Coronavirus – Financial Planning Challenges

For those near retirement this year’s global pandemic has thrown up new challenges for them and their Financial Advisor.

Early retirement due to losing a job, the running down of emergency funds, and a low interest rate environment are new challenges facing those about to retire.

Events this year are likely to have significant repercussions for how individuals conduct their financial planning.  Specifically, how they approach spending and saving goals.

The pandemic will likely have lasting implications for how people think about creating their financial and investment plans, and therefore raises new challenges for the Advisors who assist them.

These are the key issues and conclusions outlined by Christine Benz, director of personal finance for Morningstar, in her article, What the Coronavirus Means for the Future of Financial Planning.

In relation to the key issues identified above, Benz writes “All of these trends have implications for the way households—and the advisors who assist them—manage their finances. While the COVID-19 crisis has brought these topics to the forefront, their importance is likely to persist post-pandemic as well.”

Although the article is US centric, there are some key learnings, which are covered below.

How the Pandemic Has Impacted Financial Planning for Emergencies

The Pandemic has highlighted the importance of emergency funds as part of a sound financial plan and the difficulties that many individuals and households face in amassing these “rainy-day funds.”

Lower income families are more at-risk during times of financial emergencies.  Research in the US found that only 23% of lower-income households had emergency funds sufficient to see them through three months of unemployment.  This rises to 52% for middle income households.

It is advisable to have emergency funds outside of super.

The Morningstar article highlights “Withdrawing from retirement accounts is suboptimal because those withdrawn funds can’t benefit from market appreciation—imagine, for example, the worker who liquidated stocks from a retirement account in late March 2020, only to miss the subsequent recovery.”

An emergency fund helps boost peace of mind and provides a buffer and the confidence to maintain longer-term retirement goals.

Financial Advisors can assist clients in setting saving goals to amass an emergency fund, which is specific to their employment situation, and how best to invest these funds so they are there for a rainy day.

From an industry and Policymaker perspective, and reflecting many households struggle to accumulate emergency reserves, Morningstar raised the prospect of “sidecar” funds as potentially part of the solution.

Sidecars “would be for employees to contribute aftertax dollars automatically to an emergency fund. Once cash builds up to the employee’s own target, he could direct future pretax contributions to long-term retirement savings. Automating these contributions through payroll deductions may make it easier for individuals to save than when they’re saving on a purely discretionary basis.”

The concept of sidecar funds has recently been discussed in New Zealand.

Financial Planning for Early Retirement

The prospect of premature retirement will pose an urgent challenge for some clients. 

Although those newly unemployed will consider looking for a new job some may also consider whether early retirement is an option.

The US experience, to date, has been that those workers 55 and older have been one of groups most impacted by job losses.

Morningstar highlight that early retirement is not always in an individual’s best interest, actually, working a few years longer than age 65 can be “hugely beneficial to the health of a retirement plan,”….

They note the following challenges in early retirement:

  • Lost opportunity of additional retirement fund contributions and potential for further compound returns; and
  • Earlier withdrawals could result in a lower withdrawal rate or reduce the probability the funds lasting through the retirement period. 

Financial Advisors can help clients understand the trade-offs associated with early retirement and the impacts on their financial plans.  Often the decision to retire is about more than money.

Individual circumstances in relation to access to benefits, pensions, health insurance, and tax need to be taken into consideration.  Given this, a tailored financial plan, including the modelling of retirement cashflows on a year-to-year basis would be of considerable value.

Accommodating Low Yields in a Financial Plan

The low interest rate (yield) environment is a challenge for all investors. 

Nevertheless, for those in retirement or nearing retirement is it a more immediate challenge.

Return expectations from fixed income securities (longer dated (maturity) securities) are very low.  Amongst the best predictor of future returns from longer dated fixed income securities, such as a 10-year Government Bonds, is the current yield.

In the US, the current yield on the US Government 10-year Treasury Bond is not much over 1%, in New Zealand the 10-Year Government Bond yields less than 1%.  Expected returns on higher quality corporate bonds are not that much more enticing.

