Finding the Port in the Perfect Economic Storm (published in March of 2010 in the SB News Press)

Two weeks ago, I wrote about the possibility of a perfect economic storm, which could combine several potentially devastating occurrences, which in turn could drive the economy into a double-dip recession.  In this week’s column, I will discuss some of the possible investments that would potentially benefit from this kind of negative economic environment, or that would, at least, perform relatively better than other investment choices.

Before we begin, readers should keep in mind that I am not making any direct investment recommendations, and each investor must understand their own investment objectives and risk tolerance, and should consult investment and tax experts before making any investment decisions.
First, allow me to recap what I wrote in the previous article regarding the possible negative economic outcomes.  As I see it, the greatest threat we are facing today is a cascading default throughout southern Europe on sovereign debt, starting with Greece.  If this were to occur, I would expect the dollar to strengthen against the Euro dramatically.  This, in turn, would cause U.S. companies that sell overseas to lose significant revenues, since their goods would be much more expensive, at least in Euros, but probably in all other currencies, since a massive default across Europe would be catastrophic to the global economy. 
Additionally, there would likely be a big inflow of capital to the U.S., despite the stronger dollar, because we would be seen as a safe haven.  This inflow of capital would strengthen the dollar even further, as foreign investors would sell their currencies to buy dollars.  That capital would likely go into treasuries for the most part, which would drive prices up and yields down.  To a lesser extent, prices on other types of bonds, such as high-quality corporates, would likely increase as well (their yields would also decrease).  The amount of capital flowing into corporate bonds would be somewhat limited due to the negative impact I mentioned above regarding lost sales overseas.
Continuing with this theme, since corporate profits for many of our largest companies would decline, I would expect to see corporate earnings decline overall, forcing analysts to reduce their earnings estimates, and thereby causing stock prices to adjust down significantly to reflect the new, lower expected profits of companies.  Firms with little or no foreign sales would perform much better than those with a heavier dependence on foreign sales, and more defensive sectors of the economy, such as healthcare and consumer staples, would likely perform better than more economically sensitive, higher growth sectors, such as technology, energy, industrials, and consumer discretionary.
A stronger dollar would also very likely force commodity prices down significantly.  Most commodities trade in dollars, and also depend on economic growth to support demand.  The threat of inflation tends to drive commodity prices higher, so, if the dollar strengthens dramatically and the economy is weakened globally, commodity prices would drop.  (I think they are grossly overvalued anyway.)

Even though our economy would fare better than that of Europe, and likely most other areas of the globe, we would still be negatively impacted here at home.  Lost revenues for companies selling overseas would cause unemployment to rise even further, weakening demand for goods and services made by all companies that sell in the U.S. market.  Again, this would make stocks less attractive and would likely force prices lower.  The economy would likely double dip, moving back into recession, and the duration of the hard times we are facing, and have faced since December of 2007, would be extended; likely for several more years.
Real estate prices, under this scenario, would also decline, since demand would be damaged with increasing unemployment.  Lower interest rates could help somewhat, but without demand there would likely not be a sufficient number of buyers to prevent additional price declines.  (I believe we are still due for more downside in real estate prices – probably 10% to 15% more (at least) – regardless of what happens to the economy.)
What to do?  Under this scenario, there would be many opportunities to sell short.  One could short commodities across the board, and especially gold.  Stocks would be a good short in the short-run at least, with those sectors that are the most economically sensitive offering the best opportunity.  Lower quality bonds, especially high-yield (junk) paper would likely perform pretty poorly as well.
On the long side, treasuries, as stated above, would likely increase in price, so those who own treasuries prior to the defaults would profit.  The same could be true for higher quality corporates, but again, to a lesser extent.  Longer maturities would likely perform better than shorter maturities, although I would be careful about tying money up for longer than ten years at the outside, since I feel that eventually, we will see rates rise (more on this below). 
For stock investors, I would expect an initial, very negative reaction across the entire market, resulting in an oversold condition, dropping valuations to far below even their adjusted valuations, taking into account the loss of revenues, etc.  This would be followed by a rebound of some magnitude, with those sectors that are most defensive (healthcare and consumer staples) rebounding more aggressively, as investors look for the safest companies to own. 
If we do not see a broad-based default across Europe, we still face some potentially powerful and negative economic challenges.  I do expect to see interest rates start to rise this year, and we already witnessed the Fed take the first step when it raised the discount rate to 75 basis points a few weeks ago.  If inflation starts to heat up, the Fed will have to make a very difficult decision, which is to raise rates quickly and by a large amount to combat inflation, crushing the economy, or to allow inflation to run rampant.  I can tell you that they will fight inflation, even if it hurts the economy. 
If rates start to rise, bond prices will suffer.  This is why I am keeping all maturities in the portfolios I manage to five years or less, and am also staging maturities (using ladders).  In this way, I will have bonds maturing at intervals, providing capital that I can then reinvest for my clients at ever higher rates (as rates rise). 
Under the higher inflation/higher interest rates scenario, stocks could do alright as long as rates do not rise too quickly, killing the economy.  A little inflation is actually good for stocks, commodities and real estate (all inflation is good for commodities).  Too much inflation however will crush stocks because it will crush the economy, hurting earnings.  So, if one feels that inflation will get out of hand and rates will rise too quickly, the investor would either want to avoid stocks, or would only want to own those same defensive sectors.  If however, the investor feels that inflation will be moderate, they would want to own higher growth sectors that will benefit from the economy heating up.
One other issue to consider is where your money is held.  Although my firm is a small independent investment management firm, I use Fidelity Investments to hold my client assets, which has about $2 trillion in assets under custody, and is one of the largest and safest financial firms in the world.  They, unlike many others, did not participate in the derivatives party, did not issue any mortgage-backed securities, and did not take any TARP money.  Most financial institutions have insurance and are reputable, but it is a good idea to double check, just for peace of mind.
There are many more potential economic negatives we face; some that would cause only a short-term shock, and others that could have effects that linger for years.  Depending on your analysis of the situation and your expectations, you will need to make appropriate adjustments to your portfolio to protect your investments, and to hopefully benefit, where possible.  As always, consult experts if you need assistance.

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