Is Now the Time to Diversify?

Economic Data - Previous Week
Date Series Actual Forecast Prior
2/26 Case-Shiller Home Price 0.88% 0.65% 0.65% Strongest monthly gain since 2Q12 & largest YoY since '06
2/26 Consumer Confidence 69.6 62.0 58.4 Improved outlook driven by low inflation expectations
2/26 New Home Sales 15.6% 3.0% -3.8% Robust gain on low existing inventory & low mortgage rates
2/27 Durable Goods Orders -5.2% -4.8% 3.7% Transports drive decline, robust gain in nondefense orders
2/28 4Q GDP (2nd Est) 0.1% 0.5% 0.1% Net exports revised higher, inventory investment revised down
3/1 Personal Income -3.6% -2.4% 2.6% Steeper drop on fiscal cliff effects, but spending holds up
3/1 U. of Mich Confidence 77.6 76.3 76.3 Strong gain in both current conditions & expectations
3/1 Construction Spending -2.1% 0.4% 1.1% Drop in public construction offsets residential growth
3/1 ISM Manufacturing 54.2 52.5 53.1 Strong acceleration on robust new orders & backlog growth
Economic Data - Upcoming Week
Date Series Actual Forecast Prior
3/5 ISM Non-Mfg -- 55.0 55.2 Modest weakening expected on restrained consumer income
3/6 Factory Orders -- -2.2% 1.8% Decline expected on lower government spending
3/7 Consumer Credit -- $15.00B $14.59B Continued growth expected on consumers' easy access to credit
3/8 Nonfarm Payrolls -- 160K 157K Improvement expected to continue on private sector gains
3/8 Unemployment Rate -- 7.9% 7.9% Rate to hold steady as gains offset by higher participation
3/8 Wholesale Inventories -- 0.3% -0.1% Inventories to rise as orders start to outpace sales growth
Source: Bloomberg

Sequester Passes With Little Fanfare

The sequester came and passed, but equity markets were no worse for wear, with the S&P 500 Index rising 0.2% and the Dow Jones Industrial Average posting a gain of 0.6%.

Economic data in the U.S. leaned positive last week, but several reports disappointed – most notably the fourth quarter GDP revision and personal income for January. On the aggregate, economic data is showing a slight level of positive surprises, as measured by the Citigroup Economic Surprise Index.

In late January, we received the first estimate of fourth quarter 2012 GDP. At that time, the advance estimate showed the economy contracting by 0.1%. Last week, that number was revised up to 0.1%; while an improvement, economists were disappointed by the meager pace of growth to end last year. Weakness in inventories and government spending was generally offset by consumer spending and business investment.

Source: Econoday

With talk of the fiscal cliff and sequestration on the horizon, it was no surprise to see government spending contract. The size of the contraction was telling, however, as it fell nearly 7% in the quarter and 1.7% for the full year. Also hard hit were sectors such as defense, down over 20% annualized.

It was also revealed last week that personal income gave back its unusual December gains in the start of 2013. Personal income jumped 2.6% in December due to a number of one-time items, such as special dividends and bonuses paid in advance of the 2013 tax environment. Fast forward to January and, as expected, personal income fell 3.6%. The biggest reasons for that decline were fewer dividends, higher payments to government insurance (i.e. expiration of payroll tax cut) and lastly, an overall decline in wages, partially attributable to bonuses being shifted to December.

Source: Barclay’s

On the spending side, consumers held up okay, with personal consumption increasing 0.2%. There was not a lot to report in terms of spending, but consumers were forced to dip more heavily into their savings accounts to fund January expenditures. The personal savings rate jumped from 4% in November to 6.4% in December, but collapsed to 2.4% in January.

In an interesting development, the Federal Reserve Bank of New York noted that for the first time since 2008, consumer debt outstanding increased. The increase was modest at $31 billion, but represents a potential reversal of the consumer deleveraging process that was a clear headwind for economic growth.

Source: Federal Reserve Bank of New York

There is some reservation, though, because growth in student loans is a primary contributor to the headline expansion. Several economists are calling student loans the next great credit bubble and we saw a sharp pickup in delinquency rates in the fourth quarter to confirm some of those fears. Nearly 12% of student loans were 90 or more days delinquent. Compounding the problem, the NY Fed pointed out this understates the severity of the issue as 44% of student loans have yet to enter the repayment period.

Source: Federal Reserve Bank of New York

There was some encouraging data last week, primarily in the form of manufacturing. The ISM Composite Index continued its recent rise, going from 53.1 in January to 54.2 in February. Most of the gain came from the new orders and production sub-indices, which generally bodes well for future strength.

