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Successful Investing in a Low Growth Economy: A Historical Perspective


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The U.S. economy has grown about 3.5% annually from the 17th century until the late 20th century. Most of American industry and wealth can be attributed to significant technological advancements starting in the Industrial Revolution. Over recent decades, productivity has significantly dropped off with some estimates of the economy growing at 1.8% annually.

Returns from innovation appear to be entering a period of stagnation. Although the causes and implications of such events remain in question, it has become increasingly vital for investors to analyze performance across similar environments in history to successfully navigate uncertain markets.

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Successful Investing in a Low Growth Economy: A Historical Perspective

  1. 1.        SUCCESSFUL  INVESTING  IN  A  LOW  GROWTH  ECONOMY:   A  HISTORICAL  PERSPECTIVE         Aaron  Careaga   Research  Analyst         WEALTHMARK  LLC.   1329  North  State  Street,  Suite  206   Bellingham,  WA  98225   February  2013            
  2. 2. ABSTRACT  The  U.S.  economy  has  grown  about  3.5%  annually  from  the  17th  century  until  the  late  20th  century.  Most  of  American  industry  and  wealth  can  be  attributed  to  significant  technological  advancements  starting  in  the  Industrial  Revolution.  Over  recent  decades,  productivity  has  significantly  dropped  off  with  some  estimates  of  the  economy  growing  at  1.8%  annually.  Returns  from  innovation  appear  to  be  entering  a  period  of  stagnation.  Although  the  causes  and  implications  of  such  events  remain  in  question,  it  has  become  increasingly  vital  for  investors  to  analyze  performance  across  similar  environments  in  history  to  successfully  navigate  uncertain  markets.      Aaron  Careaga  WealthMark  LLC.  1329  North  State  Street,  Suite  206  Bellingham,  WA  98225       2  
  3. 3. 1. Introduction  Most  academic  and  professional  theories  on  productivity  are  based  on  the  Solow  Growth  Model,  which  is  predicated  off  the  fact  that  economic  growth  is  continuous  along  an  infinite  horizon.  There  has  recently  been  significant  discussion  of  economic  papers  forecasting  dismal  growth  with  the  possibility  of  little-­‐to-­‐no  return  on  investment.    Economist  Robert  Gordon  argues  that  prior  to  1750,  the  growth  that  we’ve  become  accustomed  to  today  was  nonexistent  and  recent  productivity  is  likely  an  outlier  in  the  larger  economic  history  of  the  world.     Source:  Gordon  2012  Technological  advancements  from  the  Industrial  Revolution  significantly  progressed  economies,  but  innovation’s  ability  to  further  growth  appears  to  becoming  less  effective.  Basic  inventions,  such  as  indoor  plumbing  and  controlled  energy  (light  bulb),  heightened  the  standard  of  living  far  more  than  social  networks.  Society  might  not  be  as  well  connected  without  recent  innovations,  but  at  least  the  standard  of  living  would  remain  higher  than  that  of  agrarian  ancestors.      Gordon  explains  that:   Attention  in  the  past  decade  has  focused  not  on  laborsaving  innovation,  but  rather  on  a   succession  of  entertainment  and  communication  devices  that  do  the  same  things  as  we   could  do  before,  but  now  in  smaller  and  more  convenient  packages.  The  iPod  replaced  the   CD  Walkman;  the  smartphone  replaced  the  garden-­‐variety  “dumb”  cellphone  with   functions  that  in  part  replaced  desktop  and  laptop  computers;  and  the  iPad  provided   further  competition  with  traditional  personal  computers.  These  innovations  were   enthusiastically  adopted,  but  they  provided  new  opportunities  for  consumption  on  the  job   and  in  leisure  hours  rather  than  a  continuation  of  the  historical  tradition  of  replacing   human  labor  with  machines  (Gordon  2012).  Jeremy  Grantham,  cofounder  and  chief  investment  strategist  at  GMO,  recently  wrote  an  influential  newsletter  on  the  subject  called  On  the  Road  to  Zero  Growth.  The  paper  examines  Gordon’s  research  and  the  fact  that  U.S.  GDP  growth  has  remained  above  3  percent  in  recent  history.     3  
  4. 4. Grantham  contends  that  growth  rates  near  3  percent  are  unsustainable  and  exhibit  only  a  small  blip  in  history,  fueled  by  population  growth  and  industrialization.  As  resources  dwindle  and  populations  peak,  he  forecasts  U.S.  real  growth  of  0.9  percent  through  2030  and  dropping  to  0.4  percent  from  2030  to  2050.  Most  valuation  models  use  annual  growth  rates  around  5  percent.  How  do  you  value  investments  necessary  for  retirement  in  a  0.9  percent  real-­‐growth  economy?  Pricewaterhouse  Coopers  also  updated  its  long-­‐term  economic  outlook  in  January  2013,  titled  The  World  in  2050.  The  report  includes  an  analysis  of  key  growth  drivers  and  implications  of  global  shifts  with  a  forecast  of  total  GDP,  average  real  GDP  growth,  and  income  per  capita  for  developed  and  emerging  countries.    PwC  projects  China  to  overtake  the  U.S.  in  terms  of  total  GDP  between  2017  (PPP  estimate)  and  2027  (MER  estimate)  depending  upon  underlying  assumptions.  The  U.S.  is  expected  to  be  the  second  largest  economy  behind  China  by  2050  with  annual  growth  slowing  relative  to  younger  economies.  China  is  forecasted  to  produce  3-­‐4%  real  growth  with  the  U.S.  and  E.U.  countries  growing  at  a  significantly  lower  pace.  As  the  following  chart  displays,  Nigeria,  Vietnam,  and  India  exhibit  the  greatest  potential  for  real  annual  growth  through  this  period.     Source:  Hawksworth  and  Chan  2013  PwC  states  that  recent  claims  on  a  slowing  technological  frontier  and  real  U.S.  growth  projections  around  1%  seem  “rather  at  odds  with  the  accelerating  pace  of  change  in  ICT  and  the  potential  for  further  rapid  progress  in  areas  like  nanotechnology  and  biotechnology  over  the  coming  decades”  but  they  believe  that,  “it  is  possible  that  measured  GDP  growth  could  slow  down  due  to  difficulties  in  measuring  technology-­‐related  improvements  in  the  quality  of  some  services”  (Hawksworth  and  Chan  2013).  Multiplier  effects  of  technological  innovation  are  rarely  obvious,  especially  in  traditional  measures  of  productivity,  and  often  lag  business  sentiment  for  such  advancements  relative  to  classic  examples  of  innovation  in  living  standards.    As  an  alternative  perspective  on  the  above  pessimistic  outlook  of  technological  innovation,  the  Economist  argues  that,  “the  main  risk  to  advanced  economies  may  not  be  that  the  pace  of  innovation  is  too  slow,  but  that  institutions  have  become  too  rigid  to  accommodate  truly  revolutionary  changes”  (Economist  1,  2013).  This  is  probably  another  major  factor  contributing  to     4  
