Manager Insight - Storm Clouds Ahead
By Ronald L. Altman, M.D.Sass Investor Services, Subadviser to the Aston Funds
Given the return of turmoil to equity markets recently, investors may be grappling with whether to become more aggressive or defensive at this juncture. For many, it is tempting to opt for the former based on the perceived low valuation levels of the broad market S&P 500 Index using consensus earnings estimates for 2012. Taking an aggressive posture based on a price/earnings basis, however, assumes that the earnings estimates for the market, or companies in the index, are generally accurate. The global economic deceleration witnessed lately suggests that those earnings estimates could very well be significantly off the mark, particularly if it leads to a recession in either Europe or the U.S. in 2012. In our opinion, it is quite probable that S&P 500 earnings would decline substantially in a recession, causing the valuation argument to lose its validity.
U.S. Economic Outlook: Cloudy
We believe that it is more appropriate to focus on the economic issues facing the developed world over the next few years rather than valuations. The overriding issue is the impact of de-leveraging in the U.S., and Europe, and how it might affect final demand. Considering the degree of leverage that has been layered on consumer and government balance sheets during the past few decades, it is unlikely that excess leverage will be redressed in the short term. A substantial amount of the debt that governments owe is opaque, with entitlements such as Social Security and Medicare /Medicaid serving as only the tip of the iceberg. Underfunded pension plans at the state and local levels likely amount to trillions of dollars, and retirement medical benefits that municipal workers have been promised contractually are typically paid out of current cash flow and not counted as debt. The unwinding of excess debt and government obligations will take time and will ultimately dampen cash flows to consumers.
Consumer debt in the U.S. has not been reduced sufficiently during the past few years. After rising dramatically from 2000 to 2008 on the back of the housing boom and credit bubble, consumer debt still has a long way to go before returning to reasonable levels. Until housing prices begin to recover and debt levels decline considerably, the willingness of consumers to increase spending at past rates will fail to materialize.
As Washington continues to argue with itself about how to fix the federal government debt and budget problems, and fails to act decisively, we believe consumer confidence will remain low. There is no easy fix to spur economic growth as the country goes through a cycle of de-leveraging. Saving rates have to go up, the tax system needs to be overhauled, and government spending must be reduced.
The good news in our view is that the outlook is much less dire than during 2008 to 2009. Still, the situation is not altogether attractive from a domestic point of view. The U.S. banking system has raised a substantial amount of capital through equity offerings, asset sales, and retained earnings. Therefore, a repeat of the last financial crisis in terms of severity in this country is unlikely. On the other hand, fixing the government debt problems will likely cause final demand to decline domestically, dampening efforts to keep the economy out of another recession. In addition, Europe is a major trading partner for American companies, and multinationals that have a considerable presence in Europe are likely to be affected by the negative economic situation in that region.
Multi-national companies derive a substantial degree of revenue and profit from their subsidiaries that are domiciled in Europe. A decline in final demand in Europe will result in a decline in sales and profits for those companies. In addition, any resulting decline in the Euro against the US dollar would hurt the translation of sales and profits over the next one to two years depending on how much each individual company has hedged its currency risk.
The bigger risk is the interconnection of the U.S. financial sector with that of Europe. As we learned in the last financial crisis, linked risks of this type are seldom fully reserved for, or appreciated, beforehand. While we are quite confident that no major U.S. financial institutions are exposed to a major extent, there is likely to be some fallout.
European Outlook: Stormy
We think the Euro zone is facing the same issues as the U.S., but without the ability to monetize its debt. An economic union and a common currency without a political union limits the ability of government to manage fiscal problems. As the stronger Northern European countries demand austerity from the southern euro zone as the price for financial aid, the ability of the recipients to pay back that aid, which is in the form of debt, is clearly suspect. For Europe as a whole, the real problem is that the major banks own much of the sovereign debt of the weaker countries. We question whether they can deal with a default of that debt.
This situation is similar to the U.S. banking crisis of 2008 - 2009, when the subprime mortgage market melted down. The question then was how big a "haircut" banks would be required to take to reflect the real market value of bad loans, and how much additional capital needed to be raised in order to cover the markdowns. We wonder if the European banking system is prepared to take the markdowns, and whether they can raise sufficient capital to stay viable. Without a political union, Europe can not engage in a TARP-like program similar to the U.S. in 2008, complicating any short-term solution.
