Keeping It Simple: The “Great Intervention Rally,” the “Fiscal Cliff,” and You

Keeping It Simple: The “Great Intervention Rally,” the “Fiscal Cliff,” and You

“Under current law, on Jan. 1, 2013, there’s going to be a massive ‘fiscal cliff’ of large spending cuts and tax increases.  All those things are hitting on the same day, basically. It’s quite a big event.” – Ben Bernanke

There is always a lot to be said for keeping things simple, and it is gratifying to see how robustly accurate some of our straight-forward, commonsense methods of asset class forecasting continue to be.

Yet as the last decade of experience has shown repeatedly, not many professional forecasters seem to be able to draw the obvious, right conclusions.  No doubt this phenomenon is the result of the investment business being dominated by short-term pressures and its default position to always be biased towards bullishness.

By sharp contrast, Sand Hill is not bound by either constraint.  Instead, we follow a highly-disciplined, catalyst-driven approach grounded in a contrarian mindset and paired with a long-term investment horizon.  That combination has served us well throughout the recovery and it remains the hallmark of our investment process.

Our investment outlook has been predicated on the belief that this cyclical economic recovery – fueled by unprecedented government intervention – would persevere.  The significant 30 percent rally in the S&P500 over the last six months, following the capitulation-like sell-off late last summer, is a direct response to the accelerating economic recovery as well as coordinated action by central banks globally to remove any risk of Lehman Brothers 2.0 from unfolding.  These dynamics combined to produce the strongest first quarter since 1998.

You will have to excuse us for not being heartened by the comparison with 1998 as we remember that year well; it was the year that the markets kept ignoring the growing Asian currency crisis until they could no longer do so.  The dramatic 28 percent correction that began in the middle of 1998 wiped out the recent bull market gains, yet at the time there was little warning issued by the bullish financial press or from the investment industry.

While it’s true, thanks to the world’s central banks, there isn’t a Long-Term Capital Management (the infamous leveraged bond fund that froze the credit markets in 1998) lurking in the shadows, there are plenty of known systemic risks around the globe. Those risks are largely centered on the recession in Europe and the heightened tensions out of the Middle East.  But strangely, the financial press and the investment community as a whole appear to largely be ignoring the most significant of risks: our own rapidly approaching “fiscal cliff.”

We enter 2012 facing mandatory “fiscal austerity” in the form of higher personal tax rates and reduced federal spending that will take effect on January 1st of 2013.  It is rare to be staring down such a well-defined, specifically-timed event of this significance.

If left unchecked before year-end, the government is scheduled to: (1) end the payroll tax holiday, which means a tax increase for workers of as much as 2 percent of wages; (2) let the Bush-era income tax rates expire, raising taxes not only for the rich but for nearly all taxpayers; (3) begin mandatory, across-the-board cuts in government spending totaling $1.2 trillion over many years; and (4) bump up against another recently-raised debt ceiling, providing a second round of headlines concerning a potential US default.

For context, with the economy growing between two and three percent, this aptly-named fiscal cliff, as currently constructed, would create a negative three to four percent drag to economic growth, likely resulting in a mild recession in 2013, ceteris paribus.  Despite the market’s willingness to look past this event, believing that politicians will either “kick the can down the road” in an eleventh hour agreement or the Federal Reserve will turn on its printing press with additional quantitative easing, we are far less sanguine.  As our simple math displays, if left unchecked, this fiscal cliff would undermine an economy not yet fully recovered from the Great Recession.

The timing of this event is far from random.  The current recovery, which we have dubbed the “Great Intervention Rally” given the role the U.S. government and the Federal Reserve played in its origin, is jubilantly celebrating its third anniversary.  In response to trillions of dollars of stimulus programs and monetary intervention, the market has risen 110 percent over the last three years.  But now we find ourselves at a crossroads as the country must begin to “pay the piper” for these unsustainable initiatives.  So what does this mean for you?

The number of unknowns in the economic mix prevents us from drawing any broad-based conclusions about what the future has in store.  However, following this significant rally in global markets, Sand Hill Global Advisors is “keeping it simple” and has begun the process of taking recent profits off the table.  Implicit in that decision is to seek out capital preservation and as such, to accept the prevailing lower return profile that accompanies it.  This means many things, from investing in high quality multinational companies to increasing your allocation to less market correlated investments.  It also means incrementally increasing your allocation to bonds. This last comment requires some explanation.

We have all heard the bears’ case against bonds.  With the end of the 30-year bull market, with governments drowning in debt, and the Federal Reserve artificially containing rates, yields can only rise – and quickly – impacting bond investments negatively.  But not so fast: while the 30-year bull market for bonds, which saw long-term Treasury yields decline from the mid-teens in the early 1980’s, is over, the bear market remains elusive as rates are unlikely to spike dramatically any time soon.  The shrinking supply of high quality bonds, the high demographic demand for yield as the Baby Boomers retire, and the continuation of loose monetary policies will conspire to keep a tight lid on yields for years to come.

The only “bubble” in the bond market appears to be the overinflated talk of bond market bubbles in recent years.  All signs point to bonds remaining well-bid, even if rates rise modestly.  In the meantime, to mitigate risk, Sand Hill Global Advisors utilizes a “bond ladder” approach that offers reinvestment risk protection against rising interest rates.  We also use a variety of other bond market investments, such as high yield bonds, to provide diversification and better income opportunities for a portion of your bond portfolio. In effect, we think yields will drift higher over time but not materially so for many years.

In the meantime, to protect your portfolio in the coming slower growth environment, investors will need to ratchet down their return objectives in exchange for stability and capital preservation of their hard-earned retirement assets.  It’s important to remember that although the bond market is notoriously pessimistic, sometimes it’s actually right.  Sometimes yields are low for a reason.  And it is always possible that just maybe there aren’t as many good investment alternatives out there as the short-term focused, bullishly-biased investment world thinks there are.

Articles and Commentary

Information provided in written articles are for informational purposes only and should not be considered investment advice. There is a risk of loss from investments in securities, including the risk of loss of principal. The information contained herein reflects Sand Hill Global Advisors' (“SHGA”) views as of the date of publication. Such views are subject to change at any time without notice due to changes in market or economic conditions and may not necessarily come to pass. SHGA does not provide tax or legal advice. To the extent that any material herein concerns tax or legal matters, such information is not intended to be solely relied upon nor used for the purpose of making tax and/or legal decisions without first seeking independent advice from a tax and/or legal professional. SHGA has obtained the information provided herein from various third party sources believed to be reliable but such information is not guaranteed. Certain links in this site connect to other websites maintained by third parties over whom SHGA has no control. SHGA makes no representations as to the accuracy or any other aspect of information contained in other Web Sites. Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. SHGA is not responsible for the consequences of any decisions or actions taken as a result of information provided in this presentation and does not warrant or guarantee the accuracy or completeness of this information. No part of this material may be (i) copied, photocopied, or duplicated in any form, by any means, or (ii) redistributed without the prior written consent of SHGA.


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