2011 Year In Review
The past year reminded investors that they should hope for the best, prepare for the worst, and be thankful when reality does not match their fears. Investors entered 2011 with hopes that the world economy would continue recovering from a long and painful deleveraging process. Equity markets had posted two straight years of positive performance, central banks remained committed to pro-growth monetary policy, and major developed nations were focused on reducing debt.
By mid-year, however, optimism faded as troubling events around the world dominated headlines. The devastating earthquake and tsunami in Japan, political unrest in the Middle East, rising oil prices, a US credit downgrade, the threat of another global recession, and an escalating debt crisis in Europe weighed heavily on markets. As stock market volatility returned to global financial crisis levels, investors faced a major test to their discipline and staying power.
Although US stocks experienced some of the highest volatility in years, the broad US market delivered flat performance in 2011. Developed markets logged negative returns, and emerging markets had mixed performance, with most countries also underperforming the US. The bright spots were in the fixed income arena, where a flight to quality triggered by the euro debt crisis and US credit downgrade boosted returns on US government securities, inflation-protected securities, and municipal bonds.
The above headliner graph features some of the year’s most highly publicized events in the context of the Russell 3000 Index, a broad indicator of US stock market performance. These events are not offered as an explanation of market performance, but as an illustration that a volatile news environment can challenge even the most disciplined long-term investors.
The World Stock Market Performance chart below offers a snapshot of global stock market performance, as measured by the MSCI All Country World Index. Actual headlines from publications around the world are featured. Again, these headlines are just a sample of events during the year.
Throughout the year, investors could find a host of reasons to avoid stocks and wait for more positive news before returning to the market. As these select headlines suggest, determining the right time to invest is a difficult task since the market anticipates news and quickly factors in new information.
The Year in Review
In 2011, global diversification proved as important as ever. Although diversification may not have prevented losses, investors with broadly diversified portfolios were better equipped to endure the uncertainty. Major themes during the year included:
European Debt Problems
The sovereign debt crisis intensified as European authorities struggled to avert a Greek debt default and alleviate fiscal pressures in Italy and France. But these restructuring attempts fell short of market expectations, which spooked investors and raised concerns of additional sovereign debt downgrades and a possible breakup of the Eurozone. The crisis also hurt European banks holding large positions in sovereign debt. To avoid losses, leading institutions reduced lending and dumped assets, which depressed asset values. Higher borrowing costs in the most indebted countries, combined with reduced government spending and revenues, raised more concerns that the Eurozone was entering a recession in late 2011.
Economic Uncertainty
Since the global financial crisis in 2008, central banks and governments have taken bold measures to fuel business activity and stabilize financial markets—and investors have eagerly awaited signs that economic recovery has taken hold. The economic signals continued to be mixed in 2011. Favorable US news included strong corporate profits and dividends, substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, record-high share prices for some multinationals, and improved fourth-quarter numbers in manufacturing, exports, consumer confidence, and employment. Pessimists could point to the longstanding jobless trend, slumping home prices, tepid growth in retail sales, worrisome levels of government debt, and political gridlock at both the national and state levels.
Although emerging economies showed resilience, investors were concerned that another recession in Europe would impact its trading partners in emerging economies—and particularly in China, where high inflation and a manufacturing slowdown threatened to send its previously fast-growing economy into recession.
Rising Volatility
Investors in US equities had to endure a heavy dose of uncertainty for their moderate gains. The S&P 500 Index reflected this volatility by closing up or down over 2% on thirty-five days in 2011, compared to twenty-two days in 2010. By contrast, before the global financial crisis, the index did not have a single day with a 2% or more movement in 2005, and only two days in 2006.
Market observers also documented higher correlations among individual stocks and between asset classes. In 2011, there were sixty-nine days in which 90% of the S&P 500 stocks moved in the same direction, which is more than the combined total for 2008 and 2009. Higher correlations are common during periods of uncertainty, as macroeconomic forces overshadow the impact of a company’s business fundamentals on its stock price.
