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Portfolio Projections from 2013

This will be my last “live” post of 2013. As such, I want to thank all of you who have taken the time to read my articles, recommend them, re-tweet them, and re-blog them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.

In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.

So thank you all. May you have a blessed holiday season and a happy new year. And, if you find yourself with time to spare over the next few weeks, stop by this blog or check your email (if you have signed up) as I will be re-blogging some of my (subjectively considered) “best” articles from the last four years. Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these post, or follow me @inflation_guy on Twitter.

And now, on to my portfolio projections as of December 13th, 2013.


Last year, I said “it seems likely…that 2013 will be a better year in terms of economic growth.” It seems that will probably end up being the case, marginally, but it is less likely that 2014 improves measurably in terms of most economic variables on 2013 and there is probably a better chance that it falls short. This expansion is at least four years old. Initial Claims have fallen from 650k per week in early 2009 to a pace of just barely more than half that (335k) in the most-recent 26 weeks. About the best that we can hope for, plausibly, is for the current pace of improvement to continue. The table below illustrates the regularity of this improvement over the last four years, using the widely-followed metric of the Unemployment Rate:

‘Rate (change)
12/31/2009 9.90%
12/31/2010 9.30% -0.60%
12/31/2011 8.50% -0.80%
12/31/2012 7.80% -0.70%
11/30/2013 7.00% -0.80%

Sure, I know that there are arguments to be made about whether the Unemployment Rate captures the actual degree of pain in the jobs market. It plainly does not. But you can pick any one of a dozen other indicators and they all will show roughly the same pattern – slow, steady improvement. There is no doubt that things are better now than they were four years ago, and no doubt that they are still worse than four years before that. My point is simply that we have been on the mend for four years.

Now, perhaps this expansion will last much longer than the typical expansion. But I don’t find terribly compelling the notion that the expansion will last longer because the recession was deeper. Was this recession deeper because the previous expansion was longer? If so, then the argument is circular. If not, then why would that connection only work in one direction? What I know is that the Treasury has spent the last four years running up large deficits to support the economy, and the Fed has nailed interest rates at zero and flooded the economy with liquidity. Those two things will at best be repeated in 2014, not increased; and there is a decent chance that one or the other is reversed. Another 0.8% improvement in the Unemployment Rate would put it at 6.2%, and I expect inflation to head higher as well. A taper will be called for; indeed, it should never have been necessary because policy is far too loose as it is. Whether or not an extremely dovish Fed Chairman will actually acquiesce to taper is an open question, but economically speaking it is already overdue and certainly will appear that way by the middle of the year, absent a crack-up somewhere.

Global threats to growth do abound. European growth is sluggish because of the condition of the financial system and the pressures on the Euro (but they think growth is sluggish because money isn’t free enough). UK growth has been improving, but much of that – as in the U.S. – has been on the back of housing markets that are improving too quickly to make me comfortable. Chinese growth has recently been downshifting. Japanese growth has been irregularly improving but enormous challenges persist there. Globally, the bright spot is a modest retreat in Brent Crude prices and lower prices of refined products (although Natural Gas prices seem to be on the rise again despite what was supposed to be a domestic glut). Some observers think that a lessening of tensions with Iran and recovery of capacity in Libya, along with increasing US production of crude, could push these prices lower and provide a following wind to global growth, but I am less sanguine that geopolitical tensions will remain relaxed for long and, in any event, depending on a calm Iran as the linchpin of 2014 optimism seems pretty cavalier to me.

Note that the muddled growth picture contains some elements of risk to price inflation. The ECB has been kicking around the idea of doing true QE or experimenting with negative deposit rates. The UK housing boom, like ours, keeps the upward pressure on measures of core inflation. There is no sign of an end to Japanese QE, and the PBOC seems willing to let the renmimbi rise more rapidly than it has in the past. And all of these global risks to domestic price inflation are in addition to the internally-generated pressures from rapid housing price growth in the United States.

