Quarterly Update: Summer Newsletter 2013

With the economy now in its fifth year of weak expansion, US equity markets recently making new highs, interest rates beginning to rise, and investors finally beginning to move money back into stocks, I thought this would be a good time to review what we believe are the major economic themes moving forward.

Theme 1: Inflation. While we don’t seem to have much inflation at the moment (at least according to official government numbers), many believe that a strengthening economy coupled with the current loose monetary policy will likely lead to some inflation, and perhaps a lot for a while.

Theme 2: US Energy Boom. We believe that the US economy is poised to experience a generational boom in energy. The amount of natural gas and oil discovered in the US and now accessible due to modern technology stands to potentially have us independent from foreign energy sources by 2020.

Theme 3: Emerging Markets. While emerging market equities have done poorly as of late in comparison to US equities, we believe the next decade will see significant transformation as many of these countries are poised to potentially grow at significantly faster rates than developed countries and as greater numbers of the poor in these countries move into the middle class. Keep in mind that international and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

Theme 4: Bond Bubble. Since 1980 interest rates on the 10 year US Treasury Bond have fallen from about 15% to below 2%. This has provided an unprecedented bull market for bonds. At these low rates, there are only two directions we are likely to go: 1) we stay between 1% and 2% on rates due to the US economy experiencing deflation much like Japan has in the past 20 years, or 2) interest rates begin to climb back toward a more normal 4-6%. Since our demographics are significantly different from Japan, I believe the second outcome is more likely. Consequently, bonds will be pressured and may give clients fairly low rates of return (those in longer dated bonds face serious principal risk). Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Theme 5: The need for more diversified portfolios. The markets tend to run in cycles, and we tend to want more of what is working just when it becomes more dangerous to do so. For example, many investors wanted more growth and technology stocks in 1998-1999 just when that bubble was about to pop. Similarly, investors fell in love with real estate in 2004-2007 as that bubble reached its peak. Today, investors seem to want more bonds and now US stocks as other investments seem to pale in comparison. We believe the best answer is to own very diversified portfolios designed to manage the risk of a blow-up in any one area while hopefully providing meaningful long-term potential returns. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Thank you for your continued trust and please call your wealth manager if you have any questions.