As Morningstar note, “These low yields constrain the return potential of portfolios that have an allocation to bonds and cash, at least for the next decade.“

The low yield and return environment have implications as to the sustainability of investment portfolios to support clients throughout their retirement.

The impact of low interest rates on “withdrawal rates” is highlighted in the graph below, which was provided by Morningstar in a separate article, The Math for Retirement Income Keeps Getting Worse, Revisiting the 4% withdrawal rule

The 4% withdrawal rate equals the amount of capital that can be safely and sustainably withdrawn from a portfolio over time to provide as much retirement income as possible without exhausting savings.

For illustrative purposes, the Morningstar article compares a 100% fixed income portfolio from 2013 and 2020 to reflect the impact of changes in interest rates on the sustainability of investment portfolios assuming a 4% withdrawal rate. 

As Morningstar note, since 2013 investment conditions have changed dramatically. When they published a study in 2013 the 30-year Treasury yield was 3.61% and expected inflation was 2.32%. Investors therefore received a real expected payout of 1.29%.

When they refreshed the study in 2020, those figures are 1.42% and 1.76%, respectively.  This implies a negative expected return after inflation.

The graph below tracks the projected value of $1 million dollars invested in 2013 and 2020.  The prevailing 30-year Treasury yields for July 2013 and October 2020, as outlined above, are used to estimate income for each portfolio, respectively, over time.  A “real” 4% withdrawal rate is assumed i.e. the first years $40k withdrawal grows with the inflation rates outlined above.

As can be seen, the 2013 Portfolio lasts up to 30 years, the 2020 Portfolio only 24 years, highlighting the impact of lower interest rates on the sustainability of an investment portfolio.

Financial Advisors can help in determining the appropriate withdrawal rates from an investment portfolio and the trade-offs involved.  They may also be able to suggest different investment strategies to maintain a higher withdrawal rate and the risks associated with this.

This may also include the purchase of annuities, to manage longevity risk (the risk of running out of money in retirement) rather than from the perspective of boosting current portfolio income.

Morningstar suggests that new retirees “should be conservative on the withdrawal rate front, especially because the much-cited “4% guideline” for portfolio withdrawal rates is based on market history that has never featured the current combination of low yields and not-inexpensive equity valuations.”

The 4% withdrawal rate is an industry “rule of thumb”.  Further discussion on the sustainability of the 4% withdrawal rate can be found here.

I have posted extensively about the low expected return environment and the challenges this creates for the Traditional Portfolio of 60% Equities and 40% Fixed Income.

The following Post on what investors should consider doing in the current market environment may be of interest. This Post outlines some investment strategies which may help in maintaining a higher withdrawal rate from an investment portfolio.

Likewise, this Post on how greater customisation of the client’s invest solution is required and who would benefit most from targeted investment advice may also be of interest.

Lastly, Wealth Management.com covers Benz’ article in Retirement Planning in a Pandemic.

Please read my Disclosure Statement

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

Who would benefit most from targeted investment advice?

Those in the Retirement Risk Zone would benefit most from targeted investment advice.

The Retirement Risk Zone is the 10-year period before and after retirement (assumed to retire at age 65 years).

It is the 20-year period when the greatest amount of retirement savings is in play, and subsequently, risk is at its highest.  It is a very important period for retirement planning.

The Retirement Risk Zone is the worst possible time to experience a large negative return.  How much you lose during a bear market (20% or more fall in value of sharemarkets) may not be anywhere near as important as the timing of that loss.

Therefore, the value of good advice and a well-constructed portfolio aligned with one’s investment objectives is of most value during the Retirement Risk Zone.

Impact on timing of market losses

If a large loss occurs during the Retirement Risk Zone it will result in less money in retirement and raise longevity risk (the risk of running out of money in retirement).

The risk that the order of investment returns is unfavourable is referred to as sequencing risk. 

Sequencing risk can be viewed as the interaction of market volatility and cashflows. The timing of returns and cashflows matters during both the accumulation of retirement savings and in retirement.

Once an investor needs to take capital or income from a portfolio volatility of equity markets can wreak havoc on a Portfolio’s value, and ultimately the ability of a portfolio to meet its investment objectives.