The good news on inflation domestically is that M2 money growth has slackened from the 8%-10% pace of last year to more like 6%-8% (see chart, source Bloomberg). This is still too fast unless money velocity continues to slide, but it is certainly an improvement. But the bad news is that money growth remains rapid in the UK and is accelerating in Japan. The only place it is flagging, in Europe, has a central bank that is anxious not to be last place on the global inflation scale. I expect core inflation (and median inflation) in the U.S. to rise throughout 2014 and for core inflation to end up above 3% for the year.

allemsNow, I have just made a number of near-term forecasts but I need to change gears when looking at the long-term projections. In what follows, I make no effort to predict the 3-month, 6-month, or 12-month returns of any market. Indeed, although I will present long-term risk and return outlooks, and they are presented as point estimates, I want to make it very clear that these are not predictions but rather statements of relative risk and return possibilities. For many types of instruments, the error bars around the average annual performance are so large as to make point estimates (in my view) nearly useless. The numbers come from models of how markets behave when they are priced “like they are now” in terms of several important metrics. They are not prescient. However, that is what investing is really all about: not making the “right” bet in terms of whether you can call the next card off the deck, but making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge.

I also will not make portfolio allocation recommendations here. The optimal portfolio allocation for you depends on more variables than I have at my disposal: your age, your career opportunities, your lifestyle, your goals, any insurance portfolio and your risk tolerance, to name just a few.

What I will do here, though, is to give top-down estimates of the long-run returns and risks of some broad asset classes, and make some general observations. I don’t analyze every possible asset class. For this exercise, I limit the universe to stocks, TIPS, nominal bonds (both long Treasury and corporate bonds), commodity indices and (since many of us already own it) residential real estate. My estimates and some notations about the calculations are in the table below.

Inflation 2.50% Current 10y CPI Swaps
TIPS 0.68% Current 10y TIPS. This is not at equilibrium, but it is what we can lock in today. It is the highest rate available at year-end since 2010.
Treasuries 0.37% Nominal bonds and inflation-linked bonds ought to have the same a priori expectation, but Treasuries trade rich to TIPS because of their value as repo collateral. Current 10y nominal rate is 2.87%, implying 0.37% real.
T-Bills -0.50% Is less than for longer Treasuries because of liquidity preference.
Corp Bonds -0.69% Corporate bonds earn a spread that should compensate for expected credit losses.  A simple regression of Moody’s “A”-Rated Corporate yields versus Treasury yields suggests the former are about 45bps rich to what they should be for this level of Treasury yields.
Stocks 1.54% 2.25% long-term real growth + 1.83% dividend yield – 2.54% per annum valuation convergence 2/3 of the way from current 24.3 Shiller P/E to the long-run mean. Note that I am using long-run growth at equilibrium, not what TIPS are implying. This is the worst prospective 10 year real return we have seen in stocks since December 2007. Now, to be fair in 1999 we did get to almost -2%, which would imply up to another 35-40% upside to stocks before we reached an equivalent height of bubbliness. That is a 35-40% that I am happy to miss.
Commodity Index 6.26% Various researchers have found that commodity futures indices have a long-run diversification return of about 3.5%. To this we add 1-month LIBOR to represent the return on the collateral behind the futures, and a ‘relative value’ factor to reflect the performance (relative to the expected model) of hard assets relative to currency.
Real Estate (Residential) -0.19% The long-run real return of residential real estate is around +0.50%. Current metrics have Existing Home Sales median prices at 3.79x median income, versus a long-term average of 3.55x. Converging to the mean over 10 years would imply an 0.69% per annum drag to the real return. This is the first time since 2008 that housing prices have offered a negative real return on a forward-looking basis.

The results, using historical volatilities calculated over the last 10 years (and put in terms of ‘real annuitized income,’ a term that means essentially the variance compared to a fixed 10-year real annuity, which in this analysis would be the risk-free instrument), are plotted below. (Source: Enduring Investments).


Return as a function of risk is, as one would expect, positive. For each 0.33% additional real return expectation, an investor must accept a 1% higher standard deviation of annuitized real income. However, note that this is only such a positive trade-off because of the effect of commodities and TIPS. If you remove those two asset classes, which are the cheap high-risk and the cheap low-risk asset classes, respectively, then the tradeoff is worse. The other assets lie much more closely to the resulting line, which is flatter: you only gain 0.19% in additional real return for each 1% increment of real risk. Accordingly, I think that the best overall investment portfolio using public securities – which has inflation protection as an added benefit – is a barbell of broad-based commodity indices and TIPS.

