If you’ve seen the news over the past two weeks, you’ll have noticed there is much joy in the U.S. financial picture. The Dow has reached an all-time high of 17,000, unemployment dropped again in June to 6.1% after 280,000 new jobs were created, and fear levels, as measured by the various “fear indices,” are at lows that have not been seen more than once a decade. Stocks are up another 8% for this year, on top of last year’s meteoric rise, and bonds, which were assumed to be poised for a significant decline, are, in fact, up this year by 4%. There is no shortage of good news when it comes to investing.

The risks and realities, however, are very different. The U.S. economy actually contracted, for the first part of this year; long-term unemployment is still at levels never seen in the modern U.S. economy; and the level of global conflict has risen to a level not seen since the 1970s. Globally, sustained growth is still in doubt: Europe has still failed to extract itself from a recession and risks deflation, Asia is looking for that “soft landing” of slowing the asset bubbles without cratering the economy, and wealth inequality is beyond comprehension.

We are in fact, looking at a tale of two minds. One mind believes in the ability of stocks to rise in any situation; the other mind is on constant alert for the next set of bad news that could impact the global balance.

If we stick to home, and take a closer look at the U.S. economy, we can get a better picture of how the goods news we are used to seeing in asset prices is still ahead of the good news we need about overall economic recovery.

All major asset classes have shown similar growth in 2014 thus far, indicating a “risk-on” market mentality as investors seek returns through greater risk taking. While not matching last year’s performance in equities, the consistency of returns in unique.

Markets – Equities

On the bright side, markets continue their rise after a rocky start to the year. Last year’s meteoric upswing in equities was quickly met with a harsh pause in January, as stock prices closed out that month down 6%. What could have been a further rout of markets was, it appears, a retesting of market levels and a chance for some to take risk off the table. With the market more than doubling since the lows of 2009, it is not unusual for an entire group of investors to take a breather and turn those gains into cash thereby protecting themselves again sudden declines.

By the end of Q1, the markets regained their equilibrium, and demonstrated a slight gain for the year. That gain of just a few percent was tenuous for the next few weeks until May and June, when equities reached new highs and are now posting 8% gains for the S&P 500.

Interestingly, in this rally, the gains have been in the larger valuation companies, not growth firms. Specifically, large and mid-cap value companies have gained 8% and 11% respectively, while small-caps are doing only a fraction of that at 2-4%. This difference reflects an interesting change from the dot-com rally of the 1990s – investors are looking for some substantiation of the company’s stock price, not just a whiff of promise that the firm might make enormous profits later. Although this is not a strict trend, it points to some sanity in the current rally.

Markets – Fixed Income

As opposed to stocks, whose rise was almost universally projected at the beginning of the year – albeit to varying degrees – bonds were supposed to fall. I did not read a single prediction that bonds would rise in 2014; naysayers pointed to the Fed’s reduction in quantitative easing and rising interest rates. Instead, rates have stayed level or gone down, with bonds up across the board.

While the average bond market return of 4% YTD (8% annualized) is impressive in any environment, the composition is even more interesting. High-yield bonds (non-investment grade corporates), have some of the lowest spreads to treasuries in recent history, posting a 5.5% gain for the year, while thirty-year U.S. treasuries posted a 14% gain this year. The compression of spreads on high-yield is an indicator of the continued economic recovery, amid predictions that corporate defaults will be extremely low. These phenomena are consistent with the complacency we have seen in the equity markets. The explanation I’ve heard on the treasuries is a little more complicated, but in short, there are simply not enough bonds to go around. Institutional investors, who need these risk-free bonds to hedge portfolios and meet investment mandates, demand them while the available supply dwindles.

All these dynamics are reflective of the accommodative monetary policies of our central bank, the Fed, as well as the global central banks. The Fed grew their balance sheet by $3.5 trillion from 2008 to today – all of that representing “new money” in the banking system. Around the globe, the figures are similar in size. From that new money, and the Fed’s use of it to purchase bonds in the market, we have seen rates down and prices up.

The downside of this stimulus is difficult to predict. The Fed will stop printing new money in the fall, as anticipated, yet we have not seen any of the market reaction that we might have expected. Notably, inflation has remained negligible. The fear four years ago was that inflation would run to extreme levels and hamper the recovery; now, we are now faced with the opposite problem. We need some inflation to stimulate consumption (encouraging buyers today, when things are less expensive), yet global developed markets have seen flat prices and the US inflation index is under 2%.

The immediate impact is on retirement planning. In effect, if you wish to invest your money risk- free for the next ten years, the spread between income and inflation is nearly zero. Your money, in terms of real dollars, will not grow. This can have a potentially devastating impact over the coming years as the economy returns to historical averages for these measures. Namely, some areas of price inflation hit ordinary people very hard – food prices, for example. In fact, food prices have risen steadily over the past few years with some basics, such as meats, seeing 15-20% annual price increases. Yet food is not counted in the inflation gauge (called non-core CPI), and hence we are left to feel the impact without acknowledging the problem.

Economy

The perverse dynamic of inflation is best understood in the context of the jobs market. As we continue to remind folks, the measure of jobs health used by the media is misleading. Unemployment does not reflect the jobs participation rate, ignoring those who have simply left the market. Instead, we look at total employment as a percent of the population, as you’ll see below. While the trend has been encouraging, it shows only marginal improvement from the end of the recession five years ago.

An equally disturbing trend is the long-term unemployed. As you can see from the chart below, those unemployed for 27 weeks or longer as a portion of the total unemployed population spiked to levels never seen before. And while the trend has brought that level down from 1-in-2 unemployed to 1-in-3, it is still well above historical levels.