  5. 5. slowing  economy  productivity,  but  data  backing  these  claims  will  likely  not  be  apparent  for  many  years  to  come.    Projecting  recent  behavior  onto  future  expectations  is  extremely  capricious.  Forecasts  can  give  investors  comfort  in  seeing  the  future,  but  events  almost  never  unfold  as  initially  expected.  James  Montier,  a  member  of  GMO’s  Asset  Allocation  team,  believes  that,  “attempting  to  invest  on  the  back  of  economic  forecasts  is  an  exercise  in  extreme  folly,  even  in  normal  times.  Economists  are  probably  the  one  group  who  make  astrologers  look  like  professionals  when  it  comes  to  telling  the  future…  They  have  missed  every  recession  in  the  last  four  decades!  And  it  isn’t  just  growth  that  economists  can’t  forecast:  it’s  also  inflation,  bond  yields,  and  pretty  much  everything  else”  (Montier  2011).    With  these  thoughts  in  mind,  it  has  never  been  as  imperative  to  learn  from  past  experiences  given  recent  levels  of  volatility  and  potential  conjunction  of  multiple  forces.  Technological  pessimism  is  not  a  new  phenomenon  and  historic  performance  is  never  a  definitive  indicator  of  future  returns,  but,  regardless  of  the  outcome,  it  is  necessary  to  analyze  market  trends  and  investor  reactions  throughout  similar  periods  in  attempt  to  better  prepare  for  an  uncertain  future.           5  
  6. 6. 2. Deciphering  the  Past  Prior  to  the  1800s,  societies  across  the  globe  were  primarily  agrarian  driven.  Wealth  was  mostly  derived  from  farming  and  the  exploitation  of  labor,  resulting  in  mild  income  inequality  and  distinct  levels  of  society.  Four  features  characterized  pre-­‐industrial  societies  across  history:  high  fertility  rates,  little  education,  the  dominance  of  physical  over  human  capital,  and  low  rates  of  productivity  growth  (Clark  2004).  Technological  innovation  led  to  a  major  change  in  economic  structures,  resulting  in  significant  supply  and  demand  shifts  across  labor  and  resource  markets.    On  financial  evolution,  it  is  important  to  recognize  that  bankers  and  other  facilitators  of  trade  have  existed  since  Roman  time  and  ultimately  laid  groundwork  for  the  current  financial  structure.  European  banking  institutions  started  to  facilitate  trade  and  the  transfer  of  funds  in  the  1600s.  The  New  York  Stock  Exchange  was  created  in  1792  and  most  of  the  bellwether  U.S.  financial  institutions  were  founded  around  the  mid  1800s.  The  Civil  War  was  a  catalyst  for  debt  securities  around  this  same  time  as  bonds  were  issued  to  finance  wartime  expenditures.  But,  nothing  on  today’s  scale  of  financial  markets  ever  existed  prior  to  industrialization  and  advancements  in  communication.    Investing  before  the  industrial  revolution  was  drastically  different  from  today  and  somewhat  limited  from  the  common  man.  Markets  were  inefficient,  assets  hard  to  transfer,  time  was  a  luxury,  and  most  did  not  have  discretionary  capital  to  invest.  The  transition  in  standards  of  living  and  societal  structure  can  be  seen  in  the  significant  real  wage  growth  spurred  from  industrialization.       Source:  Clark  2004  History  has  been  plagued  with  slow  economic  productivity  until  the  19th  century.  Common  investment  vehicles  utilized  pre-­‐industrialization  were  in  hard  assets  (land,  gold,  silver)  constrained  by  supply,  leading  to  a  more  dependable  store  of  value.    Capital  became  increasingly  necessary  to  build  the  factories  and  railroads,  leading  to  the  issuance  of  corporate  bonds  and  stocks.  One  of  the  leading  academics  on  financial  history  is  Niall  Ferguson,  who  authored  the  book  “The  Ascent  of  Money”.  In  summary  of  financial  evolution,  Ferguson  explains  that:     6  
  7. 7. From  the  thirteenth  century  onwards,  government  bonds  introduced  the  securitization  of   streams  of  interest  payments;  while  bond  markets  revealed  the  benefits  of  regulated  public   markets  for  trading  and  pricing  securities.     From  the  seventeenth  century,  equity  in  corporations  could  be  bought  and  sold  in  similar   ways.  From  the  eighteenth  century,  insurance  funds  and  then  pension  funds  exploited   economies  of  scale  and  the  laws  of  averages  to  provide  financial  protection  against   calculable  risk.  From  the  nineteenth,  futures  and  options  offered  more  specialized  and   sophisticated  instruments:  the  first  derivatives.  And,  from  the  twentieth,  households  were   encouraged,  for  political  reasons,  to  increase  leverage  and  skew  their  portfolios  in  favour  of   real  estate.  (Ferguson  2008,  341)  Reiterated  in  the  chart  below,  the  Economist  mapped  significant  innovations  across  the  timelines  originally  constructed  in  Gordon’s  research.  Major  improvements  in  transportation  lagged  GDP  growth,  but  it  seems  that  advancement  in  communications  were  adopted  at  a  quicker  pace  and  jumpstarted  the  largest  period  of  economic  growth  (GDP  terms)  in  history.       Source:  Economist  1,  2013  Technological  innovation  has  also  greatly  impacted  employment  demand  over  the  past  couple  of  centuries.  Manufacturing  advancements  streamlined  production  and  allowed  workers  who  were  previously  employed  in  labor-­‐intensive  roles  to  reevaluate  career  opportunities  and,  in  some  cases,  to  seek  higher  education.  The  reallocation  of  labor  from  agriculture,  low  skill  jobs  towards  white  collar  and  high  skill  occupations  becomes  evident  in  a  decade-­‐by-­‐decade  analysis  of  U.S.  civilian  employment  distributions.       7  
  8. 8.   Source:  Katz  and  Margo  2013  As  GDP  is  derived  from  the  productivity  of  a  nations  workforce,  effects  from  technological  innovation  on  employment  demand  shifts  are  indicative  of  long-­‐term  economic  trends.  From  the  1980s  through  2010,  research  has  displayed  a  hollowing  of  middle  skill  occupations  likely  due  to  the  computerization  of  related  duties  (Katz  and  Margo  2013).  The  polarization  of  workers  is  also  likely  to  impact  economic  growth  as  many  significant  drivers,  from  consumer  spending  to  income  taxes,  are  derived  from  this  middle  class.    To  further  understand  financial  market  relationships  through  more  recent  periods  and  to  help  investors  prepare  for  future  volatility,  an  analysis  of  four  cases  of  economic  uncertainty  are  presented  below.  Germany’s  Weimar  Republic  has  become  a  prime  example  of  monetary  policy  and  it’s  affects  on  investors  through  currency  debasement  and  uncontrolled  hyperinflation.  The  Great  Depression  gives  insight  into  the  political  monetary  relationship,  investing  through  high  unemployment,  economic  stagnation  and  unstable  price  environments.      Analysis  of  the  U.S.  economy  through  the  1970s  provides  investors  with  possibly  the  best  indicator  of  future  environments,  if  long-­‐term  forecasts  discussed  above  play  out,  because  it  was  the  birth  of  Staglfation  –  little  to  no  economic  growth  and  high  levels  of  inflation.  Finally,  a  look  at  the  top  performing  investments  through  Japan’s  lost  decade  and  beyond,  allows  insight  into  market  reactions  to  economic  stagnation,  an  aging  workforce,  high  debt  levels,  and  long-­‐term  price  instability.       8  
