Month: September 2020

Kiwi Investor Blog has published 150 Posts….. so far

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Kiwi Investor Blog has published over 150 Posts, so far! 

Thank you to those who have provided support, encouragement, and feedback. It has been greatly appreciated. Kiwi Investor Blog achieved 100 Posts in October 2019.

Consistent with the current investment environment and the outlook for future investment returns, the key themes of the Kiwi Investor Blog Posts over the last twelve months have been:

  1. Future returns are unlikely to be as strong as those experienced over the last decade
  2. Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to alternatives e.g. Private Equity
  3. What portfolio diversification is, and looks like
  4. Positioning portfolios for the likelihood of higher levels of inflation in the future
  5. Time to move away from the traditional Diversified Balanced Portfolio
  6. Occasions when active Management is appropriate and where to find the more consistently performing managers – who outperform
  7. Investing for Endowments, Charities, and Foundations
  8. Navigating a Bear market, including the benefits of disciplined portfolio rebalancing

Links to the key Posts to each of these themes is provided below.

Kiwi Investor Blog’s primary objective is to make available insights into Institutional investment strategies, practices, and processes to a wider audience in simple language.

The Posts are written in the spirit of encouraging industry debate, challenging the status quo and “conventional wisdoms”, and striving to improve investment outcomes for clients.

Future returns are unlikely to be as strong as those experienced over the last decade

The year started with a sobering outlook for long-term investment returns as outlined in this article by AQR.  The long-term outlook for investment markets has been a dominant theme this year, where the strong returns experienced over the Past Decade are unlikely to be repeated in the next 10 years.  Also see a related Bloomberg article here.

Interestingly, even after the strong declines in March and April of this year, Forecasted investment returns remain disappointing, given the nature of longer-term market returns.

If anything, the outlook for fixed income returns has deteriorated over the course of 2020.

Investment strategies for the next decade likely to include real assets, tail risk hedging, and a greater allocation to Alternatives

The challenging return environment led to a series of Posts on potential investment strategies to protect your Portfolio from different market environments in the future.

This includes the potential benefits of Tail Risk Hedging and an allocation to Real Assets.

A primary focus of many investment professions currently is what to do with the fixed income allocations of portfolios, as outlined in this article.

This series of Posts also included the case against investing in US equities and the case for investing in US equities (based on 10 reasons by Goldman Sachs that the current US Bull market has further to run).

The investment case for a continued allocation to Government Bonds was also provided.

Theses Post are consistent with the global trend toward the increasing allocations toward alternatives within investment portfolios.  This survey by CAIA highlights the attraction of alternatives to investors and likely future trends of this growing investment universe, including greater allocations to Private Equity and Venture Capital.

One of the most read Post this year has been a comparison between Hedge Funds and Liquid Alternatives by Vanguard, with their paper concluded both bring diversification benefits to a traditional portfolio.

What Portfolio Diversification is, and looks like

Reflecting the current investment environment and outlook for investment returns, recent Posts have focused on the topic of Portfolio Diversification. These Posts have complemented the Posts above on particular investment strategies.

A different perspective was provided with a look at the psychology of Portfolio Diversification.  Diversification is hard in practice, easy in theory, it often involves the introduction of new risks into a Portfolio and there is always something “underperforming” in a truly diversified portfolio.  This was one of the most read Posts over the last six months.

A Post covered what does portfolio diversification look like.  A beginner’s guide to Portfolio diversification and why portfolios fail was also provided.

On a lighter note, the diversification of the New Zealand Super Fund was compared to the Australian Future Fund (both nation’s Sovereign Wealth Funds).

A short history of portfolio diversification was also provided, and was read widely.

The final Post in this series provided an understanding of the impact of market volatility on a Portfolio.

Positioning Portfolios for the likelihood of higher levels of inflation in the future

Investors face the prospects of higher inflation in the future.  Although inflation may not be an immediate threat, this article by Man strongly suggests investors should start preparing their Portfolio for a period of higher inflation.