Falling Commodity Prices
In early 2011, commodities soared with expectations of improving economic growth around the world. Copper, cotton, and corn hit all-time highs in the first half of the year. Crude oil experienced double-digit returns in response to anticipated higher demand and threats of supply disruptions tied to political unrest in the Middle East. The Dow Jones-UBS Commodity Index peaked in April, then fell 20% as the global economic outlook faded. The index returned -13% for the year—its first negative return since 2008. The most notable exception was gold, which set more records in 2011 and peaked at $1,888.70 per ounce in August before declining in the fourth quarter to return about 10% for the year.
Investor Risk Aversion
The fragile world economy made markets particularly vulnerable to shifting investor sentiment. During the year, investors reacted to uncertainty by moving to asset classes they deemed more stable, including large cap stocks and government bonds. Despite the Standard & Poor’s downgrade of the US credit rating in early August, investors fled to US government securities as concerns mounted over the sovereign debt crisis in Europe and political stalemate over the US debt ceiling.
2011 Investment Overview
Most global equity investors experienced negative returns in 2011. After a strong first-quarter start, developed equity markets grew more volatile in response to discouraging news on the economy and sovereign debt crisis. Despite a brief rebound in July and during the fourth quarter, most equity markets logged negative performance for the year.
The US stock market was one of the few developed markets to experience positive returns. The S&P 500 logged a 2.11% gain (dividends reinvested), and the Russell 3000 returned 1.03% for the year. Despite strong returns in the fourth quarter, developed and emerging markets logged negative returns, with forty of the forty-five countries that MSCI tracks posting losses. The MSCI World ex USA Index returned 12.2% and the MSCI Emerging Markets Index returned 18.4% for the year. Ireland and New Zealand were the only developed markets besides the US to end the year in positive territory, and Greece was by far the worst performer. Indonesia and Malaysia were the only emerging markets that ended the year with positive returns, and Egypt was the worst performer.
The US dollar fluctuated but finished about 3% above where it started against most developed-market currencies. It sharply appreciated against the main emerging market currencies, especially against the Indian rupee and the Brazilian real. This relative strength negatively impacted dollar-denominated returns of emerging market equities. The euro remained stable during the year even as analysts began predicting the dissolution of the currency zone, and the Japanese yen and the Australian dollar both gained against the US dollar.
Along the size dimension, large caps outperformed small caps in the US, non-US developed, and emerging markets. Value stocks underperformed growth stocks in the US, but mostly outperformed growth among emerging markets and had mixed results in developed markets.
In the fixed income arena, US intermediate-term government securities and TIPS performed exceptionally well, returning over 9.4% and 13.5%, respectively. Real estate securities in the US had strong positive returns and excellent performance relative to other US asset classes; in other developed markets, REITs had sharply negative returns but still managed to have good performance relative to other asset classes.
Quarterly Highlights
First Quarter
Despite natural disasters in Japan and other countries, increased political turmoil in the Middle East and North Africa, and rising commodities prices, world equity markets logged positive performance. Strong returns in January and February gave the US equity market its best first quarter since 1998. The broad US market gained over 6%, with all asset classes delivering positive returns. Investors were encouraged by improving economic data, especially in the labor market.
Overall performance in other developed markets was above average, although not as strong as in the US. Markets experienced divergent performance at the individual country level. Japan, which suffered a devastating earthquake and subsequent tsunami and nuclear crisis, had sharply negative returns for the quarter. Some of the worst performers in 2010—including Spain and Italy—were the top performers in the quarter. The US dollar lost ground against most major currencies except the yen, which helped the dollar-denominated returns of developed market equities.
Emerging markets had subpar but positive returns and trailed developed markets in the quarter. As in developed markets, there was much dispersion in the performance of emerging markets. Russia and other Eastern European countries performed exceptionally well in the quarter. The US dollar also lost ground against the main emerging market currencies in the first quarter, which contributed positively to the dollar-denominated returns of emerging market equities. Most fixed income securities had flat or slightly negative returns in the quarter. Inflation-protected securities, which had very strong returns, were the main exception. Real estate securities had strong returns in the first quarter and good performance relative to other asset classes.
Second Quarter
Despite weaker-than-expected economic data in the US, and Europe’s sovereign debt crisis, equity markets around the world were little changed in the second quarter. The broad US market was flat, and in US dollar terms, overall performance in other developed markets was slightly positive. As in most of the past few quarters, there was much dispersion in performance at the individual country level. Greece, which once again had to be bailed out by the European Union and the International Monetary Fund to avoid defaulting on its sovereign debt, had sharply negative returns for the quarter. New Zealand and core European countries such as Germany and France had strong positive returns.
