As investors and financial advisors approach the end of 2021 and consider their annual recalibration of portfolio mix for the coming year, they would be prudent to factor in some difficult economic realities that can no longer be ignored–that will alter stock and bond performance into and well past 2022.
geralt / Pixabay – Valuewalk
And those hard realities urgently argue for a different approach for attaining attractive returns while effectively managing the ever-present, but growing, risks in the financial markets.
The U.S. Economy Is Fragile
Multiple data points show a current U.S. economy as fragile as the coming snowflakes. To name a few:
- The U.S. economy is struggling. It grew at a 2 percent annualized pace in the third quarter, its slowest increase since the end of the 2020 recession. This follows a 6.5 percent rise in the second quarter, which was well below expectations.
- Inflation is getting worse. Inflation is at a 30-year high, growing to a 4.4 percent annual rate in September, while personal income declined at a faster pace than expected. All while Congress and the administration has and adamantly continues to push to inject more money into the economy through its varied and multiple stimulus programs. So far this fiscal year, the federal government has run a cumulative deficit of $2.7 trillion, which is 150 percent larger than the fiscal year 2019 deficit ($1.6 trillion greater) at this point in the year.
- Bond yields are bottom of the barrel and are eroded by inflation. Current 10-year Treasury Bonds are yielding roughly 1.5 percent. (Let me do the math for you: 4.4 inflation minus 1.5 yield equals down 2.9 percent).
- The Federal Reserve is out of bullets. Rates are already near zero and can only go up (thus adding to inflationary pressures).
- The labor shortage is becoming a fixture of the U.S. economy. The country is missing more than four million workers compared to the start of the COVID-19 pandemic. Employers are struggling to fill 10 million job openings.
- The nation’s supply chain is in chaos and according to Moody’s Analytics, supply chain bottlenecks are disrupting the global economic recovery and are “getting worse.”
- Consumer demand and spending is strong (Econ 101: high demand plus product shortage equals rising prices).
The Hard Economic Realities Have Yet To Catch Up With Earnings
Yes, these are the hard realities, so how to explain the stock market’s record highs? While the Fed has flushed a record level of liquidity into the markets, at the end of the day, equity valuations are largely determined by the earnings of listed companies and prospects for future earnings. When companies make more money, their share prices go up. The acute concern is that the hard economic realities have yet to catch up with corporate earnings. Investors today are ignoring what could be very reduced profits in the new year and beyond as the bad economics accelerate.
Fiscal and monetary policy prescriptions taken to address the impact of COVID-19, while offering some short-term stability at the peak of the pandemic, have shown little positive impact in mitigating the challenges for investors and longer-term economic health. I’m for fixing roads and bridges as much as the next person, but it does not solve for the serious underlaying problems in the economy.
Investors face an increasingly redefined world today in which traditional portfolio construction is ill-suited to replicate historical returns. Therefore, investors should redefine how they invest and build portfolios to capture opportunities and mitigate risk.
Hedged equity, as an asset class, may provide some timely relief from these unprecedented challenges in both equity and fixed income markets by expanding the toolbox of traditional asset allocation. Where bonds have traditionally served dual roles of capital preservation and income, the current rate environment invites more risks and mutes return forecasts for bonds. In a low-yield environment, investors are nudged towards increased risk asset allocations and away from bond allocations with negative real rates of return. Hedged equity provides investors growth potential fueled by rising equity markets, while allowing them to mitigate portfolio risk through the use of options to hedge market risk, without relying on bonds.
The economic world in which we live and invest today is unlike anything seen in our lifetimes. The hard economic realities which exist compel different financial planning and approaches than in the past – something most of us haven’t had to consider in our lifetimes.
About the Author
Randy Swan is the founder and lead portfolio manager of Swan Global Investments, based in Durango, Colorado.
Swan Global Investments is an SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (DRS). Please note that registration of the Advisor does not imply a certain level of skill or training. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is no guarantee of future results and there can be no assurance that future performance will be comparable to past performance. This communication is informational only and is not a solicitation or investment advice. Further information may be obtained by contacting the company directly at 970-382-8901 or www.swanglobalinvestments.com.