  9. 9. GERMANY’S  WEIMAR  REPUBLIC  Days  of  mass  stimulus  have  been  tried  before  and  held  devastating  consequences.  The  current  economic  and  monetary  environment  displays  traits  similar  to  that  of  past  crisis.  Learning  from  historic  market  events  and  how  to  manage  risks  associated  with  similar  policies,  mitigating  volatility  with  the  goal  of  earning  return  is  critical  to  today’s  investor  success.    The  Weimar  Republic  is  a  classic  period  of  hyperinflation,  where  unemployment  ran  wild,  economic  growth  stalled,  and  the  value  of  the  Reichsmark  dropped  like  a  hot  rock  until  it  ultimately  collapsed.  Germans  struggled  to  survive  during  this  period  due  to  the  devaluation  of  currency  resulting  in  the  erosion  of  most  life  savings.  Citizens  were  forced  into  a  pure  survival  mindset  that  challenged  many  societal  values.    Wartime  activities,  supply  shocks,  and  the  removal  from  the  gold  standard  allowed  the  German  government  to  exploit  its  currency  until  the  point  of  failure,  as  shown  in  the  chart  below.  Those  who  benefited  during  this  time  were  debtors  as  the  value  at  which  agreements  were  entered  vaguely  represented  the  present  value  of  underlying  currency.  Loans  were  written  off  at  relative  cents  on  the  dollar.       Source:  Gresham’s  Law  2011  Ronald  H.  Marcks,  who  wrote  Dying  of  Money  under  the  pen  name  Jens  Parsson,  described  equity  performance  throughout  this  period  as:   “At  the  height  of  the  boom,  stock  prices  had  been  bid  up  to  astronomical  price-­‐earnings   ratios  while  dividends  went  out  of  style.  Stock  prices  increased  more  than  fourfold  during   the  great  boom  from  February  1920  to  November  1921.  Then,  however,  shortly  after  the   first  upturn  of  price  inflation  and  long  before  the  inflationary  engine  faltered  and  business   began  to  weaken,  a  stock  market  crash  occurred.  This  was  the  Black  Thursday  of  December     9  
  10. 10. 21,  1921.  Stock  prices  fell  by  about  25  percent  in  a  short  time  and  hovered  for  six  months   while  all  other  prices  were  soaring.     Stocks  in  general  were  no  very  effective  hedge  against  inflation  at  any  given  moment  while   inflation  continued;  but  when  it  was  all  over,  stocks  of  sound  businesses  turned  out  to  have   kept  all  but  their  peak  boom  values  notably  well.  Stocks  of  inflation-­‐born  businesses,  of   course,  were  as  worthless  as  bonds  were.”  (Parsson  1974)  Investing  through  this  period  of  hyperinflation  was  obviously  more  volatile  than  anything  experienced  in  recent  years,  but  profitable  traits  still  remain  true  to  today’s  environment  and  managing  such  risk.  The  last  place  you  want  to  be  invested  in  times  of  extreme  inflation  is  cash  or  other  forms  of  debt  denominated  in  the  underlying  currency.  A  leading  journalist  and  author  on  Germany’s  Weimar  Republic  experience  explains  that,  “Speculators,  wealthy  industrialists  who  can  borrow  cheap,  debtors  like  the  government,  farmers,  and  those  with  mortgages  have  benefitted  the  most  from  hyperinflations”  (Fergusson  1974).  Investors  turn  to  hard  assets  (precious  metals,  real  estate)  and  commodities  as  a  store  of  value,  where  supply  is  constrained  by  relative  availability  or  production.  As  demand  for  necessities  increases  so  does  the  possible  return  from  transferring  such  assets.    A  necessary  consideration  of  investing  in  real  estate  is  the  opportunity  cost  of  renting  versus  owning  a  home.  As  inflation  rises,  the  purchasing  power  of  an  individual’s  income  shrinks  relative  to  an  increasing  rental  price.  Much  like  the  Weimer  Republic  days  of  hyperinflation,  investors  who  came  out  better  were  those  who  held  debt  financing.  Vehicles  such  as  TIPs  and  other  inflation-­‐indexed  hedges  are  now  available  to  protect  portfolios  should  a  similar  scenario  arise  today.    Stocks  generally  do  not  perform  great  during  periods  of  high  inflation,  but  past  experience  has  shown  they  are  on  average  better  investments  compared  to  holding  cash  or  government  bonds.  Equity  focus  should  be  constrained  to  inflationary  protected  businesses  that  operate  with,  or  own,  a  decent  amount  of  hard  assets.  Consumer  retail  and  financial  related  stocks  will  be  hit  the  hardest  when  individuals  lose  purchasing  power,  demand  plummets  and  creditors  are  left  holding  the  bag.    Takeaways:   • Debtors  benefit  during  periods  of  hyperinflation   • Avoid  cash  and  similarly  sensitive  investments  affected  by  the  debased  currency   • Hard  assets  and  commodities  typically  offer  protection  from  inflation’s  effects  and   offer  a  decent  return  opportunity   • Inflation  indexed  investments  can  by  utilized  to  hedge  volatility   • Seek  equity  investments  in  inflation  protected  businesses,  avoid  consumer  cyclical  and   finance  sectors     10  
  11. 11. THE  GREAT  DEPRESSION  The  fall  of  the  Weimer  Republic  to  Hitler’s  Germany  gave  way  to  the  Great  Depression  in  1930  and  eventually  WWII.  This  period  was  seen  with  high  unemployment  levels,  currency  swings  between  deflation  and  inflation,  and  stagnant  economic  growth  across  the  globe.  In  periods  of  deflation,  cash,  bonds,  and  other  debts  denominated  in  the  underlying  currency  increase  in  value.  Cash  becomes  a  scarce  resource,  increasing  its  relative  value,  as  the  real  value  of  hard  assets  drop.  It  pays  to  maintain  a  high  level  of  liquidity  as  financing  terms  tighten  and  debt  payments  become  costlier.  Fixed  income  assets  become  more  attractive  than  most  non-­‐dividend  paying  equities  to  preserve  capital.  As  the  real  value  of  hard  assets  drop,  the  purchasing  power  reserved  in  deflated  currencies  increases,  allowing  investments  at  more  equitable  entry  points.    Financially  stimulating  policies  implemented  through  the  middle  of  the  Great  Depression  swung  deflationary  pressures  to  inflationary  and  resulted  in  spurring  growth.  