What Should I Pack?

Eric Stein, CFA
Senior Director, Investments

Imagine you are going on a trip to a location you have never been to before. There is an uncertain weather forecast and therefore you are also not sure what activities you will be doing. Should you bring clothes for warmer temperatures or cooler temperatures? Are you going to need more clothes for walking around during the day or more clothes for possible visits to the gym, pool, and spa? Let’s not even talk about the choices of shoes! What would you pack not knowing exactly what was going to happen or what the forecast was going to be?

In many respects, investing in today’s markets can be compared to packing for this trip. We are in a current cycle of uncertainty and financial markets simply do not like uncertainty. There are “market experts” calling for a bull market while their peers promise we are entering a bear market and double-dip recession. Our view is that we understand there are an enormous number of forces that have an impact on the economy and these forces can change daily, or even faster. Therefore, our approach is to “pack” your portfolio with investments that can make sense in many different scenarios.

What could happen?

Question #1:

Will interest rates stay low or will they increase? When?
The Federal Reserve has left the Fed Funds rate at near zero levels. However, once the economy starts to improve, the expectation is that at some point rates will need to rise (they can’t go down and won’t stay flat forever).

What should an investor do?
Conventional wisdom says that when rates are expected to rise, fixed income investors should invest in the short end of the yield curve, taking advantage of rising rates. However, conventional wisdom may not be right this time. Let’s say that since the Fed lowered rates to their current levels in December 2008 you have been concentrating bond purchases in the short end of the curve and have been waiting for rates to rise. That strategy has cost you in the form of opportunity cost by not investing in higher yielding bonds further out on the curve. For investors that have bond ladders, we continue to recommend ladders of 3- 7 years in length and to not concentrate fixed income holdings in one maturity.

Investors that only have short-term fixed income mutual fund holdings have different reasons for concern. When rates rise in the future, it may be that short term rates rise significantly while intermediate to long-term rates don’t change by much. Remember, a rise in rates equals a decrease in price. Historically the income generated in a mutual fund has been able to offset the decline in bond prices (returns may still be positive). However, with rates near zero, there may not be enough income generated to offset falling bond prices, leading to potential negative fixed income returns. For investors that have fixed income mutual fund holdings, having some short and intermediate holdings can provide benefits in a variety of scenarios. In addition, we would recommend holding various types of fixed income holdings (i.e. government, agency, sovereign, corporate, municipal).

Question #2:

Is the economy strong or weak?
In a strong economic recovery scenario, the unprecedented global stimulus takes hold and the pent-up demand from businesses and consumers will drive economic activity and job creation. This scenario is generally seen as a positive for stocks but a potential negative for bonds (i.e. lower demand for government debt, increasing rates=lower prices).

In a weak economic recovery scenario, ongoing concerns and fear continue to dominate market headlines. Currently fear is coming from many potential sources, including but not limited to possible contagion in European markets, the debt of the US government continuing to increase, trouble with US municipalities, continued job loss, or the threat of deflation. Some economists are anticipating a double-dip recession, a fairly rare event. A weak economy generally means lower corporate earnings, a negative for stocks. However, a weak economy generally means a “flight to quality” for bonds (in particular Treasury bonds), driving yields down and prices up.

What should an investor do?
We believe that the allocation between equity and fixed income investments is a primary driver of risk and return. We work with our clients to understand their ability, need, and willingness to assume investment risk as well as understand their return requirements.Therefore the allocation to equity and fixed income investments should be strategic and not one that constantly shifts between them based on the news of the day.

Question #3:

What is the impact expected from rising or falling currencies (i.e. dollar or euro)?
It was only last summer when there were numerous articles detailing the coming fall of the dollar as the world’s reserve currency. The implications of these articles were that investors should hold more non-US investments in an unhedged fashion. Interestingly, many of these articles opined that the euro would overtake the dollar as the world’s new reserve currency. A few months and a few crises later, the dollar has strengthened as it relates to the euro, other experts are suggesting investors hold less non-US investments, and investors are left wondering if the euro will survive.

What should an investor do?
We do not believe the US vs. non-US equity allocation should be driven by currency expectations. We currently recommend a US equity allocation of 60% and a non-US equity allocation of 40%. The difference between our recommended allocation and the market portfolio (which says that non-US equities should have a higher weight versus US equities) stems from 2 primary reasons including:

1. most US investors are not comfortable holding more non-US equity investments versus US equity investments and
2. the current recommended weighting provides a good use of the risk budget.

In addition, when we recommend non-US equities, we generally recommend they be held on an unhedged basis. This is done because the hedge adds to the expense (i.e. lower returns) and as important, over the long term we expect zero return from currency (i.e. rising and falling currency rates balance themselves out over long periods).

A seasoned traveler might talk to someone who has been there before and understands the uncertainty surrounding the weather and activities. Similarly, an investor should talk with a wealth advisor that understands the challenging environment and can remain disciplined in the face of uncertainty. As we have shown, the investment ideas for one scenario are generally quite different if an opposing scenario happens. With the amount of uncertainty in the markets today, our recommendation is to pack wisely, and prepare for many potential possibilities.

Wealth Management Disclosure