The unfolding fiscal crisis across Europe and the U.S. is perhaps the most widely followed storyline in the world today and is clearly weighing on financial markets. In the days both preceding and following the debt ceiling debate, investors fled equities (stocks) en masse, opting for the conventional safe havens of cash and U.S. Treasury securities.
Put differently, investors fearful of the implications of debt have fled to debt! This perverse course of action is a clear sign that both the investing public and institutional community are still reeling from losses incurred during the market turmoil of 2008. It is also reflective of a deeply rooted comfort level with U.S. dollars and Treasuries, irrespective of fundamental analysis. These developments, being structural in nature, have lasting implications on our investments and financial affairs.
Ultimately, the cash in our bank accounts and the U.S. government bond mutual funds in the IRAs of our country’s retirees are nothing more than pools of loans secured by the “full faith and credit of the U.S. government.” Since the end of World War II, these instruments have essentially been considered free of credit risk. In other words, the possibility of default is not factored into the interest rate bond investors command for loaning money to the U.S. government.
For example, as of August 4th, the interest rate associated with a 10-year Treasury was just 2.46%. In essence, this means an investor is willing to lend money to the U.S. government for 10 years in exchange for annual interest payments of just 2.46%. This rate of return is significantly less than historical, annual inflation (~4%); the rate at which prices of goods and services increase in dollar terms over time. In our view, this is a clear sign that investors today are making decisions based on emotion rather than prudent expectations of return on investment.
Federal government revenue, which is largely derived from income and payroll taxes on individuals and corporations, amounted to ~$2.2 trillion in 2010. As federal expenditures in 2010 were ~$3.5 trillion, the government spent ~$1.3 trillion more than it took in. By the end of 2011, the nation’s public debt load as recognized by the U.S. government is projected to reach $15 trillion. The U.S. government also has unfunded or “off balance sheet” liabilities on the order of $60 trillion by conservative estimates. These unfunded liabilities are mainly reflective of future Social Security and Medicare payments.
Now, consider a middle class family interested in purchasing a home. Both adults in the family have stable employment, with a combined annual income of $100,000, but they spend over $159,000 per year. Do you think a bank would loan this family over $3.4 million, throwing in an extremely low interest rate and no money down to sweeten the deal? Of course not!
This hypothetical family is merely a scaled down version of the U.S. government’s fact pattern as presented above. While the U.S. government has several tools which may serve to prevent an outright default, the current path is clearly unsustainable. At some point down the road, emerging countries such as China, India, and Brazil will outgrow their dependence on our debt securities as a storage facility for their savings, leaving us with no access to credit. Entitlements, along with many government programs, must be overhauled, eliminated, or turned over to the private sector.
However, our nation’s political leadership seems unable to accomplish meaningful, fiscal reform. Rather our politicians have deferred to the Federal Reserve to pump prime the economy with a sea of liquidity while simultaneously devaluing the debt by increasing the supply of the paper it is printed on. So long as this trend remains in place, U.S. dollars and by extension Treasury securities will not be a store of wealth. Though the economy remains weak and millions of the jobs lost during the recession will not come back, we must maintain an allocation to stocks in our portfolios, regardless of investment horizon and risk tolerance.
To completely avoid investment in stocks is to make one or both of the following arguments:
- Human beings around the globe will not reproduce and life expectancies will no longer increase.
- Innovation will cease to occur.
In the words of legendary value investor, Benjamin Graham, “The future is uncertain.” We simply have no reasonable way to predict what the world will look like 10, 20, or 30 years from now. Accordingly, we must install a disciplined risk management approach, invest across asset classes and geographies to spread out our risks, and disregard the emotional swings perpetuated by short-term market volatility.
Specifically, investors should install position limits by asset class so that your results are not overly exposed to any one risk factor. The portfolios of many Americans were dominated by their residence(s) and suffered as real estate prices declined dramatically. Limit the size of any one investment or investment theme to 10% of your portfolio.
Invest in bonds and stocks issued outside the U.S. as well as less traditional asset classes. American investors often exhibit a domestic bias, allocating the majority of their capital to companies operating predominantly in the U.S. or bonds issued domestically in dollars. Accordingly, these investors are tremendously exposed to political risk and other developments local to the U.S. Less indebted emerging countries will likely experience robust long-term growth, offer more attractive interest rates, and ultimately experience currency appreciation.
Furthermore, investment in precious metals and Master Limited Partnerships may drive returns less correlated to traditional bond and stock investments, and thus representation in any prudent asset allocation.
Precipitous declines in stock market averages cause many panicked investors to race for the sidelines. When the sidelines are a combination of non-yielding cash and U.S. Treasuries with World War II era yields, such a move does not provide a satisfactory expected return on investment and fails to protect purchasing power over time. Think rationally, especially when volatility is very high.