Two years after the steep recession of 2008-2009, the economy appeared to be picking up steam, only to have the pace of growth sputter and potentially stall. The reason for this rather disappointing comeback is the nature of the downturn itself. Not only did we have a traditional economic recession as part of the normal business and inventory cycle, but on top of it we suffered a far less frequently occurring credit recession which resulted from everyone—public sector and private—borrowing too much, spending too much, and expanding their debt.
The economy now faces headwinds because of the lingering effects of the credit recession, which will likely cause another contraction in early 2012. The good news, however, is this downturn will be comparatively mild and will likely spark positive changes, particularly with regard to reducing personal debt levels, that could really get things moving again.
Faced with the prospect of an economic contraction and perhaps a full-fledged recession (albeit milder than 2008-2009), investors would do well to become more defensive in their portfolios. The objective is not to catch the bottom or call the top, but to reduce volatility, preserve and protect capital, and provide peace of mind through periods of uncertainty.
At Astor Asset Management, we utilize a macroeconomic model, investing based on the current economic trend. During periods of market expansion, we use long ETF positions in diversified non-correlating market averages to provide positive returns. During economic contractions, we become defensive, which may mean overweighting cash and fixed income using ETFs, or even inverse exposures to broad market averages using ETFs that gain in value when indices decline. Our overall goals are to achieve a less volatile return and a better risk-return ratio than our benchmark.
What matters most to the firm is not a particular direction of the economy, but the ability to identify it. We use a variety of economic indicators and data to identify fundamental economic trends. At every stage, whether it is expansion, peak, contraction, and trough, we rely on ETFs, believing that the transparency and low expenses of these funds make them ideal for this macroeconomic approach. Depending upon the current stage of the economic cycle, we would typically invest in multiple asset classes such as equities, fixed income, commodities, currencies, and other hard assets.
Late in the third quarter of 2011, in the midst of weak economic recovery, we became more defensive, decreasing equity holdings and therefore our risk exposure. In mid-Q4 2011, the Astor Long/Short Balanced program, our flagship portfolio consisted of approximately long equity 15%, fixed income 42.5%, non-equity 12.5%, cash 10%, and inverse equity 20%.
During the current period of "risk on/risk off" investing, based on global political and fiscal issues, the correlation between equity sectors remains very high. Therefore, sector selection is less important than the allocation percentages. Going forward, if or when an economic contraction is confirmed, we may decide to make further adjustments, such as potentially decreasing long equity, increasing inverse equity, and/or increasing fixed income.
Significantly, we do not move ahead of the trend to pick tops and bottoms. The focus is on identifying and confirming the current economic cycle using a variety of indicators and data. In late 2011, a persistent unemployment rate around 9.0% and sub-optimal GDP growth indicated to us an increased likelihood of a contraction or mild recession occurring in 2012.
Even if the economy manages to limp along with very slow growth, it may feel enough like a recession to qualify for one—certainly when it comes to consumers who will retract their spending at any sign of weakness. Without consumers, who account for about two-thirds of gross domestic product in the United States, the economy could very well enter into a recession for real.
The likelihood of a double-dip recession has been forecasted ever since the last downturn occurred because of the depth of the contraction and the seriousness of the financial meltdown. Recall the dismal GDP readings of -6.3% in Q4 2008 and -5.5% in Q1 2009, which by any measure is a serious recession. The growth that followed was certainly an improvement, but GDP readings have been rather anemic: +1.9% in Q1 2011 and +1.3% in Q2 2011, followed by an advance reading for Q3 2011 of +2.5%.
Although the economy has been making headway, the aftermath of the credit recession is like trying to walk with a piano on your back. Good luck getting very far. The economic growth experienced in the first two years of the recovery only masked the seriousness of the credit recession.
Sovereign debt continues to capture the headlines, but the real problem is private debt. According to a National Bureau of Economic Research report, U.S. household leverage doubled between 2001 and 2007 to $14 trillion from $7 trillion. The household debt to income ratio increased by more during those six years than the prior 45.
Globally, there are serious issues that will also affect the U.S. The devastating earthquake and tsunami in Japan in March 2011, followed by a nuclear disaster, took the world's third biggest economy and a large supplier of global capital temporarily off line. Until Japan gets going again, it will likely be a drag on world economic growth. In addition, beyond the Euro zone debt crisis, there is the problem of poor and slowing growth in Europe. Recent figures show Q3 2011 GDP in the Euro zone grew at an annualized rate of 0.6%. Clearly, the U.S. is not going to benefit from growth in demand overseas to help pull its domestic economy out of the doldrums.
However, a second contraction would not be as severe as what we endured in 2008-2009. We simply don't have that far to fall this time, because we never made it very many steps up the recovery staircase. In addition, there is clearly value to be had out there, which will become more apparent if the stock market corrects. Values of equities will go down, but not to the tune of the 50% correction that we saw during the financial crisis. Therefore, the next recession, if it does occur, will not be something to fear. No matter how much people want to draw parallels between 2008 and now, we are in no danger of a meltdown of catastrophic proportions.
Our outlook for 2012 is for a relatively mild contraction, with growth slowing and probably stalling to the point that it qualifies as a recession. But rather than believe the sky is falling again, there is cause for optimism. A shock to the system may be exactly what the patient needs to finally follow doctor's orders to shed debt and adopt healthier fiscal habits with regard to deleveraging and increasing savings. If that's the case, then we'll come out of the second dip all the better for having had to endure another downturn.
In the interim, we believe that applying an ETF investment strategy that seeks to reduce volatility and preserve capital will be the most prudent way forward.
Rob Stein is Senior Managing Director, Head of Global Asset Management of Astor Asset Management, a wholly owned subsidiary of Knight Capital Group, Inc. He also serves as Senior Portfolio Manager of Astor's separately managed account programs and the Astor Long/Short ETF Mutual Fund. And, he is the author of The Bull Inside the Bear: Finding New Investment Opportunities in Today's Fast-Changing Financial Markets, and several other books.