Client Communications

Interim Report - Some Current Asset Allocation Thoughts August 16, 2020

We have wanted to comment on the global goings-on for more than a week now but events are unfolding so quickly and from so many directions that gaining a proper perspective for more than a day or two has proven to be a challenge. Add to that the wildest stock market volatility in more than 70 years, according to our technical market analysis service, and it’s easy to understand why investors and businesses around the country are moving towards a hunker-down, bunker mentality.

In this report we have distilled down the disparate information to present our view of the most significant risks of the day which are affecting client investments and our asset allocation decisions for your portfolio.

1. Euro Area Turmoil

Greece, Portugal and Ireland are all yesterday’s news. For the most part, their fiscal crises have been dealt with for the near term and markets have moved on to an entirely new set of fears over the solvency of Spain, Italy, and most recently, France. These countries are all too large to bail out if investors decide not to lend these governments more money. The banks across Europe are the most significant owners of these countries’ sovereign debt and the typical European bank is significantly more leveraged than the typical U.S. bank. Technically, significant numbers of European banks are now bankrupt but because they are not required to “mark-to-market” the current market value of their sovereign debt holdings, each country can maintain the fiction that their banking system remains solvent. Because of the precarious position of the banks within their own borders, the stronger Euro-area countries continue to come to the rescue of the weaker countries when the rising cost of selling new debt has shut them out of the investment markets for their ongoing cash needs.

Keeping control over the spreading contagion within the Eurozone is causing the European Central Bank and other pan-European financing organizations to move towards the eventual issuance of European bonds, to be guaranteed in some proportion by all member countries, which will be available for the liquidity needs of all member countries – at a painful price. That price is the loss of varying degrees of sovereignty over their own economic and political choices. To their credit, many entitlements have been, and continue to be slashed in the weaker Euro countries, and policies to improve global competitiveness have been undertaken. Just imagine the howling and possible riots that would take place in America if China or the International Monetary Fund told our President and Congress that we had to implement an immediate 20% cut in Social Security and Medicare payments in return for additional deficit funding. Our politicians have much to learn from what’s going on in Western Europe.

Interestingly, the Euro region is in better fiscal shape than the U.S. according to a variety of economic measures: net government debt, household debt and trade balances being some of the most significant examples. Perhaps for this reason the Euro currency has held up surprisingly well in the face of periodic panics. Success by European financial authorities in creating Euro-area wide bonds, could, we think, be the catalyst for a significant rise in European stocks.

We consider the Euro currency to be a major indicator of the future health of our own economy. If the Euro were to crash and the European Union implode, we believe the effect on the U.S. economy would be very damaging. A major decline in the Euro would cause us to further reduce client equity exposure.

2. China

China is the primary growth engine for Asia and a major prop for global commodity prices. What happens in China matters here at home and around the rest of the world. Earlier this year China began a series of efforts to cool an escalating inflation rate, particularly in the agricultural area. Interest rates have been increased on a number of occasions and concern began to mount that the country might experience a significant growth slowdown, or even worse, a recession.

Under that scenario, major commodity exporting countries in Asia, Latin America and Africa would suffer the consequences. Emerging market stock markets have sold off around the world. Spillover effects would affect various American companies in similar fashion.

Under that scenario, major commodity exporting countries in Asia, Latin America and Africa would suffer the consequences. Emerging market stock markets have sold off around the world. Spillover effects would affect various American companies in similar fashion.

Growth of the Chinese economy has indeed slowed down this year but we think it is a fairly safe bet that top government officials will not allow growth to be further choked for the benefit of further reductions in inflation. Furthermore, a significant proportion of China’s economic growth stems from its own infrastructure development which sucks up massive amounts of all types of commodities. Commodities markets bear witness to this view as they have maintained a greater degree of stability than have global stock markets in the recent decline.

If China economic data began to decline in a meaningful way from here on, accompanied by sharp declines in various infrastructure-type commodities, we would take this as a signal of growing global stress and as a result we would consider further reducing client equity exposure.

During the past few months we have in fact reduced our Emerging Market (EM) stock holdings. It is our present intention to maintain a diminished presence in China and other emerging market equities until such time as this segment of the market re-establishes its superior growth patterns of the past ten years.

3. Politics and the U.S. Government Downgrade

For the second time since the end of the last recession, U.S. economic growth has turned "mushy" from its already anemic beginnings. There is much fear that we are heading back into a renewed recession which, given the present weak state of the economy, would be devastating to the country.

The U.S. is also approaching the point where its rising debt load will eventually meet with funding resistance in the market place, resulting in higher interest rates on each additional increment of debt. We have said many times in the past however, that identifying the point in time of a financial crisis is not possible. It could be next year; it could be 10 years from now. Regardless of what you may see or hear in the media, no one can predict the timing of this event. We manage your asset mix based upon this belief.

