Divesting vs. Reallocating Exposure

As we approach the half-way mark for 2017, echoes of uncertainty continue to plague global markets.  With China experiencing its first downgrade since 1989, the Brits heading back to the polls in June for a snap election, and a deja vu scenario playing out in Brazil.  The S&P 500 has proven resilient to the investigations plaguing the Trump administration, as “political risk takes a backseat to improving economic fundamentals”.  Eight years into a bull market, it is natural for investors to be concerned, as the media continues to plant the seed of concern with talks of an impending bear market.  This month’s issue of The Samra Report will focus on divesting vs. reallocating exposure, depression babies, and alternative investments in the new housing market. 

Investors and advisors with a flawed fundamental understanding of macro-economics, are certain to experience negative returns during times of market appreciation, as they neglect to factor an appreciation of domestic currency, against the appreciation of foreign equity and debt instruments.  To simplify this: imagine converting US Dollars to Euro’s, investing Euro’s in an appreciating German company.  When it is time to liquidate the investment, if the USD to the Euro has increased in value, the investor stands to lose on this trade, on a currency adjusted basis.  In the past, the most common methods to hedge currency risk was via SWAP contracts, or holding foreign currency outside of the United States for investment purposes.  More recently, with the advent of currency hedged Exchange Traded Funds (ETF’s), these investment vehicles have allowed for a low cost alternative to investors with limited, or no options trading experience, exposure to foreign markets with a currency hedged strategy.  This strategy becomes significantly more important, as investors and advisors contemplate divesting assets out of select markets.

Oftentimes overlooked, investors have the capacity for investment exposure to almost any economy in the world, without direct foreign investment.  In fact, only 52% of revenue generated by S&P 500 firms is generated domestically.  

The United States is not alone, when it comes to crossing borders, to generate revenue.  Nestle, better known for its Swiss chocolate operations, generates more revenue ($92.36 Billion) from bottled water in the United States, than it generates with chocolate sales domestically.  Should the Trump administration be able to move forward with their campaign promises of: a border adjustment tax, and lowering the corporate tax rate to allow for domestic companies to repatriate cash held overseas investment strategies with global exposure will require fine tuning.  As Fortune 500 companies hold an estimated $2.4 Trillion in cash overseas, repatriating these funds at a lower corporate tax rate would further strengthen fundamentals. 

With Technology leading the S&P 500 YTD (20.03% vs. 7.73%) and over the last year (32.36% vs. 17.46%), a tech-led stock market, tends to frighten investors.  With flashbacks of the dot-com bubble, strong balance sheets, increasing technological innovation, and $70 Trillion in cash on the sidelines, we expect the bull market to continue at a similar trajectory.  Investors should take into consideration; the stockpiles of cash tech companies hold overseas.  A lower corporate tax rate, would allow these companies to repatriate the overseas holdings, further streamlining their operations. 

In the later stages of a bull market, fundamentals give way to market sentiment, as investors dismiss strategy and follow the crowd, in search of higher yields.  With interest rates forecasted to stay at historically low levels, it is likely holders of cash will grow impatient, take on additional risk, in search of higher returns.  Investors who exited the financial markets and moved to cash during the great recession, guaranteed their losses, missing out on an 8-year rally, and the potential to redeem their investment losses.  This trend dates back to the great depression, with investors who are better known as Depression Babies: “their experience of large macro-economic shocks affected their long-term risk attitude,” as a result, they never re-entered the financial markets.  A “recent Gallup poll showed 52% of Americans have money in the stock market, compared with 65% in 2007”.  With millennials sheltered from the market turmoil, we believe the bull market will continue to be fueled until technology and automation has a negative impact on labor demand.

For investors concerned with market volatility, modern portfolio theory states investors can optimize returns, lowering volatility by allocating a portion of their portfolios towards alternative investments.  Investments other than traditional (Cash, Stock, and Bonds), typically consisting of allocations towards real estate, hedge funds and commodities, as these investments have little to no correlation with stocks and bonds.  The subprime mortgage crisis, created a massive pool of abandoned homes, a problem for the foreclosing lenders, however, an area of opportunity for private equity and investment companies.  Investment firms purchased rental properties in bulk, entering the rental real estate market, while providing their clients with investment opportunities.  Recently, declining inventory has caused these firms to enter the new home and newly renovated multifamily rental markets.  With WTI fluctuating at session lows, Gold appreciating, but unlikely to hit new highs, and dismal historic hedge fund performance during bull markets, real estate within select markets is an area we expect to see grow.  The addition of an alternative investment allocation to a portfolio can be accomplished through sector specific ETF’s or SMA’s.  However, investors with sophisticated needs, may want to consider utilizing a private equity firm, specializing in this area. 

In January’s issue of The Samra Report, we predicted the FOMC would raise interest rates once in 2017, a contrast from Merrill Lynch and UBS who have predicted 3 hikes, while J. P. Morgan predicted 4 rate hikes this year.  With the stock market rallying for an eighth year, consumer sentiment at 97%, and April’s unemployment falling to 4.4%, it makes sense for the FOMC to raise key interest rates to steady inflation.  The Fed’s mandate of maximizing employment, stabilizing prices and moderating long-term interest rates, would be in line with the expected June 14th rate hike.  However, using Core Inflation (inflation minus energy and food) as a measure, over inflation, investors will notice a downtrend this year, ending April at 1.9%.  Furthermore, as Net Exports have been in decline since Q3 2016, a rise in key interest rates would lead to further declines. 

Economics at the most basic level, correlates a rise in interest rates with a decline in Net Exports.  Simplifying this statement: as interest rates in the domestic economy rise, the domestic economy experiences an influx of foreign investment, driving up the strength of the local currency.  As a result, domestic goods become more expensive to foreign consumer, driving down demand for domestic goods and services.  

It is our opinion, the Fed should consider the following factors, prior to raising interest rates:

  1. Homeownership rates in the United States have declined to levels not seen since the 1960’s.
  2. A lower corporate tax rate, triggering repatriation of foreign assets would lead to an influx of domestic assets. 
  3. Credit card default rates have seen an uptick from Q1 2016.
  4. The rise of automation and machine learning is cannibalizing domestic labor demand.

 

 

 

 

 

 

 

 

 

 

All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed.  All economic and performance data is historical and not indicative of future results.  All views/opinions expressed herein are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. The information and material contained herein is of a general nature and is intended for educational purposes only.  This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. Before investing or using any strategy, individuals should consult with their tax, legal, or financial advisor

Samra Wealth Management, A Member of Advisory Services Network, LLC