The challenge of the current environment is also covered in this Post, which provides suggestions for Asset Allocations decisions for the conundrum of inflation or deflation.

Time to move away from the traditional Diversified Portfolio

A key theme underpinning some of the Posts above is the move away from the traditional Diversified Portfolio (the 60/40 Portfolio, being 60% Equities and 40% Fixed Income, referred to as the Balance Portfolio).

Posts of interest include why the Balanced Portfolio is expected to underperform and why it is time to move away from the Balanced Portfolio.  They are likely riskier than you think.

There has been a growing theme over the last nine months of the Reported death of the 60/40 Portfolio.

My most recent Post (#152) highlights that the Traditional Diversified Fund is outdated as it lacks the ability to customise to the client’s individual needs.  Modern day investment solutions need to be more customised, particularly for those near and in retirement.

Occasions when active Management is appropriate and where to find the more consistently performing managers

Recent Posts have also covered the role of active management.

They started with a Post with my “colour” on the active vs passive debate (50 shades of Grey), after Kiwi Wealth got caught up in an active storm.

RBC Global Active Management provided a strong case for the opportunities of active management and its role within a truly diversified portfolio.

While this Post covered several situations when passive management is not appropriate and different approaches should be considered.

Another popular Post was on where investment managers who consistently outperform can be found.

Investing for Endowments, Charities, and Foundations

I have written several Posts on investing for Endowments, Charities, and Foundations.

This included a Post on the key learnings from the successful management of the Yale Endowment.

How smaller Foundations and Charities are increasingly investing like larger endowments.  See here and here.

Navigating a Bear market, including the benefits of disciplined Portfolio rebalancing

Not surprisingly, there have been several Posts on navigating the Bear Market experienced in March and April of this year.

Posts on navigating the event driven Bear Market can be found here and here.

The following Post outlined what works best in minimising loses, market timing or diversification at the time of sharemarket crashes.

This Post highlighted the benefits of remaining disciplined during periods of market volatility, even as extreme as experienced this year, particularly the benefits of Rebalancing Portfolios.

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required

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Although it has been evident for several years, the current investment environment highlights the shortcomings of the one size fits all multi-asset portfolio (commonly known as Diversified Funds such as Conservative, Balanced, and Growth Funds, which maintain static Strategic Asset Allocations, arising to the reference of the “Policy Portfolio”).

The mass-produced Diversified Funds downplay the importance of customisation by assuming investment problems can be portrayed within a simple risk and return framework.

However, saving for retirement is an individual experience requiring tailoring of the investment solution.   Different investors have different goals and circumstances.  This cannot be easily achieved within a one size fits all Diversified Fund.

Modern-day investment solutions involve greater customisation.  This is particularly true for those near or in retirement.

A massive step toward offering increased customisation of the Wealth Management investment solution is the framework of two distinctive “reference” portfolios: A Return Seeking Portfolio; and Liability-Hedging (Capital Protected) Portfolio.

Details and implementation of this framework are provided in the next section.  The benefits of the framework include:

  • A better assessment of the risks needed to be taken to reach a client’s essential goals and how much more risk is involved in potentially attaining aspirational goals;
  • An approach that will help facilitate more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework helps in assessing what is the best course of action and trade-offs involved; and
  • A more efficient use of invested capital.  This is a very attractive attribute in the current low interest rate environment.  The framework will be more responsive to changing interest rates in the future.

These benefits cannot be efficiently and effectively achieved within the traditional Diversified Fund one size fits all framework; greater customisation of the investment solution is required.

With modern-day technology greater customisation of the investment solution can easily be achieved.

The technology solution is enhanced with an appropriate investment framework also in place.

Implementation of the Modern-Day Wealth Management Investment Solution

The reasons for the death of the Policy Portfolio (Diversified Fund) and rationale for the modern-day Wealth Management investment solution are provided below.