It is untrue to say that volatility does not matter for the long term when cashflows are involved.  For further discussion on this issue see this Post, Could Buffett be wrong?

Longevity Risk

The portfolio size effect and sequencing risk have a direct relationship to longevity risk.

For individuals, longevity risk is the risk of outliving ones’ assets, resulting in a lower standard of living, reduced care, or a return to employment.

One-way longevity risk manifests itself is when an investor’s superannuation savings is subject to a major negative market event within the Retirement Risk Zone.

Materiality of Market Volatility in Retirement Risk Zone

Research by Griffith University finds “that sequencing risk can deplete terminal wealth by almost a quarter, at the same time increasing the probability of portfolio ruin at age 85 from a probability of one-in three, to one-in-two.“

Based on their extensive modelling, investors have a 33.3% chance of not having enough money to last to aged 85, this raises to a 50% chance due to a large negative return during the Retirement Risk Zone.

They also note “It is our conjecture that, for someone in their 20s, the impact of sequencing risk is minimal: younger investors have small account balances, and plenty of time to recover …… However, for someone in their late 50s/early 60s, the interplay between portfolio size and sequencing risk can cause a potentially catastrophic financial loss that has serious consequences for individuals, families and broader society.”

This is consistent with other international studies.

Managing Sequencing Risk

Sequencing risk is largely a retirement planning issue. Albeit a robust portfolio and a suitably appropriate investment approach to investing will help mitigate the impact of sequencing risk.

Two key areas from an investment perspective to focus on in managing sequencing risk include:

The Retirement Goal is Income

The OECD’s Core Principles of Private Pension Regulation emphasis that the objective is to generate retirement income.  This is different to the focus on accumulated value.  A key learning from the Australian Superannuation industry is that there has been too greater focus on the size of the accumulated balance and that the purpose of superannuation should be about income in retirement.

An important point to consider, without a greater focus on generating income in retirement during the accumulation phase the variation of income in retirement will likely be higher.

Therefore, it is important to have coherency between the accumulation and pay-out phase of retirement as recommended by the OECD.

The OECD recommends the greater use of asset-liability matching (LDI) investment techniques.   

This is not just about increasing the cash and fixed income allocations within the portfolio but implementing more advanced funds management techniques to position the portfolio to deliver a more stable and secure level of income in retirement.

This is aligned with a Goals Based Investment approach.

A greater focus on reducing downside risk in a portfolio (Capital Preservation)

This is beyond just reducing the equity allocation within the retirement portfolio on approaching retirement, albeit this is fundamentally important in most cases.

A robust portfolio must display true portfolio diversification, that helps manage downside risk i.e. reduce degree of losses within a portfolio.

This may include the inclusion of alternative investments, tail risk hedging, and low volatility equities may also be option.

The current ultra-low interest rate environment presents a challenging environment for preserving portfolio capital, historically the role of Fixed Income.  Further discussion on this issue can be found in this Post, which includes a discussion on Tail Risk Hedging.

This article in smstrusteenews highlights the growing issue of capital preservation within the Australian Self-Managed Super Fund (SMSF) space given the current investment environment.

Meanwhile, this article from Forbes is on managing sequence of returns in retirement, and recommends amongst other things in having some flexibility around spending, maintaining reserve assets so you don’t have to sell assets after they fall in value, and the use of Annuities.

Many argue that sequencing risk can be managed by Product use alone. 

My preference is for a robust portfolio, truly diversified that is based on the principles of Goals-Based Investing.  Longevity annuities could be used to complement the Goals-Based approach, to manage longevity risk.

This is more aligned with a Robust Investment solution and the focus on generating retirement income as the essential investment goal.

Further Reading 

For a more technical read please see the following papers:

  1. Griffith University = The Retirement Risk Zone: A Baseline Study poorly-timed negative return event
  2. Retirement income and the sequence of-returns By: Moshe A. Milevsky, Ph.D., and Anna Abaimova, for MetLife

The case for a greater focus on generating retirement income is provided in this Post, summarising an article by Nobel Laureate Professor Robert Merton.  He argues strongly we should move away from the goal of amassing a lump sum at the time of retirement to one of achieving a retirement income for life.