TIPS by themselves are not particularly cheap; it is only in the context of other low-risk asset classes that they appear so. Our Fisher model is long inflation expectations and flat real rates, which merely says that TIPS are strongly preferable to nominal rates but not a fabulous investment in themselves (although 10-year TIPS yields are better now than they have been for a couple of years). Our four-asset model remains heavily weighted towards commodity indices; and our metals and miners model is skewed heavily towards industrial metals (50%, e.g. DBB) with a neutral weight in precious metals (24%, e.g. GLD) and underweight positions in gold miners (8%, e.g. GDX) and industrial miners (17%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)

Feel free to send me a message (best through the Enduring website http://www.enduringinvestments.com ) or tweet (@inflation_guy) to ask about any of these models and strategies. In the new year, I plan to offer an email “course”, tentatively entitled “Characteristics of Inflation-Protecting Asset Classes,” that will discuss how these different assets behave with respect to inflation and give some thoughts on how to put an arm’s-length valuation on them. Keep an eye out for the announcement of that course. And in the meantime, have a happy holiday season and a merry new year!

  1. eric
    December 13, 2013 at 9:30 pm

    Where do you get the real risk value for corporates? It seems low. Is that based on the idea that default risk goes inversely with duration risk?

    I still think Munis look like the best deal in credit out there. I also like miners better than their respective metals.

    • December 13, 2013 at 11:11 pm

      I didn’t make any default assumptions. I agree it seems very low, but did you realize the correlation of the Barclays Long-term Treasury index with the TIPS index is about 0.62 for the last decade or so, while the correlation of the Barclays Agg with the TIPS index is 0.8?

      That’s the reason why when you look at risk with the annuitized-real-risk lens, corporate bonds seem less volatile. Now, why is that correlation significantly higher?

      I suspect that at least partly it’s a data artifact owing to the 2008 crisis, when TIPS dramatically underperformed Treasuries andcorporate spreads widened dramatically. That artificially increases the correlation and makes corporate bonds appear safer than they really are. It may also be the case that corporate spreads really do correlate better with real rates than with nominal rates, but that’s a harder case to make.

      So you’re probably right, and the corporate bonds dot should be farther to the right.

      I agree that munis look awfully good, even to taxable investors. But it’s a pretty archaic market with lots of idiosyncrasies…although I once worked on a method to arbitrage the BBI40, I no longer feel qualified to give much of an opinion on munis so I leave them out (also, one’s relative interest in munis has a lot to do with one’s tax situation).


  2. December 13, 2013 at 11:59 pm

    Michael, I have to agree that 2014 could be the year of ‘big change,’ especially in inflation and probably in interest rates, which should climb 100 basis points on a 10-year Treasury to hit a logical level. It looks like tapering again is beginning to be priced into Treasurys, and with the congressional budget deal the Fed lost a major excuse for QE to continue.

    It will be an interesting year ahead, and I look forward to hearing your ideas. Have a great holiday season!

  3. CharlesD
    December 14, 2013 at 12:57 pm

    Michael – a first class review of asset classes and their prospects, possibilities and probabilities. Thanks much. I have only one quibble. You say the Fed has “flooded the economy with liquidity”. I assume you are referring to QE. My understanding (which could be wrong) of QE is that the Fed is crediting the banking system with reserves, a new bank asset. This money is “printed” (created out of thin air). At the same time, the Fed is removing securities (let’s say Treasury securities) from the asset side of the banking system’s balance sheet. Thus, at the end of the day, the private economy has experienced no net change in financial assets. Only the composition has changed. For example, if you or I had part of our savings invested in Treasuries and the Fed replaced them with a credit to our bank account, we obviously have no more (or less) financial assets than before this transaction. The composition, but not the amount, of our savings has changed. From your standpoint, am I missing something? Thanks and good health along with some enjoyment and fulfillment in the coming year! .

