Confidence Amidst Uncertainty

The most debilitating shroud over the economy and likely for months to come remains that of uncertainty. The uncertainty regarding the direction of government policy has been largely answered with the elections, but huge questions remain regarding if and how the fiscal cliff of tax cuts and government spending will be addressed. Senator Bob Corker said “personally, I think the conditions are exactly perfect for us to move ahead with this right now.” It is going to take the president being committed to doing this and sitting down and rolling up his sleeves and making it happen.” We hope he’s right.

Today, economists from the Congressional Budget Office detailed new warnings of recession in 2013 should lawmakers fail to act. The CBO report said that eliminating the spending cuts would have more positive impact on GDP than eliminating the tax cuts. But at the same time, extending all the tax cuts would protect 1.8 million jobs from being lost. Among that number, 200,000 jobs would be protected by extending those of top earners (the $250,000 level Mr. Obama continues to champion). By comparison, eliminating the government spending cuts would prevent 800,000 jobs from being lost, CBO said.

The major long term concern facing capital market investors is a massively growing government, deficit and debt. CBO projected that not activating the automatic spending cuts would take the federal debt from last year’s 73% of gross domestic product to 86% in 2020. The larger the government and its debt become, the bigger its drain on the economy. Corporate earnings growth will be impeded both at home and abroad given the sheer size of the US market. At some point though, international growth will resume as non-American and non-European markets grow in wealth and importance.

Perhaps the most destructive obstacle ahead is the increasing threat of inflation. It is said that the American economy does not experience inflation without wage pressures. With near-eight percent unemployment inflation threats may seem remote. But economists say that America is on the verge of a drought in highly skilled workers required to staff new modern domestic production facilities. Under this scenario it is quite possible that we could see wage pressures starting even with relatively slow economic growth and high unemployment.

Our portfolios are designed to efficiently and effectively navigate severe capital market shocks and our planning process ensures that our clients are exposed to no more risk than is necessary to meet and possibly exceed their goals. We use 7-10 year US Treasurys to offset stock market volatility in our portfolios. These assets usually rise to offset stock declines when investors seek the safest of havens. In fact work done by Dave Loeper of Wealthcare Capital Management indicates that 7-10 year Treasurys provide significantly better risk offsets than do real estate or gold going back to 1926.

The worst enemy to any fixed income asset is inflation. Given the likelihood that government debt will continue to rise, the threat of inflation rises along with it and we may see damage to our Treasury holdings. Let’s take a closer look at what could happen.

Dave Loeper wrote a whitepaper in December of 2010 entitled Gold’s Twelve Month March to $3,800 an Ounce. In it he examined three periods (we’ll look at two for brevity) in American history of high inflation and the impact it had on various asset classes. Our focus will be on the Treasurys as shock absorbers, not return instruments.

The first major bout of inflation in our sample ran from 1973 to 1975 when the CPI spiked from 3.41% up to a high of 12.34% before settling back to 6.94% by the end of 1975. Table 1 below examines how various asset classes performed during this period.

You can see that even with inflation raging up to 12.34% Treasuries lost only 1.82% in all 12-month periods included. You will also notice that gold did very well indeed with a compound return of 29% compared to Treasurys’ 5.4%, but remember, we don’t own them for return. Look also at the worst 12-month loss of 25%. While in the neighborhood, check out real estate’s worst loss of 48% during the period.

The next period of massive inflation occurred between March of 1978 and February of 1982 when inflation rose from 6.55% to 14.76% before settling back to 7.62%.

Here you can see that Treasuries didn’t fare as well as before in terms of worst 12-month return, but their loss was remained single digit. In fact, the 7-10 year Treasury has not lost more than 9.45% since 1926.

But we don’t own Treasuries alone and we don’t own them for return. Our Balanced Income portfolio is comprised of 50% half Treasuries. It will provide a good example of what our clients might have experienced overall during these two historical inflationary periods. Just for fun, we’ll include Dave’s comparison of similar portfolios using 10% gold and real estate as alternative hedges against inflation.

Notice that the gold portfolio outperformed in the 78-82 period, but not the 72-75. In fact, Dave’s third period 12/86 to 12/90 showed that our portfolio outperformed the gold and real estate. So given the three period sample, odds are with our Treasury portfolio over the gold for better performance during inflationary cycles.

It is said by some that we are in uncharted times,  that may or may not be. There have been plenty of periods where conditions were worse than they are today and we survived them. Importantly, our portfolios survive them today as we continually stress-test them through Great Depression-like crises. President Obama and House Republicans have every reason to compromise and work together to find solutions to the problems of debt and entitlement spending. Businesses have incredible amounts of cash and are as healthy and lean as they have ever been.

There are plenty of reasons fur us to be hopeful for a better future. Accept that there are things we cannot change and focus on the things we can. If you worry about your future, let us help you reach your ideals by navigating these uncertain times with confidence.