Q3 2013 Market Commentary
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By Matthew T. Skaves, CFA
When asked to come up with a list of potential investment risks, investors often mention business risks: corporate bankruptcy, company mismanagement, recession, fraud, etc. However, more pernicious than business risks are the risks from bad public policy: political risk, interest rate risk, and inflation. These risks are often underappreciated and misunderstood by investors, leading to incorrect assumptions and unfortunate decisions. In fact, if we assume for a moment that all investment risk can be broadly defined as “the risk of permanent loss of purchasing power over time” then we find that, for an otherwise well-diversified investor, public policy is arguably one of the biggest sources of investment risk.
The reasons are many. Bad public policy can negatively affect multiple asset classes at the same time, meaning it can have long-lasting ramifications that are difficult to avoid via diversification. Further, the fallout is not always recognized at the outset, making it hard for investors to proactively protect themselves or understand the risks at hand. Perhaps an example is best. Let’s look at John, a typical low-risk investor in retirement:
John has spent the past several years trying to eke out reasonable gains in his conservatively managed investment portfolio. However, because of the Federal Reserve’s low interest rate policy, his income has been greatly reduced. He knows he could try taking on more investment risk, but he lost a lot of money in stocks when the last Fed-fueled investment bubble popped in 2008. Therefore, he’s reluctant to go down that road again. After all, he needs his portfolio to last him for the next 30 years.
Back in early May, John bought what he thought was a low-risk investment: a 10-year U.S. Treasury Note yielding 1.63%, which was the going rate at the time. Though it was a lower interest rate than he might have liked, John saw little other alternative.
What John didn’t realize was that, if inflation averages 3% over the next decade, then his purchasing power will actually decrease by 1.37% every single year. Each year, his portfolio will buy a little less than it did the year before.
John’s friend, Carl, points this sad fact out to him over lunch. Disheartened, but ever the optimist, John rationalizes his decision: he might be losing a bit to inflation each year, but that’s better than losing a lot all at once in the stock market, right?
Not necessarily. John thinks that, because he bought a Treasury Note backed by the full faith and credit of the U.S. government, it is essentially risk free. Come July, however, thanks to a few inopportune comments by the Federal Reserve, the going rate on a brand new 10-year U.S. Treasury Note is 2.71%. John’s bond has lost almost 10% of its value in two months. What happened?
John didn’t realize that rising interest rates can be a significant source of risk for bonds, especially long-dated bonds. Now, no one wants to pay full price for John’s crummy 1.63% bond when they can buy a brand new one and receive 2.71%. If interest rates continue to rise, then the value of John’s bond will continue to fall. True, if John waits until maturity in 10 years then he will eventually get the full nominal value of his bond. But that doesn’t count the opportunity cost of holding a low yielding investment for a decade.
Frustrated, John decides to sell his bond and accept the 10% loss. The stock market is up nearly 20% for the year, so he figures he can easily make his money back and then some by switching into stocks. Unfortunately for him, the federal government shuts down a week later over a budget impasse, and stock market volatility increases significantly. John begins to wonder if he made the right choice, and whether he can handle the additional risk he’s taken in his account.
John’s situation is a common one. Like many investors, he has had a difficult time navigating the economic ups and downs of the past decade. These ups and downs have been largely caused, and/or amplified, by government policy, both legislatively and monetarily. More so than companies like Lehman, the government has been responsible for economic volatility, because the government created the policies that allowed such corrupt companies to thrive and become systemic risks. Therefore, investors need to be wary of how public policy might impact their portfolios.
The federal government’s shutdown this week is but the most recent example of why this is the case. The political climate in Washington is highly partisan and increasingly unstable, meaning that, even in the absence of a continued shutdown or default, investments risk being caught in the crossfire. Congress has shown itself unable to compromise or legislate on a variety of fronts, and if the shutdown continues over the coming weeks then markets will become increasingly fearful of a government default. Though we do not anticipate a default, there is a first time for everything.
This leaves investors in a catch-22 situation. Many worry they should reduce their investment risk and let the political climate settle down. But, while reducing risk might lower the possibility of incurring large, short-term losses, it almost certainly guarantees, like it did for John, that smaller losses will be locked in long term. This is because “safe” investments, like bonds and cash, currently offer negative returns after inflation. Therefore, an investor looking to de-risk must be willing to pay this premium, which is essentially a hidden tax.
The Fed would argue that, because inflation is tame, it’s okay for interest rates to remain artificially low. This is disingenuous. There is a big difference between 2% inflation when interest rates are in a more normal 4-6% range, as opposed to 2% inflation when interest rates are in a 0-3% range. In a more normal situation, a bond investor might still earn a positive return net of modest inflation. Today, investors are forced into flat or negative returns after just a little inflation is factored in.
The Federal Reserve, of course, knows this and is okay with it. That’s because the government owes too much money, and a negative real return is a conveniently inconspicuous way to make savers pay some of it back. Low interest rates also force savers out of safe assets and into riskier assets, like stocks, against their better judgment. A rising stock market provides the appearance of a more healthy economy.
But there comes a point when interest rates must rise naturally, and we may have reached that point whether the Fed likes it or not. This poses a risk for investors. Interest rates spiked this summer at the mere possibility that the Fed might start tapering its bond purchases. This caused an immediate, significant price correction in bond markets, illustrating that the Fed may not be able to control interest rates in the end.
As both market observers and participants, one thing is obvious to us: current government policies and behaviors are unsustainable and inherently unstable. Investors are right to want to protect themselves from fickle politicians; but the question remains, how? We believe that holding tight and sticking to a long-term investment discipline is the only plausible option out of a range of lesser options. We don’t want to be like John, continually reacting to changes in public policy and jumping between stocks and bonds. We don’t believe in our ability, or anyone’s ability, to get the timing perfect, as would be required to make John’s tactics work. Instead, it is our opinion that, though we might have little control over how investments move on any given day, we do have control over how we react to those movements. “First, do no harm” seems to be a good motto at a time when both uncertainty and the opportunity for self-harm are significant.
Only time will tell what comes to pass in the weeks ahead, but we encourage you to call us should you have questions or concerns along the way. In the meantime, let’s hope for some political sanity. Until next time, may you and yours have a healthy and prosperous upcoming holiday season.