A Brief Digression

Earlier this year S&P issued a warning that based on our present fiscal policies and demographic trends the U.S. would lose its "AAA" rating at some point in the not-to-distant future. S&P commented in a July 14 press release that "If Congress and the Administration reach an agreement of about $4 trillion and if we conclude that such an agreement would be enacted and maintained throughout the decade, we could affirm the "AAA" long term rating on the U.S."
Instead of $4 trillion in cuts over 10 years, Congress and the President ultimately agreed upon $2.4 trillion in cuts over that period of time in exchange for an approximate $2 trillion increase in the debt ceiling. This grand compromise, memorialized as the Budget Control Act of 2011(the "Act"), insured that S&P would follow through on its downgrade warning press release statement.
In its downgrade of America’s debt, S&P explained its thinking as follows: "The downgrade reflects our view that the effectiveness, stability, and predictability of American policy making and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2020. Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government’s debt dynamics anytime soon."
One part of the Act calls for the convening of a Congressional "Super Committee" to determine where the spending cuts over the next 10 years will come from. Before they even begin their work, observers of the individuals selected to comprise this group note problems with many of the members’ willingness to find compromise solutions. All the Republican members, for example, have signed a pledge against voting to raise taxes. Various Democrats on the Committee have fought hard to preserve government spending programs like Social Security and Medicare.
Should the Committee be unable to agree on the $1.5 trillion of budget savings during the next four months then supposedly, $1.2 trillion in automatic, across the board, spending cuts will be triggered over a decade, starting in 2013.
Unfortunately, the Act is simply another example of ‘kick the can down the road.’ What it did accomplish however was to raise the debt ceiling by $2 trillion (which was the only common objective of both parties), enabling "the federal borrowing binge to continue for up to another 18 months, until early 2013" according to Barrons newspaper.
The complete package of $2.4 trillion in cuts over 10 years is highly suspect, assuming the bi-partisan congressional committee can agree upon them at all. The "cuts" are heavily back end loaded for the second five year period. In addition, according to the Congressional Budget Office, if enacted, they will barely slow the rate of growth in public debt between now and 2021.
Recognizing the Act for the failure that it will be, we are left pretty much where we were before the whole sorry budget showdown process got underway, i.e. with out-of-control spending, uncompromising politicians and an upcoming election in 2012 to try to sort the mess out.

Our position regarding these budget cutting debates is that they are nothing more than political theater. It's a sideshow to the more important factors which affect the rate of our domestic growth. We have repeatedly noted in our quarterly letters that investors in treasury securities simply do not care about our current level of deficit spending or whether the U.S. is a AAA or AA credit. Interest rates in the U.S. continue to decline and the Treasury Department has no problem selling all the new debt it creates. This week, for example, Treasury sold $72 billion of notes and bonds at the lowest rates on record, according to Bloomberg News. In further support of this view, both Moody's and Fitch have now reaffirmed their AAA rating on Treasury securities. In their view, the U.S. enjoys a special status as provider of the world's principal reserve currency. Under this view, the U.S. has the ability to leverage up well beyond current levels before a global crisis in confidence occurs

On the positive side, Bernanke's decisions to 1) hold short term rates near zero through mid 2013, and 2) push down interest rates in the 3-7 year portion of the yield curve, are powerful inducements for investors and companies to purchase stocks. Current interest rates present a clear disincentive to hold cash and CDs. Americans are now saving more than 5% of their disposable income and corporate cash is at the highest levels ever. This cash is desperately seeking return opportunities. Any generally positive turn in economy-wide economic indicators, or a bi-partisan longer-term plan to seriously attack the rate of growth in government debt could unleash an explosive stock market rally.

Furthermore, we believe this recent severe stock market decline has created some attractive buying opportunities in companies whose economic prospects remain bright.

Given our assessment of these principal concerns together with our interpretations of other investment indicators, we have positioned client equity holdings around the midpoint of their allowable ranges, or somewhat below, after taking into consideration certain hedging strategies now in effect.

4. Gold

The price of gold has "gone vertical" of late but there is no conventional method that has been discovered to calculate its true value. In the late 1970's, Charles Kindleberger, a Professor of Economics at M.I.T. wrote a book entitled Manias, Panics and Crashes in which he identified three conditions for a financial mania. They are: a powerful theme which catches investors imagination; low interest rates, and; investment vehicles that allow rampant speculation. Clearly, gold meets these three conditions today indicating that its ownership has become increasingly risky.

On the other hand, the cyclical factors which have driven up its price remain in effect. Two of the principal factors in our opinion include our government's deteriorating fiscal position and negative real (after inflation) yields on a growing portion of the treasury yield curve. Furthermore, emerging market countries having been heavy acquirers of gold in the recent past as part of their diversification efforts away from a depreciating dollar.

This love affair with gold could end rather abruptly if our government were to adopt a credible plan to address our long term fiscal situation or if our economic recovery gained sufficient strength to allow the Fed to remove its stimulative policies.

Our present strategy is to maintain client's gold investment at approximately 5% of total portfolio value until the cyclical factors mentioned above or other economic conditions influence our thinking in a different direction.

5. Conclusions

Bringing these various issues together into one comprehensive investment strategy, we have, during the past few months, reduced all client equity positions to the lower half of their agreed upon ranges through a combination of security sales and various hedging strategies. Should global markets generate positive equity performance through the end of the third quarter, our hedging actives may result in account under performance relative to our global equity index proxy. If, on the other hand, global equity markets generate a loss through the third quarter, our hedging activities should reduce this loss potential.

Our bond strategy has focused primarily on owning investment grade corporate bonds or bond funds while gradually increasing the foreign percentage of total holdings through the direct purchase of foreign bonds and/or foreign bond funds.

Our alternative investment segment has held fairly steady at approximately 5% gold and 5% other commodity funds.