This year, like last, presents investors with an array of risks. Europe seemingly creates new financial and economic concerns daily, while, in the United States, fiscal questions and election uncertainties trouble the outlook. Still more dangerous issues surround the military and diplomatic maneuvering in the Persian Gulf. And these are just a sample of the sources of investment concern. But even as all this prompts people to hide in cash and the usual safe havens, such as U.S. treasury bonds, these investment choices pay such poor yields that presumed safety comes at tremendous cost. Investors, then, must consider riskier investments.
Among those choices, credit-sensitive fixed-income instruments would seem to offer superior returns with reasonable security. Among equity choices, opportunities also present themselves. Among developed markets, North America seems to offer the best risk-reward balance. Though stock valuations are better in Europe and Japan, the one still needs to deal with its debt crisis and the likelihood of recession, while the other faces the very fundamental matter of severely aging demographics as well as the immediate adverse impact of an expensive currency. Emerging markets, though, offer a reasonably bright outlook. Though they are not likely to generate anything near their former growth and return records, they still promise much more impressive rates of expansion than the developed world, which, given rather attractive valuations in these emerging markets, promises much improved equity returns. Here, then, is a brief analysis of the situation in each area and the associated investment prospects.
The Safe Havens Look Risky
The turmoil and uncertainty that have plagued markets since 2008 has driven many individual and institutional investors into the usual safe havens. Yields on U.S. treasury bonds — the quintessential hiding place in uncertain times — have accordingly fallen to record lows, as have German and other favored government yields. Gold prices, though uneven of late, have soared. Meanwhile, the Federal Reserve's monetary ease has driven down all short-term dollar-based rates to fractions of a percent, as has the Bank of England to sterling-based rates. The Bank of Japan did the same to yen-based short rates a while ago. The European Central Bank (ECB) had bucked the trend, but the demands of the sovereign debt crisis have forced a reversal of that policy so that more recently Eurozone short rate targets have fallen as well.
Matters have gone so far that these havens now offer ridiculously low returns. Recently, German government yields actually dipped into negative territory. Investors, in other words, paid Berlin for the privilege of lending it money. Ten-year treasury bonds in the United States, with yields below 2%, still pay a positive nominal return, but after accounting for even modest rates of inflation, they leave investors with a real loss, effectively paying the U.S. Treasury in real terms for the privilege of lending it money. Short rates, in all seemingly safe developed markets, whether on government debt or deposits, remain so low that any funds left in them lose in real terms with each passing day.
Offered such low returns, investors seem likely to look for better deals elsewhere with the slightest improvement in economic or financial conditions. Even a modest abatement in the pattern of European panic, for instance, or an improvement in the U.S. economy or even signs of stability in the emerging economies, could draw funds out of government bonds, raise their yields and impose capital losses on their holders, as well as on those in gold. Easing tensions in the Middle East (and such a thing is possible) could have a similar effect. Meanwhile, it is hard to see what would cause these safe-haven yields to move much lower. Investments in these areas, then, look generally unattractive, offering a continuation of inadequate yields at best or capital losses on the least improvement anywhere.
In such a situation, it would seem better to lean toward lesser-quality more credit-sensitive fixed-income instruments. These carry yields much higher than most government bonds and other seemingly safe investments. In the event that matters remain as worrisome, they should at least offer a positive real return. And, in the event that there is the slightest improvement on any front, they should protect against the capital losses likely in U.S. treasury and other stronger government bonds, even if they do not necessarily promise capital gains. Of course, not all lesser credits are equal. Bonds issued by Europe's endangered periphery may require more intestinal fortitude than most investors want to exhibit.
But in the United States, for instance, high-yield bonds offer yields some 700 to 800 basis points above treasuries, a gap 300 basis points above their long-term averages. Intermediate-grade corporate issues offer similarly attractive, if less dramatic, yield spreads. Since default experiences have actually improved, the picture is one of an attractive risk-reward tradeoff. For many U.S. tax payers, municipal bonds, even after their very good 2011 performance, offer an even more attractive investment picture for much the same reasons.
Europe: A Fountain of Bad News
While the stock losses engendered by Europe's sovereign debt crisis have given European stocks some of the most attractive valuations in the world, their prospects still look dubious. The crisis will remain for a long time to come, and Europe this year faces the strong likelihood of at least a mild recession. At some future date, attractive valuations will make European equities a generally good investment choice. But it would be premature to make a general move into European equities now.
Of course, European stocks would soar if the Eurozone could resolve its debt crisis satisfactorily. Though 2012 does offer the prospect of some relief, now that the European Central Bank (ECB) seems to have decided to provide additional amounts of liquidity to support markets, that improvement will prove inadequate to the needs of the situation. The best the liquidity can do is blunt the market panic. It cannot address more fundamental issues. Even with a gratifyingly active ECB, an excess of debt will remain. Concerns about the ability of Europe's nations — both in the periphery and the core — to make fundamental fiscal reforms will continue to threaten European investments. Questions about the biases implicit in the basic structure of the euro will also weigh on markets. All, even with expected ECB help, will likely prevent European stocks from fully realizing their value.
Meanwhile, recessionary pressures will raise further concerns about European equities. Even if Europe's policy makers could arrive at a promising plan today, something that is hardly likely, Europe would still face a legacy left from past troubles. Liquidity shortages that developed in 2010 and 2011 have created a great caution among businesses that will not lift quickly. The uncertainties engendered by the crisis also will take time to lift. Businesses, in the periphery certainly, but also across much of the continent, will consequently remain reluctant to expand and to hire. The past reluctance of the ECB to ease the strains of the debt crisis will also leave the continent struggling to overcome what amounts to two years of monetary restraint. Bank reserves have hardly grown at all, while money in circulation has expanded too slowly to support normal economic needs much less those created by the debt crisis. Even now that the ECB seems ready to correct these past mistakes, it will take time for the policy change to have an economic effect. Still more, the fiscal austerity imposed on Europe's periphery will restrain growth in these economies and consequently impair export growth prospects in Germany and other stronger European economies. Austerity efforts in these stronger economies, though less severe than in the periphery, will further restrain growth.