The US dollar lost ground against all major currencies, which helped the dollar-denominated returns of developed market equities. Emerging markets had negative returns and trailed developed markets in the quarter. Indonesia and other small emerging markets in Asia did well. On the other hand, some of the largest emerging countries such as China, Brazil, India, and Russia had sharply negative returns and were among the worst performers. The US dollar also lost ground against the main emerging market currencies, which contributed positively to the dollar-denominated returns of emerging market equities. Most fixed income securities had excellent returns, especially inflation-protected securities. Real estate securities had strong returns and excellent performance relative to other asset classes.
Third Quarter
Equity markets around the world had their worst quarter since the end of 2008, as investors reacted negatively to the continuing sovereign debt problems in Europe, the budget stalemate in the US, and poor economic data in most developed countries and in some large emerging countries such as China. The broad US market lost over 15%.
In US dollar terms, overall performance in other developed markets was even worse, but that performance differential with the US was entirely due to currency fluctuations. Greece, which remained at the center of Europe’s sovereign debt problems, was by far the worst performer. At the other end of the spectrum, Japan, whose dollar-denominated returns greatly benefited from the strength of the yen, and New Zealand were the top performers. The US dollar gained against most major currencies except the yen, which hurt the dollar-denominated returns of developed market equities.
Emerging markets as a whole had similar performance to developed markets, but a strengthening dollar relative to the main emerging market currencies resulted in sharply negative dollar-denominated returns in most emerging markets. Peru and some of the smaller emerging markets in Asia did relatively well, while Russia and other European markets were among the worst performers.
Most fixed income securities had excellent returns. Despite Standard & Poor’s decision in early August to downgrade the credit rating of the US, investors rushed to the safety of US Treasury securities in light of weak economic data in the US and abroad, and especially among concerns about Europe’s ability to resolve its sovereign debt problems. Real estate securities had poor returns but good performance relative to other equity asset classes.
Fourth Quarter
Led by the excellent performance of US stocks, global equity markets posted strong returns in the quarter. Those returns, however, were not sufficient to overcome a dismal third quarter, and most markets had negative returns for the year. The quarter was also characterized by a sharp increase in volatility.
The broad US market gained over 12% in the quarter. In US dollar terms, the quarterly returns for developed non-US markets were over 3%—above the historical average but far behind the US. Greece, which remained at the center of Europe’s sovereign debt woes, was by far the worst performer in both the quarter and the year, while Ireland, the Scandinavian countries, and Australia were the top performers for the quarter.
The US dollar appreciated against major European currencies, which slightly hurt the dollar-denominated returns of developed market equities, and had mixed performance against the main emerging market currencies. In US dollar terms, emerging markets gained about 4% in the quarter, in line with the historical average, but not enough to overcome their poor performance of the third quarter. Malaysia and other smaller emerging markets such as Thailand and Peru posted double-digit returns. Turkey and Egypt had double-digit negative returns in the quarter.
Yields on Treasury securities across the whole maturity spectrum were little changed during the fourth quarter. With regard to credit risk, spreads between more- and less-risky fixed income securities generally became wider during the quarter. Real estate securities had positive returns in the fourth quarter but mixed performance relative to other asset classes. In the US, they were among the top performers, while in other developed markets, they trailed most other asset classes.
Russell data copyright © Russell Investment Group 1995-2012, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2012, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2012 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Citigroup bond indices copyright 2012 by Citigroup. Barclays Capital data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
Managing Inflation Risk
As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This article explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful.
As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market’s expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.
Hedging vs. Total Return Strategies
Investors can prepare for unexpected inflation by following one of two basic strategies—hedging the immediate effects of inflation or earning a total return that outpaces inflation over time.
Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)
Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection.
In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up short-term inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks.
To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let’s consider each of these:
Stocks
Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return.
Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.
Fixed Income (Bonds)
Higher inflation can hurt bondholders in two ways—through falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments.
Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with short-term inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.
Treasury Inflation-Protected Securities (TIPS)
Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation.
TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.
However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.
Commodities
Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging.
Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broad-based stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.
Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio.
As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:
• Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook.
• Hedging unexpected inflation has a cost. Investments traditionally regarded as effective short-term inflation hedges have lower historical returns than stocks—and some have much higher volatility.
• Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.
Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.
Endnotes
1 Real return calculation: (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.
Disclosures
Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics.
Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes.
CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included.
The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money.
Diversification neither assures a profit nor guarantees against loss in a declining market.
More on Sovereign Debt and Stock Returns
In early August, Standard & Poor’s downgraded US government debt from a top-rated AAA to AA+.1 In the weeks preceding the event, some market observers expected a downgrade to result in higher interest rates and lower stock returns.
After the downgrade, yields on US government securities fell across the term spectrum as investors around the world fled to the safe haven of US bonds. US stocks experienced negative returns in the following weeks but logged positive performance from the day of the downgrade to month end.2
These events raise questions about whether changes in sovereign debt ratings impact the financial markets. The short answer is that results are mixed, and that many other factors affect a country’s cost of capital and stock market returns.
Regarding bond markets, history offers examples of major developed countries that experienced a credit downgrade without a significant rise in interest rates.3 Examples include Australia, Canada, and Japan, which lost their top ratings in 1986, 1992, and 1998, respectively.
Other research suggests that countries with high credit ratings may withstand a downgrade better than countries with lower ratings. One study looked at sovereign credit rating downgrades since 1990 and found that bond yields changed little among countries downgraded from the highest triple-A rating. However, countries with lower credit ratings (single A or below) experienced significant interest rate increases following their downgrade.4
Stock market impact
Another question is whether theUSdowngrade has played a role in theUSmarket downturn—and research does not provide convincing evidence.
Below is a chart that summarizes stock market performance of respective countries before and after a ratings change. It is based upon a study of ratings changes made by Moody’s from 1983 to 2009. During the twenty-seven-year period, the ratings agency made seventy-one upgrades and twenty-five downgrades to governments in the developed and emerging markets tracked by MSCI.
The study identified the date of each change and logged each country’s market performance in the twelve months before and twelve months after the event. Each country’s market returns were compared to the respective market index and the excess return averaged for all events. (Excess return refers to performance above or below the respective market index, either MSCI EAFE or MSCI Emerging Markets, as appropriate.)
Figure 1. Equity market performance before and after Moody’s ratings changes
1983–2009
| Cumulative Return in Excess of Market | |||
| Sovereign Bond Rating Change | 12 Months Before | 12 Months After | |
| Upgrade |
13.83% |
3.87% |
|
| Downgrade |
−6.56% |
3.73% |
|
Analysis conducted by Dimensional Fund Advisors using sovereign bond rating data from Moody’s Investors Services, “Sovereign Default and Recovery Rates, 1983–2009.” Returns are in US dollars and represent performance in excess of MSCI EAFE Index for developed markets and MSCI Emerging Markets Index for emerging markets. A positive excess return indicates market outperformance; a negative excess return indicates underperformance. The table reports the return of an equal-weighted, event-time portfolio. Past performance is no guarantee of future results.
The aggregate results show that stock markets of upgraded countries outperformed their respective market index in the twelve months before the rating change (13.83%), while stocks in downgraded countries aggregately underperformed the market index before the event.However, cumulative returns in the twelve months following a ratings change were almost the same for the upgraded and downgraded countries (3.87% vs. 3.73%).5
These results suggest that market prices reflect all available information and expectations about a country’s economic prospects—including the possibility of a ratings change. By the time a country’s debt rating is upgraded or downgraded, the market has already integrated the news into prices. Stock markets reflected positive economic developments prior to a ratings upgrade and negative developments before a ratings downgrade. After the event, markets did not appear to perform much differently, in aggregate.
Conclusion
This research underscores the importance of looking to market prices for signals about the fiscal health and prospects of a country or a company. Based on the foregoing analysis, markets appear to work faster and more accurately than ratings firms to assess a country’s financial condition and evaluate the potential impact on its cost of capital and equity market.