Modern-day investment solutions have two specific investment portfolios:  

  • Return seeking Portfolio that is a truly diversified growth portfolio, owning a wide array of different return seeking investment strategies; and
  • Capital Protected (Liability) Portfolio, is more complex, particularly in the current investment environment.  See comments below.

The allocations between the Return Seeking portfolio and Capital Protected portfolio would be different depending on the client’s individual circumstances.  Importantly, consideration is given to a greater array of client specific factors than just risk appetite and risk and return outcomes e.g. other sources of income, assets outside super.

Although the return seeking portfolio can be the same for all clients, the Capital Protected (Liability) portfolio should be tailored to the client’s needs and objectives, being very responsive to their future cashflow/income needs, it needs to be more “custom-made”.

The solution also involves a dynamic approach to allocate between the two portfolios depending on market conditions and the client’s situation in relation to the likelihood of them meeting their investment objectives.  This is a more practical and customer centric approach relative to undertaking tactical allocations in relation to a Policy Portfolio.

The framework easily allows for the inclusion of a diverse range of individual investment strategies.  Ideally a menu offering an array of investment strategies can be accessed allowing the customisation of the investment solution for the client by the investment adviser.

Implementation is key, which involves identifying and combining different investment strategies to build customised robust investment solutions for clients.

The death of the Policy Portfolio

Modern Portfolio Theory (MPT), the bedrock of most current portfolios, including the Policy Portfolio, was developed in the 1950s.

Although key learnings can be taken from MPT, particularly the benefits of diversification, enhancements have been made based on the ongoing academic and practitioner research into building more robust investment solutions.  See here for a background discussion.

The Policy Portfolio is the strategic asset allocation (SAA) of a portfolio to several different asset classes deemed to be most appropriate for the investor e.g. Diversified Funds

It is a single Portfolio solution.

A key industry development, and the main driver of the move away from the old paradigm, is the realisation that investment solutions should not be framed in terms of one all-encompassing Policy Portfolio but instead should be framed in terms of two distinct reference Portfolios.

A very good example of the two portfolios framework is provided by EDHEC-Risk Institute and is explained in the context of a Wealth Management solution.  They describe the two reference portfolios framework involving:

  1. Liability-hedging portfolio, this is a portfolio that seeks to match future income requirements of the individual in retirement, and
  2. Performance Seeking Portfolio, this is a portfolio that seeks growth in asset value.

The concept of two separate portfolios is not new, it dates to finance studies from the 1950s on fund separation theorems (which is an area of research separate to the MPT).

The concept of two portfolios has also been endorsed by Daniel Kahneman, Nobel Memorial Prize-winning behavioural economist, a “regret-proof” investment solution would involve having two portfolios: a risky portfolio and a safer portfolio.  Kahneman discusses the idea of a “regret-proof policy” here.

The death of the Policy Portfolio was first raised by Peter Bernstein in 2003.

Reasons for the death of Policy Portfolio include:

  • there is no such thing as a meaningful Policy Portfolio. Individual circumstances are different.
  • Investors should be dynamic; they need to react to changing market conditions and the likelihood of meeting their investment goals – a portfolio should not be held constant for a long period of time.

Many institutional investors have moved toward liability driven investment (LDI) solutions, separating out the hedging of future liabilities and building another portfolio component that is return seeking.  More can be found on LDI here.

These “institutional” investment approaches, LDI, portfolio separation, and being more dynamic are finding their way into Wealth Management solutions around the world.

Evolution of Wealth Management – Implementation of the new Paradigm

In relation to Wealth Management, the new paradigm has led to Goal-Based investing (GBI) for individuals. GBI focuses is on meeting investor’s goals along similar lines that LDI does for institutional investors.

As explained by EDHEC Risk Goal-Based Investing involves:

  1. Disaggregation of investor preferences into a hierarchical list of goals, with a key distinction between essential and aspirational goals, and the mapping of these groups to hedging portfolios possessing corresponding risk characteristics (Liability Hedging Portfolio).
  2. On the other hand, it involves an efficient dynamic allocation to these dedicated hedging portfolios and a common performance seeking portfolio.