The other bit of good news was in the housing markets, where both Case-Shiller Home Price Indices were up 0.9% in December. In the past year, the 20-city index is up nearly 7%.

Is Now The Time To Diversify?

The use of global diversification in constructing client portfolios has come under fire in recent years due to the underperformance of many risk assets. Traditionalists who stuck to their familiar S&P 500 and BarCap Aggregate Bond index blends generally outperformed their diversified peers in 2011 and 2012, as historic risk premiums failed to materialize and various alternative investment strategies faced headwinds.

These effects were particularly pronounced in 2011, when the S&P 500 (+2%) and the BarCap Agg (+8%) shined amid sizeable losses in foreign and small cap stocks. Hedge funds posted only their second negative year in history when the S&P 500 was positive (as measured by the HFRI Fund of Funds: Diversified Index), while managed futures strategies also suffered losses. Long-only commodity allocations also retrenched amid a global economic slump.

The most recent calendar year saw only a slight reprieve from this trend. The S&P 500’s 16% return was in line with small caps (Russell 2000) and just slightly behind the returns of MSCI EAFE and MSCI Emerging Markets indices. But with volatility levels nearly 60% higher in developed international stocks (5x the ratio from 2000-2010), and 90% higher in emerging markets (2x the ratio from 2000-2010), one could fairly question whether the additional 190 and 263 bps of performance, respectively, adequately compensated investors for this level of risk. A look at annual Sharpe Ratios from the past two years suggests they were not.

2012 was also another disappointing year for non-traditional strategies. Hedge funds once again put up muted performance (+5%), which was about on par with the BarCap Agg, while losses in managed futures persisted. Commodities posted an annual loss for the second year in a row. Depending on your specific allocation to these strategies, a diversified portfolio likely underperformed a naïve large cap equity/fixed income mix in 2012.

This phenomenon has come to be known as “di-worsification.” With correlations among such assets spiking during the financial crisis and poor performance following suit, investors have questioned the value of these diversifying allocations. Indeed, this trend has continued into 2013, with US large cap stocks soundly outperforming their international counterparts, and hedge funds once again lagging (although BarCap Agg performance is slightly negative YTD).

There are plenty of reasons to think that diversification is not dead, however. The first is the intermediate term outlook for equities. Forecasts for equity market returns over the next seven years by GMO see flat returns in US equities, with premiums of 300-500 bps in foreign stocks. This generally mirrors other forecasts in the marketplace: US stocks are a poor relative value to non-US. While the world seems to be a scary place at the moment, the fact remains that US stocks are much more expensive than their foreign counterparts.

Source: GMO

US stocks have always enjoyed a valuation premium over foreign equities due to a more open economy and stronger corporate governance. But relative to their own histories, US stocks are trading near their long term averages, while non-US stocks are at generational lows. This suggests a tailwind for such holdings for the patient, long-term investor.

Of course, the other critical piece of the traditional portfolio is also facing a growing threat. The much-discussed 30-year secular decline in interest rates is nearing an end. Whether rates reverse course or remain pinned down, the fact is that high quality fixed income allocations do not offer much return potential for investors moving forward (and with the investment grade index trading with a 7-year duration and just a 2.8% yield, they look downright frightening). The use of more flexible strategies that can limit interest rate risk and generate idiosyncratic returns will become necessary as this threat becomes a reality.

Diversification will also likely be more important than ever as we exit a regime of incessant intervention. Many of the structural issues present in developed economies and the excesses of easy money will create (has already created?) many dislocations in markets. These are precisely the opportunities that alternative investment managers can exploit to generate outsized returns. While the group has generally struggled in an environment not driven by fundamentals, a decline in the proportion of risk on/risk off trading should provide a tailwind for such strategies. Indeed, cross-correlations between securities and asset classes appear to be waning for the first time in years.

There is a reason that asset allocation is characterized as a “strategic” activity. It is an exercise designed for intermediate-to-long time horizons, and should not be abandoned in response to year-to-year market gyrations. Market studies have shown that investors are notoriously poor market timers, with some suggesting detrimental effects to the tune of 500-600 bps per annum. Disciplined investors may find themselves better off maintaining their “di-worsified” portfolios at a time when recent performance suggests otherwise.

the week ahead

Overall, this week is about quality as opposed to quantity. The jobs report on Friday is the focal point and economists are calling for 160,000 new jobs. Also of note will be the ISM Non-Manufacturing Index on Tuesday, the Federal Reserve’s Beige Book on Wednesday, and data on consumer credit Thursday.

Central banks will be busy this week, with meetings scheduled in Brazil, Canada, Japan, Mexico, England, and Australia, among others.

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