July 2011

2011 3rd Quarter Newsletter

What Is the Government Doing to My Investments?

We would like to welcome Amy Boyd to our team of advisors at Wagner Wealth. She has 10 years of experience in investment management. She holds an MBA from the University of Colorado and a BA in English from the University of Texas at Austin. Amy has also earned the Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP®) designations.
During the 2nd Quarter the major stock indexes were volatile, but after a last minute rally, ended the period basically unchanged. The fundamentals of U.S. stocks appear to be sound. Prices of stocks are below average on an earnings basis, and look even cheaper when compared to corporate cash flows. But company fundamentals don’t seem to be driving the markets, aside from the few weeks each quarter known as earnings season. Lately, the markets are paying more attention to what governments are doing. So now is a good time to take a look at the role of policy makers in our investments. That’s a polite way of asking “What are governments doing to help or hurt our investments and what should we do about it?”   
Beginning in Greece, the government was able to pass an “austerity package” that reduces spending and avoids default in the short term. This is like inning 1 of a 9 inning game. There will be more innings, as no one thinks Greece can actually pay its debts in the next few years. Central banks will likely continue to have to help in return for more promises from the Greek government to cut spending. 
It’s not that Greece is a big piece of the global economy. That’s not the concern. Our investments are concerned about two things – civil unrest and credit default swaps.   A group of Greek taxpayers don’t want to cooperate in reducing government benefits to them and are rioting. If left unresolved over time, the possibility of default in Greek bonds, although remote, becomes a little more realistic. Some of the countries that hold these bonds don’t have strong balance sheets either, creating the potential for “contagion” in the event of a default.   
Our investments are also worried about our old enemy the credit default swap. In the Greek context, the credit default swap is insurance sold by a bank or investment house insuring that a Greek bond will make the agreed upon payments. If the buyers of that insurance ever call up the seller and say “That Greek bond defaulted, so can I have my insurance money?” those banks that sold the insurance will fail or have to be bailed out. Sound familiar? It should. 
So what do we do about it? If there is any chance of a credit crisis and more bank failures, we have to remain conservative in our allocation of stock in portfolios. Stocks don’t do well when banks fail.
Over the pond here in the U.S., Congress is making no progress on debt reduction. The Democrats paint the Republicans as haters of the elderly, while the Republicans paint the Democrats as irresponsible spenders. Very impressive. Meanwhile, over at the Federal Reserve, we lowered interest rates on U.S. bonds as low as we could, and then we bought some treasury bonds to make sure prices stayed high and interest rates stayed low (Quantitative Easing).   What do our investments think of all this?
Well, first our investments don’t like lending money to our Government if it doesn’t have its house in order. Having thought it over a little more, our investments get angry. The Federal Reserve is capping interest we can earn on Treasury bonds at artificially low levels, and doing so on purpose. And who is getting the rest of the interest we should get? That money is going towards paying down the national debt. (For more on this point, see the widely publicized paper “The Return of Financial Repression” by Carmen Reinhart and others).
So what do we do about it? We buy fewer Treasury bonds and buy other income producing investments, e.g., corporate bonds that offer more interest for similar risk, bonds of emerging countries with better balance sheets, or income producing real estate.   
Taking a trip east, the Chinese government has initiated measures to slow lending and property speculation in their economy. The demand in China and other emerging economies for real estate and commodities has created inflation they are trying to control. Most economists view this government action as short term. China has a centralized economy and also has many levers to re-accelerate growth.
What do our investments think? Our investments are worried about inflation. If emerging market economies need metals, energy and food to fuel intense growth, their consumption will continue to inflate prices.   Because commodities trade on global markets, inflated prices are exported, to be shared by everyone, including us. 
What do we do about it? First, we hedge against the inflation by investing in its source, commodities. Second we consider investing in the economic growth that seems certain to occur in emerging market countries. 
In summary, we can’t really control what governments do, but we can control some things. Most importantly, we can keep our own balance sheets in order. And we can tilt our investments in anticipation of government action. In our portfolios, we are maintaining our conservative posture, but we have been leaning away from U.S. Treasury bonds. With commodity prices dropping in the 2nd Quarter, we are now considering increasing our allocation to commodities. And we are considering another increase in our stock and bond investment in emerging countries with strong balance sheets. We’ll be communicating more about these opportunities in the coming months.
Please feel free to call us with any questions.
The Wagner Wealth Team


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