GBI is consistent with the two portfolios approach, fund separation, LDI, and undertaking a dynamic investment approach.

The first portfolio is the Liability Hedging Portfolio to meet future income requirements, encompassing all essential goals.

The objective of this Portfolio is to secure with some certainty future retirement income requirements. It is typically dominated by longer dated high quality fixed income securities, including inflation linked securities.  It does not have a high exposure to cash. In the context of meeting future cashflow requirements in retirement Cash is the riskiest asset, unless the cashflows need are to be met in the immediate future.  For further discussion on the riskiness of cash in the context of retirement portfolios see here.

The second portfolio is the return seeking portfolio or growth portfolio. This is used to attain aspirational goals, objectives above essential goals. It is also required if the investor needs to take on more risk to achieve their essential goals in retirement i.e. a younger investor would have a higher allocation to the Return Seeking Portfolio.

The Growth Portfolio would be exposed to a diversified array of risk exposures, including equities, developed and emerging markets, factor exposures, and unlisted assets e.g. unlisted infrastructure, direct property, and Private Equity.

Allocations between the Hedging Portfolio and the Growth Portfolio would depend on an individual’s circumstances e.g. how far away they are from reaching their desired standard of living in retirement.

This provides a fantastic framework for determining the level of risk to take in meeting essential goals and how much risk is involved in potentially attaining aspirational goals.

This will will lead to a more efficient use of invested capital and a better assessment of the investment risks involved.

Importantly, the framework will help facilitate a more meaningful dialogue between the investor and his/her Advisor. Discussions can be had on how the individual’s portfolios are tracking relative to their retirement goals and if there are any expected shortfalls. If there are expected shortfalls, the framework also helps in assessing what is the best course of action and trade-offs involved.

For those wanting a greater appreciation of EDHEC’s framework please see their short paper: Mass Customization versus Mass Production – How An Industrial Revolution is about to Take Place in Money Management and Why it Involves a Shift from Investment Products to Investment Solutions  (see: EDHEC-Whitepaper-JOIM)

A more technical review of these issues has also been undertaken by EDHEC.

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

The case against US equities

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Extremely high valuations at a time of overwhelming uncertainty sits at the core of the case against US equities.  The US equity market appears to be priced for a perfect outcome. 

For those that demand a margin of safety, there is very little safety margin right now in US equities.

GMO’s James Montier recently outlined the reasons not to be cheerful toward US equities. 

This contrasts with Goldman Sachs 10 reasons why the US equity market will move higher from here, which I covered in my last Post.

In the GMO article it is argued the US sharemarket is priced with too much certainty for a positive outcome.  Nevertheless, with so much uncertainty, such as shape of the economic recovery and effectiveness of efforts in containing further outbreaks of the coronavirus, investors should demand a margin of safety, “wriggle room for bad outcomes if you like”. 

The article concludes there is no margin of safety in the pricing of US stocks today.

In his view, “The U.S. stock market looks increasingly like the hapless Wile E. Coyote, running off the edge of a cliff in pursuit of the pesky Roadrunner but not yet realizing the ground beneath his feet had run out some time ago”.

This view in part reflects that GMO does not fully support the narrative that has primarily driven the recovery in the US stock market over recent months and is expected to provide further support.

The centre of the positive market outlook narrative is the US Federal Reserves’ (Fed) Quantitative Easing program (QE).  QE involves the buying of market securities, leading to an expansion of the Fed’s Balance Sheet.

In short, Montier thinks it is tricky to argue any direct linkage from the Fed’s balance sheet expansion programs to equities.  In previous Fed QE periods longer-term interest rates rose, which is not supportive of equities.  It is also observed, in other parts of the world where interest rates are low, equity markets are not trading on extreme valuations like in the US.

On this he concludes the “Fed-based explanations are at best ex post justifications for the performance of the stock market; at worst they are part of a dangerously incorrect narrative driving sentiment (and prices higher).” 