Equities  became  attractive  as  inflation  eroded  the  value  of  holding  cash  and  similarly  denominated  assets.    Top  performing  industries  through  the  Great  Depression  include  aerospace,  defense,  energy,  technology,  and  materials.  The  best  returning  stocks  if  purchased  during  the  depression  were:     Source:  Moscovitz  2009  Defense  spending  and  aviation  innovation  fueled  the  growth  of  companies  like  Electric  Boat  and  Honeywell  due  to  the  unique  demands  of  the  era.  If  the  U.S.  and  other  major  countries  were  to  enter  another  globally  conflicted  phase,  either  fueled  by  government  or  business  demand,  similar  companies  are  expected  to  return  a  comparable  market  performance.  The  key  is  trying  to  forecast  which  companies  will  be  driven  by  long-­‐term  demand  and  not  affected  by  intermediate  fluctuations.    Another  consideration  is  that  deflation  increases  an  individual’s  purchasing  power  and,  in  times  of  stagnant  economies  and  low  wage  growth,  people  are  more  willing  to  spend  their  discretionary     11  
  12. 12. income  on  cheap  fixes  that  provide  temporary  happiness  or  escape.  Sin  stocks  in  tobacco,  alcohol,  and  candy  companies  saw  more  growth  than  say  luxury  auto  manufacturers  through  the  Great  Depression.  When  compared  to  the  Great  Recession,  fast  food,  alcohol,  and  electronic  producers  have  seen  increased  sales  over  private  jet  or  high-­‐end  jewelry  firms  in  recent  periods  of  stagnation.       Source:  Zweig  1,  2009  WWII  boosted  the  global  economy,  giving  people  a  source  of  jobs  and  stimulus  through  government  wartime  spending.  The  period  following  this  era  also  exhibited  the  highest  real  incomes  in  U.S.  economic  history.  From  1963  to  2010,  the  top  performing  sectors  of  U.S.  equities  during  the  recessionary  phase  of  market  cycles  were  less  economically  sensitive  and  included     12  
  13. 13. consumer  staples  (100%),  health  care  (71%),  utilities  (71%),  and  telecom  (57%)  (Fidelity  Management  and  Research  2010).      Takeaways:   • Deflation  typically  increases  the  value  of  cash,  fixed  income  assets,  and  other  debts   sensitive  to  the  underlying  currency   • Inflation  erodes  the  value  of  holding  cash  and  similarly  sensitive  assets,  equities  offer   greater  return  opportunity   • Sin  stocks  and  cheap  luxuries  (ex.  personal  electronics)  typically  outperform  consumer   cyclical  and  luxury  sectors  through  periods  of  stagnation   • Consumer  staples,  health  care,  utilities,  and  telecom  sectors  of  U.S.  equities  have   performed  the  best  through  recessionary  phases  of  market  cycles       13  
  14. 14. DANCING  WITH  ANIMAL  SPIRITS  The  seventies  were  an  astronomical  decade  in  U.S.  monetary  policy,  a  turning  point  that  forever  changed  the  economic  political  relationship.  The  Federal  Reserve  vigorously  grasped  its  newly  acquired  tools  unshackled  from  the  gold  standard,  attempting  to  satisfy  mandates  by  directing  markets  through  fluctuating  interest  rates  and  the  money  supply  while  using  inflation  and  employment  as  indicators.    As  a  brief  history  of  central  bank  policy  modifications  and  market  reaction  through  this  period,  Steven  Cunningham  and  Polino  Vlasenko  explain:   On  August  15,  1971,  the  U.S.  abandoned  the  gold  exchange  standard  by  jettisoning  the   Bretton  Woods  Agreement.  The  dollar  depreciated,  and  oil  was  priced  internationally  in   dollars.  The  result  was  that  the  real  incomes  of  oil  producing  nations  crashed.  In  1973,  the   Shah  of  Iran  claimed  that  Middle-­‐Eastern  oil  producers  were  paying  300  percent  more  for   U.S.  wheat,  but  had  not  adjusted  oil  prices  accordingly.  On  October  16  of  that  year,  OPEC   raised  the  price  of  oil  by  70  percent  to  $5.11  a  barrel.  By  1981,  it  was  nearly  $40  a  barrel.     With  billions  of  dollars  redirected  to  oil-­‐related  purchases  in  the  U.S.  economy,  the  prices  of   other  goods  in  the  economy  would  have  fallen  as  demand  for  them  decreased.  According  to   the  Phillips  curve,  the  lower  prices  would  have  meant  higher  unemployment.  The  logic  left   the  Fed  with  little  choice.  If  the  Fed  did  not  increase  the  money  supply  to  stabilize  the   prices  of  non-­‐oil  products,  the  U.S.  would  have  faced  economy-­‐wide  deflation.   Unemployment  would  soar  as  profit  margins  collapsed.  Trying  desperately  to  manage  the   situation,  the  Fed  pumped  money  into  the  economy.   Once  the  oil  prices  stabilized,  the  Fed  could  not  remove  the  additional  money  from  the   economy  fast  enough.  The  result  was  higher  overall  inflation.  With  the  expectations  of  high   inflation  built  into  the  economy,  this  higher  inflation  no  longer  produced  lower   unemployment.  Instead,  the  economy  stagnated.  Stagflation  was  born.  (Cunningham  and   Vlasenko  2012)  Stagflation  is  characterized  as  an  economic  cycle  that  displays  slow  business  growth,  high  unemployment,  and  rising  inflation.  Graphed  below  is  the  annual  change  of  the  consumer  price  index  in  the  United  States  through  the  1970s.  With  normal  CPI  growth  in  the  range  of  2-­‐3%,  the  worst  years  of  this  decade  reached  12-­‐15%  annual  growth.  Upward  price  pressure  and  downward  business  and  wage  growth  created  a  difficult  environment  for  consumers  and  investors  alike.     Source:  Trading  Economics,  Bureau  of  Labor  Statistics  2013     14  
  15. 15. Analyzed  on  a  longer  time  frame,  it  becomes  apparent  that  consumer  prices  remained  consistently  stable  from  1775  until  1970.  Since  the  removal  from  the  gold  standard,  prices  have  jumped  ten  times  relative  to  purchasing  power  in  the  early  twentieth  century.  Although  major  economic  advancements  have  come  through  a  looser  monetary  policy,  the  frequency  of  market  volatility  and  downside  risk  associated  with  rebalances  has  increased.     Source:  Liberty  Blitzkrieg  2013  U.S.  Consumers  will  likely  be  hit  the  hardest  due  to  their  inability  to  evade  inflated  prices  of  necessary  goods  and  erosion  of  cash  sensitive  accounts.  The  yield  on  most  money  market  or  savings  type  accounts  will  net  a  negative  return  with  high  inflation,  increasing  the  need  to  venture  into  higher  risk  assets.  Investors  looking  for  a  diversified  portfolio  including  fixed  income  should  seek  short  duration  terms  and  inflation  protected  vehicles  to  minimize  negative  effects.  So,  what  asset  classes  performed  the  best  through  recent  periods  of  inflation?    It  all  depends  on  the  relative  economic  stage.  Equities  outperform  all  other  classes  as  inflation  rises  from  a  low  below  3.3  percent,  as  displayed  in  the  chart  below.  After  this  median  is  reached  and  inflation  continues  rising,  commodities  become  the  top  performing  sector  and  equities  returns  significantly  fall.  Rebalancing  a  portfolio  to  adapt  to  these  changes  is  increasingly  difficult  due  to  the  lag  in  data  available  relative  to  real  time  market  decisions.       15  
