News & Insights
Rounding the Corner into a Challenging 2008
We believe that the chances of an economic recession are rising. Problems in the housing and credit markets are not going away as long as risk-averse banks and other market participants are loathe to enter into transactions with fellow banks that have unknown exposure to the “subprime” issue. This will place a lid on economic growth. Another specter is inflation. Strong global structural trends are in place to contain inflation, but in the near term it may increase above the level that is comfortable to central bankers and investors.
The combination of slow growth and moderate inflation presents unique risks and a conundrum for policy makers. Will lower rates and easier money positively stimulate growth or light up inflation? Faced with this Hobson’s choice, we believe the Fed will do what it must to keep the economy out of recession even at the risk of an uptick in inflation. The unknown consequences of such a policy increase the risk of investing in stocks.
In our view, the broad U.S. stock market is fairly valued on an absolute basis and cheap when compared to bonds. The S&P 500 provides about 6.2% in (hopefully increasing) earnings based on its current price while the 10-year Treasury yields only 4.4% in static interest. Historically, the earnings yield of the S&P is below that of the long term Treasury rate, but these are hardly average times.
Is it possible to pursue an investment policy that will protect a portfolio from the possibilities of rampant inflation, recession or both? If the worst manifestation of these possible outcomes becomes reality, it will be bad for all investors. Only the most idiosyncratically risk-averse investors (think moving to Montana, hoarding gold and storing your own food and water) will come out on top. The worst outcome, thankfully, is highly unlikely, in our view.
It seems to us though that the uncertainty presented by current conditions warrants a renewal of the more defensive stance we de-emphasized in mid 2005. We believe that there are specific steps that an investor can take that will allow them to stay largely invested while insulating themselves somewhat from the value sapping effects of a weak economy and possible inflation. Financially robust companies in less cyclical industries such as health care and household products should weather the potential financial storm better than the market as a whole. An asset allocation strategy that includes inflation adjusted government bonds, certain commodities and even gold should provide a bulwark against a possible inflationary environment.
Even in these uncertain times, we believe that a long term investor should keep a portion of their funds invested internationally, balanced between the developed markets such as Europe and Japan and the faster growing emerging economies of Asia and Latin America.
Bonds offer poor value at the present time, but play an important part in a diversified portfolio. We believe bond portfolios should be shorter in maturity than the market and higher in quality. In 2008, there may be opportunities to pick up riskier bonds at bargain prices, but as we close 2007, that time has not yet arrived.
The Altavista Investment Team -Winter 2008