July 2009: Deflation, Reflation, Moderate or Excessive Inflation?: Portfolio Strategy for the Lean Years Ahead
Ask any unrepentant expert, analyst, pundit, or TV talking-head on Wall Street's beat for an opinion on the economic outlook, and a flavor-of-the-month projection is always forthcoming. At the moment, most prognosticators start with assumptions about future purchasing power erosion, and build their economic model projections upon whether deflation, continuing reflation (i.e., accommodative central bank policies) or serious inflation lies ahead. Remembering that "perception", reflected in investor psychology, is what drives financial markets in the short run, attempting to discern investor and consumer inflationary expectations today is more than of just passing interest to equity investors.....
Presently, an evolving consensus amongst portfolio strategists (also shared by this firm) is that after three quarters of declining Gross Domestic Product (GDP) numbers, a bottoming is at least at hand; and that the turn in economic output will become evident in current and 4th Quarter 2009 reports. A small portion of the Federal Government "stimulus" package (really a grab bag of political payoffs and income redistribution legislation) has begun to impact the construction industry, as well as the traffic situation (at least in the Boston area) as pavers close off major roads and bridge repairs get under way. But it is becoming more evident, as most politicians were even admitting, if only off the record at the time of their vote, that last November's stimulus bill was never intended as purely economic legislation.
On the national monetary front, access to credit for corporations and consumers has improved. Bank capital reserves continue to rebuild toward more normal levels. Corporations have been able to recycle debt into lower cost bonds and raise new equity. Residential housing markets, depending, as always, on location, are beginning to stabilize. Extraordinary corporate financial write-downs, whether deleveraging tactics or other special, non-operating charges to earnings appear to be tapering off. Corporate employment rolls have been pared to lean and mean levels, unemployment, which will probably continue to rise throughout this year, will be a constant reminder of the economy's frail state, product inventories across the board are at bare minimum levels, and manufacturing capacity utilization ratios indicate room for improvement in productivity without burdensome added costs.
Although all of this has been painful to endure, therein also possibly lies the seeds for a much stronger-than-expected rebound in corporate profits. Further, this return to higher levels of profitability could be achieved without an immediate need to be concerned about the inflationary impact of the government's excessive banking system liquidity infusion of the past 11 months. Rising unemployment (above 10% by the end of 2009), a global phenomenon, could also serve as a further lid on wage escalation and a dampening on inflation expectations.
World stock markets have turned around on the assumption that the worst may be behind us. Historians may label this a "relief rally," driven by the realization that asset prices had reached a compelling under-valuation level too cheap to ignore. Since its March 9th market nadir, U.S. stocks are up 37% as of June 30th and up 3% calendar year-to-date. Today, global financial market values strike us as reasonable if based on the conventional wisdom that the improvement in corporate earnings for the remainder of this year and next will be gradual and restrained. Should a V-shaped corporate earnings rebound scenario materialize, which appears to be a distinct possibility, particularly if accompanied by the perception that inflation will remain moderate, stock prices (primarily in the U.S.) could surprise on the upside.
As always, risks abound. The media will agitate; commercial real estate refinancing problems will dominate the financial headlines; endowment declines will force non-profit institutions to continue to retrench; consumers will save more, impacting retail sales; and a more conservative attitude about personal finance appears to be emerging. This adjustment period may well remain a "mind-altering experience," but perhaps one with constructive attributes of a long-lasting effect.
So whether we are in the wake of the storm, or merely in the eye of the hurricane as some prophesy, near-term balanced portfolios, in our view, should be structured to deal with continued deflation through their fixed income (i.e., bond) allocation and moderate inflation through a global equity focus on smaller- and medium-sized companies. We have included a more detailed recap of our portfolio strategy and aggregate results later in this letter.
ETF Mania
Sixteen years ago, the first exchange traded funds (ETFs) were introduced, initially tracking traditional, broad market indexes such as the S&P 500 and the Dow Jones Industrial Average. Today, there are over 700 ETFs many which have gone beyond tracking typical indexes to emulating proprietary, managed benchmarks, which are often times sold as "unique" to the vendor's offering. We can thank investment product manufacturers (i.e., today's financial engineers) for creating exotic strategies and obscure indexes which are then conveniently mapped by ETFs. We can also thank partially informed financial journalists, brokers and marketers who have pitched these funds ad nauseum. Despite the evolution of the product and myriad vendors, one question remains: Are ETFs useful to the individual investor?
ETF purveyors will give credit for the product's growth to the supposed benefits over competing products - passive or indexed mutual funds, closed-end funds, etc. One benefit is that they can be traded like stocks, unlike mutual funds which are priced and traded at the close of each day's market. By contrast, ETFs are priced in real time, can be traded throughout the day, and can be sold short. Indeed, the tagline for the first ETF was: "Trading the Market All Day Long in Real Time."