Further detail is provided below on why he is skeptical of positive market outlook narrative centred around ongoing support for the Fed’s policy.

The article concludes:

“Investing is always about making decisions while under a cloud of uncertainty. It is how one deals with the uncertainty that distinguishes the long-term value-based investors from the rest. Rather than acting as if the uncertainty doesn’t exist (the current fad), the value investor embraces it and demands a margin of safety to reflect the unknown. There is no margin of safety in the pricing of U.S. stocks today. Voltaire observed, “Doubt is not a pleasant condition, but certainty is absurd.” The U.S. stock market appears to be absurd.”

This view is consistent with a “long term value” based investor and has some validity.  From this perspective, the investment rationale provides a counterbalance to Goldman’s 10 reasons.

The counter argument to GMO’s interest rate view is that the fall in interest rates reflects higher private sector savings and easier monetary policy rather than pessimism about growth and corporate earnings.  Reflecting the expansionary polices of both governments and central banks corporate earnings will recover.  Although weaker, the temporary fall in corporate earnings are not in proportion to that implied by lower interest rates.  This means lower interest rates really do justify higher market valuations.

Also, the two contrasting views could be correct, the only difference being a matter of time.

Implementation of investment strategy is key at this juncture in the economic and market cycle, more so than at any time over the last 20 years.

Historical sharemarket movements and over valuation

Since reaching the lows of 23rd March 2020, the U.S. equity market has rallied almost 50% and other world markets nearly 40%.

The movements in markets have been historic from the perspective of both the speed and scale of the market declines and their rebound.

GMO provide the following graph to demonstrate how sharp the fall and rebound by comparing the Covid-19 decline to others in history, as outlined in the following graph they provide:

Source: Global Financial Data, GMO

The sharp rebound in markets has pushed the US markets back up to extreme valuation levels.

The article outlines the following observations:

  • In 1929 the U.S. market P/E was 37% above its long-term average, and earnings relative to 10-year earnings were 46% above their normal level
  • In 2000 the market P/E was 98% above its average, and earnings relative to 10-year average earnings were 37% above their normal level.
  •  

As displayed in the following graph provided, valuations are in the 95th percentile, “right up there in terms of one of the most expensive markets of all time”.

Source: Schiller, GMO

It is clear to see there is very little margin for safety with such high valuation levels set against an uncertainty economic environment.

Accommodative US Federal Reserve Policy

A portion of the GMO article addresses the notion that an expanding Fed Balance Sheet will continue to support US equities.  The notion being that QE lowers interest rates, reducing the discount rate, and therefore drives up stock markets.

James prefers to focus on fundamentals and therefore has several issues with this viewpoint:

  1. He is skeptical of a clear link between interest rates and equity valuations.  As noted, Japan and Europe both have exceptionally low interest rates, but their stock markets are not trading on extreme market valuation like the US.
  2. Interest rates are low because economic growth is low, this needs to be reflected in company valuations.  See the note below, Role of Interest Rates for a fuller explanation.
  3. QE hasn’t actually managed to lower interest rates.  As can be seen in the Graph below, all three of the completed cycles of QE have actually ended with interest rates higher than they were when the QE began.
Source: Global Financial Data, GMO

The graph also highlights how low US interest rates are!

A Note on the Role of Interest Rates

The following extract from the Article outlines James’ explanation as to the Role of Interest Rates:

“I am no longer unique in my questioning of the role of interest rates. The good people at AQR Capital released a paper in May 2020 entitled “Value and Interest Rates: Are Rates to Blame for Value’s Torments?” In it they say, “As the risk-free interest rate is one component of the discount rate, when interest rates go up, the discount rate increases and the asset price falls – if everything else stays constant. Hence, if expected cash flows are unchanged and if the risk premium associated with those cash flows is unchanged (where the risk premium is determined by both the amount of risk exposure the cash flows have and the price of aggregate risk to those exposures in the economy), then the formula tells us how prices will change when riskless interest rates change. However, in the case of stocks, these other components rarely stay constant. Changes in real or nominal interest rates are often accompanied by (or are often a response to) changes in expected inflation and/or changes in expected economic growth, and hence expected cashflows are often changing as well. There may also be a change in the required risk premium, which is the other (and often larger) component of the discount rate. All of these components have their own dynamics and are likely simultaneously being affected by macroeconomic conditions in possibly different ways.”

