What is known and unknown about today’s markets

The following is excerpted from the July issue of “No-Load Fund Analyst” newsletter published by Litman Gregory.

We continue to be very concerned about the same problems we’ve written about repeatedly in recent years. Europe seems to be close to either spinning out of policymakers’ control, or nearing a trigger point of more comprehensive and effective action. As we go to press there are indications that it might be the latter as Germany agreed to soften their stance on direct capital infusions into Spanish banks, and other measures which suggest movement in the direction of more integration. (We don’t have all the details at this time so we can’t comment on the significance of these proposals.) While the wrong outcome here could be extremely harmful to global equity markets and the global economy, the crisis is beginning to create some opportunities. By early June, the sharp sell-off in the European and emerging-markets stock markets had, in our view, fully priced in a slow-growth scenario that we believe is most likely. These markets are now very attractive relative to the U.S. stock market. However, they are not yet a full-fledged fat pitch on an absolute basis and in our more pessimistic scenario, which we do not dismiss (in fact we could argue that its odds have risen somewhat), they would likely experience a sharp sell-off. Consequently, we have stuck a toe in the water by adding dedicated European exposure in early June and incrementally increasing our emerging-markets and broad-based international exposure. Context is always critical to decision-making, so let us walk you through some of what we think we know, what we don’t know, and how this informs our decisions.

What we know
— We know that extremely high debt levels have created a headwind to global growth resulting in a weak economic recovery with risk of another significant economic and market downturn. This risk has been turning into reality in Europe for a number of months and is reflected in an economic recession, which includes extremely high unemployment in the weak peripheral countries, slowing growth in the core countries, and a large decline in European stock prices.

— Generally, we know there is no easy solution to the problems of excess debt that almost all of the developed economies are suffering from. It is likely that taxes will need to rise and spending growth will decline over several years, and this will continue to be a drag on economic growth.

— We know that conflicting political motivations and economic circumstances across nations in Europe are a huge impediment in dealing with the crisis there. The need for a fiscal union or fiscal integration is central to the problem, but it requires surrendering some control of country budgets, tax policy, etc. Gaining agreement will require heroic efforts on the part of politicians. (Germany’s concessions at the June 28 EU summit suggest compromise is possible but very difficult decisions and negotiations lie ahead so uncertainty remains very high.) All of this suggests that a partial breakup of the eurozone is very possible. If that happens, the hope is that it will be well planned so as not to unnerve the markets, thus avoiding a possible credit freeze and increased capital flight, which would exacerbate the risk to the entire eurozone and trigger a major economic downturn. This scenario is a major worry and has been rapidly intensifying.

— We know that Japan also has a huge debt problem (relative to GDP their debt is actually greater than in the United States or Europe), though to date there has been no market focus on Japan.

— We know that the United States has its own debt and political dysfunction over both the short- and long-term. Near term there is the potential “fiscal cliff” of large spending cuts and tax increases which, depending on how it plays out, is estimated to reduce GDP in 2013 by 1% to 4.5%—a sizable amount. (The wide range of GDP impact is due to accounting for the probability that all measures might not be implemented.)

— We know that in the United States, recovery continues and there has been improvement in some areas. Housing is showing signs of a possible bottom. The labor market has improved a little, though more recent data has been less encouraging. The economy remains weak overall based on employment, consumer spending, disposable income, residential fixed-investment, household net worth, and overall GDP. This weakness makes the United States vulnerable to economic shocks.

— We know deleveraging in the U.S. private sector is progressing (16 consecutive quarters of debt reduction), but mostly through debt defaults. We also know the financial sector has been deleveraging on a quarter-by-quarter basis. This progress is important, but we also know that this process is by no means complete. Overall debt levels in the private sector are still high, though debt service is low compared to incomes because of low interest rates—and this is a big help. And in the public sector, debt has been building—so deleveraging there has not yet begun but it will have to. Our deleveraging analysis last year suggested that the process could take another five years.

— We know that if business confidence increases, U.S. companies and many global multinationals not domiciled in the United States will have large amounts of cash and the potential to move quickly into a more investment/expansionary mode.

— We know that based on our analysis, Europe and the emerging markets seem to be pricing in the subpar growth world that we anticipate. This means that even if this scenario plays out, investors could capture reasonably good returns—over 10% annualized in these regions. However, our analysis indicates the U.S. stock market is not fully pricing in this scenario (we project sub-5% returns over the next five years for U.S. stocks in our subpar growth scenario). Though we have a high degree of confidence in our analysis, there is no guarantee that it is right with respect to the general level of returns we forecast.

— We know that in our worst-case scenario, our analysis projects negative returns over five years in global equity markets with this probably playing out via a sizable bear market along the way.

— We know that traditional investment-grade bond yields are so miniscule that very low returns are assured over the next five years. Our annualized return range for the asset class over five years across all of our scenarios is -0.6% to +1.7%. This being said, there are opportunities in certain fixed-income sectors.

What we don’t know
The bottom line is that while we believe the subpar growth scenario is most likely, we are not highly confident in making this prediction. Not knowing which economic scenario will play out is a big unknown, but it is very helpful in our decision making to be able to be honest about this and to instead define and understand the range of potential outcomes. Here are some of the key unknowns:

— Importantly, policymakers have the potential to take actions that could have various outcomes, positive or negative, for the global economy and the markets—including actions that could trigger positive market surges. While we think it is more likely than not that their choices will be a net positive (because the consequences of bad choices could be truly awful), we are not confident which choices they will make, especially given the politics involved.

— We continue to worry about the possibility of a hard landing in China impacting the global economy. Developments in the Middle East (e.g., war with Iran, etc.) could also significantly impact oil prices. Neither of these risks are easily analyzed.

— As always, there are unknowable risks and developments that could blindside us either positively or negatively.

This all nets out to an investment environment that is likely to be volatile, as was the case in 2010, 2011 and so far this year, with periods of strong market performance followed by selloffs. These risk-on/risk-off periods are often driven by positive economic reports or comments/decisions made by government policymakers that result in investor optimism. But soon thereafter, investors are reminded of the magnitude of the debt problems we face. It seems to be déjà vu all over again . . . and again, and again. We continue to believe that risk is high, even in our less pessimistic, slow-growth scenario, with a meaningful possibility of sizable market declines at times over the next few years. While it is the same downer message we have been communicating for the last several years, at least we can say that forward-looking equity returns are starting to look better, especially outside the United States, mostly due to price declines. Overall though, all equities are subject to very high risk in our most pessimistic scenarios, and of the major markets, the United States is not pricing in the subpar growth world that we think is likely.

Given this context, we will continue to refrain from trying too hard to capture uncertain returns in a choppy, potentially very high-risk environment. But, we do seek to add value where we can while we wait for better opportunities. While we are not excessively defensive, we are conservative enough that we risk underperforming if the stars align: the eurozone pushes the right buttons, U.S. and global growth accelerates, and China avoids a hard landing.