3rd Quarter 2012 SMA Commentary
The third quarter of 2012 witnessed relatively strong capital market returns. This is surprising, given the continued weakening economic data from nearly everywhere around the globe. Briefly, Europe continues to be a slow motion train wreck as Greece was once again unable to make good on its financial pledges to the European Union. Spain is quickly following Greece down the same slippery slope as Mario Drahgi, President of the European Central Bank (ECB) made a series of vague pledges that capital markets eagerly accepted. The stark reality is that there has only been further economic deterioration in Europe, not improvement. Each month more data also arrives confirming further slowing in China’s economy.
In the U.S., we have seen various rounds of quantitative easing—QE1, QE2, and now QE3—by the Federal Reserve. The Fed’s efforts to maintain (manipulate) low interest rates has had far-reaching effects—including the assumption of greater asset risk by investors, rising prices of essential commodities, capital misallocations by corporations, and suppressed equity market volatility. Let us not forget the Middle East, where there has been increasing political unrest and decreasing stability. Near record volatility in spot oil prices highlight the uncertainty of global markets.
These macro-economic conditions are reflected in the continued cautious portfolio positioning in the strategy. As stated numerous times in the past, we do not forecast earnings, nor engage in macroeconomic forecasting. Our model does “pick up” this information through market price activity, however. Admittedly, results have lagged significantly behind those of the broader market averages. A significant portion of the underperformance has been due to the shorter maturity/higher credit-quality component of the fixed-income portion of the portfolio as those types of bonds have underperformed long-maturity, lower credit-quality issues during the period.
We view capital markets as complex systems. As such, when pricing mechanisms (interest rates) and normal volatility of capital markets have been artificially suppressed, we think they tend to silently accumulate risks beneath the visible surface. Central bankers and regulators who seek to suppress pricing mechanisms paradoxically increase the probability of tail risk (i.e. an extreme outlier or Black Swan) event.
Our model continues to see signs of significant risk across financial markets. As a result, the portfolio continues to maintain a risk-averse stance. This is particularly true of fixed-income instruments. Hence, shorter-maturity and higher credit-quality continues to be emphasized.