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 Quarterly Newsletter: April 2009
Click here to view the Index Returns for 1st Quarter 2009
(PDF,92kb)
Capital Markets
The extreme market challenges of 2008 continued in the first quarter. All equity asset classes except Emerging Markets posted double digit declines. The bond market provided little support with a breakeven performance. Falling home prices and rising unemployment continued to squeeze consumers and pressure the financial system.
Returns for March were excellent; after reaching new lows, equity markets bolted higher to finish the quarter on a stronger note. Market observers have not declared this the end of the bear market but are looking for signs of growth.
Bold Policy Actions
The Federal Reserve, Treasury and FDIC have launched several new initiatives to combat the financial crisis. Though the list of acronyms is long, the programs have recurring themes: reduce interest rates, recapitalize the banking system, add liquidity to the financial markets and restart the flow of credit to consumers and businesses. Congress has joined the fight by passing an $800 billion stimulus package and proposing an aggressive budget. Through unprecedented monetary and fiscal stimulus, government leaders aim to reflate the economy.
Negative Consequences?
Crisis management is difficult work–there are no easy solutions. Even well designed policy responses may have unintended consequences. With home prices down 30%, gas prices in half and wage increases hard to come by, inflation is not top of mind these days. However, when the economy begins to strengthen, inflation may very well be our next challenge. Given the severity of the recession and the political risk of raising interest rates too soon, the Fed may keep interest rates too low too long. In addition, commodity producers are delaying projects to expand capacity due to weak prices and tight credit. Meanwhile, China and India continue to exert their influence as larger consumers in the global economy.
Effects of Inflation
As consumers, we are well aware of the effect of inflation–our dollars do not go as far when the prices of goods and services increase. To investors, inflation poses a similar threat–it dampens our real returns (i.e., our investment return net of inflation), much like an additional tax. Over the long haul, we need our assets to grow in line with or faster than inflation, so that our retirement savings can support an equal or better lifestyle. Inflation can be especially harmful to bond holdings that pay a fixed income.
The chart below illustrates the path of inflation and long term interest rates since 1962 (the earliest data available). Bond yields and inflation tend to be strongly correlated over long periods of time. As inflation and bond yields rose from low levels in the 1960's, bond investors suffered muted total returns and declining principal values. Once inflation peaked, the cycle reversed–investors had the wind at their backs, enjoying high interest income and rising principal values. With inflation and interest rates now at historic lows, it is prudent to build in protection for investment portfolios.
Inflation Defense for Portfolios
Fortunately, there are a number of asset classes that tend to be inflation friendly.
Commodities
Commodities include oil, natural gas, aluminum, copper, gold, silver, livestock, grains, etc. Generally, commodity price changes coincide with economic trends that produce inflation. As consumers increase their demand for goods in a strengthening economy, the demand for key inputs also increases, usually resulting in higher commodity prices. An additional benefit is greater portfolio diversification, since commodities tend to have a low correlation with stocks and bonds.
Treasury Inflation Protected Securities (TIPS)
TIPS are issued by the U.S. Treasury. Unlike traditional fixed rate Treasuries, TIPS' principal is linked to the Consumer Price Index. So, as inflation rises, the principal value of a TIPS bond increases, making it an effective inflation hedge.
Floating Rate Securities
Floating rate notes pay variable interest that is tied to a short term base rate, like the London Interbank Offered Rate (LIBOR). As the Fed raises short term interest rates to combat inflation, the interest paid on floating rate notes also increases. The investor's income is enhanced at the very time when inflation introduces an additional cost.
Real Estate Investment Trusts (REITs)
REITs are companies that invest in commercial real estate. REIT dividends tend to follow increases in rental income, which is commonly indexed to changes in the Consumer Price Index.
Short Term Bonds
Fixed rate bonds with shorter maturities are less susceptible to inflation. When interest rates rise, the value of short term bonds will decrease less than that of long term bonds. Also, the investor doesn't have to wait as long to reinvest the principal to lock in the newly higher rates.
Other News
Barclay's has announced its intention to sell its iShares exchange traded fund business. We recently met with an iShares representative to inquire about any changes in the fund offering or expenses. Though no material changes are anticipated, we will continue to follow this closely.
As a final note, please find enclosed our annual privacy notice for your review. As always, we welcome any questions that you may have.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Arbor Investment Advisors, LLC. Please remember to contact Arbor Investment Advisors, LLC if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. Please also advise us if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. A copy of our current written disclosure statement discussing our advisory services and fees remains available for your review upon request.
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