Long-term unemployed (27 weeks or greater) as a percentage of total unemployed. We reached levels (45%) double the long-term average, and have not employed most of these workers in the recovery thus far. While the level has dropped to 33%, we still have an unprecedented problem.

The impact is devastating on the economy and on people. There has been a wave of forced retirees, folks who were at the prime of their career with vast experience and education who simply cannot find suitable work. This has also fed the inflation dynamic mentioned above – people are unwilling to switch jobs for fear of losing theirs. With fewer employed folks job-hunting, this puts a damper on wage increase and ultimately lowers the cost of labor for firms. Labor costs, being one of the major components of inflation, have helped to tamper inflation as measured by the government. Yet, while wages remain flat, basic costs such as food and fuel continue to rise, creating an impact on Americans’ daily lives.

As we look at the other aspects of the U.S. economy, the message is equally mixed. We are seeing a renaissance in energy, with U.S. reserves and production of natural gas and crude exceeding even the wildest estimates from just five years ago. Yet energy prices continue to climb as global conflict creates uncertainty and the cost of refining keeps prices high on gasoline and heating oil.

Another paradoxical phenomenon is general economic growth. Consumer confidence, the general measure of how likely people are going to spend, is back to its long-term average and touching levels not seen since the Great Recession began. Yet, GDP, the measure of production, and by inference, consumption, contracted in the first quarter by -2.9%, again the first time since the Great Recession ended. Although much of that contraction has been blamed on the bitter winter, it is still a reduction in the economy that requires a steep recovery.

GDP quarter-over-quarter annualized change from 2000-2014. While we have shown steady growth since 2009, Q1 saw a -3% decline. Q2 numbers, due out shortly, will test the assumption of a sustained economic recovery.

Global Conflict and Perception

One of my earliest lessons learned as a student of international relations was the damning relationship between the economy and global conflict. As discussed in the Wall Street Journal (“An Arc of Instability Unseen Since the ‘70s,” July 14, 2014), we are facing the most challenging set of circumstances we have witnessed since the late 1970s and the height of the Cold War. There are two civil wars that have the potential to spill over into U.S. interests (Syria and Iraq); Afghanistan is facing an electoral crisis; Russia is promoting ethnic strife in Ukraine after invading Crimea; the Israeli-Palestinian conflict is heating up with little signs of easing. In short, we are seeing some of the worst conflicts of our generation peak at roughly the same time.

[Note: This article was being finalized as a Malaysian Airlines passenger jet was shot down over the Ukraine, emphasizing just how volatile these conflicts have become]

I am loathe to make any sort of political commentary, but each and every one of these conflicts has the potential to draw the U.S. back into an armed conflict, even during a time when the US has resoundingly shown little interest in engagement. This perception – that the U.S. will not engage to resolve conflict – has created the adverse effect of increasing the belligerence of rogue actors. It is a perverse situation that echoes through the history of nation-state politics: perceived weakness breeds conflict, while the threat of might promotes peace. The impact on our economy is unmistakable. Put succinctly, what happens abroad can destroy our recovery at home.

These conflicts are developing rapidly against a backdrop of pressing global issues that are damaging our ability to grow. From climate change and viral outbreaks to food scarcity, we are facing a growing global series of challenges that will require a coordinated and intelligent response. Yet the denial is palpable. For instance, rising sea levels have put major roads in Miami under water during regular tide surges, a trend that will continue to engulf the city in sea water in the coming years. Yet real estate prices continue to climb in the city, development is robust, and elected politicians continue to deny there is a problem.

The math is undeniable: the economy will suffer and our quality of life will be threatened. To combat the rising tides in South Beach, the city of Miami has already committed $1.4 billion to shoring up the roads. That is money spent to stem a problem, money that could have been better used to invest in a technology or build up our educational system. We are increasingly short sighted as a society as the world quite literally “heats up.”

As a parting thought, I offer this last chart, which shows the fear gauge on the S&P 500, a broad measure taken from the futures market that shows how stock traders view the short-term future. A lower number indicates a perception of calm and rising markets, a higher number indicates rocky or down markets. For reference, the index bottoms out at 10 during strong bull markets, and peaks at 80 during market calamities such as 2008, with an average level of 20. In the past two weeks, VIX has hovered between 10 and 12. Perception of financial risk, at this moment in time, is the lowest it has ever been. Are we putting our heads in the sand? And what will the consequences of our denial be?

VIX from 1990 to 2014. At only three times in the past 24 years has the VIX reached a low of 10 – a level that shows perception of financial risk is at its lowest possible. Once in 1993, another in early 2007, and today.

As I am fond of saying, perception is reality. Today, the markets perceive low risk and rising assets ahead. That perception, however, will be fragile as broader issues take root in daily life. And as perception changes, so will the financial risks that we all face.

I want investors to be aware that although some things are stabilizing, we live in destabilizing times. It is this balancing act of perception against reality that drives our portfolio composition. We have seen that managed volatility in our portfolios, while capturing growth from a variety of asset classes and strategies, leads to stable returns over the long haul. Put another way, these portfolios are designed as an all-weather strategy, a welcome approach when the line between perception and reality becomes blurred.

Rest assured that we at Vodia are keeping abreast of current issues in order to keep our investors informed and our assets as protected as possible. We remain optimistic, and realistic.

It is our job to monitor the world and manage the portfolios. It is your job to enjoy the summer.

Regards,

David B. Matias, CPA
Managing Principal