The New Norm
As the second half of 2009 begins, a summary of year to date performance should serve as the starting point in an attempt to identify investment opportunities in potentially attractive assets. One change has already become apparent. We have entered a period where much of the standard dogma concerning historical returns can be tossed aside with yesterday's newspaper.
Just 10 years ago, the United States and their European cohorts represented the power brokers of the financial world as we dictated financial and economic policy to emerging nations. Regional specific financial crises such as the Asian Contagion and defaults on loans by Latin American countries like Brazil and Argentina occured periodically. In a remarkably rapid turnaround, these countries have become creditor nations while Europe and the US inflate their deficits to avert a prolonged recession. With almost $1 trillion invested in US Treasuries, the Chinese represent our largest creditor and are in a position to exert significant influence on our monetary policy.
As such, these foreign economies, with hundreds of billions of dollars in reserves, are posed to rebound quickly from last year's global economic meltdown. Recovery in these economies is not stymied by the overwhelming consumer debt that may suppress GDP growth in the United States.It is no surprise that these stock markets were among the top performers during the first half of the year.
Perhaps the most volatile asset class in 2008 was commodities. At this time last year, prices for commodities had escalated by 30-35% as gasoline prices exceeded $4 per gallon. But as quickly as prices escalated, they crashed and burned during the second half and ended down 50% by the end of the year. With a resilient albeit slower growing economy, China has taken advantage of this opportunity to stockpile commodities as they build infra-structure. In hindsight, the resultant increase in commodities prices in 2009 was relatively easy to forecast.
Last year, bonds experienced their worst performance in decades. As credit conditions stabilized, bonds presented investors with a golden opportunity to participate in their recovery. With the massive infusion of funds by the Treasury and Federal Reserve that lowered interest rates, yield spreads remained abnormally wide providing investors with a strong tail wind. It is little wonder that many bonds produced double digit returns during the first 6 months.
While credit conditions normalize as the economy grasps for the resumption of growth, this recession is likely to take much longer to end than recent periods of economic decline. A compelling factor is the increase in savings and reduction in consumer spending that will prevent the normal jumpstart to the economy. While GDP grew between 3-4% annually in the recent past, the new norm is likely to range between 2-3% once the recovery begins.
Based on studies that analyze historical data during “normal” economic times, average annual returns ranging between 7- 8% on US equities represented a standard measure that was applicable for planning purposes. If the economy has entered a period of slower growth, questions arise whether expectations should be lowered and a new norm established. A possible outcome of this new norm is that returns on bonds may exceed equities.
These seismic changes in the global economy require forward thinking if long term investment objectives are to be attained. First, investors must recognize that optimal growth opportunities in equities probably do not reside in the United States or Europe but in emerging markets. Second, anomalies in prices and yields on bonds have created an environment where it may be possible to experience equity type returns in bonds. Third, embracing tactical allocations that take advantage of unique opportunities is essential. This strategy may involve shorter time horizons for allocations. Fourth, investment options that lower correlations to the markets should be continually explored and incorporated where appropriate. This strategy requires a consideration of alternative investments as a low correlation asset.
While asset allocation is alive and well and should be the pillar of any portfolio, greater flexibility and a willingness to go out-of-the-box should be employed in an effort to reach investment goals. The global economic crisis has created great challenges but also tremendous opportunities and those investors who acknowledge and accept this new reality will stand to reap the greatest benefit.
I hope you are enjoying your summer.
Clifford L. Caplan, CFP®
In the News: Since my last newsletter, I have been quoted in two Associated Press articles, “Five Tips for Reviewing Your Investments” and “Midyear Portfolio Checkup in Order”, both published in June. I was also quoted in the June 26-July 2 edition of the Boston Business Journal in an article titled “Post-plunge, Advisors Find Fresh Challenges, Opportunities”.