  16. 16.   Source:  JP  Morgan  Asset  Management  2012  Investing  in  businesses  that  hold  competitive  advantages  and  are  focused  on  commodities  or  other  hard  assets,  operating  in  international  and  emerging  markets,  can  insulate  portfolios  from  rising  domestic  inflation  risk.  Certain  producers  are  also  positioned  better  to  maintain  profit  margins  as  demand  of  necessary  goods  (food,  clothing,  shelter,  transportation)  varies  less  then  discretionary  sectors  through  high  inflation  and  slow  growth.    The  rapidly  evolving  U.S.  energy  market  will  become  even  more  important  to  investors  as  energy  and  the  development  of  domestic  natural  resources  increases  as  an  economic  growth  driver.  Balancing  responsible  economic  and  environmental  policies  to  control  resource  extraction  and  development  will  increase  sector  volatility  in  the  short-­‐term,  but  investing  in  well  diversified  and  alternative  energy  companies  to  return  alpha  is  a  necessary  consideration  for  today’s  investors.  The  1970’s  in  the  United  States  were  a  period  of  high  unemployment,  rising  prices  (inflation),  and  stagnant  business  growth  spurred  from  policy  changes  and  supply  spikes.  Based  on  research  referenced  throughout  this  report,  it’s  plausible  the  U.S.  economy  is  reentering  a  similar  phase,  which  some  predict  to  last  much  longer  then  what  was  experienced  in  the  seventies.  Takeaways:   • Equities  outperform  all  other  classes  as  inflation  rises  from  a  low  below  3.3  percent,   above  this  median  commodities  become  the  top  performers   • Businesses  that  hold  competitive  advantages  and  focused  around  commodities,   operating  in  international  and  emerging  markets,  can  insulate  portfolios  from  domestic   inflation  risk   • Necessary  goods  producers  remain  more  consistent  than  discretionary  sectors  through   high  inflation  and  stagnant  growth   • Diversified  energy  companies  and  related  alternative  tech  innovators,  aimed  at   improving  energy  productivity,  hold  significant  growth  opportunity     16  
  17. 17. THE  LOST  DECADE  During  the  1980s,  Japan  was  a  model  economy  that  most  developed  country’s  strived  to  emulate.  After  twenty  plus  years  of  stagnation,  Japan  has  become  the  prime  case  in  analyzing  how  to  profit  through  similar  environments.    The  collapse  of  a  housing  and  stock  market  bubble  has  left  Japan’s  economy  in  a  rut  that  government  policy  makers  cannot  seem  to  resolve.  The  chart  below  is  of  the  NIKKEI  225,  an  average  price-­‐weighted  stock  index  that  tracks  the  top  225  companies  on  the  Tokyo  Stock  Exchange.  Japan’s  market  peaked  in  December  1989  at  38,916  and  has  fallen  81.9  percent  to  its  lowest  level  of  7,054  in  March  2009.  The  NIKKEI  has  slightly  recovered  from  its  low  and  currently  trades  around  11,000;  about  70  percent  below  it’s  1989  peak.       Source:  Yahoo  Finance  2013  The  Japanese  people  have  dealt  with  a  great  deal  of  economic  volatility  since  the  bubble  collapsed,  mainly  high  unemployment  with  swings  of  deflationary  pressure.  The  country’s  central  banking  authority,  the  Bank  of  Japan  (BoJ),  recently  adapted  its  monetary  strategy  to  follow  similar  expansionary  policies  as  the  Federal  Reserve  in  hope  of  stimulating  economic  growth.  BoJ  plans  to  inject  13  trillion  yen  ($145B)  per  month  in  an  attempt  to  achieve  2%  inflation  target,  possibly  starting  in  January  2014.  This  could  initiate  a  similar  environment  in  Japanese  equities  that  the  U.S.  markets  experienced  in  mid  2009,  rallying  from  historic  lows.  Stephen  King  of  HSBC  recently  told  Reuters  that:   Japan  has  failed  to  deliver  lasting  recovery  for  two  decades  now  so  the  political  case  for   doing  something  more  radical  is  now  quite  high  and  I  think  the  BoJ  understands  that,  but  if   this  is  pushed  too  far,  the  BoJ  simply  becomes  an  agent  of  MoF  and  then  the  risk  is  that   either  foreign  investors  or  domestic  residents  lose  their  faith  in  money,  raising  the  risk  of   inflation  overshoot  and  yen  collapse…  Weak  financial  systems  can  be  more  easily  managed   when  structural  growth,  led  by  productivity  gains,  is  so  high.  Japans  problem  was  that  it   reached  the  global  technology  frontier  in  the  late  1980s,  exposing  its  banking  weakness.   (Reuters  GMF,  pers.  comm.)  Capital  injections  will  translate  into  a  cheaper  Yen  relative  to  international  currencies,  where  the  BoJ  hopes  to  inflate  away  some  government  debt  and  stimulate  increased  exports  as  prices  of     17  
  18. 18. goods  manufactured  domestically  become  relatively  cheaper.  Neighboring  Asian  manufacturers,  such  as  South  Korea,  will  likely  feel  negative  economic  impacts  from  Japan’s  accommodative  monetary  policies  as  their  pricing  becomes  less  competitive.  Markets  are  already  pricing  in  stimulus  expectations  as  exhibited  through  the  recent  rally  in  Japanese  equities.    But  until  the  effects  from  stimulus  take  hold  it  remains  necessary  to  avoid  currency  denominated  or  driven  investments  in  a  deflationary  environment.  Financial  companies  lose  on  liabilities  as  consumers  profit  from  holding  currency  in  periods  of  deflation.  The  top  performing  stocks  through  Japan’s  20  year  stagnation  have  been  focused  in  stable  operating  environments  fueled  by  strong  consumer  demand,  usually  diversified  amongst  export  markets  (Weeratunga  2010).    The  composition  of  sectors  included  in  major  Japanese  indices  changed  significantly  over  this  period,  but  all  major  indicators  of  the  local  equity  market  display  similar  trends.  The  best  sectors  in  the  TOPIX,  which  tracks  the  first  section  of  Tokyo  Stock  Exchange,  from  1990  to  2010,  were  health  care,  utilities,  consumer  discretionary,  and  information  technology.       Source:  Weeratunga  2010  Bellwether  firms  that  hold  proprietary  research,  brand  name,  or  any  other  form  of  competitive  advantage  differentiate  true  winners  amongst  the  crowd.  These  companies  exhibit  long-­‐term  growth  prospects  not  likely  to  be  undercut  through  competition  or  damaged  by  intermediate  economic  fluctuations.  When  analyzing  not  only  long-­‐term  sector  trends,  but  also  individual  company  returns,  it  becomes  apparent  that  successful  firms  globally  diversify  revenue  streams  (Weeratunga  2010).  The  following  table  displays  top-­‐performing  companies  in  the  TOPIX  from  1993  to  2010.       18  
