I try to be macro-aware when making bottom up investing decisions. If I look forward to the macro environment in 2013, I can't help be nervous.
I imagine the following three scenarios that can play out in 2013.
Much ink has been spilled over the various central bank quantitative easing manoeuvres around the world. I don't intend to repeat that here. Summing up all the unorthodox central bank actions, I get the distinct impression that they are trying to spike the punch at the dead party that is the world economy. They may actually succeed and unleash a massive debt growth with requisite inflation.
Second possibility is that the central banks are marginally successful, just like all the years since 2010; and we all muddle along. Market makes more highs with sharp reversals when the underlying weakness periodically shows up.
Third possibility is that deflation truly shows up unexpectedly, greeting the central bankers and governments sitting with little or no firepower. This scenario would be disastrous for equity investors, and great for government bond holders. With the market hovering near Shiller P/E of 22, the fall would be rather significant and sudden.
The underlying reason behind the weakness out there is the deleveraging process that has just begun around the world. United States is ahead of the pack with their private sector and household deleveraging. All of Europe joined in the process in 2012. China may be following quite soon, as the real estate bubble popped in 2012. 2013 may be the year when the market realizes that Japan's debt is unsustainable and starts to demand yield that reflects the risk. Other rich world is going to join in soon. Real estate bubble in Canada started to deflate this year. Australia is going to feel direct pain from a deleveraging China.
Deleveraging isn't fun for the borrower. It requires paying excess income towards reducing debt, thereby always feeling poorer.
Portfolio Positioning
Since I have no idea what lies in the future, all I can do is prepare for the unpredictable. I believe second or third scenarios are the most likely. Due to the lack of ideas out there, the cash position of the portfolio is rather large and has been slowly growing through 2012. This would act as ballast in the case of scenario three and will also help me scoop up equities if they are available on sale.I still have some undervalued equity positions that should continue to do very well in the second scenario, and even the first. In either of the first two scenarios, I will have lots of cash undeployed and earning nearly nothing. This will continue to erode portfolio returns, but I believe that is an acceptable risk.