    • December 14, 2013 at 8:16 pm

      Thanks for the note, Charles. While it is true that the Fed is merely exchanging one asset for another, if that has no effect on liquidity then…why do it? For that matter, since every transaction the Fed ever does exchanges one asset for another – the Fed cannot ‘print’ money; only the Treasury can do that – then why have a Fed at all?

      The reason is that these assets have different uses, different “marginal propensities to be consumed” if you will. You can’t lend a Treasury security to a homeowner who wants a mortgage; you CAN lend cash supported by reserves. Thus, the reserves are subject to multiplication which leads to increasing liquidity which leads, ultimately, to inflation.

      Now, in this case the Fed is helping to sequester most of those reserves by paying banks not to use them, but that is an inherently uncertain position. However, to the extent that they have traded securities for unopened boxes of money, then you’re absolutely right: they have done nothing…which is why many of us have been scratching our heads for YEARS wondering why the Fed would add reserves and then pay to make sure they remain sterile. It’s nonsensical, and yet very risky because (a) we don’t know how to remove them without risk and (b) we don’t know (and won’t know until it’s too late) whether the value of lending is currently higher or lower than the value of holding excess reserves. It WAS, but we don’t know about tomorrow. And that means that the liquidity could enter the system at the drop of a hat. Or just continue to leak in slowly, as it is.

      Good question!

  4. eric
    December 15, 2013 at 9:29 am

    “which is why many of us have been scratching our heads for YEARS wondering why the Fed would add reserves and then pay to make sure they remain sterile”

    here is one answer. curious what you think of it:


    • December 15, 2013 at 11:28 pm

      Well, that answers why pay IOER to keep rates positive, and yes we DID know that part – if there were no IOER, rates would actually more likely be negative given the huge oversupply of excess reserves. The mystery is why the Fed would do that AND continue to supply reserves. As the FT Alphaville blogger points out, yes – this sort of sterilizes the reserves. So why keep adding them if you’re going to sterilize them?? The only effect is to forcibly de-lever the banks (which is one reason why return on equity for banks remains, 5 years after the crisis, well below the standard low-single-digits that generally prevailed prior to 2008). But whatever the reason that made QE worth doing, if you sterilize the QE then the STATED reason for doing them is complete nonsense!


  5. CharlesD
    December 16, 2013 at 7:34 pm

    Thanks for your thoughtful comments on my “QE as simply an asset swap” question. Indeed, as even Mr. Bernanke has pointed out, the direct impact of QE is moderately deflationary because the bonds being removed from the private sector yielded more than the reserves being added to the private sector. Thus the private sector loses interest income of about $80B a year. In addition, my understanding (which, as always, could be wrong) is that the volume of bank loans is a function of (a) the demand for loans (b) credit standards and (c) expected loan profitability (which could be moderately impacted by the rate paid on reserves).. This demand has no relationship to the volume of reserves. Even if the banks were short of reserves, they still make the loans and get the reserves later. The point being that loan volume will be what it will be. QE has not had and will not have a meaningful impact on loan volume (and the resulting monetary growth). The Fed itself has explained this. See, for example, “Money, Reserves and the Transmission of Monetary Policy. Does the Money Multiplier exist?”( Carpenter and Demiralp -Federal Reserve Board discussion series – 2010). Among other things, they note: “changes in reserves are unrelated to changes in lending. We conclude that the textbook description of money in the transmission mechanism can be rejected. Deposits do not create loans. Loans create deposits.
    If all this is true, then there is no transmission mechanism between QE and inflation rates. That does not mean higher inflation will not occur, of course, but it does mean it will not be related to the effects of QE.
    But this leads to your question of “why do QE in the first place”? Apparently, as Mr. Bernanke has explained, the objective is to increase loan demand and monetary growth indirectly with lower long-term interest rates, thereby increasing the demand for housing, consumer durables and private borrowing in general. While long rates have not behaved over the past year or so, Mr. Bernanke thinks overall this indirect objective has had a positive effect, especially with respect to housing.
    But, aside from these indirect effects, the direct effects of QE can be explained in one sentence “the private sector receives reserves in exchange for bonds and loses interest income in the process”. No wonder it has had little impact!
    Anyway, I realize this is a bit of a different take on things. However, it is my understanding, based on thoughtful analyses of others. So I thought readers would find interesting. As always, it is subject to revision by minds greater than mine. .