  19. 19.   Source:  Weeratunga  2010  In  times  of  uncertainty  non-­‐cyclical  economically  defensive  stocks  offer  refuge  from  volatility  through  consistent  revenue  and  common  dividend  payments,  resulting  in  performance  comparable  to  the  Great  Depression  period  in  the  U.S.  The  portion  of  internationally  diversified  earnings  relative  to  long-­‐term  market  performance  is  also  clearly  visible.  This  trait  will  likely  become  harder  to  achieve  in  U.S.  equities  due  to  significant  increases  in  market  correlations.  Japan  also  holds  a  significant  aging  population  that  drives  profitability  of  health  care  related  companies,  another  trend  likely  to  develop  further  in  U.S.  markets  as  similar  demographic  shifts  unfold.    Takeaways:   • Financial  companies  lose  on  liabilities  as  consumers  profit  from  holding  currency  and   debt  in  periods  of  deflation   • Best  performing  Japanese  equities  have  been  focused  in  stable  operating  environments   fueled  by  strong  consumer  demand  with  internationally  diversified  earnings.  Top   sectors  include  health  care,  utilities,  consumer  discretionary,  and  information  technology   • Seek  bellwether  firms  that  hold  proprietary  research,  brand  name,  or  other  forms  of   competitive  advantage  to  protect  against  volatility   • Non-­cyclical  economically  defensive  stocks  offer  refuge  from  volatility  through   consistent  revenue  streams,  and  many  offer  dividend  payments         19  
  20. 20. 3. Adding  it  Up  Market  performance  across  history  has  taught  invaluable  lessons  that  must  not  be  ignored  given  the  similarity  in  recent  developments.  With  that  in  mind,  developed  economies  seem  to  be  entering  a  period  unique  to  only  future  environments  that  are  certain  to  differ  from  past  market  reactions.  The  globalization  of  economies  and  significant  improvements  in  financial  efficiency  has  led  to  highly  interconnected  markets  that  shift  on  a  multitude  of  factors.    Germany’s  Weimar  Republic  displayed  the  damaging  effects  of  uncontrolled  currency  debasement,  supply  shocks,  and  resulting  hyperinflation.  Relative  to  today,  investors  must  take  away  the  importance  of  avoiding  cash  and  equally  affected  investments  and  seek  diversification  amongst  equities  more  protected  from  inflation’s  eroding  power.    The  Great  Depression,  1970s  U.S.  experience,  and  Japan’s  Lost  Decade  exhibit  many  differences  unique  to  each  period,  but  also  similarly  profitable  investing  traits.  In  times  of  high  unemployment,  stagnant  economic  growth,  and  price  instability,  investors  are  best  served  by  seeking  refuge  in  economically  defensive  assets  that  hold  competitive  advantages  unlikely  to  be  stolen.  Examples  of  these  include  vehicles  driven  by  necessity,  like  healthcare  and  sin  stocks.  The  value  of  short  duration  debt  holds  when  interest  rates  rise  and  chance  of  default  increases,  commonly  seen  in  periods  of  inflation.  U.S.  real  asset  returns  across  investment  classes  throughout  recent  history  exhibit  the  importance  of  such  considerations.       Source:  Barro  and  Misra  2013  The  most  recent  decade  of  monetary  intervention  is  unprecedented  as  the  majority  of  central  banking  authorities  the  world  over  hold  to  seemingly  unending  quantitative  easing  and  zero  interest  rate  policies.  The  infusion  of  cheap  credit  is  not  driven  by  actual  demand,  rather  asset  purchase  programs  attempting  to  stimulate  real  economic  growth.  As  an  investor,  it’s  necessary  to  question  if  recent  market  gains  are  inorganic  and  try  to  anticipate  what  will  happen  when  the  music  stops.  Hopefully  these  monetary  authorities  can  successfully  balance  policy  objectives  while  smoothly  deleveraging  without  collapse.    Central  banks  are  left  with  little  room  for  downward  rate  movements  given  the  zero  bound.  Because  of  this,  it  is  likely  the  yield  on  cash  and  rate  sensitive  investments  have  only  one  direction  to  move.  This  is  bad  for  fixed  income  assets  because  relative  values  are  inversely  related  to  interest  rates,  meaning  as  rates  adjust  upward  the  prices  at  which  bonds  trade  will  fall.       20  
  21. 21. Given  the  current  environment,  the  Economist  recently  projected  future  returns  over  the  next  decade  and  found  that,  “Government  bonds  look  like  the  least  attractive  asset  to  hold”,  and  achieving  superior  equity  returns  will  be  difficult  because,  “the  cyclically  adjusted  price-­‐earnings  ratio  is  well  above  the  historical  average”  (Economist  2,  2013).  They  believe  the  highest  opportunity  for  return  will  be  found  in  U.S.,  European,  and  British  equity  and  housing  markets.       Source:  Economist  2,  2013  When  looking  at  the  relative  equity  market  value  as  a  whole,  in  price  to  earnings  terms,  over  the  long  run  it  becomes  apparent  it’s  currently  slightly  overvalued  but  nowhere  near  the  heights  of  the  dot  com  bubble.  If  investors  lose  hope  on  U.S.  stock  returns,  the  retreat  to  safer  assets  and  more  auspicious  markets  will  lower  domestic  valuations  and  create  opportunity  for  higher  returns.  This  concept  was  exhibited  through  the  market  rally  from  U.S.  equity  lows  of  2009.    Investors  holding  U.S.  stocks  over  the  long  run  will  likely  outperform  those  flipping  between  investments  in  more  short-­‐term  rosy  markets.  A  country’s  economic  growth  relationship  with  stock  market  returns  can  be  deceptive.  For  example,  “the  Chinese  economy  has  expanded  far  faster  than  those  of  Latin  America.  Meanwhile,  Latin  stocks  earned  an  average  of  8.2  percent  annually,  while  Chinese  stocks  averaged  less  than  a  1  percent  annual  return”  (Zweig  2,  2012).  As  demonstrated  in  the  chart  below,  the  most  consistent  highest  returning  investments  include  emerging  and  international  equity  market  indexes.  Analyzing  total  returns  across  asset  classes  over  the  past  decade  reaffirms  the  importance  of  diversification  and  rebalancing  to  minimize  volatility.  This  concept  will  be  discussed  in  greater  detail  in  the  following  portfolio  strategy  section.           21  
