What, me worry?

Many market participants have learned the hard way that markets often seem to exist to frustrate even the smartest investors. Just when you think you have the economy and markets figured out, something comes along that change everything. Could a bit of market paranoia be healthy? I am convinced of it. I always begin to worry when our viewpoint becomes the mainstream view. We are kind of in that situation here, given the astounding equity market performance in 2013. We expect 2014 to be a good year for the equity markets and a continued challenge for bond owners. We actually believe that the public has just begun to participate in the equity move and that discussion of a bubble is premature. Frequently, I am asked: What would change my mind about the financial markets outlook in 2014? I often think about the timeless quote from Mad Magazine icon Alfred E. Neuman: “What, me worry?” The truth is that anyone with money invested in markets finds that worrying is just a way of life. Here are a few things that keep me thinking and rethinking our position. 1. What if inflation heats up? Very few people are concerned about inflation in the United States. In fact, globally, central banks are uniformly fighting deflation by conducting monetary policy that historically has been very inflationary. To see inflation appear rapidly, we would need to see the velocity of money pick up abruptly. We would need to see input prices rise sharply. The Fed is not worried about creating inflation because the labor markets are quite slack and wage pressures are almost nonexistent. Higher inflation is usually positively correlated with interest rates. So, a little inflation is good, but too much can derail the equity run. Inflation is always a challenge for bond owners. Higher rates pressure bond prices. Tangible assets tend to win as inflation pressures rise. 2. What if there's another sovereign credit crisis? If there is another major government bond crisis, there could be a flight of capital from the world bond markets. The worst event that could happen is if the U.S. credit rating drops or foreign investors demand higher interest to buy our debt. This is the exact opposite of what we believe will happen. However, remember that our Federal Reserve essentially is monetizing billions of dollars of debt each month. Monetization of debt can lead to a failure of the bond market or even a failure of the dollar. The idea is that by creating the billions of dollars used to purchase U.S. Treasury and mortgage-backed security debt each month, the Fed is watering down the value of the dollars in circulation. Much of the world wealth is held in U.S. dollars. As the value of the dollar is eroded by the Fed, the wealth held in dollars is punished. The owners of that wealth will look for places to move their wealth to stop or hedge the devaluation. Many folks laugh at Bitcoin and its value as an alternative currency. We fear that Bitcoin is simply one small example of a world that is looking for alternatives to fiat currency. A failure of the dollar or a U.S. debt crisis would kill an equity market rally. 3. What if the U.S. energy boom turns to bust? We note that the recent boom in U.S. energy exploration and production was not forecast by many. People knew that fracking was very effective in releasing hydrocarbons from tight rock formations but few knew its drawbacks. We wonder what could reverse this trend. Could environmentalists actually dig up enough dirt on fracking as a potential threat to ground water? Could President Barack Obama's continued resistance to change current regulation to permit the export of natural gas dampen the “shale” fever? We are not so naive to believe that the energy boom in North America will last forever, but we do believe it should last a few years. If that assumption ends abruptly, it could have a negative effect on the U.S. economy. 4. What if the Federal Reserve Bank becomes insolvent? Everyone knows that the Fed has been buying trillions of dollars of U.S. obligations. The balance sheet, which stood at under $1 trillion in 2008, has surpassed $4 trillion. This great experiment has never been tried before by any central bank to this extent. The fear is that should interest rates rise over the next few years, the value of the bonds on the Fed's balance sheet would sink. Because of the extreme leverage that the Fed employs, it would not take much to cause the Fed's equity (assets less liabilities) to sink below zero. Now, we do understand bank accounting, which allows them to classify the bonds purchased under quantitative easing as “held to maturity” thus not being forced to mark them to the market. However, the world will know that the value has decreased and the media would become a willing participant in advertising that the Fed was technically insolvent. The reality is that the Fed will likely never sell any of its hoards of bonds. The loss they would suffer would be politically untenable. We think they are stuck with them until they mature. A perception of insolvency could cause financial market unrest and prevent the Fed from conducting its intended monetary policy. These are just a few of the potential “black swans” out there. In the end, we don't expect any of them to derail 2014 as another good or great year for financial assets. Things that we normally associate with a continued growth for company profits are present now and we don't see them going away. The yield curve is very positive, unemployment is easing, corporate profits are growing and the Fed has committed to staying easy for the foreseeable future. Thus, although we will keep a sharp eye out for trouble, we are comfortable to stay fully invested while we worry! Scott Colyer is chief executive officer and chief investment officer of Advisors Asset Management.