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

The case for owning equities – 10 reasons why the current bull market has further to run by Goldman Sachs

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In what has been an extraordinary year, and despite a sharp bounce back from the sharemarket lows in March 2020, Goldman Sachs (GS) provides 10 strong reasons why they think US equity markets can continue to move higher from here.

GS issued their report earlier this week, 7th September 2020, after last week’s sharp declines. 

Quite rightly they highlight markets are currently susceptible to a pull back given their strong run since earlier in the year.  Nevertheless, over the longer term they think there are good reasons for them to move higher.

GS provide context in relation to the current market environment.

Firstly, the current global recession is unusual, not only to how sudden, sharp, and widespread the recession has been, also that it was not triggered by economic or market factors.  The recession was caused by government actions to restrict economic activity to contain the coronavirus.

Secondly, GS provides analysis as to the characteristics of the bear market (sharemarket fall of greater than 20%) earlier in the year.  They note it was characteristic of an “event driven” bear market (other types include structural and cyclical).  GS note that event driven bear markets typically experience falls of ~30% and are generally shorter in nature.  A sharp fall is often followed by a quick rebound.  They estimate that on average event driven bear markets take 9 months to reach their lows and fully recover within 15 months.  This compares to a structural bear market which take 3-4 years to reach their lows and around 10 years to recover.

See this Post for the history and comprehensive analysis of previous bear markets by Goldman Sachs: What too expect, navigating the current bear market.

GS also see lower returns than historically in the current investment cycle, this is expected across all asset classes.

Reasons why the current bull market has further to run

Goldman Sachs provide 10 reason why the current bull market has further to run.

Below I cover some of their reasons:

  • The market is in the first phase of a new investment cycle.  GS outline four phases of a cycle, hope, growth, optimism, and despair.  They see markets in the phase of hope, the first part of a new cycle.  2019 had the hallmarks of optimism.  The hope phase usually begins when economies are in recession as investors start to anticipate an economic recovery. 
  • The outlook for a vaccine has become more likely.  This is a positive for economic growth.  This combined with the expansionary policies by governments and central banks suggest economies will recover. 
  • The Policy environment is supportive for risk assets, including sharemarkets.
  • GS economists have recently revised up their economic forecasts.  This will likely lead to upward revisions to corporate earnings, which will help drive share prices higher.
  • Their proprietary analysis indicates there is a low level of risk for a new bear market, despite current high valuations.
  • Equities look attractive relative to other assets.  Dividend yields are attractive relative to government bonds and in GS’s view cheap relative to corporate debt, particularly those companies with strong balance sheets.
  • Although higher levels of inflation are not likely in the short/medium term, Equities offer a reasonable hedge to higher inflation expectations.
  • They see the technology sector continuing to dominate as the digital revolution continues to gather pace. They also note that many of the large tech stocks have high levels of cash and strong balance sheets. 

This article by the Financial News provides a good review of Goldman Sachs’ 10 reasons why the current bull market has further to run.

In my last Post I looked at the investment case for holding government bonds and fixed income which might be of interest.

Happy investing.

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

The Case for holding Government Bonds and fixed income

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The case for holding Government Bonds is all about certainty.  The question isn’t why would you own bonds but, in the current environment, why wouldn’t you own bonds to deliver certainty in such uncertain times?

This is the central argument for holding government bonds within a portfolio.  The case for holding government bonds is well presented in a recent article by Darren Langer, from Nikko Asset Management, Why you can’t afford not to own government bonds.

As he argues, government bonds are the only asset where you know with absolute certainty the amount of income you will get over its life and how much it will be worth on maturity. For most other assets, you will only ever know the true return in arrears.

