July 03, 2021

All investors face capital-market risk. Managing that risk, evaluating opportunities in the context of an investor’s goals, and assessing specific investments efficiently requires broad, objective, close-to-the-capital-market thinking. An asset allocation framework does not need to be a black box that processes many statistical variables and then spits out an investment plan. It should be a logical framework that lays out choices for investors. The LJE Asset Allocation Process strives to accomplish these objectives. First, it summarizes in a logical and consistent way the investment choices recommended by our assessment of the coming economic environment. Second, we strive to provide in straightforward, plain English an explanation of our views and the rationale for the tilts to the portfolio. Our outlook for the major economic drivers, guides the LJE asset allocation process. The global political threats lead to a flight to quality to the safer place where property and political rights are most protected. We look for the US dollar to appreciate and or remain above its Purchasing Power Parity, PPP, level. Whenever the Dollar is above its PPP line, the US outperforms the rest of the world. As capital flows into the US to take advantage of the excess rate of return, the real exchange rate and US returns decline and in time are eliminated at which point the US returns to PPP. In fact, the dollar could fall another 10% and still be above the PPP line. The investment implication is simple: If the US dollar is above its PPP line, an increased exposure to US assets is warranted. In the US, the consensus appears to be that the US inflation rate is on the rise. That the Biden administration intends to raise tax rates. That absent the ability to raise tax rates, it will implement its agenda through regulations. In the past we have stated that rising tax rates, regulation and inflation favor the nimble and smaller capitalization stocks. This line of reasoning points to an increased exposure to the smaller capitalization stocks in the coming quarter. Our framework suggests that the increased tax rates and regulations will be a drag on the recovery. That the administration and fed forecast are overly optimistic. We expect the economy to expand at a healthy pace, albeit slower than the administration and fed predict. This discussion also dovetails with our inflation forecast. Given the Fed belief in the Phillips Curve, we expect the fed to tighten a bit and as a result the inflation rate will come in below the fed forecast. The Fisher equation tells us that a lower-than-expected inflation rate, a lower-than-expected real rate of return due to the lower-than-expected real GDP growth combined with a flight to quality stronger dollar all add up to lower bond yields. A lengthening of the duration of the fixed income portfolio is warranted. Finally, the positive earnings growth tilts the balance in favor of the equity allocation. Hence, we recommend an increased exposure to equites over bonds in the coming months.

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