Public Sector Influence on Private Sector Activity

In my short time in the field of financial services, the normal conversation started with “how about these markets?!”  Now you don’t need to be a genius to understand the basic movement of the equity and debt markets foreign and abroad.  If you have been following recently I’m sure you have been a little confused but optimistic at the same time.

History says that commodities rise when the prospects of growth on a macroeconomic level decrease (hence the recent record highs for gold, silver, and other commodities).  Gold has been on a decline recently though, each trade dependent on unemployment and GDP numbers.  By definition, we are out of the recession but that doesn’t mean that we are actually out of the recession.  Ask nearly 9% of Americans if they feel as if we are out of the recession.  Ask 1 out of every 2 college graduates that is either unemployed or underemployed if they feel as if the recession is ended.  The fact of the matter is that the economy is not where it should be, GDP growth is soft, and job growth is weak.  We may not be in the same predicament as Spain, Greece, or Portugal but we are most definitely not in the clear.

So why is this?  Why after almost 4 years have we still not recovered?  Why is it that corporations are continuing to grow, but maintaining the same amount of employees?  The answer is uncertainty.  There is uncertainty on a massive level, created by the public sector.  We are currently watching the unraveling of governments who have created an unreasonable amount of debt in which before they thought was sustainable.  Now they are watching their best case scenario financial model deteriorate before their own eyes.  The unfortunate part of this, is that the people are suffering from the indiscretion of the few.  The majority loses its strength when the financial well being of all parties is compromised.

What investments are safe?  Where should you put your money?  Below I will summarize what I think is going on in each category of investment and what you should do.

Domestic Equity

Right now, if you live in the US or abroad you need to have your money invested within the United States.  We may not have superb growth, but currently we are the best area to invest.  Our currency, diluted as it is, isn’t in danger of being eliminated.  Our economy isn’t ideal but it is functioning.  And regardless of crap economic numbers we are still growing.  Businesses large and small still have access to credit to either start up or grow their business.  This is what’s needed to keep an economy going.  The access to credit is the most important part of the private sector.  The ability to RESPONSIBILY leverage yourself is how you take a mom and pop shop and make it into a multimillion dollar conglomerate.

I would recommend investing in large to mid cap equities in this area of the market.  This will provide you with moderate growth and atleast an almost guarantee that your portfolio will not go down to 0.  On a side note, if you are invested in large cap blue chip stocks and your portfolio goes belly up, then we have bigger issues then your 401k to worry about.

Domestic Fixed Income

To those not familiar with this terminology, fixed income means bonds.  Bonds come in all forms including but not limited to treasuries, corporate, municipal, and junk.  These are used to hedge your portfolio to the implied risk of equity markets.  Normally these are pretty safe investments with a pretty regular rate of return.  Like any investment though, they can prove to be problematic if purchased at the wrong time with the wrong mindset. 

I would say that currently bond funds are not safe.  Interest rates on bonds are established by the rates offered by the Federal Reserve.  If the Fed is lending money to other banks at 2% then chances are the 10 yr treasury will pay a 5% return, the 10 yr well rated corporate bond will pay 7% and the 10 yr junk bond will offer 12%.  These rates are always a function of what the Fed is lending at.  Now right now, I’m sure you have noticed that rates are extremely low.  They are low on mortgages, treasuries, corporate debt, and of course at the Fed.  So if you’re buying a house right now you are making out, but if you are looking to make your portfolio more conservative with bond funds then you are in for an unpleasant surprise. 

Sooner or later the Federal Reserve will be forced to raise rates.  They will do this when they feel as if the economy is at a point in which the credit markets will still continue to flow when funds are lent out at 6% instead of 3%.  Here is when the issue arises.  If you buy a 10 yr corporate bond fund when fed rates are at .25% and your portfolio is planned to pay out 5% annually then an increase in fed rates is going to hurt the present value of your portfolio.  Now, comparable 10 yr bond funds are paying out 7% instead of your 5% so people are going to pay less for the bonds that make up your fund.  Your bond fund manager is going to sell, because he/she can’t afford to hold them to maturity.  He/she is going to want to get into the higher rate paying bonds being issued.  This means that you are going to take a loss on your fund in the short term.  If your 25 yrs old and just messing with bonds that’s fine, but if you are 75 yrs old and retired in which your portfolio is 100% in fixed income then there is an issue.  That retired person is going to take a very large loss on their principal and it will most likely affect the pay out of the bond fund as well.

All in all, bond funds are not a good place to be in right now because of the interest rate risk currently out there.  One may argue that there is less risk and fluctuation in a blue chip equity fund than there is in a bond fund.  So if you do decide to go the route of fixed income please go with a short maturity fund that is staying in AAA+ rated corporate debt.  At least, with this strategy you are gaining the consistency of a bond fund but you’re not leaving yourself out there for heaving fluctuations in interest rate changes.

