Koesterich, The Ten Trillion Dollar Gamble

Russ Koesterich, iShares chief investment strategist and global head of investment strategy for BlackRock Scientific Active Equities, anticipates a rather bleak economic future for the United States. In The Ten Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now (McGraw-Hill, 2011) he explains why we should expect higher interest rates and slow growth. He then offers solid practical advice for the investor, from a series of tells that are useful in timing market shifts (because, as he writes, “timing is critical to your success” [p. 43]) to asset allocation in this new environment.

The picture Koesterich paints of the future is familiar. Barring major reform of entitlement programs, especially health-care spending, the U.S. structural deficit will only get worse. And “in the not-too distant future, it will start to push rates higher and economic growth lower, and it eventually may set off an inflationary spiral.” (p. 22)

“The not-too-distant future” is of course terribly vague. Given the looming economic risks, “you should hold a portfolio with less money in U.S. equities and bonds, more in cash, and a higher allocation to commodities. But you want to move to these new allocations at the right time. You don’t want to move too late, but you also don’t want to anticipate conditions that may take a few years to develop.” (p. 44)

What should an investor watch in order to decide when to act? A lot: debt (government, corporate, and consumer), both supply and demand; the yield curve; labor markets, especially wage growth; capacity utilization; the money supply; the Fed’s balance sheet.

The author’s recommendations do not require the investor to make a dramatic shift in asset allocation; it’s not that he should dump stocks and go into commodities whole hog. It is a question of more or less, not all or nothing.

In five chapters covering cash and debts, bonds, stocks, commodities, and real estate, Koesterich explains specific steps the investor should take in the new environment. For example, keep your debts long and your cash short—that is, have a fixed-rate mortgage instead of a variable-rate mortgage and keep cash in money market funds or short-term CDs. And hold a lot of cash in a rising rate environment.

Are TIPS a good way to hedge inflation risk? Yes and no. “The TIPS will not insulate the holder from a rise in real interest rates. Also, the extent to which the TIPS insulate you from inflation will be determined by the inflation expectations that are embedded in the bond and the breakeven level, as well as the holding periods. The breakeven level refers to the amount of inflation that the TIPS bondholders are expecting. If the expectations are too high, and you don’t hold the bond to maturity, you may still be better off with a plain vanilla bond.” (p. 108)

Koesterich recommends investing the majority of your stock portfolio outside of the United States, with particular attention to emerging markets. The remaining portion devoted to the domestic market should overweight “stocks and sectors that are more resilient to rising rates. Practically this means overweighting stocks in the energy, health-care, and technology industries and owning less of financial, utility, and consumer discretionary companies.” (p. 133)

Commodities should be part of every portfolio. The recommended allocation is half to a broad commodity basket and the other half to gold, starting with 5% of your total portfolio to each and doubling that position “when the leading indicators of inflation start to flash yellow.“ (p. 165)

Koesterich acknowledges that the economic scenario he envisages may not come to pass. There may actually be real fiscal reform, although the odds are against it. So he sketches out two portfolios, one defensive (if deficit spending continues unabated) and the other aggressive (in the wake of meaningful deficit reform). The former will hold 10-15% cash, 15-25% bonds, 40-55% stocks, and as much as 20% in commodities and gold. The latter will hold 5-10% cash, 20-25% bonds (especially high yield bonds), 60% stocks, and about 10% commodities (energy and industrial metals, not gold).

The Ten Trillion Dollar Gamble is a well-crafted book. At every turn the author explains the rationale for including or excluding particular assets in a portfolio, especially as they react to higher interest rates, slower growth, and possible inflation. The investor who is worried about protecting his wealth in the coming decade(s) would do well to consider Koesterich’s advice.