Looking back at the past year from an investment point of view, I’d sum it up in one word: terrible.
I got one single major macro call right. The inflation threat that everyone was worried about at the start of the year began to fade in the last few months. But almost everything else was completely wrong.
Safe havens did much better than I expected, but so did some risky assets. Meanwhile, those in between got hammered.
Let’s take a look at what did best and what did worst – and where the long-term value might be now.
US Treasuries were among the best bets in 2011
You can see what each broad asset class has done on the chart from Capital Economics below. And the problems start with the very first column.
I certainly wasn’t upbeat coming into 2011. But I didn’t expect that the already miserly yield on US Treasuries could shrink much further. Yet they have been one of the top performing asset classes.
That’s a broad measure as well. Long-term Treasuries are up much more, with a total return of around 30% year-to-date.
This can be easily explained. It’s the flight to safety from problems in the eurozone and elsewhere. Although I recognised that many European countries were bust, I underestimated the problems it would cause this year.
Policymakers have been even slower to acknowledge the problems than I expected. They’ve also been far more willing to try unhinged ideas like putting countries already stuck in a currency trap into a fiscal straitjacket.
That’s a blueprint for disorderly default or a European depression – markets have understandably been rattled at these constant displays of incompetence.
Most risky stocks have done badly – but not all
But a flight from risk doesn’t explain everything. As you saw above, emerging markets have performed especially badly overall. Yet Indonesia and the Philippines are actually up slightly year-to-date. A couple of others, such as Malaysia, haven’t done too badly either (see chart below).
The riskier Southeast Asian economies outperformed last year as well, as investors continued to reassess their prospects. Much of that was deserved – but I still thought the trend had got carried away and that they would underperform safer markets such as Hong Kong and Singapore in 2011, especially if we were heading into trouble.
I could not have been more wrong.
I still find this remarkable. Yes, Indonesia’s growth during the past year and its outlook for next year is very solid by past standards and by expectations for the rest of the world. But it’s still striking that such a high-risk market has held up well while investors are pulling out of risky assets elsewhere.
Emerging market currencies were hit – but debt wasn’t
Action in the currency markets was equally surprising. While I have never subscribed to the idea of emerging markets as a safe haven, I thought that EM currencies would hold up relatively well this time, even if we hit a few bumps.
But if you look at the chart below, which shows the performance of a basket of EM currencies versus the dollar (the blue line), that definitely hasn’t been the case. (Although some currencies – notably the Singapore dollar – have been relatively stable, in contrast to the across-the-board sell-off in 2008.)
As usual, the dollar has performed well during a bout of fear, as investors rush back to US assets. But the dollar index hasn’t reached the same highs that it did in 2008-2009 or March 2010, even though I would say the level of fear today is much greater than it was at any point in 2010.
Perhaps oddest of all, the euro has been up and down against the dollar throughout the year, yet seems set to end 2011 at almost exactly the same level it began it. That doesn’t seem consistent with way that fears about the eurozone have spiralled in recent months.
And you can point to plenty of other oddities. EM debt has generally held up rather well, defying my doubts about this popular trade a few months ago. That’s despite the fact that the EM currency sell-off will have hit returns from local currency debt for the foreign investors who are piling into it in search of a yield.
As for gold – well, it’s had a respectable year. But it got whacked in September during one of the most panicky phases of the year – not much of a safe haven at that time.
Timing the market is very difficult
Individually all of these things can be explained. Investors are willing to stick with a story that offers good growth. They’re so desperate for income that a 6% yield on a ten-year bond from a non-investment grade sovereign with currency risk looks a great deal. When the margin calls come in, a liquid asset like gold can be the first thing to get dumped even at a time when you’d usually want to hold it.
But collectively, I think you’d have been hard pressed to put all those together. Frankly, 2011 did not pan out at all the way I expected.
So what’s the outlook from here? I’m going to avoid making any forecasts for what markets will do in 2012. I’ve long maintained that trying to predict what happens in the short term is likely to be a losing game.
There may be a few traders who can time the market exceptionally well, but I have never met them. But I have met a lot of people who’ve lost a lot of money trying.
Forecasting the long run is just a bit easier, if you have the patience. There are certain disruptive events we can’t predict – some good, some bad. To protect against those, you diversify. But absent revolutions, disasters or miracles, long-term returns largely depend on valuation – how cheaply you buy future growth.
While I don’t pay attention to many forecasts, one that I find interesting is the monthly outlook published by investment firm GMO. They estimate probable real returns over the next seven years for a range of asset classes, based on current and historical valuations. (Seven years may seem an odd choice, but apparently they’ve found that the data has the best predictive record over this time frame.)
The chart below shows their latest forecasts. As you can see, their method suggests you are likely to earn a respectable return on both emerging market and non-US equities and on high quality US equities. But the wider US equity market and most debt is expensive.
This fits with my own views, which to be honest is probably why I pay attention to it. I don’t think emerging markets are expensive. I can see value emerging in Europe and the UK. And while the S&P 500 looks overpriced on long-term measures like the cyclically adjusted price/earnings and equity q, from a bottom up perspective, many excellent US companies look relatively cheap.
Treasuries are pricing in a Japan scenario
Obviously, things could turn out differently. Yes, the ten-year US Treasury now yields 2% – but that yield could go lower. Japanese bond yields have headed lower over two decades and are now at 1% with no sign the bottom has been reached.
But for that to happen – for US Treasuries to fall further and still deliver a positive return for bondholders – the current crisis has to turn out almost exactly like Japan’s: ie, persistent deflation.
I think that’s unlikely. There are substantial differences between Japan and the US: difficult demographics, the tendency of firms to overinvest, the willingness of the central bank to countenance deflation without very aggressive quantitative easing, and the general global disinflationary trend are all missing in America today.
You might be able to make a better case for a deflationary depression in Europe, at least if the eurozone holds together. But how many European government bonds would you want to hold in that situation?
It would be good if equities were a bit cheaper. Hopefully we’ll get that opportunity at some point in 2012, which is why I suggest holding a reasonable amount of cash.
Nonetheless, a high quality company that offers a respectable dividend or a well-run firm in an emerging market with growth prospects already seem better value than anything most Western governments are offering.
I imagine that the next few months will be difficult. I can see that Treasuries might perform well again. But at these levels, government bonds look like a trade, not an investment.
That’s all from me this year. I’d just like to wish you all a Merry Christmas and Happy New Year. Hopefully 2012 will prove to be a little more profitable.