Foreign Equity & Fixed Income

For the past 3 years, Financial Advisors have been selling foreign funds because of their high returns in comparison to the US markets.  At the time, they were correct with their recommendations.  Are businesses overseas subpar?  Are corporations over leveraging themselves like we see at times in the states?  For the most part, no they are not.  The issue is with the governments overseas.  The financial distress of certain nations creates issues for the private sector.  If a government can’t pay its debts, what does it do?  It raises taxes.  This is the issue with investing overseas in the EU and also in emerging markets.  Their governments are the biggest hindrance for growth.  The uncertainty on high taxes, increased social programs, and the overextension of investing in foreign equity is why you should stay away from these funds.

From 2000 to 2008 the United States was the place to invest if you lived overseas.  Governments, Businesses, and people were throwing money to us because of the almost 12% perpetuity we were offering with our equity and debt markets.  The choice investment was a AAA rated investment on par with US treasuries but offering a higher rate of return with the same amount of risk.  The investment of choice was CMO’s (collateralized mortgage obligations).  I don’t think I need to go into this investment, because we all experienced first hand the volatility of this perceived safe investment.  If we can learn anything from this it’s that if there are two investments out there with the same risk, A and B, and A pays more than B then only two things can be true.  One, A is either going to decrease in return eventually because the market will correct itself or A is riskier than B.  The frequency of arbitrage investments is very slim, especially in the fixed income arena.

Foreign investors learned the hard way and individual investors, companies, and governments suffered because of it.  Companies and individual investors can work themselves out of losses, but governments can’t.  They either increase taxes or default.  If the people they are taxing don’t have the taxable income to raise tax revenues then the government will fail (Greece). 

In one way or another, all foreign nations are subjected to this type of risk if they overextend themselves on debt.  If these same governments offer a lot of social programs and spend at a high % of GDP then losses from investments can put them in the red permanently.  This is precisely why it is important to stay away from overseas investing.  As exciting as it may be, as much research as you do, you can’t take into effect the stupidity of governments to ruin a good thing.

Overall

We are currently in a very difficult arena for investment.  The exciting part of it is that we aren’t in a period of bad business, we are in a period of bad government.  I’m not going to tell you that we need 0 government interference, no social programs, and only pro business policy.  The fact remains that government is needed to keep countries going; although we need to redefine what is needed to facilitate private sector growth but also take care of the less fortunate.  Investing is the simpler aspect of this question.  Once we figure out the proper size of government, the proper amount of taxation, and the proper amount of regulation the private sector will thrive through those advancements. 

I feel that if I were responsible for a federal budget I would want to treat it as my own budget.  I would plan with the worst case scenario in mind, plan with frugality so you can absorb future fluctuation in costs or costs not expected.  The overextension of personal debt, on a massive level is what put us into the predicament that we are in currently.  In order for us to learn and adapt, we need to live more frugal and we need our government to spend more frugal. 

We need government to provide the necessities.  They need to protect us abroad, protect our borders, and enforce our laws.  They need to help people that can’t help themselves, but at the same time show them a way out of poverty.  We can’t continue to have generation of families stay at the same income level because of the lack of opportunity across the board.  In the investment world, past performance is a good predictor of future performance.  I don’t believe we can accept this when it comes to how we treat our less fortunate citizens.

I’m currently working on an extensive report on the connection between economic reform and social reform.  My thesis is based on the fact that if you balance the importance of the two then the country will consistently improve.  If you have read anything I’ve written before, I base all of my political ideology on bipartisanship.  This isn’t because I want everyone to get along, it’s because I understand and believe in the importance of working together to achieve both wants/needs of both parties.  The relationship between republican economic reform and democrat social reform should be connected in a way in which they balance themselves out.  Economic reform should occur in low income areas across the nation, this would reduce the reliance on social programs offered by the federal government.  This is how you fix an economy.  Not by across the board tax cuts.  You fix the economy by fixing parts of the economy that are always forgotten.  All people need the same opportunities, they all need an opportunity to provide a living for themselves and their family.

If you think this is off topic, I urge you to reconsider.  A more productive economy will be reflected in GDP growth, GDP per capita, and more importantly it will be reflected in the equity markets.  A more productive economy means higher consumer consumption which drives growth.  As cliché as it sounds, everything is connected.  And if we don’t want to end up like the EU we need to start implementing policy aimed towards creating a sustainable economy.  I know our leaders won’t allow us to end up like Greece, but if they falter I can assure you that I will not allow us to end up like Greece.