Everyone should know that predicting the future is by definition uncertain. Why then, does the Federal Reserve believe the outlook for the economy to be even more uncertain than usual?
The various risks that make investors nervous nowadays are quite extreme and often contradict one another. We will now review the various fear factors investors face, present our conclusions and the investment posture we have put in place to help protect your assets.
Fear Factor 1: Printing money and government spending will lead to runaway inflation
There are two missing ingredients for such runaway inflation scenario to take hold:
1) Before it can be spent in the economy, the money “printed” by the government has to make its way to people’s pockets. That money currently sits in bank reserves and is likely to remain there: under new rules1, banks need to keep more capital.
2) People’s wages need to rise in response to higher prices. With unemployment hovering around 10%, employees have no leverage to demand higher wages. Without rising wages an inflationary spiral cannot develop.
How we deal with the inflation risk: At this time, the protection against inflation provided by TIPS (Treasury Inflation Protected Securities) is cheap, so holding a limited amount may prove to be prudent in case inflation rises unexpectedly. However, increasing such protection at this time may prove to be premature.
Fear Factor 2: Interest rates could spike if foreigners will sell their US debt
Other nations hold US debt as part of their central bank reserves. The US dollar enjoys the status of main reserve currency because of the scale and relative stability of the US economy.
At this time, there is no viable alternative2 to replace the dollar, thus we do not expect central banks to “dump” their dollar holdings. However purchases of new US debt by foreigners may slow, as some central banks seek to diversify their reserve holdings. Such adjustments are likely to remain gradual and orderly.
How we deal with the rising interest rate risk: Diversify bond holdings to non-traditional (but commonly used and proven in the institutional endowment world) strategies that may benefit from a rise in interest rates. Such strategies may include flexible long/short hedged portfolios of bonds as well as bond substitutes such as merger arbitrage. At the same time, increase exposure to select international bonds.
Fear Factor 3: We’re heading for a double-dip recession
The only double dip recession the US has ever experienced was in the early Eighties. The “double dip” was triggered by Paul Volcker’s Fed fight to curb inflation. By aggressively raising rates the Fed beat inflation but caused a “double-dip” recession in the process.
Today, the Fed battles deflation not inflation. The Fed made it abundantly clear it would stop at nothing to prop up the economy by flooding markets with liquidity. In the face of the Fed’s all out actions we view the probability of a “double dip” as remote.
How we deal with the recession risk: Maintain some of the equity exposure in defensive, hedged strategies designed to limit the damage of stock market declines, while still providing reasonable upside potential.
Fear Factor 4: We’re heading for a Japanese style “Lost Decade”
There is an increasingly vocal and highly articulated argument being made that the US may experience a long-term Japanese style deflationary period. One of the champions of this argument is James Bullard, the chairman of the St Louis Fed.
With inflation trending towards zero, Mr. Bullard argues that the economy may enter a state in which the expectation of falling prices may become a self fulfilling prophecy. That is what happened in Japan.
Although it had recently reversed course, Japan had long maintained policies to defend its currency. Such policies pulled money out of the system, exacerbating deflationary pressures. In the US, the Fed wages its all out battle against deflation from the get go, without worrying about the dollar.
Of course, there is no guarantee the Fed will succeed, but the fact that the deflation risk alarm comes from Fed insiders increases our confidence that Fed actions will indeed succeed. Besides, fighting the Fed has hardly ever been a successful investment strategy.
How we deal with the deflation risk: Continue to maintain a significant enough exposure to US Treasury bonds. Treasury bonds stand to benefit in a deflationary environment.
The overall portfolio strategy
All of the risks described above are real and should be weighted appropriately in developing an investment strategy. However, we do not see any of them as the most likely scenario. Overreacting in either direction may prove to be a bigger mistake than not acting at all.
We believe the most likely scenario for the economy remains one of slow and uneven growth. We attribute the slow pace to our collective need to cut down unsustainably levels of debt. As with nursing a hangover, there is no substitute for the passage of time when paying down debt. The growth path is also likely to be uneven. The economy has become increasingly dependent on the success or failure of government policies. Sometimes the government will get things right, but many times it will not.
Given such background of “unusual uncertainty” maintaining a balanced portfolio of stocks, bonds as well as non-traditional investments is more important than ever.
Most importantly, the balance of your portfolio must always stay consistent with your investment objectives and risk tolerance. At Fragasso Financial Advisor we track and review your progress towards your financial goals as well recommend any appropriate strategy changes along the way.