05 Oct Economic Risk
“Prudence dictates protecting against the downside…, especially now.” – The Lonely Realist
Cassandra recently confirmed prophesies she first presented 3.5 years ago: that America’s economy would continue to expand – it indeed has been experiencing ongoing expansion; that inflation would be falling – inflation is in free-fall; and that America would experience ongoing growth – annual GDP growth has been sustained at a healthy >2% clip. America’s stock market has responded by more than fully pricing-in those economic positives. Cassandra had predicted that the Federal Reserve would manage America’s economy to a soft landing…, and that is precisely what analysts currently believe has happened, as reflected in the 50 bps reduction in the Fed Funds Rate announced last month by Federal Reserve Chairman Powell: “The labor market is in solid condition. The US economy is in good shape…, growing at a solid pace, inflation is coming down. The labor market is at a strong pace. We want to keep it there. That’s what we’re doing.” Kudos to both! If their predictions continue to be correct, a rosy American future lies ahead. However, even though TLR is a fan of both Cassandra and Jay Powell, there remains the possibility that today’s “soft landing” could all-too-easily transform itself into a “hard landing,” perhaps as soon as 2025. After all, the world is filled with “abounding uncertainties” that include a contentious Presidential Election, the European Ukraine War, escalating Middle East conflicts, climate change, trade wars, a weakening Chinese economy (though one recently reversed capped by central government action), a huge overhang of national (and international) debt and deficits, further pandemic risks, and the cyclical, doomsday scenarios forecast by Ray Dalio, John Mauldin, Peter Turchin and others. Only last month, Christine Lagarde, the President of the European Central Bank, cautioned that the past appears to be providing a roadmap for a gloomy global future: “We have faced the worst pandemic since the 1920s, the worst conflict in Europe since the 1940s and the worst energy shock since the 1970s”; the global economy, she warned, is being threatened by economic nationalism and a collapse in global trade similar to that of the 1920s that portends a repeat of the 1930s – that is, an economic breakdown coupled with geopolitical upheaval. The number and depth of macroeconomic, geopolitical and environmental risks creates an unstable mass of uncertainties any one of which – yet alone several of which in unison – could trigger catastrophic consequences. What might be appropriate economic safeguards for these real-world risks?
The investment mantra for the past 15 years has been “invest it all in equities and hold virtually forever”…, a mantra whose followers experienced unprecedented economic gains. Is that the appropriate mantra for today? Will the continued buying and holding of index funds through thick and thin result in similar rewards…, or be rewarded at all? Equity performance to-date certainly suggests that the stock market will continue attaining almost daily new all-time highs. After all, why can’t profits-per-share and earnings multiples continue to skyrocket?
The answer, as TLR has often noted, is that nothing lasts forever. Stein’s Law states that “If something cannot on forever, it will stop.” No one knows when today’s stock market boom will stop, not even Cassandra or Jay Powell. Even though America’s economy is on an unprecedented winning streak, the world is faced with a litany of significant known and unknowable economic, military, political and ecological threats at the same time as world-wide stock market liquidity is trending down, the growth rate in America’s money supply has reversed, consumer spending (especially by low-income households) is slipping, and employment trends are cooling. JP Morgan CEO Jamie Dimon nevertheless sees those economic risks taking a back seat to the geopolitical ones, warning that “The most important thing that dwarfs all other things is the war in Ukraine, what’s going on in Israel, in the Middle East, America’s relations with China and the attack on the rule of law that was set up after World War II.”
What to do?
As every institutional investor is aware, prudent investing necessarily is centered on diversification, a means of preserving and enhancing wealth while minimizing risk, and not on “deworsification,” a strategy by which investments are concentrated in a single asset class – for example, stock indices. Deworsification is an aggressive approach to risk and reward. If correct in choice of asset and timing, it increases gains, sometimes exponentially. If wrong, losses are magnified. A diversified mix of assets and asset classes, on the other hand, safeguards against magnifying losses while sacrificing a portion of the potential upside. It relies on cautious optimism rather than hope and irrational exuberance. In structuring a portfolio, the past indeed is prologue and is worth careful study, but “the past” is not only the last 15 years. Moreover, it is axiomatic that past results do not guarantee future performance.
Diversification most often is achieved through a formalized method that balances a mix of equities, debt instruments, real estate, alternative investments, cash and cash equivalents, and gold/silver (and perhaps Bitcoin). It relies on the concept that owning different kinds of assets is less risky than owning only one type. It requires investors to accumulate assets with varying convex correlations that minimize the negative effect any one asset or asset class might have under a variety of potential outcomes. Its key insight is that an asset’s risk and return should not be assessed in isolation, but by how it contributes to a portfolio’s overall risk and return. Diversifiers structure their portfolios to perform well in a variety of market conditions by relying on Modern Portfolio Theory.
The purpose of the Fed’s September 50 bps Fed Funds cut was to bolster the American economy and ensure employment growth…, or was it to avoid recession and increasing unemployment? Only time will tell. The one thing that’s clear is that America’s economy is slowing. What is unclear is how quickly it will continue to slow, if at all. Pandemic-driven employment growth is waning and COVID stimuli have been exhausted. Bonds are becoming more competitive with equities. What effect these plus macroeconomic and geopolitical pressures will have on America’s economy and stock market prices are anyone’s guess.
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Finally (from a good friend)
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