Tailwinds vs. HeadwindsSubmitted by Antaeus Wealth Advisors on March 1st, 2013
- 01/01/13 average price per 10,000 million British thermal units of natural gas in the United States: $4.03. In the United Kingdom: $10.11. In China: $13.70. In Japan: $14.10. (J.P. Morgan Asset Management)
- Total cost of raising a child to independence in the Northeast United States: $1.8 Million (Nadia Taha, The New York Times)
- The nation’s debt ceiling as of 01/20/09: $11.3 trillion. As of 01/20/13: $16.4 trillion. (Treasury Department)
- Annual interest on the national debt as of 09/30/2012: $432 Billion. (U.S. Government Accountability Office)
- Annual tuition and fees at an average 4-year private college have increased +526% in the last 30 years, almost 4 times more than the CPI increase of +136%. (College Board, Department of Labor)
- Average annual yield of money markets as of 02/21/13: 0.02%. As of 02/21/08: 3.05%. (CNN)
- Percent of their healthcare costs U.S. consumers directly paid in 2009: 12%. In 1960: 48%. (National Geographic)
- 2012’s returns (including dividends/interest): MSCI Europe, Australasia and Far East +22.1%; S&P 500 +15.4%; Gold +6.6%; Barclays Aggregate Bond +5.8%. (Yahoo! Finance)
- Tailwinds: Cash rich U.S. companies, accommodative global monetary policies, stabilizing U.S. housing market, domestic shale gas energy breakout, growing consumers in emerging markets.
- Headwinds: Eurozone recession, geopolitical risks, slowing global growth, debt throughout the developed world, impact of spending cuts and fiscal drag on U.S. economic growth.
While bonds belong in a diversified portfolio for a number of reasons, few have seen the bond market look less attractive than today. We are at the end of a three-decade-long interest rate cycle, culminating with Ben Bernanke’s near-zero rates. Conventional fixed income derives over 85% of returns from interest rate risk; i.e. rising in value when interest rates fall, and falling in value when rate rise. Based on this logic, the bond party has a year at best left: unless we enter negative interest rates, overall bond prices will not go higher. History also has shown that interest rates can rise rapidly when they do turn. Combine this predicament with low coupon payments, and the total return going forward for bonds is paltry at best.
Based on the above, Antaeus’ current strategy for the bond component of clients’ portfolios incorporates three pieces: high quality bonds bought with the intention of holding until maturity; floating rate paper with coupons that increase with rising interest rates; and unconstrained strategies where portfolio managers may pull multiple levers to manage risk and seek out return.
We see more value in stocks than bonds going forward. Many companies are able to fund their operations internally, and interest coverage ratios are at record levels. A bull market could get some legs from the general trend up in housing, manufacturing and employment. Nevertheless, valuations in the stock market are a bit rich, especially in the telecom and utilities industries. Investors seem to have shrugged off their losses in 2008 and 2009: last month saw the largest net inflows into domestic stock mutual funds in over nine years. It is important to remember that while stocks provide opportunities to compound wealth, equities took over 20 years to recover from 1929’s crash.
For now, the tail risk of a breakup of the European Union appears to me mitigated. Europe currently is more a story of pessimism with falling wages, rising unemployment and negative growth, than a story of panic. At some point, however, Germany may decide that the burden of keeping the Euro intact is too heavy, especially if France continues to deteriorate. This decision could be made by Germany’s parliament, Chancellor Merkel, the German courts or the general public. Europe’s serious underlying problems have not been solved: excessive leverage, a real estate bubble and uncompetitive labor costs.
If the Germans pull the rug from the Euro, Spain and then Italy and even France probably will default, sending asset prices into a tailspin. Also note that the United Kingdom’s debt was downgraded by Moody’s on February 22nd by one notch from Aaa to Aa1. Even worse, as Japan’s pile of debt continues to grow, ultimately Japan could face a bank run if its savers conclude that their government’s obligations are too large to be safe.
Here at home, while corporations are strong and many economic indicators have improved, Washington’s can kicking is a serious threat to long-term growth. Even though the GOP approach would have taken a decade to balance the budget, this fiscal tonic was too harsh for the electorate. With our deficit spending, America is like a wealthy family increasing the mortgage on its wealth in order to consume more than it produces. Voters want to believe that the days of ample spending, low taxes and easy credit can continue – and they will punish anyone who tells them otherwise. President Obama’s 2013 budget proposal did nothing to address the long-term debt, because it did not propose the structural reforms needed to control costs associated with aging baby boomers. As PIMCO’s Bill Gross writes in his February 2013 investment outlook: “Our credit-based financial markets and the economy it supports are levered, fragile and increasingly entropic – it is running out of energy and time.”
Strategy and Opportunities
So what is prudent investment strategy in this environment? First, maintain a portfolio that addresses two bi-modal risks: a deflationary bust (coming out of Europe) and hyperinflation (due to loose monetary policy). For deflation, cash is king; and owning some silver could help if the U.S. dollar declines. For inflation, a combination of Real Estate Investment Trusts, commodities, dividend growing stocks, and floating rate bonds is appropriate.
Second, recognize that the world is interconnected, making it more prone to “black swans” as responses to significant events: the collapse of the EU, a pandemic, or a cyber-attack, to name a few. Holding a portion of your portfolio in assets and strategies that tend to thrive during periods of high volatility – such as managed futures – is one strategy for addressing this risk of black swans.
Third, be careful chasing yield, and prepare for rising interest rates. Junk bonds and companies that pay high dividends but exhibit minimal growth have shot up in price in this low interest rate environment; and their prices are vulnerable if interest rates increase. Further, as a satellite to your portfolio’s core, utilize certain alternative investment strategies that tend to do well in rising interest rate environments.
In terms of opportunities, the fundamentals of technology stocks are excellent: low debt, strong free cash flow and hardy growth. It is an exciting time to start returning to emerging market stocks: growing companies in China, Russia and frontier markets have valuations much lower than several years ago. Companies that sell to the growing middle class in emerging markets have lots of opportunity ahead of them as well, regardless of domicile. Finally, certain commodities may rise over time as a result of increasing demand by consumers in emerging markets: energy, fresh water and food.
In summary, we are in unchartered territory in terms of the levers being pulled by central bankers to boost the global economy. Antaeus’ primary concern is that these policies have inflated asset prices in the short-term, thus laying the foundation for a market crash and deflation in the future. We will continue to seek out opportunities for our clients while remaining vigilant of the potential risks to our clients’ wealth.
Evan P. Welch, CFP®, AIF®
Chief Investment Officer
Antaeus Wealth Advisors, LLC
February 25, 2013
Disclosure: Indices mentioned are unmanaged and it is not possible to invest directly in an index. No single strategy can assure profit or guarantee against loss. Past performance does not indicate future returns. The opinions expressed in this commentary are those of Antaeus Wealth Advisors, LLC and are based on information believed to be reliable; however, these views may change as information changes or becomes out of date.
 Blackrock, 09/30/12