When you plan for retirement, do you take the long-term economic outlook into account? The world is changing, and if we are to be prepared, we should step out of the box and look at what may be driving the markets in the coming years.
While you may be busy developing your retirement plan for the distant future, Ben Bernanke, successor to Federal Reserve (Fed) Chairman Alan Greenspan, will be guiding the Fed for the foreseeable future. As we elaborate below, Bernanke inherits unprecedented challenges. We lay out scenarios that may not be captured by traditional allocation models. Should you agree that these scenarios are possible, you may want to consider taking additional steps to diversify your portfolio.
Inflation may be picking up just as consumer spending is slowing down. To understand the challenges we face, how the Fed may react to them, and what it means to your portfolio allocation strategy, it is helpful to take a step back and look at the big picture. In the center of the scenario, we have the American consumer, responsible for about 70% of US Gross Domestic Product (GDP). While corporate America went through a recession as the tech bubble deflated, monetary and fiscal stimuli (low interest rates and tax cuts) kept consumer spending up. As consumers have piled on additional debt, their interest payments remained contained because of lower interest payments. The Fed had to redefine the way it gauges how much households spend on serving their debt, as consumers can buy anything and everything on credit now. Your monthly salary can be stretched much further if you buy everything on credit. However, this tendency makes American consumers, and with it the economy as a whole, much more interest-rate sensitive. Interest-rate sensitivity has been amplified by consumers refinancing their homes with adjustable rate mortgages, as well as by linking credit cards to home equity loans.
In the post-bubble period, corporate America cleaned up its balance sheets, raising cash and increasing the average maturity (duration) of its debt. The federal government, however, followed irrational consumer behavior by suspending 30-year bond auctions a few years ago, thereby significantly lowering the duration of federal debt.
The American consumer not only drives the US economy, it is the engine of growth for the world economy, especially economies in Asia. China and much of Asia is building its middle class by building an infrastructure to sell to American consumers. To subsidize their sales, much of Asia pegs its exchange rate to the dollar. Add to that an effectively unlimited supply of cheap labor, and you have a formidable engine, supplying the American consumer with low-cost goods.
US fiscal and monetary policy, combined with Asia's growth aspirations, have led to elevated commodity prices. Corporate America is squeezed by high raw material prices and little pricing power on consumer goods. Pricing power is limited because the flood of imports ensures that consumers do not have to pay more for goods and high consumer debt further reduces corporations' ability to pass on costs. To maintain margins, corporate America has to accelerate its outsourcing to Asia. As a result, real wage and job growth have been lackluster and job security has been on the decline.
The flood of Asian imports, combined with a dismantling of the US manufacturing base, has led to an escalating trade deficit. As dollars leave the country to pay for imported goods and other financial flows abroad, non-US economies must recycle about US $2 billion back into the US economy just to keep the dollar from falling (this is the current account deficit). As international consumers do not purchase an adequate amount of American goods and services to make up for the shortfall, non-US entities purchase US denominated debt and assets. Central banks around the world -- in particular, China and Japan -- purchase US treasury notes to finance our deficit. If Asian countries converted the dollars they earn into local currency, their currencies would rise, making their exports more expensive; this would lead to more inflation in the US and a slowdown in Asia.
In recent months, international buyers have diversified away from buying US government securities to buying real assets, especially those which will help secure their future natural resource needs. This shift was highlighted last summer when Chinese oil conglomerate CNOOC was rebuked in its attempt to purchase Unocal. Chinese firms have since made a number of large acquisitions in Canada, Latin America and Australia; China has also taken the first steps needed to diversify its massive dollar reserves to a basket of currencies.
There are numerous warning signs that not all is well with the American consumer. If consumers only purchase cars when lured with "employee discount" programs, it is a clear sign that consumers are stretched. A slowing housing market reduces the ability to use one's home as an ATM. As the result of high energy prices, consumers will experience a rude awakening when they see their heating bills this winter. Responding to regulatory pressures, credit card companies have doubled the minimum payment consumers must make on their balances. Setting up what may become a "perfect storm" swirling around consumers, retailers have put incentives in place to induce consumers to spend for the holidays as early as possible--before they realize that they cannot afford discretionary holiday spending. The plight for consumers may last for a long time, amongst others, because of the high levels of debt to be served in a higher interest rate environment; and because competition from Asia is likely to continue to cause real wage growth to be disappointing.
