July 2010: Quarterly Letter

Dear Clients and Friends,

It has been an interesting quarter.  I have seen a rise in the uncertainty level from investors over the last three months.  The major US indexes are down about 12% since the beginning of April and European indexes are down slightly more - around 13%.  As a result of all this uncertainty, when people find out I am an advisor, I frequently get questions about various markets.  From, "What do you think about Greece?" to "Are government bonds still safe?"  I imagine in good times people will be telling me about how great their investments have performed, but for right now, fear and uncertainty certainly seem to be the themes.

All that uncertainty can be uncomfortable.  And there are big structural reasons for uncertainty: government stimulus ending, massive deficits in developed countries, unfunded liabilities for pensions and entitlements, high unemployment.  The list goes on.  We equate uncertainty with risk.  That's natural, but it is not always correct.  In fact, periods of uncertainty can often drive prices of assets so low, that future periods of higher returns are extremely likely.

Inflation Expectations and Portfolio Construction
(Or: Lions and tigers and bears, oh my!)

Early in my career I read something that has always stayed with me: "If you are going to make predictions... predict often."  For me, this is an excellent tag line for the mainstream financial media.  I take the opposite approach and try to avoid making predictions all together.  Don't get me wrong, I will debate with the best of them, but at the end of the day, most of these topics are highly complex and any predictions we make will invariably be wide of the mark.  On the other hand, I don't like standing in front of a bus if I can avoid it.  So I tend to think of things in probabilities wherever possible (spoken like a true former Engineer).

Which brings me to my current topic: inflation.  If you read any of the financial press lately you will undoubtedly stumble on the debate concerning inflation, deflation - and for some of the true rebels out there - stagflation (this reminds me of The Wizard of Oz when Dorothy chants, "Lions and tigers and bears, oh my!").  While any of these are possible in the short term (short term being two to four years), I think the highest probability event in the long term is inflation.  I won't bore you with a treatise on inflation, I will just point out two items.  One: we are in totally uncharted waters in regards to the enormous size of fiscal stimulus applied around the world.  The numbers don't even cause a stir any more unless they start with "T" as in trillion.  Two: people.  Lots and lots of people.  According to the July issue of Fortune magazine, the developed world accounts for 16% of the world's population or 1.1 billion people.  The developing world accounts for the other 84%, a staggering 5.8 billion people.  Consider this: the US has a population of just over 300 million people.  If the developing world moves just 5% of its population from the poorest segment to "middle class" over the next decade that represents an upgrade of 288 million people.  Or just about one US population per ten years.

When people move into the middle class, what do they want?  I mean... after the latest iPhone?  They want a house, a car, better food, air-conditioning, a refrigerator... you get the point.  This will put an enormous strain on the resources of the world to provide all the wood, steel and concrete to support the lifestyle upgrade.  And along with that comes commodity inflation.  As a result, I believe rising commodity prices will be ultimately passed along to the consumer.

So how do we construct our portfolios to account for this?  I've outlined the common asset classes that we use and how they are likely to respond to inflation and we'll finish up with a discussion on how they all work together:

1. Commodities.  If you can't beat 'em, join 'em.  If the future plays out even remotely similar to the situation above, then one of the asset classes you need to own is commodities as they will be the leading cause of future inflation.
2. Government TIPS.  These are Treasury Inflation Protected Securities - bonds that have the principal adjusted up every year in response to the CPI (Consumer Price Index).  In the event inflation takes off, these will adjust upward to protect your investment.  Plus they yield a small amount of interest as well.
3. Stocks.  Equities are excellent long term inflation hedges.  After all, what is inflation but a rise in the general price level?  Companies will raise prices in response to higher input costs (raw materials and wages) and this raises the prices as measured by the CPI.  Unfortunately, this takes time.  Customers don't respond well to rising prices, so companies are slow react.  This means the equities often initially fall in price during inflationary periods as their margins are squeezed.  But after sufficient time, companies will pass along their higher operating costs (or they'll go out of business, which often happens to weaker companies during periods of high inflation).
4. REITs.  Real Estate Investment Trusts - these are securities that invest in office buildings, apartments, and other income producing real estate.  Similar to stocks, REITs can raise rents when inflation sets in so they are also good long term hedges against inflation.
5. Bonds.  Although bonds (other than TIPS) are not directly affected by inflation, higher interest rates often accompany periods of high inflation as monetary authorities try to slow the economy to control inflation.  In this case the best strategy is to keep bond durations extremely short since shorter duration bonds are much less sensitive to interest rate increases.

Given an inflationary scenario, what we might expect is that the commodities and TIPS react first to inflation expectations.  Your equities, REITs and bonds might actually decrease in value in the short term.  When you re-balance annually, you will be moving money from your commodities and TIPS into REITs and equities.  Over time the equities and REITs will appreciate as well, but it might not be apparent until you reach the end of an inflationary cycle.  In this case, consider your inflation related assets as a source of funds to invest into your longer term assets.  This should enable you not only to ride out a period of inflation, but to actually take advantage of the opportunity.

This is a simplified example, but I wanted to give you a sense of the different aspects of inflation protection that we can build into your portfolio.  If you have additional questions or concerns, don't hesitate to drop me a line or call.

In Closing

I know that periods of uncertainty can try investor's patience and challenge the discipline to stick with your investment strategy.  So don't hesitate to call or reach out if you have any questions or concerns about your accounts or investment strategies

Also, if you have any friends or family who have concerns, please don't hesitate to make an introduction or forward this letter.  We provide Financial Planning and Investment Management services and would be happy to talk with your acquaintances.  We will treat your friends and family with the same care and diligence that we treat you.

Thanks,

Brian McCann