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Investor Letter April 7, 2013

Investor Letter April 7, 2013

We just finished up a very odd quarter in the financial markets. The big winners were Japanese and U.S. stocks. For U.S. equities returns were led by defensive sectors like healthcare and consumer staples. Typically in an up market the leading sectors are the more cyclical market sectors, such as financials & tech. This defensive leadership speaks volumes about the quality of the risk appetite - it tells us that investors are reluctantly buying stocks. In contrast with US and Japanese equities, the majority of major foreign markets lagged badly, led by China, Brazil, Europe, Russia & India, all down for the 1st quarter in US $ terms. Commodities were down for the quarter as well, including gold, copper & corn, and fixed income was flat for the quarter.

Japanese stocks were driven by the new policies of Prime Minister Aso, along with his new head of the Bank of Japan, Hiroki Kuroda. Together they have pledged to reach and maintain 2% inflation within 2 years by targeting money supply. This means the BOJ will be increasing purchases of government bonds & begin buying Japanese equities on an unprecedented scale (a scale that makes even our own Ben Bernanke blush!). We see the weakening of the yen as the beginning of a multi-year trend.

U.S. stock markets, which were sold heavily in December 2012, ahead of the "fiscal cliff", recovered sharply in January due to a last minute agreement out of Washington and the usual seasonal buying. The U.S. markets also benefitted from foreign investors piling into U.S. equities, with enormous flows from European investors (to the detriment of European and other foreign markets). These foreign flows were driven by the poor European economic situation and the incredibly stupid policy decisions taken in the Cyprus bank bailout, which the EU (and the IMF) approved. While good for Angela Merkel’s re-election bid this September, there will be long run negative ramifications to this new policy approach, in the form of capital flight from Europe, regardless of EU insistence that Cyprus is unique & is not a "template" for other bailouts.

As many investors, both domestic and foreign, are concerned about a bond bubble in U.S. Treasuries, U.S. equities have been the major beneficiary of money flows, with U.S. equities seeing "safe haven" buying and now exhibiting characteristics of a "risk-free" asset. We expect money flows to continue from Europe and now additionally from Japan as the increasing supply of Yen finds its way to the United States.

As for commodities and fixed income, the recent FED conversations regarding its exit strategy hurt commodities across the board and the $ value of non-$ investments (as the $ rises non-$ denominated assets decline in value). Bond investors contemplating a FED exit, combined with decent economic data, hurt fixed income investments, and the Barclays Aggregate Bond Index had a rare (slightly) negative return for the quarter.

What’s next? We expect the U.S. and Japanese equity markets to continue to rally throughout 2013, with corrections driven (most likely) by problems in Europe (does anyone know where Slovenia is on a map?) and questions about Chinese growth & policy that will plague the commodity and materials sectors.

Investor sentiment about Chinese demand has large knock-on effects on commodity exporters like Russia/Australia & Brazil. China is also in a different part of their liquidity cycle than the US, Japan, and Europe, to the detriment of commodity’s and commodity exporters. Closer to home Canada, another major commodity exporter, has had two negative employment reports in a row, and its bubbly real estate market is beginning to sour. Its great advantage is having the U.S. as its trading partner (Mexico would certainly agree!). Both will continue to benefit from that relationship.

While the best valued major stock markets are Russia, India, South Korea, China and the European markets, thus far in 2013 they have acted more as value "traps". There are some positives, such as the ECB signaling an easing of interest rates next month; and while the economic outlook is currently dim, it’s important not to extrapolate the poor European economic data forever. It’s important to know too that the Chinese have the ability to liquefy their markets very quickly, even if they are currently more concerned about their own real estate bubble and beginning to crack down on rampant corruption. But we think that on balance capital will continue to flow where is sees the best returns and the lowest risk, and that place remains the United States.

There are many 3 major reasons we continue to favor U.S. equities:

  1. Low rates, low inflation & liquidity - the Fed will very likely continue its current easing policy well into 2014 (zero rates + $85billion in monthly bond purchases). Add European money flows and the new Japanese money supply increase and we see scope for a 20%+ return for the S&P in 2013.


    US stocks are well correlated with the FED’s balance sheet.

  2. Corporate profits - as the chart below shows U.S. companies have record profitability as a % of GDP. While some might interpret this as a negative we see no reason to think profits are about to collapse, given technology led productivity gains and a large global labor pool. Current estimates of 2015 S&P earnings are ~$130-$135. With the S&P at 1560ish this gives us a forward P/E of 11.5 times, hardly a demanding valuation.

  3. Investor Sentiment and positioning - investors continue to be historically underweight equities and overweight bonds and cash. We have seen signs recently of investors finally moving from bonds back to equities, but it took years for the imbalance to develop, and it will take some time before investors return to a more typical weighting. Bonds have had an extended bull run already, and while rates can stay low and even go lower still, the majority of the gains have likely been seen. Cash, as has been the case for the last five years, remains a loser in real terms. Simply put, the relative attractiveness of equities vs these alternative asset classes will continue to drive flows.

We continue to believe a secular bull market in U.S. stocks began in March 2009. Similar periods of low rates and low inflation have seen the S&P trade at multiples in the low 20’s. A repeat performance would mean the S&P could potentially double from here.

As always if you have any questions or comments please contact us — enjoy your summer!

Best Regards,
Paul Brian Gibson
HarborView Capital Management LLC
Partner, Portfolio Manager