Endnotes:
1. A sovereign credit rating is an assessment of a government’s ability to pay its debts. The US had held S&P’s top rating since 1941. S&P made the announcement after business hours on Friday, August 5, but word of the downgrade leaked during the day. Although timing of the announcement was a surprise, the downgrade was mostly expected, as S&P had issued a negative long-term outlook for the US in April and July. The other top credit agencies, Moody’s Investors Service and Fitch Ratings, have maintained top ratings for the US.
2. Two weeks following the downgrade, the US market, as measured by the Russell 3000 Index, logged a negative 6.82% return (August 5– 19). However, from the day of the announcement to month end, the market returned a positive 1.6%. Russell data copyright © Russell Investment Group 1995–2011, all rights reserved.
3. Tom Lauricella, “Lessons of Lower Ratings,” Wall Street Journal, July 30, 2011.
4. Ivan Rudolph-Shabinsky and Dennis Shen, “When ‘Risk-Free’ Isn’t Risk Free: The Impact of a US Treasury Downgrade” (white paper, Alliance Bernstein, June 2011), www.alliancebernstein.com/CmsObjectABD/PDF/Research_WhitePaper/Treasury-Downgrade_110706.pdf.
5. The twelve-month aggregate excess performance prior to the ratings change was statistically significant, while the twelve-month returns after the ratings change were not.
Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
TAGS:
Debt downgrade
Interest rates
Cost of capital
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Sovereign Debt and the Stock Investor
Last week we came across an “Economic and Policy Watch” update prepared by a major investment bank that reviewed recent government proposals to address the nation’s funding crisis. Titled “It Just Gets Worse,” the report chided policymakers for actions that “look like a poor cover for loose money, rising inflation, and fiscal problems,” and warned that “government financing needs are corrupting monetary policy.” As a result of these ill-advised tactics, the bank had turned “more negative” on the outlook for financial stability and saw “little hope of improvement in the inflation/currency mix.”
Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. We found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.
Indonesia’s sovereign debt rating at that time placed it firmly in the “junk” (non-investment grade) category: B3 from Moody’s and single-B from Standard & Poor’s. Although Moody’s upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.
What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.
Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.
For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country’s troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.
We are not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor are we suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.
Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation’s improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. Our point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a “junk” rating is no assurance of failure. A diversified strategy will have exposure to both.
Thinking in Real Terms
Since the onset of the financial crisis in late 2007, the Federal Reserve has used interest-rate cuts and other policy tools in an effort to fuel economic growth. Economists can debate the effectiveness of these policies, but everyone can agree that today’s low interest rates are a two-sided coin.
Consumers, businesses, and government all benefit from low borrowing costs. But on the other side, savers and investors earn almost nothing on their cash balances. This has been the case in most months since 2008, when the Fed cut short-term interest rates to near zero. Worse yet, investors are actually losing wealth in real terms. The inflation-adjusted yields on short-term Treasury securities have been negative in most months since October 2010. (Nominal yields reflect the stated interest rate, while real yields are adjusted for inflation.)
Earning negative real yields on short-term fixed income is not unprecedented, as shown in Figure 1. In fact, inflation has exceeded nominal interest rates in several post-war periods. This graph plots nominal and real yields of one-month Treasury bills, which are considered the equivalent of cash. The gap between the two lines is the inflation rate.
Negative real yields have occurred during periods of high interest rates (early 1980s) and during periods of low interest rates (2010–11). Regardless of the scenario, negative real yields cause investors to lose purchasing power. Keep in mind that the graph shows yields only and not total return, which also would reflect price changes resulting from interest rate movements.
You may note that some negative real yields have occurred during recessionary periods, when the Fed was cutting interest rates to spur a recovery. These times also may be when investors are most tempted to flee the capital markets for the perceived safety of cash. Investors may have a host of reasons for their flight—some might want to avoid economic uncertainty or stock market volatility, while others might fear that impending higher interest rates will cause bonds to lose value.
This is the case for many individual investors and professional money managers today. They are reportedly shifting their portfolios to money market funds and other cash instruments with the intent to return to stocks and bonds when the economy shows signs of improvement.1 The problem with this strategy is that no one can consistently time markets, and the signs are never clear. So while investors sit in cash, their purchasing power quietly erodes.
Investors may have good reasons to hold cash—for example, to keep a portion of their assets liquid. But they should understand that holding cash has a price in real terms. Investors ultimately may lose wealth even as they try to protect it.
