The State of the Financial Markets
We are at a fascinating point in history and have recently witnessed some remarkable and unnerving events in world markets. Never before has global wealth been so intertwined and capital markets been so linked. The problems within the banking system, first materializing in 2007, spread to virtually all asset classes and created a global systemic deleveraging never seen before. Governments across the globe stepped in and began supporting the financial system in the 3rd and 4th quarters of 2008, especially the large financial players, in an effort to prevent a complete collapse of the system. From that point, virtually every central bank in the world has been injecting liquidity into the capital markets to revive their economies and help support asset values. At no point in history prior to this has there been a globally coordinated effort to pump liquidity into the financial system without apparent concern for the unintended consequences that may follow.
At the top of the list of these potential consequences is inflation. So, how does one invest to keep up with and beat inflation over time? Historically, investing in a blend of equities and commodities, with an appropriate amount of high quality bonds (treasuries, municipals, and corporate) has achieved the goal of growing wealth and beating inflation over time. In our view, this approach remains sensible, with a few wrinkles. We develop portfolios by allocating assets to two basic types of investments: those that are protective of principle and those that put principle at risk in order to provide excess return. The allocation between these investments depends on the goals of the individual investor.
Within the risk bucket, we divide the world into three categories: corporate (both credit and equity), commodity, and interest rate. We believe that a diversified portfolio should have exposure to both corporate debt and equity of businesses that have high levels of free cash flow and that distribute that free cash flow. Examples include consumer staples companies (low debt/high cash generation), investment grade bonds and dividend yielding stocks. These investments will typically lag in markets such as the one we have just been through these last six months (i.e., sharp rallies) but will buffer portfolios in times of stress, as the dividend yield becomes more important to the total return (as it was in the 1970s). Other elements to consider in diversified portfolios include commodities and gold. An investment in gold provides some inflation protection as well as some protection against a weakening U.S. Dollar, in effect, preserving purchasing power for U.S. investors. Exposure to commodity-related equities in sectors such as water, infrastructure, agriculture and other resource-based materials (oil, copper, etc.) give portfolios a healthy dose of economic cyclicality and inflation protection to balance equity exposure and allow participation in a global recovery. International equities (including the emerging markets) are the best way to participate in widespread global growth due to the wealth effect being created currently in emerging market countries. These investments will also provide some diversification away from the U.S. Dollar. This demographic trend, made possible by the increasingly wider availability of credit in these regions, will become very powerful in the years to come.
On the protective side (traditional fixed income), we favor short term treasuries (1-3 years) and believe that holding some cash (5-10% of portfolios) remains sensible. We are concerned about lower-quality municipal bonds because tax receipts are going to be slow to recover and because state and municipal budgets have yet to be reigned in to reflect this reality. The situation in California bears watching very closely.
Ultimately, much of the nation’s debt bubble has now shifted from consumers to the Federal Government, likely leading to a continued devaluation of the U.S. Dollar, higher interest rates or both. In general, we are conservatively positioned, yet positioned for what we believe will be an inflationary outcome as the unintended consequence. We favor corporate risk that 1) generates and distributes free cash flow (consumer staples, dividend focused equity managers) and 2) will protect and thrive in a recovery or inflationary environment (commodity based equities). We are not comfortable taking much interest rate risk, as inflation is a real threat, preferring to own shorter term bonds (both treasuries and high quality corporate bonds). We believe that Gold and international equities will benefit from a weaker U.S. Dollar and long-term growth trends of the emerging markets. These components all translate into a portfolio designed to protect assets in volatile markets while still creating value and compounding assets through carefully placed bets and prudent allocations to risk assets.
Michael Tiedemann is a Senior Managing Director and Chief Investment Officer of Tiedemann Wealth Management.
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