The concepts in Merton’s article are consistent with the work by the EDHEC Risk Institute in building more robust retirement income solutions.

Lastly, a recent Kiwi Investor Blog Post, The Traditional Diversified Fund is outdated – greater customisation of the client’s investment solution is required, provides a framework for generating greater tailoring of investment solutions for clients.

Please read my Disclosure Statement

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

Monthly Financial Markets Commentary – October 2020

We have a winner – Maybe!

  • Markets appear to have moved on from the US election result, reflected in the 7.3% gain in the US S&P 500 index last week (its best week since April).
  • The US sharemarket declined 2.7% over October.  Global equities fell 2.4% and Oil 11.0% on rising COVID-19 cases internationally and US election uncertainty.  Europe led markets lower, falling -5.6%. Emerging markets rose 2.1%, driven higher by Chinese stocks.
  • The “Blue wave” failed to materialise. Although Biden won the US Presidency and the Democrats retained their majority in the House, control of the Senate will be decided in runoff elections in Georgia in January.  It was not the resounding win predicted by the “Polls”.
  • With a divided government, regulatory risks decline for some sectors, and government spending is likely to be less robust relative to a Blue wave outcome.  A $1 trillion dollar US Government stimulus package is now expected, less than half of what was previously anticipated. 
  • Global interest rates are expected to remain lower for longer given the US election outcome. 
  • The result is also slightly positive for emerging markets due to lower interest rates for longer and an expected friendlier global trade environment under a Biden Presidency.
  • October witnessed a rise in COVID-19 cases across Europe and in the US, resulting in fresh lockdown announcements in Europe and the UK.
  • In view of the above outcomes, economists are trimming their economic growth forecasts for the US and Europe.  Albeit the “V” shaped global economic recovery remains on track.
  • In more positive economic news, the US Labour market is rebounding more quickly than anticipated, largely due to a rehiring of temporarily laid off workers.  Measures of global manufacturing activity have also improved more than forecasted.
  • The US economy grew at a 33% annualised rate in the third quarter of 2020 but remains 2.9% lower compared to a year ago.  In the US retail sales, manufacturing, CAPEX, and the housing market underpin the bounce back in economic activity.
  • The Chinese economy continues to recover, economic activity is 4.9% higher compared to a year ago, driven by industrial production, rising retail sales, and strengthening exports.

The Red Wave

  • In a red wave New Zealand’s Labour Party (which is more aligned with the US Democratic Party) claimed a decisive victory in the General Election.
  • Like the rest of world, New Zealand is expected to see a sharp rebound in economic activity over the second quarter (the economic growth data is not available yet).  Consistent with this, Business confidence has rebounded sharply to be above pre-pandemic levels, according to the NZIER Survey of Business Opinions.
  • New Zealand’s unemployment rate rose by 1.3% to 5.3% in the third quarter’s Employment Report.  Workers covered under the Government’s wage subsidy programme are counted as employed in the official data.  Accordingly, the unemployment rate is expected to rise further.
  • The New Zealand Sharemarket continues to perform strongly in absolute terms and relative to the rest of the world.  The strong performance of F&P Healthcare and the electricity generating sector helped push the market 2.9% higher over the month.
  • The Australian sharemarket also outperformed, returning 1.9%, on an improving economy and expectations the Reserve Bank of Australia (RBA) would reduce interest rates further, which they delivered in early November by reducing the cash rate to 0.1% from 0.25%.
  • Australia and New Zealand remain relatively well placed for 2021 as the global economy transitions into a recovery phase. 
  • Australia is expected to benefit from a pickup in global economic activity, particularly if a vaccine becomes available.
  • A COVID-19 vaccine is anticipated to become available by January 2021.  If so, global economic growth is expected to pick up strongly over the second quarter of 2021.   
  • Global equities are likely to perform strongly in this scenario.