The article examines some of the reasons why owning government bonds makes good sense in today’s investment and economic climate. It is well worth reading.

Why you can’t afford not to own government bonds

The argument against holding government bonds are based on expectations of higher interest rates, higher inflation, and current extremely low yields.

As argued in the article, although these are all very valid reasons for not holding government bonds, they all require a world economy that is growing strongly.  This is far from the case currently.

They key point being made here, in my opinion, is that the future is unknown, and there are numerous likely economic and market outcomes.

Therefore, investors need to consider an array of likely scenarios and test their assumptions of what is “likely” to happen.  For example, what is the ‘normal’ level of interest rates? Are they likely to return to normal levels when the experience since the Global Financial Crisis has been a slow grind to zero?

Personally, although inflation is not an issue now, I do think we should be preparing portfolios for a period of higher inflation, as I outline here.  Albeit, this does not negate the role of fixed income in a portfolio.

The article argues that current conditions appear to be different and given this it is not unrealistic to expect that inflation and interest rates are likely to remain low for many years and significantly lower than the past 30 years.

In an uncertain world, government bonds provide certainty. Given multiple economic and market scenarios to consider, maintaining an allocation to government bonds in a genuinely diverse and robust portfolio does not appear unreasonable on this basis.

Return expectations

Investors should be prepared for lower rates of returns across all assets classes, not just fixed income.

A likely scenario is that governments and central banks will target an environment of stable and low interest rates for a prolonged period.

In this type of environment, government bonds have the potential to provide a reasonable return with some certainty. The article argues, the benefits to owning bonds under these conditions are two-fold:

  1. A positively sloped yield curve in a market where yields are at or near their ceiling levels. Investors can move out the curve (i.e. by buying longer maturity bonds) to pick up higher coupon income without taking on more risk.
  2. Investors can, over time, ride a position down the positively-sloped yield curve (i.e. over time the bond will gain in value from the passing of time because shorter rates are lower than longer rates). This is often described as roll-down return.

The article concludes, that although fixed income may lose money during times of strong economic growth, rising interest rates, and higher inflation, these losses can be offset by the gains on riskier assets in a portfolio.  Losses on fixed income are small compared to potential losses on other asset classes and are generally recovered more quickly.

No one would suggest a 100% allocation to government bonds is a balanced investment strategy; likewise, not having an allocation to bonds should also be considered unbalanced. 

“But a known return in an uncertain world, where returns on all asset classes are likely to be lower than the past, might just be a good thing to have in a portfolio.”

The future role of fixed income in a robust portfolio has been covered regularly by Kiwi Investor Blog, the latest Post can be found here: What do Investors need in the current environment? – Rethink the 40 in 60/40 Portfolios?

The article on the case for government bonds helps bring some balance to the discussion around fixed income and the points within should be considered when determining portfolio investment strategies in the current environment.

Happy investing.

Please see my Disclosure Statement

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

Optimism tempted by uncertainty

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Every year Byron Wien, from Blackstone’s Private Wealth Solutions group, holds a series of Benchmark Lunches where he invites an assortment of hedge fund managers, private equity and real estate leaders, academics, former government officials and economy and market observers.

These meetings, along with his annual “Top Ten Surprises”, not only provide great insights into current economic and market conditions but also provide perspectives to challenge consensus thinking. Particularly his top ten surprises.

In a sign of the times, this year’s Benchmark lunches where held via Zoom. 

I briefly summarise some of the topics discussed below, access to the full discussion can be found here.

Economic Conditions

In general, the tone of the sessions was one of optimism tempered by uncertainty. 

Most of the participants thought we would be back to something like the normalcy of 2019 by 2022.

There was divergence of opinion what normal would look like, albeit, to get there, a vaccine will need to be developed, tested, manufactured, and administered. 

The economy would take some time to gain its own momentum and there will be some permanent changes.

There were some more specific comments in relation to the economy.  It was felt that US unemployment would remain high for some time. 