While consumer spending is likely to slow, inflation is making its way through to the consumer. Globalization has held back inflation, but has not eliminated it. We have seen inflation creep up in anything that cannot be imported from Asia - the cost of healthcare and education are the most prominent examples. Inflation is not a light switch that the Fed can turn off; it is a cancer that has been spreading. Just because the symptoms are not yet severe doesn't mean we don't need to be concerned. Ben Bernanke may continue a policy of moderate interest rate increases. Note that while the markets believe the Fed is almost done raising rates, the Fed has merely removed its accommodating stance. In plain English, the Fed has not even begun to fight inflation, as that would require a restrictive monetary policy. Small increases in rates may stall an economy that has become highly interest-rate sensitive. To compound the situation, although the economy may stall, inflation may not be contained.
How can you position your client portfolios in this environment? Equities may be at risk: investors may need to liquidate their investment portfolios to service their mortgage payments. "Old-economy" companies will have an increasingly difficult time competing in a global marketplace if labor cost is an important element in their business model. Financial services firms may struggle in a rising interest rate environment. The flexibility of the US economy allows for new jobs to be created in industries that thrive in this environment. Consider the contrast between a General Motors with an old-economy model and unable to effectively compete on cost; and a Google, the "new-economy" rising star. Global forces have lead to a transformation at a breathtaking pace, a pace that shows no signs of abating.
Bond prices are at risk as inflationary fears mount, and bond funds provide no safe haven in a rising interest rate environment.
Should the dollar yield to the pressures exerted by the current account deficit, diversifying to cash will not preserve your purchasing power. In one of his several farewell speeches, Greenspan referred to the dollar's resistance to downward pressure as a "conundrum". He has stated that higher interest rates abroad may be the trigger for a decline in the dollar; alternatively, foreigners may opt to diversify out of the dollar over time in response to the current account deficit. Any country maintaining an artificially low exchange rate may stimulate domestic growth, but is also creating capital misallocations (in modern parlance, "bubbles") as investments are made that would not be economically viable with exchange rates set by the markets.
Will diversifying to international equities provide the desired protection when US consumer spending slows? Just as there are always opportunities somewhere in the US, there will be international firms that thrive in this environment. However, most large international firms--and those are the ones many mutual funds invest in--have significant exposure to the American consumer. Natural resource rich countries, such as Australia, New Zealand and Canada may be long-term beneficiaries of a world that is determined to consume. It is difficult to predict how commodity prices will behave short-term, but as Asia's economies are developing, they are bound to be increasing users of commodities. As commodity investments tend to be volatile, they are not for everyone. It does not make it easier that the share prices of companies involved in the commodity sectors do not always correlate with the prices of the underlying commodities.
The key change to your retirement planning is that you can no longer assume that US dollar cash is the "risk free" alternative upon which to base your model. Greenspan, Bernanke and central bankers around the world are calling for an orderly adjustment of the global financial imbalances, as evidenced by the current account deficit. Even a weaker dollar may only temporarily alleviate the pressures on the dollar unless domestic savings and investment receive a higher priority in policy decisions. A weaker dollar is politically the easiest solution to address entitlement issues: politicians can promise their constituents that retirement benefits will be paid, yet the purchasing power of what will be paid is eroding. The main danger of allowing the dollar to depreciate is to import significant inflation.
It is not possible to substitute cash holdings with something "safe". However, it may be worthwhile exploring whether to employ a basket of hard currencies in lieu of some of the cash to mitigate the risk of a decline of the dollar. We are not suggesting to introduce active currency trading to your portfolio. But you may want to evaluate whether you may be better positioned to withstand what may be long-term pressures on the dollar by providing them with exposure to a basket of hard currencies and possibly gold. We believe these pressures may be long-term as both fiscal and monetary policies over the past couple of years have been very consistent; it is these policies that have amplified the pressures on the dollar and are partially responsible why the dollar declined by over 40% from its peak to its low versus the euro.
It is the economic environment that led us to establish the Merk Hard Currency Fund. We hear central banks and politicians "hope and pray" that the adjustment process will be slow and gradual. When it comes to structuring your portfolio, you may wish to consider whether you are prepared to potentially profit from the scenarios described.
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