  22. 22.   Source:  JP  Morgan  Asset  Management  2012  As  mentioned  above,  the  relationship  between  economic  growth  and  stock  market  returns  can  be  deceptive.  GMO  research  displayed  in  Jeremy  Grantham’s  latest  newsletter  proves  a  negative  correlation  between  the  two  factors  over  the  past  thirty  years.  Even  though  this  concept  seems  counterintuitive,  historical  data  on  developed  economies  supports  the  claim.  If  innovation  stalls,  and  U.S.  productivity  continues  to  decline,  the  stock  market  might  actually  perform  better.  Even  though  this  might  be  true  over  historic  periods,  because  of  monetary  intervention  and  a  multitude  of  macroeconomic  factors  unique  to  the  current  environment  investors  must  proceed  with  caution.     Source:  Grantham  2,  2013  If  volatility  increases  and  earnings  growth  stagnates  consumers  will  be  forced  to  adapt,  shifting  purchasing  behavior  accordingly.  Expenditures  are  likely  to  trend  towards  maximizing  well-­‐being     22  
  23. 23. and  minimizing  excess.  Necessities  such  as  food  and  water,  shelter,  clothes,  alternative  transportation,  energy,  and  defense  become  vitally  important  as  capital  available  for  service  and  luxury  related  purchases  shrink.  Debt  and  equity  markets  rebalance  to  the  new  economic  conditions,  valuing  low  cost  manufacturers  of  necessities  higher  than  more  economically  sensitive  luxury  manufacturers  or  service  providers.    Resource  supply  will  greatly  influence  the  pricing  of  necessities  due  to  significant  population  growth  across  the  globe.  Securing  rights  to  critical  inputs  will  become  a  major  challenge  for  developed  governments  and  leading  manufacturers.  Companies  and  governments  with  the  capital  and  network  resources  to  secure  such  reserves  will  greatly  determine  the  long-­‐term  growth  ability  of  underlying  markets.  A  cannibalization  of  wasteful  processes  and  technologies  is  probable,  increasing  the  likelihood  of  achieving  higher  investment  returns  from  firms  that  hold  secure  competitive  advantages.  Necessity  demand  and  resource  supply  are  factors  that  must  be  considered  when  constructing  a  selectively  diversified  portfolio  in  attempt  to  increase  alpha  while  minimizing  beta.         23  
  24. 24. 4. Creating  a  Selectively  Diversified  Strategy  For  the  average  investor,  holding  a  portfolio  of  individual  companies  is  extremely  risky  and  will  most  likely  underperform  market  benchmarks.  It  has  never  been  more  important  to  focus  on  each  underlying  asset’s  resilience  when  constructing  a  strategy.  By  utilizing  the  many  financial  tools  and  vehicles  that  are  widely  available,  a  selectively  diversified  portfolio  that  arbitrages  economic  trends  has  the  greatest  opportunity  for  success  through  market  cycles  over  the  long  run.    Simple  strategies  that  are  robust  in  nature  prove  more  reliable  for  investors  to  maintain.  A  portfolio  retains  significant  capital  appreciation  through  compounding  value  gained  over  many  years  by  minimizing  transaction  costs  and  maintaining  low  turnover.  Proper  diversification  and  rebalancing  guided  by  individual  tolerances  is  also  necessary  to  achieve  these  standards.  Return  opportunities  diminish  as  more  capital  flows  into  passive  vehicles,  like  ETFs  and  index  funds.  To  optimize  this  risk  and  return  relationship,  the  following  strategy  suggestions  are  given  as  possible  opportunities.   EQUITIES  Investing  in  companies  who  hold  competitive  advantages  like  R&D,  proprietary  technology,  or  brand  image  will  prove  more  resilient  than  younger  firms  without  such  resources.  The  few  that  hold  multiple  competitive  advantages,  proven  management,  and  consistent  financial  resource  create  a  defensive  moat  further  protecting  against  volatility  and  increasing  the  probability  of  long-­‐term  growth.  Targeting  sectors  that  include  major  holdings  of  companies  that  exhibit  these  traits  should  be  given  major  consideration  when  constructing  a  balanced  portfolio.  History  has  shown  that  consumer  defensive,  health  care,  technology,  and  related  industries  that  hold  similar  traits  perform  the  greatest  through  moderate  growth,  high  unemployment,  and  politically  unstable  environments.    As  global  population  growth  continues  and  major  demographic  shifts  evolve  in  emerging  markets,  investments  in  energy  productivity  and  disruptive  innovators  will  follow.  Capturing  sectors  that  profit  from  such  demand,  securing  resources,  or  investing  in  renewable  energy  technology  in  portfolio  strategy  is  increasingly  critical.  Firms  that  position  themselves  to  harness  the  changes  already  occurring,  by  improving  or  transforming  consumption  efficiency,  should  greatly  aid  in  supporting  a  nation’s  long-­‐term  growth.  Possible  catalysts  to  innovation  include  employment  supply  and  demand  relationships,  which  have  significantly  changed  over  the  past  thirty  years.  Immigration  and  the  proportion  of  females  in  the  work  force  have  greatly  influenced  real  wage  growth  and  competition  across  almost  every  sector  of  the  American  economy.  Companies  have  a  larger  base  of  candidates  to  choose  from,  increasing  competition  and  restraining  growth  in  real  wages.  This  is  a  positive  force  for  the  country’s  overall  productivity  as  more  workers  are  generating  value,  but  could  also  be  attributed  to  the  polarization  of  income  equality.    With  relatively  cheaper  labor,  firms  become  more  selective  when  hiring  and  have  incentive  to  reinvest  capital  in  improving  operating  efficiencies.  This  drives  down  the  demand  for  low  skill  workers  and  rewards  innovation  in  improving  processes.  Optimization  is  a  supporting  factor  to  improving  short-­‐term  efficiencies,  and  ultimately  profitability,  but  can  significantly  inhibit  the  long-­‐term  disruptive  growth  opportunities  of  an  industry.  Research  on  the  various  types  of  business  innovation  and  resulting  effects  have  been  greatly  explored  by  Harvard  Business  Professor  Clayton  Christensen.       24  
