What would be my portfolio strategy going forward?
What am I long?
What am I short?
(Well, for those questions in particular I'll be starting another blog pretty soon.)
I'd start by being open and honest with my view the U.S. and the world economy in general.
The U.S. economy is still struggling and will continue to do so unless dramatic changes are made both fiscally and monetarily. Fiscally, we suffer from high taxes and regulations that make it very difficult to grow and expand small and medium sized business. On the regulatory side,particularly on the financial side, there is a substantial amount of unnecessary and burdensome regulations that do nothing to protect investors yet make it more difficult to measure a client’s expectations of risk. For example, it is very puzzling for any financial institution recommend U.S. treasuries as a “low risk” (in regards to how most regulatory agencies define “low risk”) investment when there is over $17 trillion in debt with multiple insolvent government programs on the horizon. Concomitantly, we have a Treasury Department which relies so heavily on Central Bank purchases of bonds to keep interest rates low enough to maintain affordable interest payments on the national debt; which is eerily similar to the conditions that lead to the housing bubble which also relied on low interest rates to maintain demand for mortgage borrowing. This perpetuates an economy more and more reliant on government spending in order to give the illusion of economic growth. When in reality it’s simply creating more none value added positions in government whom will resist any necessary downsizing when anyone, either a politician or the bond market, starts to demand it.
On the monetary side, the Federal Reserve’s aforementioned near-zero interest rate policy and quantitative easing continues to greatly distort asset prices including stocks, bonds and housing prices. While the removal of these policies is still hotly debated, it remains to be seen that the economy and the markets currently rely too heavily on cheap money to remove the Fed’s support. Additionally, low returns on CDs and other traditional bank products have forced many into the equity markets whom otherwise normally shy away from such volatile assets. This of course includes large State pension funds such as the already underfunded CalPERS (the California public sector pension fund). In the case of CalPERS, over 52% of its assets are in equities. Knowing this, there exists a clear incentive for the Federal Reserve and the FOMC to use whatever powers they may possess to maintain an ever rising stock market. Otherwise, there would eventually be a significant defaulting of obligations to pension and other institutional funds that will leave many with a severe haircut in income which will be felt economically around the U.S. Further, the Treasury Department simply cannot risk a return to normalized interest rate on its debt without delivering a severe shock to Washington’s ability to spend. The most unfortunate part of these policies is that the measure of success for them is now subject to an unemployment rate that only seems to decline based not upon how many people actually get gainful employment, but instead how many of them leave the work force.
What will the Federal Reserve do next? The incoming Fed Chairman (or in the most likely scenario, Chairwoman) will likely continue the Fed’s easy money policies. The New York Times recently ran an article wherein they cited Fed officials and other mainstream economists’ vexation for the perceived “lack of inflation” as grounds for further continuation of stimulus. This apparent lack of inflation is predicated on the Consumer Price Index’s reflection on consumer prices. However, the CPI is subject to hedonics, substitutions and adjustments and does not take into consideration factors of inflation where credit markets are heavily subsidized by government programs. For example, the student loan market and its effect on tuition prices. It also does not take into account the rise in equities prices which will certainly effect retirees in need of cash flow from dividends. Demographically, these retirees will make up the majority of investors going forward which will likely push higher yielding securities prices higher.
What does this mean for the markets? In the short run U.S. Treasury yields may be contained by developments in Europe, India and other places where the economic future also remain somewhat cloudy. The sovereign debt crisis in Europe has not been handle completely as austerity policies have yet to be austere enough. The unfortunate reality will soon be made clear that further cuts in government expenditures will be necessary to sure up the balance sheets of not only the periphery Euro-zone countries, but core countries such as Spain and Italy as well. The effects of this uncertainty gives U.S. debt prices a significant discount in regards to other sovereign debt products (at least for the time being). These low treasury rates will continue to offer a low alternative risk free rate further pushing capital into both the equity and the commodities markets.
What about the rest of the world? It’s difficult to predict the world’s continued tolerance for the U.S. dollar’s reserve status. Inflation policies in the U.S. are not met well in B.R.I.C. countries where there have been calls for removal of the dollar as the reserve currency.
What alternative is there? If the Federal Reserve was to immediately end its open market operations and start to raise interest rates there would no doubt be a lot of pain and suffering for many all across the U.S. The highly leveraged would feel pain as interest rates raised, bond holders would feel the pinch as bond prices fell. The Dow and S&P would decline around 50 to 60%. Housing prices would most certainly fall as they are no longer supported by low rates as well as the Fed’s MBS purchases. Millions of federal and state workers would be laid off and pension funds, now adversely effected by lower stock and bond prices, would be bankrupting before our eyes. Do you know of any politician and/or Fed Chairman willing to put themselves in the position to be the most hated figures in the public eye? Me neither.
Knowing all of the above, what investments would I suggest? I’d stick with well position companies with global exposure that have very low interest rate or U.S. / E.U. specific economic risk. Microsoft, Exxon Mobil, and other well established international companies will continue to perform well. There will be excellent opportunities in Asia especially Singapore, Hong Kong (which I’m quite fond of) and Shanghai. I’m also rather bullish on commodities such as oil and gas. What’s most likely to happen, at least in my opinion, for the next few years is for the new consensus to be “moderate” inflation of around 3% to 4.5% to be an acceptable norm. The theory behind this is that it will allow for consumer de-leveraging as well as higher profits for companies (utilizing First In, First Out accounting principles) thus making it a win-win scenario. In the meantime, the DOW will likely climb higher reflecting ever higher equity prices. Predicting U.S. Bonds prices will be a perhaps be a more challenging endeavor, as higher inflation should cause Treasury rates to raise. However, if the Euro Zone is still dealing in crisis mode, there may well still be a discount on U.S. debt enough to put real interest rates into negative territory. At the end of the day, this will be a policy that will be hard even harder to remove as it only pushes the responsible decision making further down the road.
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