Since the credit crisis started U.S. investors have been warned to prepare themselves for an extended period of sub-par returns based on lower economic growth from investment luminaries like Bill Gross of Pimco. There is little doubt we are in a very difficult, opaque investment environment. I would like to suggest that investors prepare for an increase in volatility much like we have witnessed recently. After a steep recovery rally from the 2009 stock market lows, stock prices have made wild swings in the last few months.
I would suggest this is to be expected. The business cycle, the autonomous expansion and contraction process a capitalistic economy experiences, can be aggravated by fiscal and monetary influences. The degree of monetary and fiscal influence on the current cycle could lead one to believe that the cycle will be intensified. The environment is especially volatile because we are also experiencing secular changes in the U.S. economy and in other countries. Some countries are experiencing aging populations, U.S. consumers are reducing debt, and many developed countries are addressing budget deficits.
What is a stock and bond investor to do in this environment? Should he continue using the same investment strategies that have worked in previous decades and hope that in the years ahead his account balance will have magically grown?
We are facing an economic transition that has taken place many times before. We recently left a multi-decade period during which many economic variables came together to produce a very accommodating period of economic growth. In the U.S. baby boomers were in their peak earning years. Credit was widely available and technological innovation was exploding. But all of that is changing. So it may be naive to expect your account balances to grow at the same rate they may have in recent decades simply by waiting for the economy and markets to return to normal. The process of working through major economic shifts can take a considerable period of time. But there are strategies you can use right now that may preserve and grow your investments more effectively.
The complexity of economic, market, and behavioral variables influencing today's asset prices is staggering. Take inflation, for example. You would expect high inflation in the U.S. after the massive influx of money over the last couple of years. So far it has not developed nor is there any sign it will in the near future. Interest rates are at extremely low levels for the time being and can remain there for a very long time. However, at some point we can expect inflation trouble to erupt, perhaps before bond markets have offered any signals. The future of the dollar should also be of concern to U.S. investors. Currency crisis's have a tendency to be swift and devastating. Inflation, deflation, stagflation - they all come with their ills and opportunities, but you have to have the ability to analyze the markets and deploy the appropriate tools. At present I would suggest over the next year interest rates are going to remain low, but at some point the potential for hyperinflation should have fixed income investors on watch. With interest rates low, bond prices high and the dollar vulnerable, it may also be a good time to hedge bond positions.
The manner in which stocks are behaving more cleary suggests a hedging strategy may be appropriate in the current environment. As the chart below illustrates, the market has become very choppy since the April sell-off, signaling uncertainty by stock investors.
After a reasonably good reception to Q2 earnings seasons, stocks have once again turned their attention to economic data which is starting to weaken again. If the economy continues to struggle, the potential for negative GDP growth and a recession is back on the table. That could spell trouble for stocks, unless you are able to design and implement an effective defensive plan. While we have been able to deliver growth over the last couple of years, our focus has been on managing risk, which has allowed our strategies to outperform our benchmarks. I believe that it is going to be quite a while before we will return to a constructive economic environment here in the U.S. If you agree and need help putting a strategy in place to deal with the adverse economic environment we find ourselves in, we are here to help.