Time for a Checkup
During 2008 and 2009, I wrote a series of articles regarding TARP, government intervention in the markets and the benefits of applying the principals of emergency medicine to your portfolio decisions. We also looked at the panics of 1907, 1937 and 1998 to see if there were lessons to be learned. The basic thoughts were that the probabilities favored a recovery but there would ultimately be a back half of the storm because the recovery would "depend on the growth of government spending, which is totally dependent on its taxing and borrowing ability and there are limits to both."
As we begin 2011, we may be seeing the front edges of that back half of the storm. If so, the pressures on government finances should continue to increase. This is likely to pressure interest rates, tax rates and inflation. Returning to our model of the economy as being made up of the consumer + investment + government spending + net exports, a shrinking government would imply lower growth. The government's plan during this economic downturn has always been to fill the gap in the economy and then return it to the consumer after the recession. Consumers, however, need jobs.
With the initial public offering of GM and the final selling of the government's Citigroup shares, TARP is getting closer to completion. This is similar to the Hong Kong Monetary Authority's successful IPO in 1999 of the shares it purchased during the Asian banking crisis of 1998.
Since the Federal Reserve's August announcement that it was going to do a second round of quantitative easing in order to keep interest rates low, interest rates on 10-year government bonds have actually risen nearly one percent as of early December.
The interest rates on municipal bonds have also risen as investors anticipate an end to the Build America Bond (BABs) program on December 31. BABs is the program whereby the federal government subsidizes the taxable interest rate on municipal issued debt. Other forms of stimulus over the last two years have helped states fill massive budget holes. In our state alone, it is projected that spending will need to be cut $800-900 million dollars this year.
On the announcement of the budget agreement between the White House and Congressional Republicans, the credit rating agencies began to make noise about downgrading America's triple A credit status. The Chinese credit rating agency has already made such a downgrade.
Those attempting to make estate plans are already aware of the lack of clarity regarding taxes. Meanwhile, inflation is showing up in commodities. Cotton just topped its Civil War high. Granted, inflation and growth have moved a lot in 150 years, but there is a message when a record that has held for 150 years falls. Remember the four-minute mile?
Rising interest rates are tough on bond portfolios because bond prices move in the opposite direction of interest rates. Rising taxes put pressure on incomes. Tax rate uncertainty makes planning more difficult. Higher inflation is a hidden tax on income.
If we are on the edge of the back half of the storm, what are some portfolio actions you might want to consider? First, in fixed income, look for instruments that offer more inflation hedges or floating rate characteristics, buy dips and sell rallies.
Long-short commodity strategies also have interesting portfolio characteristics when combined with stocks and bonds. If inflation becomes a runaway, commodities are likely to perform better than stocks and bonds, but if government austerity crashes the party you won't be locked into a directional inflation play.
Equities of high-quality companies, particularly if they come down in price, appear to offer reasonably good long-term prospects. This occurred in Hong Kong as equities declined for a couple of years following the rise in interest rates but later recovered as the economy completed its transition.
Other areas to consider that are not typically found in portfolios are currency and foreign bonds. The dollar is weak, gold is up, and emerging market currencies are up. The opposite held true 11 years ago. Higher interest rates over time have a tendency to attract capital. Think about this part of your portfolio as a more diversified approach to cash. Why keep all your cash in U.S. dollars and subject it to the Fed's great experiment when other countries actually have interest rates on cash?
The final important piece of a well diversified portfolio is rebalancing. Rebalance within asset classes. For example, if you are holding foreign currencies and they are up and the dollar is down, bring some money home. Also, rebalance between asset classes. Stocks have been going up and bonds down recently. The reverse may hold true in future quarters.
No one knows what the future holds, but on average, investors earn compensation for taking risk. Since the fourth quarter of 2008, the government has been underwriting risk. This can be seen in the high correlations between asset classes and within asset classes like stocks. We may, however, be moving into an environment where government is the risk and that will have broad implications for what will work going forward.