    • December 16, 2013 at 8:04 pm

      I don’t agree with some of your premises. If the quantity of reserves has no impact on the amount of money in circulation, then the whole mechanism by which the Fed has conducted monetary policy for generations – the management of the quantity of reserves – would be moot. It is the case that EXCESS reserves have no impact on money in circulation, but that is begging the question since the whole reason they are excess in the first place is that they are not being used to support loans.

      Yet what you say is true – but “expected loan profitability” is a relative number that is compared to the cost of capital. If the cost of capital is negative, as it would be now in the absence of IOER, then many more loans become profitable. So you’re right, but you abstract a very complex input into a very simple input, and it’s not.

      So loan volume will not “be what it will be,” but is definitely impacted by the quantity of banking reserves. Again, if it isn’t then we should disband the Fed because their tools have no effect.

      Now, does QE affect money? Well, we don’t really know since QE in this country has never existed without IOER. If you move the supply curve and simultaneous place a floor on prices, you can’t really know what the true clearing price is, can you?

      I appreciate you bringing this up. I find this is a pernicious misunderstanding (or at least, I believe it to be a misunderstanding…but I’d be happy if instead the conclusion was that we should do away with the Fed. Since all they can do is manage reserves, in my view it is either one or the other) and widespread. That it is widespread at the Federal Reserve, where there are few people who believe in monetarism any more, isn’t terribly shocking. Give it ten years, and the Fed will have many more monetarists.


  6. CharlesD
    December 18, 2013 at 5:21 pm

    Michael thanks much for the response to my note on the relationship between reserves and bank lending (with more bank lending leading to more money growth). Especially at a time where 0.00001% of the population has “thoughts on bank reserves” on their “to do” list!! The distinction you made between excess reserves and reserves was, I think, quite useful as were the insights on IOER, etc. I only say “I think” because I am not the expert and haven’t thought everything all the way through. As I said, “minds greater than mine” can help me out. So thanks. I should mention that In addition to the Fed paper I cited, there was another article which greatly impacted my thinking on the subject. It was entitled “Repeat after me: Banks Cannot and Do Not “Lend Out” Reserves” . It was written by the chief global economist and research director at S&P – Paul Sheard. The article can be readily Googled. I thought it was a very rare and clear exposition of how the banking system operates and thus helpful to someone like myself who wants to make sure that I understand the “basics” correctly. In any case, my “takeaway” from the article was that reserves have little or no relationship to loan volume. But I could have interpreted what he was saying incorrectly. In any case, for better or worse, the article would help you understand better the conceptual foundation of where my statements are coming from (correctly or incorrectly)- so you might find it beneficial to read. I don’t have any axe to grind. I’m just simply trying to understand reality so that I can be a better investor – so your comments are very helpful. .
    I am appreciative of your current “best of the past” blogs. They are very educational and help me to understand where you are “coming from”. Can’t promise you any business. of course, but I’ve recommended them to a couple of people keenly interested in such financial topics.

    • December 18, 2013 at 10:25 pm

      Hey, thanks very much for the recommendation to other folks! I appreciate it.

      I will look for that article. I certainly will appreciate a clear exposition from an economist on the theoretical side of things! My side is of course only from the practical side – working in banks for two decades and noting how they actually run! But that of course is one of the main reasons the Fed these days is making “mistakes” that I think we will look back on with disbelief someday. Just like “everyone” knew that the Dallas Cowboys should have been running the ball every down this last weekend, the Monday morning quarterbacking of this Fed will not be kind. If, that is, people like me are right and people like Ben Bernanke (who has never held a job in a bank, or any private sector job for that matter) are wrong.

      But so far, he’s winning. See my article “Defensive.” 🙂

      Thanks for the remarks and the links! BTW I took out a printout of our exchange from earlier this year on equity valuation/flows and am hoping to use some of my re-blog time to work it out for myself so I understand it. This is all in the category of “benefit from writing these articles!”


  1. January 29, 2014 at 9:26 pm
  2. January 30, 2014 at 10:54 am

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