Systematic Relative Strength

One of the many risks investors have to deal with, especially bond investors, is inflation risk. PIMCO has a paper out entitled “A Diversified Real Asset Approach for Managing Future Inflation Risk” that is worth reading. They discuss one way of dealing with inflation through using real assets, the most liquid of which are:

… inflation-linked bonds (including Treasury Inflation-Protected Securities, or TIPS), commodities, real estate investment trusts (REITs) and commodity-related equities.

As a benchmark, the authors suggest a one-third weighting to each of these asset classes, with the exception of commodity-related equities, which they believe are inferior to direct commodities in terms of reducing direct equity risk.

The authors also endorse tactical asset allocation:

This “one-third, one-third, one third” benchmark is also a good starting point for actively managing the mix of asset classes, which can be an important tool for enhancing the overall effectiveness of the diversified real asset strategy.

As the drivers of future inflation risk naturally evolve, relative attractiveness across these three real asset classes will change, since they each respond differently to different inflation drivers. A rigorous asset allocation methodology that can identify macroeconomic and sector-specific risks and opportunities may add value for investors by tilting the real asset mix around the static benchmark weights.

Systematic relative strength provides just such a rigorous approach. It should be a comfort to know that all of these asset classes used to manage inflation risk are included in the investment universe of our global tactical allocation products, such as the Global Macro separate account, the Arrow DWA Balanced Fund, and the Arrow DWA Tactical Fund. The investment universe of those products, however, does not stop at inflation hedges. They are also fully capable of adapting to environments with a strong equity focus, whether domestic or international, or a strong defensive focus, where cash, short-term bonds, or inverse positions (Global Macro and Arrow DWA Tactical Fund) might be in vogue. Whether the world economy faces deflation or inflation in the future, flexible allocation across a broad universe should allow a rigorous tactical process to adapt.

Click here to visit ArrowFunds.com for a prospectus & disclosures. Click here for disclosures from Dorsey Wright Money Management. Past performance is no guarantee of future results.

Most of us probably know more about Greek mythology or about Sparta from watching the movie 300 than we know about modern-day Greece. We might order moussaka when we are at a Greek restaurant, but we really don’t think about Greece the rest of the time.

In fact, the global village is now so closely linked that some economists believe the European debt crisis, emanating from countries like Greece, Spain, Portugal, and Ireland, will cause a slowdown in the U.S. economy. Europe is a big market for many American companies and as Europe’s economy slows and the Euro drops in value, U.S. corporate profits could suffer.

Calling it a European debt crisis doesn’t really do it justice. The International Monetary Fund (IMF) is now involved, which means the imposition of some kind of austerity program. Once the IMF is on your doorstep, nothing good happens. Harvard professor, former IMF chief economist, and resident genius Ken Rogoff describes it this way:

The Fund does not bestow gifts; it only offers bridge loans to give bankrupt countries time to solve their budget problems. Although countries occasionally can grow their way out of debt problems, as China did with its 1990’s banking crisis, bankrupt countries usually face painful budget arithmetic. Short of default and inflation, most countries are forced to accept big tax hikes and spending cuts, often triggering or deepening a recession.

To be fair, the Fund’s reputation for imposing austerity is mostly an illusion. Countries usually call in the IMF only when they have been jilted by international capital markets, and are faced with desperate tightening measures no matter where they turn. Countries turn to the Fund for help because it is typically a far softer touch than private markets.

But gentleness is relative. It will be very tough – not only for Greece, but for all the other overextended countries of Europe – to tighten fiscal policy in the midst of recession without risking a deepening spiral. Simply put, no one wants to be the next major IMF supplicant.

Nor does the IMF’s arrival mean that bond holders are off the hook. As Qian, Reinhart, and I document, there have been numerous instances in which countries enter IMF programs but end up defaulting anyway. The most famous case is Argentina in 2002, but other recent examples include Indonesia, Uruguay, and the Dominican Republic.

The picture is not a happy one. There is a likelihood of recession triggered by spending cuts and tax increases-and there are plenty of case where the country ends up defaulting anyway.

The U.S. is not immune from the European situation, given all of the linkages through foreign trade and currency exchange. And, frankly, the U.S. debt situation is not as different from the European one as we might like to think. Sooner or later, the U.S., too, will be forced by the financial markets to embrace some kind of austerity program-probably not sooner, but one never knows. Congress will try to delay the time of reckoning by raising taxes and/or reducing spending, but that is never an easy political task.

How should investors respond to all of this? At the present time, U.S. markets are much stronger than international markets, largely as a consequence of the stronger dollar. (Six months ago, the situation was totally reversed!) We’ve noticed that real estate has gained a strong footing in our Global Macro account due to its high relative strength. (Six months ago, there was a strong commodities focus.) In other words, an investor’s source of return may not be the same from period to period. As things continue to change rapidly, I think it is imperative that investors have a systematic way to adapt their portfolios to the changes. Trying to guess what might happen next seems like a losing proposition to me-who had any idea about Greece a year ago? A systematic approach eliminates the need to guess and just deals with what is happening now. Given everyone’s inability to forecast what might happen given all of the intricate and sometimes hidden linkages between world economies, a systematic solution incorporating relative strength may be the most practical.

Click here to visit ArrowFunds.com for a prospectus & disclosures. Click here for disclosures from Dorsey Wright Money Management. Past performance is no guarantee of future results.

Who? You should probably learn the name of the head of China’s central bank. He addressed the IMF meeting over the weekend and chided developed nations for mucking up the world economy. A recent article in the Wall Street Journal mentioned some of his concerns.

…Zhou said the outlook for the global economy faces many uncertainties, calling for developed countries with “flagging economic recoveries” to put their fiscal houses in order and accelerate reform in both their financial sectors and structural issues in their economies, he said.

They need to “restore fiscal discipline as quickly as possible by formulating and implementing a comprehensive, credible, and transparent fiscal consolidation strategy and adopting measures to contain sovereign risk and avoid cross-border contagion,” said Zhou.

The current issues with Greece certainly highlight his points, but Greece is not the only developed nation to face similar sovereign debt issues. Even the U.S. (eventually) may not be immune.

Even ten years ago, it would have been inconceivable for a developing nation central banker to chide the developed world for their unsustainable fiscal practices! Yet that is what things have come to. We have a new world order, where the source of investment returns may not come from the traditional sources. A global tactical asset allocation strategy may be what is needed to adapt to the new investing environment. If your clients are concerned about instability in global markets, you may want to explore our Global Macro separate account or to look at our global allocation funds with Arrow.

Click here to visit ArrowFunds.com for a prospectus & disclosures. Click here for disclosures from Dorsey Wright Money Management. Past performance is no guarantee of future results.