David Feldman, President and Co-CIO, Palladiem LLC
1) US Equities – Limited upside potential, but high volatility.
“Full of sound and fury, signifying nothing.” (Shakespeare) We expect continued high levels of volatility, punctuated by brief rallies on limited volume and less foundation, offset by abrupt downward slides, amounting to very little, if any, forward price progress.
We acknowledge other market participants pointing toward low trailing P/E ratios, forecasts of double digit earnings growth and a productivity boom as all potential contributors to higher equity prices. Count us among the skeptical. In our view, earnings estimates are overly rosy and the environment will remain challenging for some time.
2) Non-US Equities –European markets likely to continue to struggle, and perhaps a somewhat brighter outlook for Asia ex-Japan.
European markets face substantial challenges that government officials and policy makers have so far failed to fully address: the sovereign debt crisis, undercapitalized banks, sluggish or negative economic growth, an aging population grown accustomed to a welfare state they can no longer afford, and a cumbersome political and monetary structure ill-suited to deal with the multiple challenges they confront. Kicking the can down the road has largely been the response so far, and that can only continue for so long; 2012 may well be the road’s end. This does not constitute a healthy or attractive environment for equities, in our view.
Asia ex-Japan has been a somewhat brighter spot, but while the picture is brighter than in Europe, it is a relative rather than absolute, advantage.
3) US Fixed Income – A repeat of a strong 2011 is unlikely, but so is a reversal, in our view.
U.S. Treasury instruments have been the beneficiary of other asset volatility globally in the form of lower interest rates. Given the volatility we expect to continue and the relative dearth of very low risk investments (return of capital, not return on it, is usually the first order of business for sovereign debt buyers), a Federal Reserve commitment to maintain low short-term rates for an extended period, and a lack of supporting evidence for a broad rise in inflation, we expect rates to remain little changed across the Treasury curve.
4) Non-traditional investments – We expect will be helpful in the 2012 environment, and will be increasingly embraced by investors.
Low expectations for returns from traditional, long-only holdings of stocks and bonds coupled with high expectations of volatility lead us to believe that non-traditional asset classes and strategies should play a larger role for most investors. Specifically, we believe investors should consider deploying capital to the following:
• Long/short equity
• Long/short fixed income
• Distressed debt
• Managed futures
5) EU, Euro and Sovereign Debt Continue to dominate headlines
The European Union and its common currency, the Euro, were founded with the best of intentions: to foster closer ties among its members, lower trade barriers, compete globally as a more unified entity, and put forever behind its people the prospect of the massively destructive wars that devastated the continent in the early and mid- twentieth century.
Culture runs deep, however, and matters greatly, as does at least the perception of local control. Germany is not Greece, nor Italy. An obvious statement, of course, but with significant ramifications when diverse countries are tied to the same currency: countries with radically different debt levels, growth rates, demographic circumstances, economic bases, financial institutions, credit ratings and perspectives on all of it can expect significant difficulty in coordinating efforts.
6) Oil – Given expected weak global growth and aggregate demand, we expect oil prices to remain well contained in the vicinity of $100 / barrel.
One wild card looms large: the Persian Gulf. Iran has been making more noise than usual, possibly related to the departure of U.S. forces from its neighbor Iraq, and perhaps the perception of a “weak horse” in the form of a U.S. government focused more on an election year than on one region’s seemingly intractable difficulties. Should tensions flare here, it would likely have a substantial impact on global oil prices.
7) Gold – We expect high levels of volatility in financial markets, and unsettled circumstances generally and therefore expect gold to retain its attractiveness as a store of value and a safe haven.
Although gold bullion has had a rather substantial upward run, we believe the near term appeal remains relatively high.
8) Volatility – Uncomfortably high. Buckle in; it’s going to be a very bumpy ride.
It is reasonable to expect, in our view, that heightened volatility will be accompanied by higher levels of correlation across many asset classes, which has the unfortunate effect of lessening diversification benefits just when needed most. This is one reason we advocate the inclusion of strategies with the potential for lower correlation, and a patient, longer-term time horizon, consistent with the ultimate portfolio objective.
9) Politics – Historic Presidency ends after one term
Although President Obama ran a pitch perfect campaign in 2008, he was given strong assists from the electorate’s Bush fatigue, an inept McCain campaign, an economy and markets in turmoil, and a widespread sense among the populace that it was time for a change not only of leadership, but direction. Fast forward nearly four years, however, and a great deal of buyer’s remorse has set in; hope has not panned out, and the change of leadership and policies has not notably improved the economy nor the employment situation.
10) U.S. economic growth will again be sub-par
It is our expectation, given the substantial and myriad challenges facing the U.S. economy, that real economic growth will continue to be lackluster, somewhere in the 1-2% range. It is quite conceivable that the Fed, seeing continued economic slack, will embark upon QE III, perhaps in the form of purchasing mortgage backed securities, in an effort to reinvigorate the housing related segment of the economy, with hoped for knock-on effects.
11) Debt, and what to do about it, dominates markets, economies and elections
It is likely we will see the denouement of at least one of the troubled sovereign borrowers in 2012, with effects that will spread beyond that country, or countries’, borders, despite attempts to “ring fence” or otherwise contain the trouble. Several possibilities are apparent: default, in some form or fashion, whether it’s termed ‘haircut’ or ‘restructuring’ or some other term of art; expulsion of the member from the European Union; or exit of stronger members, or the union’s complete dissolution. In each of these, at least the short run impact is likely to be negative on most equity and bond markets globally, probably to the benefit of U.S. Treasuries and gold.
Time for a lighter note. Defying all reasonable expectations, my beloved Michigan Wolverines finished 11-2 under new head coach Brady Hoke, capping their season with a Sugar Bowl victory over Virginia Tech. Progress here, too, I think, will take a half or full step back in the 2012 season, given a considerably more challenging schedule.
In my other sports passion, I expect Tiger Woods will return to the winner’s circle on the PGA tour, but another major championship victory will not be in the cards this year. Rory McIlroy will pick up his second, perhaps the Open championship.
We shall see; as always, it will be fun to watch.