Economic data here in the US, and abroad, has not been portraying a very robust recovery. Actually it hasn’t been portraying much of a recovery at all. Several factors are combining to create a challenging climate for investing including:
- Vast amounts of debt, which are pervasive in several levels of society in the United States and throughout Europe–causing legitimate questions about the very survival of the EU in its current form.
- Difficult geopolitics in the Middle East, North Africa & North Korea.
- Absolutely despicable political leadership and fiscal policy management by congressional policy makers and the White House.
It is true that any one of these factors can be enough to cause concern among investors, however when they all combine together to form a toxic set of circumstances, fear among investors sky rockets as evidenced by a dramatic rise in the cost of insuring a portfolio (i.e. the VIX index) and stock price volatility becomes dramatic, severely disrupting compounding returns. The results of this past week have established an even more challenging environment for anyone tasked with making investment decisions–capital investments by companies as well as individuals with retirement portfolios.
Maybe it is against the American Spirit to admit defeat…but we must ask what is taking so long to admit that PIMCO and a few other economic stalwarts have made the correct call that we are facing a “new normal”? This is manifested in substantially slower growth compared with historical averages and persistently high unemployment, which will last several years into the future as balance sheets continue to be repaired on the individual, corporate, and government level throughout the developed nations. The primary reason it is essential to acknowledge that we are not going to achieve above trend growth for quite some time into the future is that policy makers risk doing far more damage to our economic prospects. An unintended consequence of policy mistakes will ultimately result in weaker economic circumstances much longer than would otherwise be the case if we acknowledge the truth: that we are still in the midst of a balance sheet recession and we need to rebuild on all fronts so that when we emerge we are stronger than ever before.
As I was driving to work this past week there was a guest on NPR who asserted that “Congress never misses an opportunity to miss an opportunity.” The Economist stated it very clearly when it argued:
“There was a deal to be had: keep up spending in the short term, with a stress on much-needed infrastructure investments, as well as extending the temporary tax cuts in exchange for a big medium-term reduction in the deficit, centered on entitlements and tax reform. Congress did precisely the opposite, failing to support the economy now and failing to find enough cuts over the next decade to stabilize America’s debt. Any hard decisions have been given to a commission–a cop-out that condemns workers and firms to more crippling uncertainty about how the country’s fiscal mess will be tackled. Would you build a factory today if you knew that taxes had to rise eventually but had no idea which ones?”
Congress is currently ill-equipped to deal with the challenges we face. In my estimation the best piece of evidence to support this claim is the mere fact that 535 members of the legislative branch of government have been set aside in exchange for a 12 person “super” committee to craft broad sweeping legislation with the hopes of improving America’s trajectory. This clearly implies something is broken in the system. It could be the system itself, but more likely it is the members within the system. Both parties are plagued with disingenuous, seriously incompetent, ideologues who lack anything remotely resembling the pragmatism this country desperately needs now more than ever. Until there is a dramatic improvement in the quality of our policy makers I fear we are doomed until further notice. That doesn’t mean some dramatic crash of 50 percent across the board…it simply means that it isn’t going to feel like a “good” economy throughout a broad array of sectors for quite some time into the future.
Investors must ask the question, in a slow growth climate, with elevated risk and heightened volatility, how should one position their portfolio?
A little over two months ago I posted an article describing a portfolio designed to exhibit relatively low volatility that would hopefully earn a compelling risk adjusted return in the context of our current investment climate in which growth is low and risks are high.
There are two important questions worth considering: (1) how has this portfolio been performing during this period of rampant volatility and (2) did the policy statement from the Federal Reserve change the outlook for this portfolio?
With regard to the first question, the portfolio has been performing quite well relative to the S&P 500 (SPY). This is largely because of its allocation to gold, which was practically the only asset that appreciated during the past week’s wild ride. As can be seen in Chart 1, the portfolio has returned 3.3% since it was recommended on June 8th, comparing favorably to the S&P 500, which has lost 9.1% of its value over the same time period. The S&P 500 had a max loss from its peak value, from the June 8 through August 12 time period, of approximately 19.4%. Over the same time period the portfolio had a max loss from its peak value of 7.2% - less than half of the losses suffered by the S&P 500.
On a year to date basis the portfolio has performed excellent in comparison to the S&P 500. As can be seen in Chart 2, the portfolio has earned a return of 13.6% versus the S&P 500, which has suffered a loss of 7.5%.
Before moving on to question two, I can easily imagine there are some concerns with regard to gold. This portfolio has an allocation of 24% to gold in the form of the ETF GLD. There are two schools of thought that come to mind. One such school is the Dennis Gartman, “we should do more of that which is working and less of that which is not”…which is to say that even though gold is at seemingly lofty levels, the portfolio is the portfolio and it has a 24% allocation to gold. The other school of thought is much more likely to view gold as overbought in the short term and due for some sort of pullback; thus, placing a 24% allocation into GLD at these levels poses possible risks of underperforming in the next month, two, or three. So it might be worth considering how the portfolio, excluding gold, has performed from June 8 through August 12.
Chart 3 paints a pretty clear picture that GLD was a tremendous help to the total portfolio. But even excluding GLD from the portfolio, the total portfolio still performed much better than the S&P 500. Since this portfolio has a significant yield, I think a good course of action would be to scale into the GLD allocation over time using an initial allocation as well as dividend proceeds from the other investments in this portfolio.
Moving on to the second question, did anything the Federal Reserve say in their policy statement change the outlook for this portfolio? The initial answer is no. The big headline out of the post meeting communiqué is that the Fed is likely to hold short term rates at 0-25 basis points until sometime in the middle of 2013. This can certainly change if economic data improves dramatically–especially if inflationary forces pick up simultaneously. If inflation picks up without economic growth or significant improvement in the labor market, I do not believe the Fed will act. After all, an on-going debate surrounding increasing inflation targets is still under way. In my view increasing the inflation target is a moot point because inflation is not bound by whatever target you place upon it…it is influenced by real economic forces which are in turn impacted my monetary and fiscal policy. Thus, inflation is impacted by policy and not a statement about policy.
The Fed is simply reducing, to some extent, the policy risk that short-term interest rates may be increased almost on a whim in the not-too-distant future. As I see it, There are at least three primary implications worth noting:
- Inflationary forces can persist in emerging market countries prompting strong interest rate differentials as their respective central banks combat local inflation.
- Allocations to risk are being incentivized, which if you adjust for relative risk…are most likely to be manifested (in decreasing order) with higher allocations in safer but higher yielding sovereign bonds, corporate bonds, junk bonds, high dividend yielding stocks, and low beta stocks.
- Companies and investment opportunities that are supported by low short-term interest rates will continue to perform quite well…i.e. mortgage bond funds.
In conclusion this portfolio has performed as expected–which is to say it is much less volatile than the S&P 500, but, has still earned a very compelling return in the context of the current economic climate. The new policy statement from the Federal Reserve adds further evidence that this portfolio is positioned to perform well on a risk adjusted basis going forward as it takes advantage of risk exposures highlighted in the points shown above.
Just in case you don’t feel like clicking the link to the previous article (which introduced this portfolio and how it was constructed), the portfolio allocations including gold are:
Aberdeen Global Income Fund (FCO), 22%
Aberdeen Asia-Pacific Income Fund (FAX), 21%
PCM Fund (PCM) 18%
PIMCO Corporate Opportunity Fund (PTY), 13%
SPDR Gold Trust ETF (GLD), 24%