The Great Uncertainty
It is no wonder that symptoms of confidence in the US – from consumer sentiment to the flavor of political discourse – remain depressed despite the strong stock market performance this past quarter, especially in September: the U.S. economy is in unfamiliar territory. The “Great Recession” has been followed...so far...by the most shallow recovery in employment on record, measured in terms of absolute numbers of jobs. Hiring was weaker in the aftermath of the relatively mild downturns of 1990-91 and 2001, when the unemployment rate topped out at 7.8% and 6.3% respectively, but fewer jobs were lost. The Great Recession was much more severe, with a peak unemployment rate of 10.1% and more than eight million jobs lost. Slightly more Americans were working when the recession ended in the middle of 2009 than are working now, over a year later.
Source: Bureau of Labor Statistics; The Economist.
* Recessions defined by the NBER.
Adding insult to injury, concern about the stumbling recovery in the US has been rising just as anxieties about the European economy have faded. Some economists believe the disappointing U.S. GDP growth of 1.7% in the second quarter (after 3.7% in the first quarter) could be the start of a slide towards a second recession and that the dollar is the weakling among developed markets currencies. In contrast, booming sales to fast-growing emerging markets drove the strongest German economic growth in decades in the second quarter and pushed unemployment down to 7.6%, a bit lower than at the start of the financial crisis.
Yet only a few months ago, the fortunes were reversed. The US seemed to be recovering strongly and Europe was the laggard. The dollar was riding high as investors fled the euro area’s debt crisis and street protests against austerity measures in Greece turned violent.
This emotional rollercoaster is a symptom of the “great uncertainty” facing the global economy. Each day brings headlines which seem to justify the dominant mood (fear or greed) and each day the economic compass seems to point in a different direction. Here we present our attempt to look through the noise and focus attention on the critical opportunities and challenges of the next year.
Three Things Which Should NOT Keep You Awake at Night...
Inflation/higher interest rates. Inflation is not determined by random forces outside of the economy, but rather is largely determined by the supply of money relative to other goods. With tremendous spare capacity in the economy, demand-side inflation factors are mute; the balance is in favor of money – money’s value is remaining strong, with little inflation in the prices of most goods and services.
What if we’re wrong? Because much of the inflation in the economy (other than supply-induced commodity price spikes) is the result of market expectations and long-term dynamics, unexpected inflation will likely appear only gradually. There are a number of scenarios (geopolitical events, natural disasters) which could cause commodity prices to spike, which could have a severe impact on global economic growth.
Portfolio implications. We have maintained allocations to longer-duration bonds (especially municipal bonds) and have tilted our fixed income portfolios toward a “barbell” structure (more short- and long-duration, less intermediate), which we expect to outperform in a rising rate environment. We are prepared to further adjust durations of client portfolios or buy direct protection if we see inflation on the horizon. Our commodity allocation mitigates the impact of commodity price inflation.
Municipal bond risk. It is difficult to make sweeping generalizations about the “municipal” bond market. There are over 80,000 issuers with bonds guaranteed by state and local governments and individual project revenue. Much has been written about the difficult budget situations facing many municipalities, but we believe that media coverage has been a little one-sided. While issuers have faced revenue difficulties, states and municipalities are taking extreme measures to cut expenditures and are committed to servicing existing debt. Underfunded pension liabilities, while a serious long-term issue, do not create a near-term cash flow crisis.
What if we’re wrong? The likely adverse scenarios involve a worsening in the financial position of municipalities and concern about their willingness and ability to pay rather than widespread default. We believe a number of factors would support municipal bond values: surprisingly light municipal bond issuance due to political gridlock and a bias toward less spending, the Build America Bond program, which encourages states and municipalities to issue taxable bonds further reducing the supply of municipals; and the prospect of rising tax rates, which increases the attractiveness of municipal bond income.
Portfolio implications. Short duration, high quality municipal bond yields remain at or near historical lows and appear to have little room for improvement to result in enhanced returns to bond portfolios. Investors, generally, are giving up a lot of return to reduce interest rate risk. In contrast, we are overweighting long-duration and lower-rated sectors.
