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The Markets in 2013: Bonds Stink and Other Critical Observations

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Making sense of the 2013 investment climate means considering trouble in the bond markets, social unrest, and geopolitical turmoil.

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Despite the official statistics, there is a strong underlying inflationary spiral -- look at the prices of meat, milk, and medicine. And in the face of escalating prices, our central bank pursues accommodative measures that, in normal days, would be significantly inflationary. The US equity market has responded to the stimulus with an upward push. And yet, we have also seen the casino effect of overwhelming liquidity chasing too few investment prospects -- it dampens retail investor confidence. Hesitant retail investors and increased retirement demographics have spurred equity outflows and fixed income inflows. For long-term investors like retirees, this is the worst time to move into bonds.

CAUTION: You should only buy bonds for the following reasons:
  • To match a future liability (e.g., college, wedding, etc.)
  • To provide coupon income (hold until maturity, preferably inflation indexed)
If you are buying bonds or bond funds in the hope of taking advantage of continued declines in interest rates, or because the fund performance over the past two years has been good, then stop! Sell any bond funds now, today. Deflation is not going to happen, Mr. Bernanke has dropped the helicopter full of money! The next few years will entail struggles with inflation and higher interest rates, and perhaps a falling US dollar.

The Bernanke Covered Call

The Bernanke put has been replaced with a covered call, and that means our upside is limited and downside is wide open.

Equity markets enjoyed a good year in 2012 despite four years of economic stagnation. On the surface, it seems like the equity markets are poised to continue to grow. However, the impact of the Federal Reserve's covered call on unemployment needs to be understood.

In recent missives, the Fed stated that accommodative measures will be removed when unemployment reaches a target level. Their intent in stating this policy was to inject confidence and stimulate the equity market. As if on cue, the equity markets rose in value at the selling of Bernanke's "call option" -- that was our premium. However, as in all covered-call option trades, the upside is capped. How? The closer that we come to the stated objective, the more that the equity markets will hit choppy waters for fear that stimulus will be removed. This turbulence is the cost of living on artificial stimulus for so many years.

It is a good strategy to trade volatility in 2013. Oversized directional bets are not in the cards until stimulus measures are eased. Play within predefined ranges if you feel compelled to be long equities -- e.g., buy dips and sell highs within your risk tolerance. But, don't put your head in the sand. This is not a "set it and forget it" market for asset allocation.

The Bond Market Stinks

Despite the increased protests from Congress, there has not been a true movement of disgust toward the national debt. It should be understood that the "bond vigilantes" are the only investors that will force the US government to curtail its massive deficit spending, and until the bond investors coalesce into a rebellion, there will be deficits as far as the eye can see. No amount of doomsday forecasts by newscasters or senators will shock Americans into prudent fiscal behavior -- only the markets can have this effect.

Read the above paragraph again, memorize it, act accordingly.

How Could the Bond Market unfold?
  • Catch-32. Let's assume that, despite the recent tax increases, the economy continues to improve, with stronger consumption and employment filling the headlines. This would be beneficial to the US Treasury because tax receipts would also increase. However, once we hit a moderate level of unemployment, the Federal Reserve stimulus will roll off, and the equity markets will stall or decline as the "covered call" gets exercised. The "covered call moment" will have a psychological impact on consumers and may dampen demand. We could reach a point where the fear of growing beyond our stimulus lifeline stalls the economy. If the fear of a downward swoon is strong enough, it may result in calls for more even more stimulus measures. It is never fun when the "punch bowl" gets taken away from the party.

    Remember that our debt/GDP ratio contains two dynamic variables. Debt can go up, and GDP can go down, and this could push the ratio towards a de facto default. It has happened to other countries, and the US is not immune to a double dip. Let's call our debt problem a "catch-32." You see, once our debt ratio becomes large enough, we will be required to tax $3 for every $2 of spending, because the other dollar will go toward interest payments. Catch-32 is a fiscal mess, and it is sometimes called a death spiral. Rest assured, if we ever see it, the catch-32 will severely crimp economic activity, and it would be the unfolding of the bond market and the US dollar.
  • Geopolitical turmoil. It went relatively ignored last week when the Xinhua news agency reported a Chinese official's lament that:
Washington can still borrow at low costs even when some smaller European economies are completely shut out of the global bond market. But economics and common sense do not lie. People, or governments, can overspend for some time, but they simply cannot live on borrowed prosperity forever. -- Ming Jinwei
You may not agree with the above, but don't ignore it! If China sees better financial returns for its trade surplus in its home market, then the US dollar and the bond market will suffer. Political motivations could fill a similar gap. Imagine if China uses its debt purchases to protest our foreign policy decisions or human rights complaints.

Other sources of geopolitical turmoil include Iran-Israel, Russia, Syria, and the broader Middle East. If the US acts in a manner which requires substantial financial investment to enforce our foreign policy goals, the global bond market might protest. It is plausible that US debt could be scorned, because our debt load is already ridiculously high. Hence, it has been said that a country with economic might has military might; the converse applies. A world with no "cop" is messy and volatile.
  • Crowding out. The Chinese could be required to ramp up domestic consumption measures in seeking domestic stability. If large enough, these measures may result in China running significant budget deficits. At the margin, this will always compete with the US for funds. Our other trusted lender, Japan, has embarked on an economic stimulus plan that will increase demand for borrowing, and this will, as above, compete with the demand for US Treasuries. Europe too remains mired in debt, and looks to the global markets for funds. Granted, the crowding out argument has never been fulfilled despite its intuitive appeal.
  • Social unrest. There is a budding movement of "austerity" in the US -- driven from Republican congressional leaders and other fiscal conservatives. Under the guise of saving the country, there are increasing calls for reducing payouts to Medicare, Social Security, and welfare programs. Ignore the hype! None of these programs will be cut, because if there were significant cuts in benefits, then there would indeed be protests in the streets, and this would indeed result in lost confidence, recession, and reduced financial returns. The reality is that taxes will continue to increase at the fastest rate possible with the only damper being a fear that increased taxation will crimp business growth. If democrats lose their fight to increase the welfare state, then the social unrest could be the undoing of the bond market. Ironically, the expansion of the welfare state during a severe recession has created the debt which threatens to undermine the bond market. Measures to reduce spending will fail, and if they succeed, the bond market will suffer and social unrest will rise.




Commodities

For several years, there have been calls that the USD will come under pressure due to the above-described fiscal mess. Each year it turns out to be overblown, and this year may be the same. But, given the political and fiscal mess, it can't hurt to have some of your funds in metals. No big bets, just diversification. Sell some covered calls on them in peaks to generate income, because these assets pay no dividends.

I have yet to find a commodity investment that is not laden with unpleasant tax consequences, like surprise K-1s and passive income and losses. I stay away from these vehicles despite their intuitive appeal. If you want commodity exposure, try the agribusiness, oil, or consumer products equities. They aren't great correlates, but they may show some sympathy with commodity movements.

Conclusion

Increased taxes, increased government spending, and continued political brinksmanship are near certainties. There will be volatility, there will be natural disasters, and there will be inflation. More likely than not, interest rates will come unglued from their artificial level. Position your investments to take advantage of:
  • Equity volatility (option-based strategies)
  • Rising rates (short term bonds, CDs, money markets)
  • Price inflation (TIPS, Commodities, Metals)
Hopefully, there will be happy times in your families, and joys in life that supersede any economic turbulence of 2013.
No positions in stocks mentioned.
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