Weekly View: Of Mice and Men... and Markets

SUMMARY

• QE, low rates, higher taxes, and rising inflation are important investor concerns, in our view.
• We do not believe these concerns should lead investors to abandon risk assets.
• We believe risk assets can provide protection from these concerns and should represent meaningful allocations in most portfolios.

‘The best laid schemes o’ mice an’ men, Gang aft a-gley [goes wrong]’ – Robert Burns

Since the financial crisis in 2008 we have witnessed an extraordinary behavioral phenomenon. It all started with a growing list of what we would call ‘ideological’ investor concerns that included:

1. Money Printing: ‘Money-printing’, more kindly referred to as quantitative easing (QE), has irked many investors from the start. Ideologically, they would argue that the Federal Reserve should not intervene in financial markets.
2. Low Interest Rates: One of the outcomes of money printing is artificially low interest rates. Many worry that interest rates are being kept too low for too long despite clear signs that the US economy is recovering.
3. Rising Debt and Higher Taxes: The COVID-19 crisis elevated the concern that programs such as paycheck protection, enhanced unemployment benefits, stimulus checks, and eviction moratoriums have undermined the economy’s natural healing ability. These programs would also contribute to the significant government debt, which would ultimately need to be financed by higher taxes.
4. Inflation: Rising prices (inflation) and the declining affordability of the basics like food, gasoline, transportation, and housing have further increased anxieties.

While we also share many of these worries and wonder about their long-term implications, these ideological concerns are not the behavioral phenomenon we are speaking about. The phenomenon we refer to above is the way in which many investors are reacting to these concerns. The common reaction by these investors is to sell ‘risk assets’, like stocks and commodities, and to hide in ‘stable assets’ like cash, CDs, and bonds. The irony is that a shift from risk assets to stable assets may make these investors even more vulnerable to these concerns.

This is because stable assets have less potential to rise to offset the impact of money printing, low rates, higher taxes, and/or spikes in inflation. In our opinion, this behavior of worried investors can be seen in the chart below from Ned Davis Research. The top panel shows that global stocks have consistently outperformed global bonds since 2009. Yet, the bottom panel displays a consistent pattern of fund flows out of stocks into bonds throughout most of the 12-year recovery.

Risk assets have a different return profile than stable assets. While they have the potential to decline in value - sometimes substantially - they also have the potential to rise. For example, money printing can be good for risk assets because it creates asset price inflation, which many Americans have experienced over the last decade through the ownership of their homes. Likewise, the negative implications of higher taxes and government spending can be partially offset by owning the stocks of companies that are the beneficiaries of that spending. Low interest rates are rarely a negative for risk assets like stocks since low rates provide low-cost funding for companies with attractive investment opportunities. Finally, risk assets can sometimes partially protect an investor against inflation since many companies can raise prices and pass that inflation on to consumers without sacrificing their earnings.

While we believe that the ownership of risk assets is currently the best way to protect oneself from these ideological concerns, there are times where risk assets can be expected to perform poorly and a shift away from them would be justified. One example would be a lasting economic crisis like the one experienced in 2008/2009. Another example would be an event that causes foreign investors to lose faith in the US’ ability to repay our debt. A third example would be a massive change to the tax code that would significantly impact corporate earnings. A final example would be a period of high and lasting inflation that would permanently impair stock valuations.

Crises trigger policy responses. While RiverFront’s view is that these examples are unlikely to come to fruition in the near-term, if they were to happen, we think the negative implications to risk assets would not be long-lasting. This is because policymakers would likely intervene before any such crisis could take lasting hold. Their intervention would likely follow the same playbook they have been following for over a decade; print more money, further lower interest rates, and ramp-up fiscal spending. Such a response would, when the dust settles, likely benefit risk assets while further punishing stable assets. Given these realities, RiverFront’s balanced portfolios remain overweight risk assets relative to our benchmarks. Furthermore, we think investors should consider the following:

• Accumulate Investors: Given the long-time horizons of accumulate investors, declining purchasing power poses one of the most important risks to attaining goals. Risk assets, in our view, provide the best protection against declining purchasing power and should thus be fully represented in accumulate portfolios. Additionally, declining markets offer the accumulate investor the opportunity to buy stocks at lower prices.
• Sustain Investors & Distribute Investors: Purchasing power protection is also important to sustain and distribute investors since retirement can encompass many years. According to the Social Security Administration, a 65-year-old male has a life expectancy of 19 years while a 65-year-old female can be expected to live nearly 22 years. Mathematically, this means 65-year-olds will need their money to grow 1.8x for males and 1.9x for females in a 3% inflationary environment. As inflation increases, the required growth rate also increases. For example, if inflation rose to 5%, 2.6x growth would be needed for a 65-year-old male and 3x growth for a female, all else being equal. Therefore, we believe sustain and distribute investors should consider meaningful allocations to risk assets in their portfolios and favor income vehicles that offer the potential for distribution growth, like stocks with growing dividends.