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Quarterly Newsletter July 2005

Quarterly Newsletter | July 2005

When everyone is absolutely sure of something you can bet it won’t happen. Take the dollar: Nobody would scarcely 4 months ago. In March, it cost $1.35 to buy a Euro. Now, we can buy a Euro for only $1.19; almost a 13 month high and a 12% strengthening of the dollar. Nearly every expert and TV pundit was predicting the dollar would continue its decline, becoming worthless in a few years. There were stories of central banks the world over selling dollars furiously to buy Euros. No one would buy U.S. Treasuries anymore. The dollar was sure to loose its status as the world’s reserve currency. Even our buddies, the Saudis, it was rumored, were considering requiring payment for oil in Euros; anything but dollars. How dare they? What changed? Well, for one thing everyone seemed to temporarily forget about the reality of Europe: continued sluggish growth and high unemployment. The Eurozone is forecast to growth at a meager 1.6% this year. The US will most likely grow at twice that rate. (The US grew at 3.8% in the 1st Quarter). Eurozone unemployment is about 9%, while it’s only 5% in the U.S. Then politics reared its ugly head. The French and Dutch voted NO on the European constitution. Could the so-called European Union (EU) become unglued? Why would anyone want Euros? Now don’t misunderstand me, I am not making any predictions regarding foreign exchange rates. In fact, the dollar may eventually continue to decline especially against non Euro currencies. I think the lesson here is that when the dollar’s weakness is front page news and dollar hedging strategies become the buzz, we have probably reached a turning point.

The second quarter saw a variety of returns among the major asset classes. The S&P 500 gained a modest 1.3%. Small and midsize companies continued to do better. Bonds rallied, with the Lehman Aggregate index moving up 3%. In keeping with our discipline of investing in top performing mutual funds in the most attractive asset classes, we made a change to most portfolios.  To review, every month I analyze over 50 world-wide asset classes considering both risk and return. Last month, mutual funds which invest primarily in foreign European companies became much less attractive and were sold. This reflects both the weakness in the Euro and the poor fundamentals for most European economies. Conversely, funds which invest in large growth domestic companies, (e.g. tech, health care, etc.) became slightly more attractive and replaced the foreign fund. This is notable because we haven’t had exposure to large growth for many years. Remember that normal market action is two steps forward and one step back. By continuing to move slowly toward leadership as it is confirmed, we will be positioned to reap the rewards of the next major trend. Significant periods of outperformance last several years and can result in substantial gains for disciplined investors. We call this tactical (as opposed to fixed) asset allocation. Small and mid-size domestic company funds continue to look attractive. And our mutual funds in those asset classes are top performers.

My base-case expectation is that equity returns will average in the high single digits over the next three to five years, whereas domestic bond returns—due in large part to their extremely low absolute yields—are going to have a hard time gaining beyond the low single digits, although they can still provide important diversification for more conservative investors in the event of a large equity-market decline. (Of course, there are a range of possible outcomes, and the base case is simply the mid point of the most likely outcome.) I also expect, although there are no guarantees, our disciplined investment process will add to base case assumptions. Among the equity asset classes, I view small-caps as being slightly pricey relative to large-caps. I’m neutral between value and growth (although we have seen some evidence suggesting that growth stocks are becoming more attractive on a valuation basis), and I view foreign stocks as having similar return potential to domestic equities, assuming currency movements are not factored in.

Bond Return Assumptions

Ten-year Treasury yields are often used by long-term investors as a proxy for a risk-free investment and as such become the hurdle that riskier investments must be likely to beat (Why take risk if you aren’t getting adequately rewarded for it?). For the past few years, many smart investment thinkers have been expecting interest rates to rise. While this has happened at the short end of the yield curve, as the Fed has repeatedly raised rates, it has not happened at the longer end of the yield curve. In other words, yields on cash are much better, while yields on long bonds are little changed. More recently, some smart bond people (such as PIMCO’s Bill Gross) have adjusted their views, and now expect rates to remain low for at least the next several years. I believe the risk of rates going higher, at least temporarily, remains material over the next few years, and that there are good reasons from a portfolio strategy standpoint to consider higher rates in setting return expectations. Given how close the call is between rates staying low or rising for a time (as both camps readily admit), I think it more prudent to consider higher rates in allocating our portfolios. Consequently we are avoiding the most interest sensitive bonds, e.g. US Treasuries, and emphasizing bond funds which have a flexible mandate and include high yield and emerging market debt. Also bond funds which invest in bank loans are attractive given the loans have variable interest rates.