The Euro zone risks could become the epicenter of another financial crisis that could create a global recession within developed economies. Add in a languishing Japanese economy, and our outlook for emerging countries becomes decidedly negative. Growth in China and India is likely to decelerate more than most models predict due to the decline in the end markets for their products. Although neither is likely to experience a recession in terms of negative Gross Domestic Product (GDP), both could experience a decline to mid-single digit rates of growth. Therefore, we believe that the world economy as a whole is at risk of slipping into a recession in 2012.
Having gone through the ringer only three years ago—when even the strongest companies were finding access to the credit markets challenging at best—corporations built up as much liquidity as possible as the economy recovered. Remembering the experience of a shutdown in credit in 2008 and 2009, few companies felt confident hiring or undertaking significant plant expansion amid an uncertain environment. A perceived lack of cohesiveness in Washington in terms of addressing fiscal issues will likely continue to retard hiring and domestic capital spending.
The lack of corporate confidence, coupled with a need by all levels of government to shrink employment, is contributing to a negative feedback loop that in all probability will discourage consumer confidence and exacerbate problems in the housing sector. De-leveraging is not going to end anytime soon. Decades of debt accumulation on the part of governments and consumers will take years to unwind. Thus, we are currently in something other than a normal business cycle where the Federal Reserve can lower interest rates and corporations and consumers will increase their level of spending.
What This Means For Equities
In terms of the equity markets, we believe the operative word is caution. Equity investors as a whole are unlikely to become aggressive buyers in an uncertain environment. Uncertainty is one thing that typically causes investors to retreat to the sidelines. Until the various governments in the U.S. and Europe face the realism of global de-leveraging, we are likely to remain mired in the negative economic feedback loop.
Equity markets in the U.S. are in a phase that can be best described as a protracted sideways period characterized by a succession of bull and bear markets. Historically, every substantial advance in real stock prices has been followed by a prolonged phase of very low returns relative to inflation. Given the economic storm clouds brought on by the global de-leveraging process, we doubt the next five or 10 years will bear witness to a resumption of the advance that occurred between 1982 and 2000.
Low current stock yields relative to history also suggest that total returns going forward are likely to be somewhat lackluster. The yield on stocks averaged 5% per year from the 1870s until the mid-1980s before dropping off sharply during the past few decades. We do not believe that stock prices have to decline to raise the yield on the S&P 500 back to its historic median. A more likely scenario is that companies are going to increase their payout ratio over the next decade. A combination of flat share prices and rising dividends is the way we believe the adjustment will occur. This suggests that the total return on equity investments is going to be a function more of dividends than stock appreciation. If this takes place in a low inflationary environment, then we think the real return on equities will be positive. With the low return on government and high-grade corporate bonds versus historical norms, equities appear to be the more attractive asset class on a long-term basis.
The World Is Not Coming to an End
Yes, we may have a potential financial crisis in Europe and a debt problem to fix in this country, but in the end these problems typically get resolved even though the solutions are not apparent today. The U.S. has always come through crises in the past and this one will pass as well. The only question is how long it will take before we right the ship, and how much pain will it take before we put partisan politics aside. Although no one knows exactly when these problems will be resolved, the fact that they are now being debated in every arena, and every day, suggests that the problems will be resolved sooner rather than later.
Most observers seem to fear default on sovereign debt in Europe and U.S. municipal debt, but these are not unique in terms of history. The important thing is to recognize is that there will be defaults—and that the world will not end when it happens. When the subprime issues affected the U.S. several years ago, causing a number of major financial institutions to fail, the result was that the survivors came out stronger and were better able to cope going forward.
Next year could easily be a recession year for the developed countries and as a result profit estimates will prove to be too high, but we believe that equity markets will price this event in long before it happens. By the time everyone acknowledges the recession, we believe equity markets will be recovering similar to how they have reacted in the past. Now is not the time to panic. We believe a risk-averse investment strategy is the correct approach given the difficulty in correctly timing any recovery in stock prices. And that owning the stocks of strong companies able to return capital to shareholders in the form of dividends, and that have the financial strength to sustain those dividends, should be rewarding for investors.
The information contained in this article is provided by Mr. Ronald L. Altman ("Mr. Altman") and his views do not necessarily reflect those of Aston Asset Management ("Aston").
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and Mr. Altman's views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results. For more information about Aston Asset Management LP and its subadvisors, please call 800-597-9704, or visit www.astonfunds.com.
Note: There is no guarantee that the underlying companies of income-producing equity securities will continue to pay or grow their dividends. Stock prices can lose value in response to changes in overall economic and stock market conditions.