We implement tactical asset allocation strategy as a total-return overlay that enhances strategic portfolio returns. Short-term asset prices are more influenced by ‘sentiment’ than by ‘fair value’. Our approach is to identify fundamental trends not fully reflected in the market consensus today. This means looking for existing imbalances that need to be corrected. Timing of such a correction of course represents a risk, so we will target attractive risk/return ratio.
One of the most interesting imbalances today is over-leveraging of the US consumer. This is direct result of the Fed’s rate easing cycle that began immediately after the piercing of the US stock market bubble in 2000 (see graph 1).
Arguably, the Fed has studied Japanese post-bubble example well, saw high cost of inaction and responded aggressively. Net effect of this policy is that the US has avoided full-blown recession after the sharp correction of stock prices. As markets declined, consumers continued spending. This presumably has given the corporate sector time to restructure, cut costs and repay the debts. Is the worst behind us now?
Judging by corporate spreads, US companies are still uncomfortably in debt (result of asset price bubble of the 1990s). But consumers in the US seem to be reaching limits of further borrowing. Firstly, because of deterioration of household credit quality. Mortgage delinquency and foreclosure rates are rising (graph 2) and household saving rate has reached a historically low level (graph 3). The second factor is growing risk-aversion caused by economic uncertainty, primarily by labour market prospects.
The corporate sector recovery that is taking place today is not likely to have a positive effect on consumer sentiment. Any new cash that companies generate today is likely to be channelled towards debt repayment, not new jobs. Hence – weak employment data and talk of ‘jobless recovery’.
It is very possible that US households will cut spending sharply and start saving more. Fresh supply of cheap financing will not change this. What could be the ways to resolve existing imbalances, to restore spending power of US consumer and ensure economic growth? Putting it simply: how do you get somebody out of debt?
The first way is through frugality, higher saving and painful corporate adjustment. The picture could be like Japanese ‘deflation’: low interest rates, reluctant consumers and anaemic growth. It may take less than a decade (since US economy is known to be more efficient than Japanese) but it could take a while. This would be bad news for the equity market and the corporate debt, but government bonds are likely to do well.
The second way is to inflate out of debt. A few years of high inflation can reduce debt burden of the economy to a manageable level, improve household balance sheets and lay ground for a new period of prosperous growth. The question is whether administration succeeds in fighting ‘deflation’. We believe the US has more ammunition than Japan ever had to succeed.
First weapon is new tax cut package envisaged by the administration. It amounts to shifting household debt to the books of the government. It may prevent a slump in consumer spending at the price of higher risk for holders of US treasury bonds.
Second weapon is the currency. While we believe that large US current account deficit is structural and need not be fully corrected, its sheer size may cause dollar weakness and cause some import-led inflation.
Lastly, a war in the Middle East may create economic boom on the back of military spending. It may also lead to ‘cost-push’ rather than consumer-led ‘demand-pull’ inflation through higher energy prices.
This ‘inflation’ scenario is negative for bonds. It could cause short-term equity rally, but then cash-flow-based valuations may suffer from higher discount rates. In the end, commodities would end up as the biggest winner.
Clearly, a move from a ‘deflation’ to an ‘inflation’ scenario would be some sort of a ‘trend reversal’ for today’s markets. We do not attempt to predict timing of such change but see it as increasingly likely resolution of today’s imbalances. For the moment, our tactical asset allocation reflects risks to economic growth from expected US consumption slump. Throughout this year we’ve been maintaining a negative view on US equities, neutral on US bonds and were slightly bullish on commodities. A war in the Middle East can lead to an important trend change and we shall be ready to overweight commodities, move US equities from underweight to neutral and short US treasuries.
Igor Drozdov is senior fund manager, tactical asset allocation at Mn Services in The Netherlands