THE STORM CLOUDS CONTINUE TO DISPERSE
May is turning out to be one of those months which can test one’s confidence about the overall direction of the economy and the markets. Like an ocean squalls, which can be sudden and difficult, as of this writing, the Dow Jones Industrial Average has fallen back from its March high to a level which is essentially equivalent to its December 31st, 2011, starting point. The fear, of course, is that the drop is indicative of a new storm system – a second recession or a “double dip” – and for many people, all those ugly feelings of panic we had back in late 2008 and 2009 may be coming back.
But feelings are not reality. We believe that the down drafts we’re seeing in the market today are excessive and unrealistic. The truth is that the overall economy has been gradually improving for most of the last 2 years – not necessarily at a consistent pace, but certainly at a sustainable pace – and is continuing to improve today. The other truth is that the mainstream media’s focus on whether we’re slipping back into or pulling away from the last recession masks the greatest future threat actually facing investment portfolios.
Before we jump into what the future is likely to bring and how to prepare for it, allow us to quickly review the current status of the U.S. economy, and we believe the easiest way to do that is to review 4 key sectors of the economy.
The Services Index (non-manufacturing index)
The ISM services index remains well above 50 (which signals expansion) and has now been above 50 for 27 straight months and is growing at a rapid rate.
The Manufacturing Index
Manufacturing actually came in better than expected in March and remains solidly above 50, signaling continued expansion in the factory sector. The ISM manufacturing index has now remained above 50 for 32 straight months, and the new orders index (not shown here) came in at a healthy 54.5 suggesting more growth in production ahead.
The Unemployment Index
Always a lag indicator in recovery, the employment numbers are finally showing evidence of the recovery that has been under way for some time now. Weekly initial claims for state unemployment benefits fell 6,000 to 357,000, which continues a three year run of consistent improvement in the labor market. Weekly claims at the end of March were at their lowest level since April 2008.
Consumption can sometimes appear off-cycle: increasing when other statistics are depressed, or decreasing when other statistics are elevated. But, over the intermediate and long term, consumption is one of those lagging indicators which evidences whether Americans are feeling confident enough in their improving economic circumstances to actually spend their earnings.
The American consumer keeps buying. “Real” (inflation-adjusted) personal consumption increased 0.5% in February. Even if real spending is unchanged in March, which is a pessimistic assumption, it will be up at a 2.1% annual rate in Q1 compared to the Q4 average.
These four charts, showing data through March, could be supplemented today with the just-released data on April housing starts (up 2.0% which beat expectations) and April industrial production (up 1.1% which beat expectations). Even the freshest data we can find supports the conclusion that our economy is recovering and will continue to recover.
Our view of an improving economy does not mean we’re oblivious to challenges. Too often commentators either see only good news or only bad news. They don’t see nuance. We believe the nuances can be very important. As we look forward at the economic landscape – even with the volatility of May’s downdrafts – and retain our optimism about the economy, we also see a steadily growing inflation risk. We’ve made this observation before, but it’s important to reaffirm it. We steadfastly believe inflation represents the next big risk to investment portfolios.
Now, many would put Europe’s budget issues at the head of a list of potential problems which could sink the U.S. economy, especially in light of the equity market sell-off we’ve seen thus far in May. Obviously, we don’t share that view. Many countries in Europe are in trouble (Greece, Italy, Spain, Portugal), but they don’t dominate the entire continent by any interpretation of the data. Germany, for its part, has put its fiscal house in order and is drawing a line in the sand regarding how much support it will lend those countries which can’t practice fiscal discipline. Germany is not going to let itself be dragged down the drain. In point of fact, there are some credible studies suggesting that when Germany finally stops the practice of allowing constant renegotiation of the fiscal agreements is strikes with the troubled countries, those same countries will finally be forced to deal with the spending issues that are crippling them, and that will actually have a positive impact on the global economy.
