On the surface it seems the markets are experiencing a relative period of calm with equity prices about flat year-to-date and up around 10% versus a year ago.  The credit markets have also stabilized since the 2nd quarter when it appeared that one or more of the European countries could be forced into defaulting on their debts.  However, a look beneath the surface shows some very deep and turbulent cross-currents.

Gold, historically considered a hedge against inflation, has risen about 10% year-to-date despite the increasingly recognized risk that deflationary forces are taking hold in the U.S.  The potential for deflation has shown up in long-term U.S. Treasury bond values, which have posted 15% - 20% returns so far this year. The last time gold prices and Treasury prices rose was late 2007 into 2008 ... and we know how that ended. 

 

So, how can gold and U.S. Treasury prices rise at the same time when the former prefers an inflationary environment and the latter a deflationary one?

Without getting into an overly complicated explanation, we can arrive at a two-part rationale for this seemingly schizophrenic behavior. 

 

First, in addition to being a hedge against inflation, gold is now being seen as a hedge against the devaluation of major global currencies such as the U.S. dollar and the Euro.  As governments increasingly intervene to bolster economic growth or guarantee new and existing debt, the risk is that they will opt to print money and debase their currencies.  Thus, gold is seen as an alternative form of currency.

 

Second, Federal Reserve Chairman Ben Bernanke recently said that there is "unusual uncertainty" facing the market and the economy.  His statement embodies the wide divergence of views in the market with people taking strongly opposing views on inflation/deflation, interest rates and equity valuations.  One camp of investors is drawn to the safety and yield of U.S. Treasury securities while the other camp opts out of fiat currencies in favor of precious metals.
 
The Right Medicine

In time, of course, all of this will get sorted out and we'll know what the risks really were.  But investors are faced with making hard choices with  limited information.  Those who get it right will be rewarded while those who get it wrong will learn an expensive lesson. 

 

What do we at Sextant Investment Advisors expect to see over the next 1 - 3 years? 

 

Our fixed income portfolios have performed very well this year primarily because our analysis several months ago indicated that deflation would turn out to be a greater concern than either inflation or the increased supply of U.S. Treasury debt about to hit the market.  Accordingly, we locked in rates when they were higher and positioned our portfolios longer than the benchmark durations.  We also purchased securities that would benefit the most from "rolling down the yield curve," a strategy that can add significant value when the yield curve is steep.

Those who see continued economic expansion or heightened inflation as the most likely outcomes have to believe that the Federal Reserve and Washington lawmakers will either get monetary and fiscal policies just right or overdo them.  We recognize these as potential outcomes, but we believe it is virtually impossible for Washington to get policies "just right."

 

Therefore, will Washington undershoot or overshoot? 

After spending trillions to stimulate the economy since 2008, there seems to be much less political will to increase fiscal budget deficits further with more government spending.  As for monetary policy, the Federal Reserve will likely take additional actions to keep rates low and make money available to banks.  But there is already considerable dissension on what policies to pursue among the members of the Federal Reserve board and remaining policy choices are becoming limited.  So, it seems to us, the most likely outcome is that policymakers undershoot in their efforts to stimulate the economy.

Where does that leave us? 

 

U.S. Treasury rates and yields on most bonds are not as attractive as they were in the first half of this year.  We are glad that we bought them 6 - 12 months ago when rates were higher and are reducing our duration somewhat now but we are not totally giving up on the value of intermediate and longer-term bonds of high quality issuers.  In fact, we are most concerned now with being invested in only the very highest quality issuers and have moved out of sectors and names that tend to be economically sensitive.

As for equities, we are concerned in the near-term that the cross-currents running through the market could lead to another leg down in equity prices. 

 

During a period of "unusual uncertainty," such as we are in now, negative news can lead nervous investors to rush blindly for the exits.  Of course, we all know what happens when everyone runs to the exit at the same time.  We are positioned defensively in our equity portfolio and underweight versus our benchmarks. The equities we do own are high dividend ETFs with domestic and global exposure to utilities and infrastructure. Maximizing stable income, even within our equity portfolio, is an important theme running throughout our investment strategy.  

For those investors wanting to maintain exposure to the equity market but who share our concerns, convertible securities offer an excellent way to participate in the upside while limiting much of the downside risk of owning equities directly.  Our convertible strategy has performed well in both bear and bull markets and we are positioned to limit volatility in the months ahead.

 

For more information about our investment programs and strategies, please call us at 1-800-723-2007. 

Sincerely,

David Baccile, CFA

Chief Investment Officer 

Sextant Investment Advisors, LLC

 

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www.sextantinvestment.com