Not surprisingly, many expressed concerns for large portions of the economy which are in serious trouble: hotels, restaurants, resorts, cruise lines and airlines will take a long time to recover.

The strong bounce in manufacturing and housing was encouraging, reflecting very low interest rates.

Vaccine

There was considerable optimism amongst the group for a vaccine, reflecting there are many companies working to develop one. Several of these companies are conducting clinical trials and manufacturing doses in anticipation of regulatory approval. Efforts were being undertaken around the world, Europe, Asia, and the United States.

Many expected an effective vaccine to be available for essential workers by the end of this year, with the general public possibly receiving it by the second half of 2021, and by the middle of 2022 most people who wanted the vaccine could have it.

Nevertheless, there were a wider range of views on the details, such as how long the vaccine would last, whether booster shots would be required annually or more frequently to maintain immunity, and the willingness of people to get the shots.

My take from the commentary, the availability of the vaccine is not the end game, there will be lots of issues to work through once it becomes available.

Working remotely, property sectors, and social impacts

The pros and cons of working from home were discussed, which I think are well understood.

Several real estate investors attend the various sessions.  They provided the following key insights:

  • Properties that were well financed could wait out the recession.
  • Some saw opportunities in the current environment.
  • Retail was most at risk, and that some damage to the sector would be permanent. It was highlighted that the US is over-stored and has nearly three times the retail space per capita than the next highest country, Canada.
  • There will be increased costs as people return to the office e.g. increased cleaning costs and perhaps the need to upgrade ventilation systems.

Another interesting statistic provided was that according to a June 2020 BLS study, around 40% of American workers have the ability to work remotely, but the other 60% have to be present physically to perform their duties, whether in hospitals, factories, service businesses or transportation.

It will be these people who will spend less on non-essential items. 

An important issue to consider is the social impacts of higher unemployment and uncertainty arising from covid-19.

From a societal perspective the impacts are wide ranging, discussions included the impact on young children and their development, along with university graduates looking to enter the work force at a time of economic recession. 

Effects of the enormous government and central bank policy response

Most participants expected interest rates and inflation to remain low for the next several years. 

There was a level of scepticism toward Modern Monetary Theory and the ability of governments to print money indefinitely.

For the time being, the policy approach remains appropriate, so long as real growth is higher than the rate of inflation.

The recent weakness in the US dollar was noted.  There could be several reasons for this, including Europe and Asia have done a better job of controlling the virus and are recovering more favourably.

Likewise, US factors could be playing a role, such as social unrest, poor discipline in limiting the spread of the virus, and gridlock in Washington.  In addition, “The prospect of a sweep in November with both the presidency and the Senate moving to the Democrats and a less business-friendly environment in Congress may also have had an influence on the dollar.”

US Elections

Not everyone thought a Biden victory was a sure thing.  There are a lot of issues to consider, albeit Biden has a considerable lead and he will be hard to beat.

The group felt the US as a country overall had shifted to the left.

US China relationship

The growing tensions between China and US is seen as an inevitable outgrowth of the long-term shift towards nationalism and away from globalization.

There was concern in relation to China’s policy towards Hong Kong and its military operations in the South China Sea.

On the positive side, Phase One trade negotiations were moving forward and imports from and exports to China continue. A Phase Two deal seems to be off the table for now.

Although bringing production home or relocating will be difficult, costly, and time-consuming, this trend is partially underway.

Energy Sector

A wide-ranging discussion on the energy sector was undertaken.

For a period of time the drop in oil demand this year was four times greater than during the Global Financial Crisis (GFC).  The situation has improved, and it was noted China is consuming more oil currently compared to a year ago.

The US has accumulated excess inventory and US production will remain depressed for some time.  At the current oil price shale oil production is unprofitable.

The expectation was that the Oil price will not exceed $50 a barrel for West Texas Intermediate until 2022 when the economy gets back to something close to normal.  Political conditions in the Middle East will be more unstable until the price of crude recovers.

Happy investing.

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