  25. 25. As  an  investor,  the  highest  prospect  for  future  growth  lies  with  companies  that  balance  capital  reinvestments  not  only  in  improving  efficiencies  but  also  in  disruptive  innovation.  Characteristics  of  this  trend  are  commonly  exhibited  through  private  equity  investment  risks  and  returns.  This  is  not  practical  for  the  average  person  due  to  the  capital  requirement  necessary  to  analyze  and  track  every  aspect  of  multiple  companies  while  looking  for  profitable  innovators,  but  the  main  idea  can  be  attributed  to  larger  industries  in  general.    It  is  highly  unlikely  that  technological  evolution  will  continue  along  a  linear  path.  Yet,  over  the  long  run  the  greatest  opportunity  for  return  has  been  created  by  firms  willing  to  invest  in  disruptive  innovation.  Individual  investors,  unable  to  meet  secondary  market  requirements,  should  invest  in  technology  as  a  whole.  The  reason  being  that  the  cream  (disruptive  innovators)  is  likely  to  rise  to  the  top  and  support  widespread  growth.  Whether  through  proprietary  research  and  development  or  acquisitions  and  mergers,  companies  able  to  disrupt  such  spaces  are  often  the  proven  leaders  that  hold  management  and  financial  capabilities.  Granted,  financing  such  ventures  in  an  early  stage  creates  higher  opportunity  for  return,  but  also  significantly  increases  the  risk  of  losing  capital.  This  is  often  not  feasible  to  the  average  investor  with  a  long-­‐term  strategy.  Investing  in  technology  as  a  whole  also  provides  some  diversification  against  tech  value  traps.    If  a  moderate  economic  growth  climate  persists,  the  compounding  effects  earned  from  investing  in  equities  that  pay  dividends  becomes  even  more  important.  Stocks  that  pay  dividends  offer  a  consistent  level  of  income,  above  earnings  growth,  that  significantly  increases  return.  In  fact,  research  has  proven  that  dividend  payers  outperform  non-­‐dividend  payers  through  bull  and  bear  markets  (BlackRock  2013).    Earning  a  consistent  cash  flow  over  long  periods  of  time  supports  investors  through  slowing  growth  and  economic  volatility.  For  a  historical  perspective  of  such  differences,  the  chart  below  exhibits  the  S&P  500  average  annualized  returns  broken  into  capital  appreciation  and  dividends  from  1926  through  2012.       Source:  JP  Morgan  Asset  Management  2012  Takeaways:   • Seek  robust  and  economically  defensive  equities  that  hold  multiple  competitive   advantages   • Companies  focused  on  advancing  the  energy  productivity  and  resource  acquisition  and   processing  space  offer  significant  return  potential   • Disruptive  innovators  will  drive  economic  and  portfolio  growth   • Dividends  provide  consistent  return,  protect  against  swings  in  capital  appreciation     25  
  26. 26. FIXED  INCOME  Major  emphasis  is  given  to  equity  investments  because  they  conceivably  provide  superior  protection  against  inflationary  pressures  that  are  likely  to  fluctuate  in  coming  years.  The  results  of  such  an  outcome  could  be  devastating  to  those  holding  currency  denominated  or  fixed  income  vehicles  tied  to  the  effects  of  monetary  intervention.  Given  the  time  horizon  of  many  investors,  diversification  amongst  fixed  income  vehicles  is  necessary  to  preserve  capital.  Because  the  current  environment  for  such  investments  is  likely  to  increase  in  volatility,  portfolio  allocations  should  incorporate  today’s  unprecedented  risks  before  trends  reverse.  Hedging  positions  with  short-­‐term  government  securities  or  TIPs  might  offer  a  decent  refuge  from  such  uncertainty.    Utilizing  a  globally  diversified  bond  index  or  other  form  of  high-­‐grade  credit  offers  the  greatest  opportunity  for  return  in  this  space.  Individual  fixed  income  investments  should  remain  short  in  duration  until  the  economic  outcome,  as  affected  by  central  banks,  stabilizes.  Fixed  income  assets  could  preserve  value  and  possibly  offer  decent  return,  dependent  upon  global  economic  volatility,  if  interest  rates  maintain  at  a  permanent  low  level.  If  risks  driven  by  growing  populations  and  aging  demographics  seriously  conflict  the  global  economy  it’s  likely  that  fixed  income  vehicles  would  outperform  other  investment  classes.  But,  such  a  case  is  doubtful  unless  developed  economies  crumble  or  some  catastrophic  event  occurs.    Takeaways:   • Limit  exposure  to  interest  rate  sensitive  vehicles   • Seek  short  duration  fixed  income  assets   • Indexed  fixed  income  assets  (ex.  TIPs)  provide  hedge  against  inflation,  but  also  hold   interest  rate  risk     • Globally  diversified  indexes  that  hold  high  grade  credit  offer  some  protection  against   default  and  rate  fluctuations   ALTERNATIVE  Real  estate  investments  look  appealing  given  current  valuations  relative  to  pre-­‐crisis  heights  and  low  financing  rates,  but  when  cap  rates  adjust  after  monetary  easing  ceases,  property  values  will  fluctuate  wildly.  Overly  optimistic  valuations  and  projections  of  this  industry’s  recovery  paired  with  reversing  rates  could  form  another  bubble.  Given  these  circumstances,  it  is  advisable  for  the  average  investor  to  limit  allocations  in  this  space  to  relative  need  based  on  immediate  utility  received.    One  of  the  most  plausible  methods  of  government  shedding  debt  is  by  deflating  its  currency  and  is  witnessed  throughout  many  recent  crises.  Alternative  investments,  driven  by  supply  and  demand  characteristics  or  other  unique  traits,  should  rise  in  value  over  the  long  run.  This  is  a  broad  statement  that  carries  macroeconomic  risks  unique  to  each  underlying  assets.    The  market  has  already  priced  in  current  volatility  and  as  interest  rates  normalize,  it  is  very  likely  to  see  a  reversion  in  gold  prices  maintained  at  a  higher  support  level.  Also,  it  is  important  to  note  that  today’s  financial  markets  offer  vehicles  that  more  effectively  hedge  various  risks  without  removing  as  much  alpha.       26  
  27. 27.   Source:  Kendall  and  Deverell  2013  Investors  are  likely  to  see  increased  inflation  throughout  international  markets  as  monetary  authorities  continue  their  attempts  to  stimulate  growth,  most  recent  driver  being  Japan’s  expected  2%  inflation  target.  But  these  forecasts  shouldn’t  drive  gold  price  expectations.  Research  shows  little  correlation  exists  between  changes  in  one-­‐year  inflation  expectations  and  gold  price  adjustments  over  the  past  twenty-­‐five  years  (Kendall  and  Deverell  2013).  In  terms  of  general  commodity  prices,  inflation  has  shown  to  be  more  closely  related.       Source:  JP  Morgan  Asset  Management  2012  With  resource  scarcity  in  certain  precious  metals,  shifting  weather  patterns  affecting  commodity  pricing,  and  exponentially  growing  population  demands,  commodities  and  related  investments  are  likely  to  increase  in  value  as  these  trends  evolve.  Portfolio  strategy  should  include  exposure  to  natural  resource  assets,  with  the  most  advisable  vehicle  being  an  ETF  or  similar  fund  that  contains  globally  diversified  holdings.    Capturing  such  growth  will  become  increasingly  important  to  insure  significant  return  opportunity  and  to  hedge  against  the  risk  of  rising  manufacturer  input  prices.  With  economic  growth  in  emerging  markets  projected  to  continue  at  a  decent  rate  over  the  near  future,  commodity  demand  growth  should  remain  fairly  consistent.  Further  price  support  will  be  gained  if  developed  economies  recover  better  than  expected.       27