This tagline was adopted by short-term traders who viewed ETFs as their contemporary instrument of choice. Need we remind ourselves that market timing should be left to soothsayers, gamblers and the naive, not investors?
According to John Bogle, Vanguard founder and index industry legend, the ETF model has been a successful business model for stock brokers and some speculators. But have investors been able to profit from the real time pricing and intraday liquidity offered by ETFs that is not available in mutual funds? According to a study by John Bogle, over the past five years, State Street's SPDR S&P 500 (SPY) has returned -1.9% compared to the average investor's return in the SPDR of -8.2%. Why this disconnect between the ETF return versus the return for the investors in the ETF? The turnover of the SPDR ETF was 10,105%(!) in 2009 compared to 33% turnover in mutual funds. This staggering, in retrospect mistimed, cash flow and turnover percentage proves the tagline "Trading the Market All Day Long in Real Time" was taken seriously by investors, and that it was not a profitable venture. Mr. Bogle ponders, "So you tell me if all that trading was good for the investors or not . . ." It has certainly turned out to be an annuity for brokers.
So is there value in replacing an S&P 500 Index mutual fund with an S&P 500 ETF? To date, we have not seen the often touted benefits of ETFs - intraday trading, low fees, and tax efficiency -that offer an advantage over broad market, passive mutual funds. The management fees are similar, the tax efficiencies are comparable, and we, along with John Bogle, do not see an advantage for investors of the intraday liquidity available in ETFs.
While ETFs that track broad market, passive indexes may not offer additional value when compared to similarly targeted, passive index mutual funds, actively managed ETFs are a new reality. Actively managed ETFs are in their infancy, but as more are brought to market, we will weigh the potential risks and rewards to determine the usefulness and possible impact on investment portfolios. Until then, we will take a pass on the recently offered, triple-leveraged inverse S&P 500 ETF.
A Recap of TFC's Portfolio Strategy for the 2nd Quarter 2009:
Fixed Income
As you may recall, we were heavily invested in short-term U.S. Treasury bonds/funds for nearly the entire decade until last year, opting for riskless capital preservation and liquidity. Earlier this year, we shifted out of U.S. Treasury bonds into a diversified mix of short-term government-guaranteed agency, national municipal and high quality U.S. and global corporate bonds (in most cases through low cost bond mutual funds). Aside from immunizing portfolios from potential deterioration of U.S. Treasury bond prices, we hoped to capture higher yields (relative to U.S. Treasuries) and potentially higher total returns from non-Treasury bond assets. To date, yield spreads/differentials continue to narrow, without materially increasing interest rate or credit risk in the portfolio. This strategy continues to play out advantageously. The average duration of the fixed income portfolio remains short, under 3 years. In tax-deferred or retirement portfolios, we increased our allocation to inflation-protected Treasury securities (TIPs).
Equities
For many of you, with approval, we have begun to rebalance portfolios back towards policy norms, i.e., investing excess cash into diversified U.S., international equity, global natural resource and global REIT (real estate investment trust) funds. The recent rally in global stock markets since March 9th has propelled our year-to-date equity returns into positive territory.
During the quarter ended June 30th, U.S. dollar weakness and a strong rebound from emerging markets and natural resources boosted your international equity and overall portfolio returns. We reaffirm our 40% allocation to international equities (investing in over 40 individual countries), for economic, capital market and currency diversification, and to participate in higher growth opportunities, especially in Asian and other emerging countries.
Our small, initial investment (~5% of equities) into global REITs, through the actively-managed Morgan Stanley Global Real Estate Fund, has been positive also, with the fund up nearly 40% for the quarter.
We have also increased our small cap weighting slightly (from 30% to 35%) in both U.S. and international equities, as price appreciation potential is often higher in small to medium-sized companies than larger companies during market recovery periods.
Our strategic portfolio shifts (among asset classes) may often seem insignificant, but we believe these decisions have added measurable value to our client portfolios in terms of absolute and relative performance, and more importantly to control and reduce overall portfolio risk.
Finally, although an equity market turnaround appears to have occurred from the depths of March, the economic picture has by no means resolved itself. Unemployment continues to rise (always a lagging indicator) and will probably do so for the remainder of this year. The economic cautionary flags are still flying, and we will continue the need to proceed carefully with equity market risk and volatility always in mind.
We would be happy to answer any questions you might have and welcome your comments.
Sincerely,
James L. Joslin
Chairman & CEO
Renèe Kwok
President
Lee C. McGowan
Senior Client Advisor
View detailed recap of our portfolio strategy and aggregate results (PDF)