Time To Derisk

It’s shaping up to be another interesting year for investment markets in 2012.

In my previous commentary from a few weeks ago, I discussed how investment markets were polarized between two widely divergent forces – the challenging reality of the slowing U.S. economy and Europe’s deteriorating sovereign debt crisis versus the hope that U.S. and European policy makers would intervene with extraordinary measures to combat these issues.  But after what has now been several months of choppy action for investment markets, it appears that the forces of reality may soon overwhelm any lingering hope.

The key concern as we close out 2011 and enter into the New Year is the European sovereign debt crisis.  While the U.S. economy has actually shown some signs of improvement in recent weeks, conditions in Europe are continuing to unravel.  Whereas Europe’s sovereign debt problems were once confined to smaller periphery nations such as Greece, Ireland and Portugal (a combined 6% of Euro Zone GDP), it has since spread in earnest to the vastly larger core nations of France, Italy and Spain (a combined 56% of Euro Zone GDP).  As a result, the probability for a major sovereign default in Europe is rising with each passing day, and the fallout effects for the global economy could become severe.

European policy makers squandered what could end up being their last chance to finally get ahead of the problem.  The European Central Bank met on Thursday with expectations that they may surprise with a larger than expected interest rate cut.  Instead, they delivered only what the market was expecting and couldn’t even come to a consensus on that decision, as some committee members were arguing for even less.  European leaders also held a summit on Thursday and Friday with hopes that decisive action would finally be taken to address the mounting debt problems across the region.  Instead, EU leaders continued to dither and struggled to come to consensus on even minor points.  The summit ended with an agreement characterized by the same vagueness and indecision that has limited their ability to adequately address the problem all along.  Although EU leaders are scheduled to meet again in March 2012, by then it may be too late.

A critical market to watch in the coming weeks is Italy, which is the third largest bond market in the world.  In 2012, Italy has sovereign debt redemptions needing to be refinanced totaling nearly $300 billion.  This includes $43 billion at the end of January and another $63 billion at the end of February.  As long as European policy inaction persists, the odds are rising that Italy may forced to default when attempting to carrying out one of these massive refinancing rounds.  The potential is also rising for a hard default by another sovereign or a systemically important banking institution as well.  And such an event would be the likely catalyst of another contagion like we saw starting in late 2008.

For these reasons, it is prudent to begin dialing down risk in investment portfolios at the present time.  Although the situation in Europe has deteriorated meaningfully in recent months, the U.S. stock market as measured by the S&P 500 is actually well above early October lows thanks in part to several additional injections of stimulus by the U.S. Federal Reserve.  And given that short-term risks to the downside meaningfully outweigh the potential to the upside, I have been using recent strength as an opportunity to lock in recent gains on stock positions and reallocate.  Sales have focused on stocks that have a larger percentage of sales coming from international markets including Europe.  The few remaining stock positions are those that have U.S. focused businesses from defensive sectors such as Consumer Staples and Utilities.

The variety of other asset classes beyond the stock market are positioned to hold up well if not benefit in the event of a full blown crisis event unfolding in Europe.  Two categories that would likely move to the upside during such an episode are U.S. Treasury Inflation Protected Securities (TIPS) and Agency Mortgage Backed Securities (MBS).  Fortunately, both would also be expected to perform consistently well if the European situation gets resolved.  As a result, portfolio weights have been increased to both of these asset classes.  TIPS have particular appeal because they represent a safe haven during times of crisis and have performed with consistent upside during both periods of economic calm and instability.  Agency MBS is also poised to benefit due to its short duration – many of these bonds mature within one to three years – the virtually explicit backing of the U.S. government and its generous yield premium relative to comparable U.S. Treasuries.  In addition, if the U.S. Federal Reserve were to add more stimulus with the launch of a third round of quantitative easing, Agency MBS is almost certainly what they will be buying in the dual effort of trying to support U.S. banks and the housing market.  Given the already limited supply of Agency MBS, history has shown that it has been worthwhile to own the MBS securities that the Fed is seeking to buy.

Another category that should hold steady and is likely to benefit regardless of whether we see crisis or resolution is Utilities Preferred Stocks.  Most of the preferred stock market is concentrated in financials, which is problematic because the banks have already come under pressure in anticipation of a crisis episode.  But a select group of non-financial preferred stocks exist in the Utilities sector that are stable and generate predictable cash flows, as most people will continue to keep their lights on regardless of the economic environment and these preferred stocks directly benefit from this characteristic.  While these securities might experience an initial price shock during a crisis episode due to mechanical market forces, they are likely to quickly recover their value within days and provide another safe haven destination for investors.

The next asset class worth mentioning are the precious metals of Gold and Silver.  Gold is the classic hard asset defense against both crisis as well as aggressive stimulus efforts from the U.S. Federal Reserve that weakens the U.S. dollar.  During a crisis episode, however, it may be subject to short-term price shocks.  This is due to the fact that it is a highly liquid investment that is often sold to raise cash during mass liquidation phases.  But any such sell-offs have historically proven to be short lived and ideal buying opportunities, as the price quickly recovers as investors seek to snap up this safe haven asset on sale.  Thus, Gold positions remain in portfolios but remain under close watch.  Silver is the far more volatile of the two precious metals, but it serves two functions.  First, it provides direct protection against an aggressive monetary policy move by the U.S. Federal Reserve or other global central banks.  It also provides a vehicle to maintain stock like exposure with a much smaller concentration of overall portfolio assets.  While the percentage allocation to Silver in portfolios is relatively small, it serves as an important portfolio hedge against a swift and decisive policy turn to stimulate by global central banks.

Lastly, it is worthwhile to make mention of cash.  While I typically prefer to be fully invested during most markets, an allocation to cash makes sense in the current environment.  It enables for the short-term protection of principal value while also enabling the flexibility to step in and potentially purchase stocks and other assets at a discount following any liquidation sell-offs.

Perhaps in the end, European policy makers will finally take the decisive action needed to address their crisis (this, of course, assumes that they still have time to do so).  Stocks would likely cheer the news and it would go a long way in helping to return a sense of calm to the markets.  Unfortunately, such an outcome is becoming an unsettlingly low probability event as each day passes.  Even if the U.S. Federal Reserve were to launch QE3 in the weeks ahead, the positive impact on stocks would likely be muted if Europe remains unresolved.  As a result, the priority for portfolios as we move toward the end of the year is to continue dialing down risk.  This way, if a crisis event were to erupt, portfolios will already be positioned in advance to hold steady if not benefit from such a scenario.  And if it turns out that crisis is averted, the opportunity will still be available to reallocate back into higher risk assets such as stocks at that time.  I will continue to keep a close eye on the markets and will keep you updated as events unfold.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.

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