These recessionary forces have led optimists among European economists to anticipate zero real growth this year, while the pessimists look for declines in excess of 21/2%. Likelihoods see slightly less of a decline. But even the best of those outlooks suggests few positives about European earnings. Over the longer term, after which Europe can lift the bulk of its sovereign debt burdens and work through the recessionary forces presently marshaled against it, the valuations will tell, and European stocks will make very attractive investments. But that will take 18 to 24 months at least.
America Looks More Secure
Economic fundamentals in North America, though far from robust, look better than in Europe. Businesses have huge cash hoards and are showing signs of using them at last, including for hiring. Housing prices and buying activity seem to have stabilized. If still far from an engine of growth, stability is a welcome relief from the near free fall of the past few years. Exports are booming as a consequence of the dollar's long-term declines. And households are beginning to spend again. Though consumers remain cautious, they have found relief from the worst aspects of real estate price declines and the most intense insecurities about their jobs. They have also done a lot to start the repair of their balance sheets. Having raised the ongoing flow of savings from income to 4% to 5% of their outstanding liabilities, they are in a position now to continue improving their finances without any need for further cutbacks. Circumstances hardly point to robust growth, but enough to advance the overall real economy between 2% and 21/2% even in the face of a European recession.
If American stock valuations are not as depressed as Europe's, they remain low enough to allow prices to more than keep up with the modest earnings expansion (8% to 10%) that would likely accompany such an admittedly slow economic expansion. Price-earnings multiples, after all, remain far lower than their historical averages and, compared to bond yields, look more attractive than any time since the early 1950s or even, by some metrics, the Great Depression. Attractive valuations show even more in dividend yields that, atypically, stand higher than bond yields. Though valuations and prices will face a headwind from continuing concerns over Washington's lack of policy direction, fiscal matters, at least until after the election, promise to get no worse than the mess to which investors have long since accustomed themselves. Certainly, both Congress and the White House were so chastened by the electorate's response to the nonsense of the debt ceiling debate last summer that they will do most anything to avoid any rerun of that disturbing episode. With fiscal concerns no worse than before and earnings continuing a modest expansion, there is every reason to expect attractive American equity returns even in a still slow-growing economy.
Japan Has Problems But Looks Better Than Europe
Unlike Europe, Japan's economy will likely grow, albeit modestly, in 2012. The country has room for some fiscal stimulus. Though the bulk of the recovery surge from last year's earthquake and tsunami has already run its course, some positive rebuilding effects should persist. Still, both the pace of growth and the equity response will face constraints. Investors retain questions about any long-term prospects in the face of the population's extreme aging trend. Nor has Japan even begun the fundamental reforms that all — in business, academia and government — acknowledge it needs to return dynamism and responsiveness to its economy. More immediately, Japan should feel the pinch its expensive yen imposes on its exports. The ill effects of the record yen values have already presented Japan, as 2011 closed, with, remarkably for Japan, a balance of payments deficit.
Because Japan has equity valuations about as attractive as Europe, its markets should respond positively to even restrained rates of economic and consequently earnings growth. Especially since Japan faces nothing like Europe's debt crisis, the country's risk/reward trade off looks better than Europe's. Were it not for the fundamental structural and demographic problems facing Japan, its market could probably outperform America's. However, because these deep concerns persist, Japan will likely lag. The potential for a decline in the yen, as investors worry less about safe havens, will help Japanese exports, but only partially at first and slowly. Meanwhile, such a currency correction would detract from the dollar- or euro-based returns on any yen-denominated investments.
Emerging Markets Return to Their Promise
Prospects of gain have improved for emerging market equities as many of the earlier concerns have began to ease. For the past year or so, these markets have suffered as inflation fears forced policy restraint from China to India to Brazil that in turn raised concerns about economic reverses — a "hard landing." Now with a marked easing on food prices, a major factor in emerging economies, and hence overall inflation concerns, these nations have begun to shift toward more expansive policy postures, lifting fears of recession and raising the chances for growth acceleration in 2012. Of course, the residual effects of past restraint, among other things, preclude any return to the fabulous growth rates of earlier in this century. But the development potentials in these economies should sustain growth rates that are far more robust than any in the developed economies, especially since most emerging countries have such good finances that they can readily capitalize on these opportunities. If, for instance, China ceases to grow at 10% to 12% a year, it should easily sustain 7% to 8%. Similar, if less dramatic comparisons, apply to India, Brazil, and other emerging economies.
Especially since the market reverses of the past year or two have created such good value, there is reason to expect equity markets in these economies to reflect the positive policy and economic change. Problems remain, of course. China, for instance, must deal with a real estate bubble. But it would be a mistake to draw easy parallels, between this (or other emerging economy excesses) and recent problems in the United States. Unlike America's real estate disaster, Chinese households are far from highly leveraged. By law, a Chinese home buyer must put 20% down on a first home and 50% down on a second. The leverage in China lies with the local governments, which is much easier to deal with than widespread debt problems in households would be, as the American experience has shown. Also, because China and other emerging economies are growing so fast, their excesses represent less of a threat than in developed economies. China has an ongoing flow of about one million people a month into its cities, making it a lot easier to correct its real estate overhang than it is in much slower-growing America.
Milton Ezrati is the senior economist and market strategist
at Lord Abbett and an affiliate of the Center for the
Study of Human Capital and Economic Growth
at the State University of New York at Buffalo.