Double Whammy

For a typical investor, the last two weeks have not been much fun at all. No matter what market relationship you were counting on, it probably has not worked.

Equities have been meandering, with a spot of a one-day 1% down trade thrown in for fun. In such an environment, you would have expected bonds to do well. No such luck this time around. Bonds actually sold off on a global basis. If you were counting on the dollar to save the day, well, that didn’t happen either.

When was the last time you thought European periphery spreads were going to widen dramatically and German Bunds would be having one of their biggest sell-offs in a while?

In an environment where deflationistas—or their more evolved species, disinflationistas—were having a field day, all of a sudden oil is picking up, inflation expectations are rising in a big way, and anything bond-like is getting hammered.

I get dizzy trying to make sense of all the moves, counter trends, pierced support levels, and other such mumbo jumbo.

At the moment, a lot of the price action is being driven by the positioning in the market. The price movements in Bunds or oil or the dollar are prima facie evidence in that regard. As a long-term investor, I have a lot of respect for these positioning-driven moves, but it makes zero sense for me to adjust my portfolios based on these short-term moves. So, what am I supposed to do?

Focus on the Underlying Drivers

When you get into this frame of mind, as I am at the moment, my recommendation is to stop watching the screens. Most of the time, market prices and price actions have a lot of information about the underlying drivers.

But at other times, the price action has a lot more to do with market participants than the underlying economic drivers. In those times, it is best to ignore the price action and focus on the logic of the economic drivers and just go with that.

I believe today is one such day.

So, I am ignoring the price action and, for the time being, focusing on what I believe are the fundamental drivers:

1. The U.S. economy is growing at a decent but modest clip. Growth in the first quarter of 2015 was a disaster due to multiple reasons. Things will pick up during the rest of the year but remain below trend on an annual basis. That means the U.S. Federal Reserve is going to tighten, even if it shouldn’t.
2. The European economy is picking up, but from a very low base, and likely to grow at a very modest pace. The European Central Bank will continue to provide significant support. And while Greece will be a perennial thorn in our side for the rest of our careers, there is only one solution, which is to kick the can down the road.
3. Emerging markets are slowing for sure, but probably will grow faster than developed markets and are likely to have the powerful tailwind of central bank policy easing and support.
4. Oil has recovered from its distressed levels but is unlikely to get to a materially higher level for three reasons: The slowing of emerging market economies, U.S. tightening coupled with a modestly higher dollar, and Saudi machinations.
5. Interest rates are likely to remain low on a global basis. They may rally a bit from current levels, but we have probably already seen the lows of the year. Credit should do well in the current environment.
6. In a demand short-world, inflation remains dormant and inflation expectations remain much lower than they have been in recent years.
7. Given the policy differentials, the U.S. dollar probably appreciates a little, but neither the U.S. economy nor the dollar will decouple too much from the rest of the world.

Given those underlying assumptions and market valuations, I would structure a portfolio now much the way I would have at the beginning of the year:

• Equities over bonds,
• Globally diversified equities,
• Overweight credit, especially municipals and developed market corporate credit, and
• Incorporate non-traditional sources of income such as Master Limited Partnerships and senior loans.

Tweaking at the Margins

However, if I had a few extra dollars to invest or wanted to tweak my portfolio at the margin, I would make the following adjustments:

• Buy some U.S. rates,
• Buy some more credit, but in places where things have widened a lot—the European periphery is the obvious choice here,
• Get modestly higher exposure to the dollar, and
• Buy some U.S. equities.

The bottom line is not that you have to agree with my conclusions or make the adjustments that I would make.

Instead, it is more about the investment process, ignoring the cacophony produced by market moves, and sticking with the plan while making modest adjustments at the margin.

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