We began our last quarterly narrative by expressing concern that the exceptional performance of the S&P 500 and global markets so far in 2011 had left them overstretched and susceptible to a pullback. That being said, we were not expecting to see the worst quarterly performance since the end of 2008 when we were still in the throes of The Great Recession.
During the third quarter of 2011, the S&P 500 lost 13.86% of its value, bringing its year-to-date return to a negative 8.67%. The MSCI EAFE (Europe, Australasia and Far East) fared significantly worse with a third quarter loss of 18.95% which dragged it’s year-to-date performance down to -14.62%.
Domestic equities outperformed foreign equities for the second quarter in a row as developed nations in Europe continued to struggle with their sovereign debt crisis and emerging economies dealt with rising inflation and slowing demand from China. Emerging markets took the worst hit in the third quarter due in part to the more cyclical nature of many of their key industries such as energy and mining. Additionally, the Chinese government had their banks give out $586B in loans during the financial crisis to spur growth, an amount equivalent to about 13% of their economy (the $787B stimulus in the U.S. only accounted for about 5% of our GDP for contrast). Many of these loans were invested unproductively and not all of them will be able to be repaid as they come due over the next several years. It is very possible that the central government could step in to help the problem but there is a severe lack of transparency on these issues so it is nearly impossible to evaluate the extent of the losses. We will continue to follow China closely in the coming months because they are one of the last significant drivers of global growth with the developed economies still stuck in a state of low growth and outright contraction in some parts of Europe.
The U.S. economy continued to expand with GDP growing by 1.3% in the second quarter but you wouldn’t know it by looking at the unemployment rate, which is remains above 9%, home prices which are still bouncing around near the their lows, or food stamp usage, which continues to set new records every time the data is released. Among the unemployed, almost 45 % have been unemployed for more than half a year and there are now a decent amount of unemployed who are no longer being counted in the numbers because they have fallen off of the list of people eligible to receive benefits. These persistent issues appear to be creating a significant change in investor sentiment toward domestic equities. Over the last several months, many of the sectors that had been driving the earlier rally such as financials, energy, industrials and materials have now become the worst performers as the market declined during the quarter. During this same period the best performing sectors have been defensive areas such as consumer staples and utilities (both of which are well represented in client portfolio’s).
The picture in fixed income markets was very mixed in the third quarter. In general, foreign bonds sold off during the quarter because of continuing sovereign debt concerns in Europe and rising inflation in emerging markets. Domestic bonds fared better with the Barclays Capital Aggregate Bond Index turning in a gain of almost 4%. That return should be taking with a grain of salt though because the vast majority of the gain was fueled by the biggest rally in U.S. Treasuries since 2008 and was for the most part not representative of the domestic fixed income market, which turned in relatively meager results. Inflation protected treasuries slightly underperformed the index as deflationary pressures re-entered the market and commodities sold off along with crude oil. The third quarter also marked a possible shift in investor sentiment as high-yield bonds experienced a substantial selloff as investment grade corporate bonds continued to generate positive returns. High-yield bonds had been outperforming investment grade bonds almost the entire time since stocks bottomed in 2009 and the recent divergence could suggest that investors are becoming more concerned with the return of their capital rather than the return on their capital.
In our last portfolio update, we mentioned that the U.S. Dollar (referred to as the Dollar from here forward) was consolidating in a range after having spent most of the previous year declining against the currencies of most of our trading partners. This consolidation phase ended during the third quarter as investors fearful of the debt crisis in Europe piled into Dollars and other safe haven assets such as treasuries. The Swiss Franc had been performing the best out of all safe haven currencies during the quarter but then the Swiss Central Bank announced that they would be intervening in the currency markets to prevent their currency from appreciating too much which was negatively impacting their domestic companies. This intervention caused even more upward pressure on the Dollar since it’s safe haven competition took itself out of the race.
Sharp runs up or down happen when everybody is rushing to one side of a trade. When this happens, asset prices usually overshoot to the upside or downside as momentum builds, but eventually, the underlying fundamentals come back to being the key driver of returns. Right now, the dollar is correcting from being temporarily oversold (and may overshoot to the upside) but we remain confident that the long term trend of the Dollar against its major trading partners is downward. In the end, the value of a country’s currency is derived from the demand for the goods/services produced in the country. It is also influenced by the supply of the currency in question.
In the case of the U.S., there is not tremendous demand for products made in the USA (relative to how much we import from abroad) and our Federal Reserve system has enormously more flexibility in terms of increasing/decreasing the supply of money because the European Central Bank has a great deal of restrictions that limit their monetary policy options. It is also very important to note that although three Federal Reserve presidents in the U.S. have been dissenting over what they feel is overly loose monetary policy, they will be almost entirely replaced by more accommodative presidents over the next few years as the board membership rotates.
Commodities & Precious Metals
All commodities that trade on the major exchanges are priced in Dollars so it should not be surprising that most of the commodity complex had a rough third quarter (although they outperformed equities by a nice margin both year-to-date and for the quarter). In addition to the strengthening Dollar, softening demand from China and other emerging markets continued to weigh on agricultural and industrial commodities. A major standout in the third quarter was gold which managed to rally 8.26% even as the dollar strengthened. Live cattle futures also bucked the trend and staged a 9.75% rally due to the extreme droughts in Texas which have prevented farmers from being able to provide the needed food and water to keep their herds alive. This is a disturbing development that will continue to affect cattle prices in the years ahead because many livestock breeders were forced out of the industry and will not be returning because it takes years if not decades to build up a good herd and many are semi-retired or close to retirement.
While further weakness is likely if demand from emerging markets continues to wane, we believe that it would only be transitory because the key drivers of higher commodity prices are still in place. Emerging market growth may slow, but “slow” growth over there tends to be faster than “strong” growth in developed economies. This will continue to result in an expanding middle class in emerging markets, which will increase their demand for protein which will in turn magnify demand in other soft commodities. Scientific progress is also finding new uses for commodities which is increasing demand such as the use of corn in making ethanol fuel (the USDA predicts that 2011 will be the first year in history that more corn goes towards fuel than feeding livestock). Climate change has also be negatively impacting the amount of arable land available in the world as well as water supplies (the Ogallala aquifer, which provides water and irrigation to one of the most fertile areas of the U.S. is predicted by some scientists to run dry in as little as 20 years). Increasing rates of drought and flooding is also hurting crop yields across the world.
As always, please do not hesitate to give us a call should you have any questions whatsoever.
– The Pacific Mountain Advisors Team