Endnote:
1. Jonnelle Marte, “The New Cash Hoarders: Smart or Not-So-Smart?” SmartMoney, June 29, 2011.
Past performance is no guarantee of future results.
401(k) Benchmarking
The 401(k) Fair Disclosure and Pension Security Act HR 2989 combines HR 1984 (Fee Disclosure) and HR 1988 (Investment Advice). The purpose of ERISA 408(b)(2) is to provide fiduciaries with the information they need to fulfill their mandate under ERISA. It requires disclosure in writing of information relating to fees, all direct and indirect compensation, and potential conflicts of interest. The regulation would apply to covered service providers that provide investment advisory services, recordkeeping, TPA, banking, etc. The new disclosure regulations would require the covered service providers to describe the services they perform and their fiduciary capacity, as well as the compensation received and how it is received. The disclosure regulation becomes effective in July 1, 2012.
As an ERISA 3(21) Fiduciary, I understand the fiduciary duty plan sponsors have to their plan. You are going to be receiving Fee Disclosures from your 401(k) service providers by July 1, 2012 . By Aug 31 plan participants will be receiving the fee disclosures. These significant changes to disclosure will benefit plan fiduciaries and participants in the long run.
The new rules will level the playing field and bring to light hidden costs, provider arrangements and conflicts of interest of which plan sponsors might have not been aware.
Plan sponsors are mandated to review their fiduciary status. Do you have an ERISA 3(21) fiduciary or an ERISA 3(38) fiduciary? Are you considered the fiduciary because the service provider has waived their fiduciary duties due to confusing legal disclaimers? Fiduciary responsibilities can be effectively delegated, but prudence of delegation and duty to monitor remain. Even if not formally named as a fiduciary, a person or third party may be considered a fiduciary based on his or her function and actions taken for the plan.
By delegating fiduciary responsibility to an advisor, a plan sponsor can: focus on running his or her business, attract and retain talented employees, take advantage of the tax benefits of a 401(k) plan, manage fiduciary liability and do the right thing for participants.
BENCHMARKING your 401(k) plan satisfies the mandate of ERISA 408(b)(2). There are numerous benefits to having your plan Benchmarked:
- Benchmarking also provides fiduciary documentation as part of the annual review process.
- Provides a means to compare their plan to other plans in
their industry, possibly for application in labor relations - Provides clear documentation of a fiduciary process
- Lowers probability of litigation
- Enables you to understand and move the plan toward “best practices”
- Provides a “real plans data” framework to manage plan fees and services with the recordkeeper and other service providers
- Benefits plan participants by showing you are not overpaying for services and improving communication and education
Hornquist Financial will “Benchmark” your 401(k) plans using Fiduciary Benchmarks, Inc. solutions. Fiduciary Benchmarks Inc. (FBi) is a leading authority on fees, participant success measures, support and services for defined contribution plans. FBi’s proprietary software and database of current plan information is used to build the comparisons of their reports. We will also prepare a competitive turnkey 401(k) solution using Dimensional Fund Advisors model portfolios.
What’s “New” About a New Normal
What’s “New” about a New Normal?
The 2008 global market crisis and the struggling economy have left many investors fatigued. Despite two years of strong equity returns, some investors have been slow to regain market confidence. Many are accepting the talk about a “new normal” in which stocks offer lower returns in the future.1
The concept of a new normal is anything but new. In fact, throughout modern history, periods of economic upheaval and market volatility have led people to assume that life had somehow changed and that new economic rules or an expanding government would limit growth. What they could not see was how markets naturally adapt to major social and economic shifts, leading to new wealth creation.
Let’s look at other periods when investors had strong reasons to give up on stocks, and consider the parallels to today:
1932: The US stock market had just experienced four consecutive years of negative returns. A 1929 dollar invested in stocks was worth only 31 cents by the end of 1932. Hopes were sinking during the Great Depression, and many people felt as though the economy had permanently changed. Many investors left the market, and some would not return for a generation. Amidst what is considered the roughest economic time in US history, the markets looked ahead to recovery.
