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New York, September 4, 2012, Advisor Update®
On the eve of the second US Presidential convention, we would describe America’s current condition by paraphrasing a former US President, that the only thing that is certain is uncertainty itself. Beginning with monetary policy, we have reached a point where traditional policy is ineffective and the Fed has had to resort to quantitative easing (QE) in order to keep the economy from slipping back to a recession. From an asset allocator’s perspective, this is problematic for two reasons. The first is that it is much harder to determine what market expectations for future Fed action are at any given time. The second is that the effects of QE are much more uncertain than those of traditional policy tools, both in the short and long term. Together, these two uncertainties make the effects of monetary policy much less predictable and increase market volatility.
Compounding the Fed’s monetary policy adventures are uncertain fiscal, tax, and regulatory policies. Economic policy uncertainty, as measured by Baker, Bloom, and Davis, has remained elevated since 2008 and is currently near the all-time high set last summer. Without clear policy goals out of Washington, it is much more difficult to predict economic growth and therefore earnings growth and asset price levels.
Uncertainty is the enemy of all markets and irrationality and volatility follow in its wake. In 2012, short term cross-asset correlations have been very high, but at the same time, many longer term correlations and price relationships have completely broken down. This is nowhere more evident than in the relationship between treasuries and equities, for instance the 10-yr UST and the S&P 500.
What’s the problem? The bond market is saying that equities are too expensive and that the economy is in far worse shape than the stock market says it is. The US stock market is signaling that growth is ahead and that bond yields must rise, bond prices must fall.
For the short term, we think the bond market has it right, but the caution flag is out for both asset classes.
Tactically, it means floating rate bank debt, taxable munis and high yield bonds are a better place to be when thinking about fixed income. For equities, a lower allocation is warranted and higher yielding equities are still a safer bet. It could all change very quickly, which is another reason we are still holding higher-than-usual cash levels in our Global Tactical Allocation portfolios.
The US has recovered better than many countries from the 2008 crash, but we have a long way to go; industrial production is below a peak hit seven years ago and unemployment is still stuck at 1983 levels.
The politicians in the West, led by the US, are running out of time to get their houses in order and provide companies, working people and investors with certainty. Businesses and entrepreneurs must have an environment that incentivizes them to make the money needed to pay for retirement benefits, but that won’t be enough unless Social Security and Medicare are restructured. That is a very hard truth for voters to acknowledge and it won’t happen until politicians lead them to it.