What a Lower-Rate Environment Might Look Like

Those in the rates-will-stay-low camp (there are plenty of smart people on both sides of the argument) believe rates aren’t likely to rise given that the only real demand globally stems from U.S. consumers, whose spending is partly fueled by an unsustainable inflation in asset prices such as homes. In the meantime, exporters from overseas are happy to sell us goods and their central banks loan the proceeds back to us by buying Treasuries, which keeps their currencies weaker than they would otherwise be versus the dollar, and keeps our interest rates lower, which in turn keeps asset prices inflating (the so-called “Bretton Woods II” environment, as opposed to the original Bretton Woods which set fixed exchange rates between currencies). But, in this type of environment it is also likely that:

  • Weak growth in corporate earnings from low global demand could easily discourage equity investors.
  • Americans would still not be saving enough i.e. the huge current account deficit. This would be a big problem down the road, and it’s hard to imagine the market wouldn’t reflect this.
  • The expansion of asset prices, specifically real estate, would eventually require a correction at some point.

The rates-stay-low scenarios depend on the Bretton Woods II environment holding together for a few more years. But if the Chinese allow their currency to float more freely, as they may be considering, it would likely appreciate against the dollar (meaning the dollar would decline), potentially leading Asian central banks to reduce their purchases of Treasuries. The probabilities of a Chinese yuan revaluation and/or further dollar declines are hard to assess, but compelling arguments can be made for both.

We have a huge current account deficit relative to GDP. Maybe it’s sustainable, but common sense says it’s not. The big question is when will it turn around? A declining dollar is a very big piece of how this would be corrected, and while a dollar decline would traditionally lead us to expect an increase in inflation, I think the bigger impact could come from the decline in foreign demand for Treasuries. The absence of that demand could cause rates to rise, which further down the road might have a deflationary impact if consumption plunges due to the higher interest rates and correction in home prices. I have yet to see a good answer to the question of how big a current account deficit is actually sustainable, but at an all-time high of 6.4% of GDP, it’s hard to imagine that we’ll be able to avoid additional meaningful declines in the dollar at some point. Since 2001, the dollar has dropped a lot in real terms versus major currencies (euro, yen, Canadian dollar, U.K. pound, etc.) but much less so versus other important trading partners (including China, Asia ex-Japan, Mexico and several Central American countries, Saudi Arabia, and others). So while the declines we’ve already seen might in theory eventually repair our current account deficit, in functional terms the declines have not yet taken place in many of the areas where they are most needed.

And furthermore, I see the risk as being somewhat asymmetrical: the risk of a strong, persistent dollar appreciation seems much less likely than a dollar depreciation over the next three to five years. If the euro vanished, there would probably be a short-term rally in the dollar as a “safe haven” currency amid the turmoil, but our structural imbalances would remain, and longer-term dollar depreciation would still need to take place. Of course, there could be real economic fallout from European disunity: confidence in their capital markets could deteriorate, falling currencies and weak growth could lead to stagflation, and so on. But historically it has been difficult to say with much confidence how currency movements play out in the real economy.

To summarize, I think the most likely scenario (again, there is a high level of uncertainty in any scenario, so take “likely” with a grain of salt) is that earnings weaken from current levels, and that interest rates remain fairly low. A 10-year Treasury yield of 4% to 5% (versus PIMCO’s 3% to 4.5% forecast) over a five-year horizon seems quite plausible: this would involve low to average inflation of 2% to 3%, lower-than-average real yields, but no global calamity (although I do think the dollar will weaken at some point especially vs. non Euro currencies). In this scenario, I’d expect the S&P 500 to generate average returns in the high single digits, and potentially the very low double-digits. So in spite of all the problems in the world (and there are always many) I expect our portfolios to generate very respectable returns over the coming years although there are no guarantees. Furthermore, given all the uncertainty, I believe it is more important than ever to pay attention and develop asset allocation strategies in light of a changing and dynamic global economic environment. There has never been a better time for tactical asset allocation.

Please contact me if you have any questions or comments or would like to review your portfolio. Thank you for your continued trust and confidence. I look forward to seeing you soon during our periodic review meetings.

Mike Durant, CFP®, July 2005                                                                             mike@belmontfinancial.net