One must also contrast the state of public finance with that of private corporations. While many governments in Europe have been profligate, there are many more European corporations who have shown great wisdom in the handling of their finances. These corporations are strong and thriving. So to speak of European problems, we have to be specific. We don’t advise buying many European government bonds, but we heartily recommend buying the stocks (and the bonds for that matter) of many fine European companies. The benefits of international investing have not disappeared. There will most certainly be surprises and continued market volatility (we’re experiencing that here in May) as Europe’s governments get their collective house in order, but there is nothing there of such significance that it needs to bring us back into recession.
So, the greatest risk to portfolios is not Europe. The greatest risk is inflation. Monetary policy, in the Fed’s own words has been loose and accommodating. “Quantitative Easing”, QE1 and QE2, has put more money into potential circulation than has been tried in quite some time. Because many business managers and consumers have lacked trust in the economic recovery, those dollars never really made it into circulation. They have remained in bank vaults and on the balance sheets of corporate America. When/if these dollars are actually utilized at rates anywhere near our “norm”, the impact on prices will be significant and rapid. Inflation will seemingly come out of nowhere.
The trick for the Fed is to withdraw that excess liquidity before too much of it is actually put into circulation too fast, but not to withdraw it in such a way as to cause a recession. In an election year, the inflation risk is much greater than the recession risk. It’s not an impossible task, but will require a deftness and sensitivity which large bureaucracies, such as the Fed, often find difficult to implement.
We’re already seeing oil and gas prices climb, but we’re now seeing housing costs (measured by rental costs, not home values) increase. Rentals are now up 2.0% over the last six months. Overall, “core” inflation stands at 2.2% and is above the Fed target. The bond market certainly got this message. The 10-year treasury was 1.93% in mid-February, hit 2.03% in March, and stands at about 2.3% now. That may seem like a small difference, but it represents a 20% increase in rates in less than 2-months’ time. Conceivably, this is a fore-taste of what’s to come. Once/if an inflation expectation gets built in, portfolios will need to be adjusted to reflect a potentially prolonged inflationary environment.
Investment Portfolio Ramifications
From a portfolio perspective, the strategy implications are clear. Equities in general will survive inflation much better than will bonds. That doesn’t mean all equities will rise equally or even consistently. There will be volatility, and some companies will do better than others. We continue to adjust portfolios to emphasize those equities which represent ownership in those companies which have manufacturing or delivery cycles short enough to easily and quickly accommodate cost increases and/or in those companies whose product demand is less sensitive to price increases.
Although equities will out-perform bonds in an inflationary environment, this isn’t an argument to shift away from bonds altogether, so we’re not altering our strategic allocations. Diversification still has its benefits. Bonds insulate portfolios from the volatility of equities, but the types of bonds we use is an important issue. We are adjusting portfolios to utilize those bonds which will be least affected by inflation.
Inflation will drive up interest rates across the spectrum and distort the normal differences between short-term rates and long-term rates. Bond prices always react negatively to inflation, but not all bonds will react the same. The longer the maturity of the bond, the greater will be the negative impact of rising rates.
Accordingly, we’re recommending a shift in bond holdings from the long-term toward the short-term side of the spectrum. We’re adjusting our allocations of the portion of a portfolio which should remain in bonds so that they will be skewed toward short-term bonds where inflation’s impact can be minimized. As long-term interest rates rise and settle into either more normative levels or elevated inflationary levels, bond holdings would be skewed back toward the longer term where the higher interest rates would benefit the portfolio.
In summary, our actions in both equities and bonds are focused on tactical changes appropriate for today’s environment without disturbing the core strategic structure which will ultimately achieve a portfolio’s long-term goals.
The economy is growing, and we believe it will continue to grow. Market volatility (such as we’re seeing here in May) does not mean the economy is stumbling. But even with a gradually strengthening economy, we can’t go to sleep and just expect a rising tide to lift us to new highs on the Dow. The inflationary environment we face represents the most significant risk for investment portfolios, and we are making the appropriate tactical adjustments. As always, successful investing is a process of balancing long-term strategic goals and targets with shorter-term tactical considerations.