US Stock Market Performance after 1932*
5 Years 10 Years 20 Years
Annualized Return 15.35% 10.07% 13.19%
Growth of $1 $ 2.04 $ 2.61 $ 11.92
*All stock market returns based on CRSP 1-10 Index.2
Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
1941: World War II was raging, and the US had just entered the conflict. The US stock market had experienced two consecutive years of negative performance, and the economy had shown signs of sliding back into depression. Although conversion to a wartime economy would revive industrial production and boost employment, investors struggled to see beyond the conflict. Many expected rationing, price controls, directed production, and other government measures to limit private sector performance.
US Stock Market Performance after 1941*
5 Years 10 Years 20 Years
Annualized Return 18.63% 16.67% 16.29%
Growth of $1 $ 2.35 $ 4.67 $ 20.47
1974: Investors had just experienced the worst two-year market decline since the early 1930s, and the economy was entering its second year of recession. The Middle East war had triggered the Arab oil embargo in late 1973, which drove crude oil prices to record levels and resulted in price controls and gas lines. Consumers feared that other shortages would develop. President Nixon had resigned from office in August over the Watergate scandal. Annual inflation in 1974 averaged 11%, and with mortgage rates at 10%, the housing market was experiencing its worst slump in decades. With prices and unemployment rising, consumer confidence was weak and many economists were predicting another depression.
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US Stock Market Performance after 1974*
5 years 10 years 20 years
Annualized Return 17.29% 15.92% 14.89%
Growth of $1 $ 2.22 $ 4.38 $ 16.07
1981: The stock market had delivered strong positive returns in five of the last seven calendar years, and the two negative years (1977 and 1981) were only moderately negative. Despite these results, investors were weary from stagflation, which was characterized by high annual inflation, anemic GDP growth, and unemployment, and from fears of another economic downturn. In late 1980, gold climbed to a record $873 per ounce—or $2,457 in 2010 dollars. (By comparison, spot gold reached $1,256 per ounce in 2010.) Memories of the 1973–74 bear market lingered. A 1979 BusinessWeek cover story titled “The Death of Equities” claimed inflation was destroying the stock market and that stocks were no longer a good long-term investment.
US Stock Market Performance after 1981*
5 Years 10 years 20 Years
Annualized Return 18.82% 16.58% 14.54%
Growth of $1 $ 2.37 $ 4.64 $ 15.11
1987: On “Black Monday” (October 19, 1987), the Dow Jones Industrial Average plummeted 508 points, losing over 22% of its value during the worst single day in market history. The plunge marked the end of a five-year bull market. But in the wake of the crash, the market began a relatively steady climb and recovered within two years. The effects of the crash were mostly limited to the financial sector, but the event shook investor confidence and raised concerns that destabilized markets would increase the odds of recession.
US Stock Market Performance after 1987*
5 Years 10 Years 20 Years
Annualized Return 16.16% 17.75% 11.89%
Growth of $1 $ 2.11 $ 5.12 $ 9.46
2002: By the end of 2002, investors had experienced the stress of the dot-com crash in March 2000, the shock of the September 11 attacks, and the early stages of wars in Afghanistan and Iraq. Although October 9, 2002, would ultimately mark the market’s low point, investors had endured three years of negative performance and an estimated $5 trillion in lost market value. A younger generation of investors had experienced its first taste of old-world risk in the “new economy.”
US Stock Market Performance after 2002*
5 Years 10 Years 20 Years
Annualized Return 13.84% — —
Growth of $1 $ 1.91 — —
2008−Today: The market slide that began in 2008 reversed in February 2009—gaining 83.3% from March 2009 through 2010. Despite two years of strong stock market returns, memories of the 2008 bear market and talk of the “lost decade” have led many investors to question stocks as a long-term investment. But earlier generations of investors faced similar worries—and today’s headlines echo the past with stories about government spending, surging inflation, deflationary threats, rising oil prices, economic stagnation, high unemployment, and market volatility.
Of course, no one knows what the future holds, which brings the concept of “normal” into question. What exactly is the status quo in the markets?
The chart below shows the annual performance of the US market, as defined by CRSP deciles 1-10. Since 1926, there have been only four periods when the stock market had two or more consecutive years of negative returns. In addition, annual returns are rarely in line with the market’s 9.67% long-term average (annualized). The most obvious normal may be that, over time, stocks offer expected returns reflecting the uncertainty and risk that investors must bear.
What’s new about that?