A “new normal” with slow economic growth and low returns. Expectations for economic growth in developed economies are lower than they have been historically, but, as we’ve continued to say for many years, emerging markets have more opportunity for productivity growth and room for fiscal expansion (due to their lower leverage) and are likely to grow much faster. Innovation in telecommunications and business models are increasing productivity of knowledge workers, bringing more talent into the global labor pool (The World Is Flat, in Thomas Friedman’s phrase), and more effectively addressing smaller markets. Successful innovation typically increases economic growth and eases inflationary pressure.
What if we’re wrong? A period of slow growth, if accompanied by a reduction in uncertainty about the economic environment, might still lead to a period of better than expected returns on financial investments. However, confidence in the global economy and financial system is currently low, and a self-reinforcing cycle of contraction could take hold.
Portfolio implications. Aspiriant portfolios are well-diversified, with exposure to diverse streams of economic activity around the world. We are working hard to incorporate strategies which reduce volatility and protect against severe market downturns (“tail risk”).
...And Three Things Which MIGHT
Disruption in the global financial system. One of the most important elements in any financial system is confidence. The events of the past two years and the government response around the world have shaken confidence. The impact of new regulations and policies remains to be seen and the most fundamental dangers (under-capitalized banks, shadow banking system, under-regulated derivatives markets) have not been aggressively addressed.
What if we’re wrong? A healthy financial system is essential to continued economic growth. If the financial system regains confidence more quickly than we expect, returns on financial assets will likely skyrocket (mirrored by a precipitous decline in the price of gold).
Portfolio implications. Financial market stress would likely cause very severe losses in corporate credit holdings. We recently reduced our weighting to investment grade corporate debt, feeling that credit spreads were too low to justify continuing the overweight we added in early 2010. Our commodity positions have a modest allocation to precious metals, which provide some protection against financial market disruption.
Depletion of natural resources. Demographers expect the world population to peak in 2050 at 10 billion people, just after a period of rapid economic growth in the most populous countries. There is a lot we don’t know about resource extraction and depletion. We expect economic forces to bring resource use and exploration into alignment over the long run, but if resource depletion happens quickly or governments introduce distortions (e.g., U.S. ethanol policy), the impact on the global economy could be profound.
What if we’re wrong? An excess supply of natural resources would put downward pressure on commodity prices, benefitting both industrial and individual consumers. Plentiful resources would be supportive of economic growth and reduce the power of petro-dictators.
Portfolio implications. Aspiriant portfolios have protection against commodity price inflation in the form of commodity futures. We think of these positions primarily as a hedge against unexpected developments. It’s far too early to plan extensively for the era after 2050 when the world’s population is expected to begin to decline, but one can guess than there could be truly transformative changes if resource scarcity is even more pronounced...or if, because of a then declining population, the world shifts from an economics of scarcity to an economics of abundance. Only some of us will live long enough to see how this will play out.
Geopolitical conflict and terrorism. There are complicated dynamics in the world economy, with some leaders manipulating domestic and international issues to their advantage. Populations and ideologies which are unhappy with the status quo are gaining in power and size. Religious and ideological conflict and competition over global political influence and natural resources could engender armed conflict or at least undermine cooperation.
What if we’re wrong? Increased global harmony would likely lead to improved trade policies and regulatory stability – a “peace dividend” which would be very welcome, indeed.
Portfolio implications. Geopolitical tension most frequently shows up in commodity prices, exchange rates, and interest rates. Aspiriant portfolios have extensive global diversification as well as protection against commodity price inflation in the form of commodity futures.
These topics are not meant to be exhaustive or to offer a final word on these enormously complicated issues. Instead, they are intended to provide some insight into the thinking of the Aspiriant investment research team and to serve as a preview of the discussion around our current work in reviewing our long range capital market expectations and the modifications to portfolio mixes that could emerge from that work
Jason Thomas, PhD
Chief Investment Officer