for higher interest rates and lower bond prices.

Equity Markets

We believe that the equity markets are a little stretched and a short term pull back and consolidation would be healthy.  We would view a modest pull back in the 5% to 10% range as positive and more representative of a pause that refreshes than the beginning of something more serious. There are several reasons for this, but the primary reason is the level of accommodative policies coming out of the Federal Reserve and other major Central Banks around the globe.  These policies should continue to be supportive of low interest rates and, in turn, the housing, auto and equity markets.

This low interest rate environment has allowed corporations to borrow money at historically low levels. To put this in perspective, corporate borrowing costs are at levels last seen in 1957 as measured by Moody’s Baa Bond yields.  Further, corporations have made significant strides in improving their balance sheets and have built up strong cash reserves.  The combination of historically low borrowing costs and high cash reserves have primed corporations to buy back stock, increase their dividends, embark on capital expenditures and/or look at potential merger and acquisition opportunities.  These are all supportive to the stock market.

As you will see in your portfolios, to take advantage of the current market environment we have recently expanded investments in the auto, housing and health care industries.  We believe the housing and auto industries will continue to benefit from the low interest rate environment.  Further, we have expanded our position in health care which should benefit from an aging population and a shift in U.S. demographics.

On a longer term note, we believe that the U.S. equity markets may be entering a transitional period where they are shifting from a secular bear market to a secular bull market. A secular bear market is an extended period of flat or declining stock prices.  Much like what we have seen since 2000.  A secular bull market is a period in which stock prices rise at an above-average rate for an extended period and suffer only relatively short intervening declines. Much like what we saw from 1982 to 2000. As you know, we have managed the risk through this secular bear market well.  Your portfolios were protected on the downside in the 2000 and 2008 corrections and were fully recovered shortly thereafter.  We will continue to manage the risk in the equity markets but we are happy to note that we may be transitioning to an environment with more growth opportunities ahead.

While the U.S. economy muddles along with an unremarkable growth rate and well below the norm, it will keep the pressure on the Federal Reserve to continue its quantitative easing measures in an effort to stimulate more growth.  Quantitative easing should provide support for the bond market keeping interest rates artificially low which in turn provides buoyancy to the equity markets. On the fixed income side, we believe the bond markets will most likely continue to move sideways. On the equity side, the market has an opportunity for more growth in 2013, but it would be healthy to see a short-term pullback. While we look for the pullback, we will continue to position your portfolios for opportunities both in the near and longer term.

As always, we continue to work hard to protect and grow your assets.  If you have any questions with regard to our investment strategy, please contact us.