September 28, 2012

Advisors, the Election and Portfolios: One if by Land, Two if by Sea

In his famous plan for placing either one or two lanterns in the Old North Church steeple, Paul Revere was not trying to signal whether there would be trouble; trouble was certainly coming. He just wanted to let the Colonists know whether the Redcoats would be marching overland (a longer route which would allow more time to prepare) or would arrive more quickly, by boat.

As advisors and investors, we might do well to weigh the implications of this year’s presidential election in a similar fashion. It is already well established that serious financial trouble is in the neighborhood. We just want some idea of when it will explode so we can prepare.

Whether we focus on our GDP-sized sovereign debt swelling by more than a trillion dollars a year … or on the growth of government spending in relation to the private sector, the odds look very high that some painful version of deleveraging awaits us. It seems our selection of a candidate will, at best, determine whether we confront the spiraling debt head on and soon, or ignore it until it is large enough to destroy the economic system that has made America the destination of choice for the world’s emigrants.

Even if I could accurately predict our next president, I wouldn’t design a portfolio around it because:

a) nobody knows who will control the legislature, and 

b) a president can always adapt to events.

I think the following are substantive differences between the parties in the current quadrennial quarrel:

One party is not terribly concerned about debt, so they are not all that keen on reducing government spending. Nor do they think that a steeper, more progressive income tax would impair economic growth. My expectation is that with this party’s leadership taxes, sovereign debt and the role of government will increase.

To a democratic free-market capitalist (a disposition to which I plead guilty), several investment realities are implied by this scenario.

  1. As the world’s largest debtor and the keeper of the world’s reserve currency, the temptation to cope by monetary sleight-of-hand will be irresistible.
  2. With debasement of the currency, interest rates will begin a long-lasting upturn.
  3. A growing debt burden will, at best, shrink economic growth. At worst, the late, great recession will resume, tax revenue will shrink and borrowing increase … well, you get the picture. In a few years it could become grim.

The other party seems to see the world differently, believing that prosperity is most likely to spread throughout society if conditions favor personal initiative, including the freedom to fail or to succeed. Among those conditions they would list a limited role for government, a balanced budget and encouragement of competition as the natural environment for beneficial innovation. 

What are the investment implications should this party prevail in November? Reduced government spending and attention to debt reduction might well slow the engines of commerce in the short run. But once America’s entrepreneurs became convinced of the new tone, we just might experience again the energy and rush of optimism we enjoyed when government was half its current size and when no bank was too big to fail and when loans were repaid with sound currency.

Because nobody knows how the elections will turn out or how the victors will actually behave in office, I believe a portfolio should be designed for the present reality, which is not terribly hospitable to capital. If things look different on the morning of Nov. 7, economic reality will take considerable time to evolve; there will be plenty of time to adapt. For now:

  1. Too-high sovereign debt is a global reality; current low interest rates are a contrivance that cannot last. Rates will rise. Favor shorter-term bonds issued by sound businesses.
  2. GDP growth will be grudging for some time; weakest competitors will fail (Schumpeter’s famous “Creative Destruction”). Equity portfolios should concentrate on businesses that can survive the purge and grow by gaining market share.
  3. Expect a less-hospitable economic environment until borrowing and governing begin to re-balance; a conservative equity portfolio should emphasize value more than optimistic consumer spending projections.
  4. A precious metals position is a sensible hedge against a possible runaway debt that is eventually resolved by a crisis rather than a return to fiscal propriety.

Oh, and don’t forget to vote!

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