Please read my Disclosure Statement

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

The value of Emerging Markets within a Robust Portfolio – The Attraction of Emerging Markets

Canada’s largest Pension Funds plan to increase their investments into emerging markets over the following years.  Asia, particularly India and China, are set to benefit.

The increased exposures are expected to be achieved by increasing portfolio target allocations to emerging markets, partnering on new deals, and boosting staff with expertise to the area.

The expected growth in the share of global economic activity in the years ahead and current attractive sharemarket valuations underpin the case for considering a higher weighting to emerging markets within portfolios.  Particularly considering the low interest rate environment and stretched valuation of the US sharemarket.  This dynamic is very evident in the market return forecasts provided below.

Additionally, emerging markets bring the benefits of diversification into different geographies and asset classes for investors, including both public and private markets.

Increasing allocations to Emerging Markets

As covered in this Pension & Investment ((P&I) online article emerging markets are set to become a large share of Canadian Pension Plan’s portfolios. 

As outlined in the P&I article, the Ontario Teachers’ Pension Plan (C$201.4 billion) is investing significantly into emerging markets, particularly Asia.  Their exposure to emerging markets fluctuates between 10% and 20% of the total Portfolio.

The Fund’s investments across the emerging markets includes fixed income, infrastructure, and public and private equities.  They plan to double the number of investment staff in Asia over the next few years, they already have an office in Hong Kong. 

The Canada Pension Plan Investment Board (CPPIB) (C$400.6 billion) anticipates up to one-third of their fund to be invested in emerging markets by 2025.

CPPIB sees opportunities in both equity and debt.  Investments in India are expected to grow, along with China.

The Attraction of Emerging Markets

The case for investing into emerging markets is well documented: rising share of global economic activity, under-representation in global market indices, and currently very attractive sharemarket valuations.

Although the current global economic and pandemic uncertainty provides pause for concern, the longer-term prospects for emerging market are encouraging.

From the P&I article “CPPIB estimates the share of global gross domestic product represented by emerging markets will reach 47% by 2025 and surpass the GDP of developed economies by 2029”.

Based on the expected growth outlook CPPIB “feel there are attractive returns available over the long term to those investors who take the time to study the characteristics and fundamentals of these markets and are able to identify trends and opportunities in those markets,”…..

CPPIB also highlight the benefit of diversification into different geographies and asset classes for the Fund.

Lastly, the valuations within emerging market sharemarkets are attractive. 

This is highlighted in the following Table from GMO, which provides their latest (Sept 2020) Forecasts Annual Real Returns over the next 7 years (after inflation).

As can be seen, emerging market is one of only two asset classes that provides a positive return forecast.  Emerging market value offers the prospect of the highest returns over the next 7 years.  As GMO highlight, the forecasts are subject to numerous assumptions, risks and uncertainties.  Actual results may differ from those forecasted.

Nevertheless, GMO provided the following brief commentary in this LinkedIn Post “From an absolute perspective, broad markets in the US are frighteningly bad; non-US developed markets, however, are not as bad, but that is faint praise, as our official forecast for this basket is also in negative territory. “Safe” bond forecasts are not much better. With yields this low, the very foundational justification for holding bonds — as providers of income and/or as anti-correlated money makers when equities decline — has been shaken to its core. The traditional 60/40 portfolio, consisting of heavy doses of US and International stocks and Government Bonds, is poised for a miserable and prolonged period.”

GMO Annual Real Returns over 7 years

In February 2020, GMO advised that it was time to move away from the Balanced Portfolio, as outlined in this Kiwi Investor Blog Post. GMO provide a historical performance of the traditional Balanced Portfolio (60% equities and 40% fixed income).  Overall, the Balanced Fund is riskier than people think.

In the LinkedIn Post mentioned above, GMO comment that “Our Asset Allocation team believes this is the best opportunity set we’ve seen since 1999 in terms of looking as different as possible from a traditional benchmarked portfolio.”  Where the traditional benchmarked portfolio is the Balanced Portfolio of 60% equities and 40% fixed income.

Why the Balanced Portfolio is expected to underperform and potential solutions to enhancing future portfolio returns is covered in this Post.

Please read my Disclosure Statement

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

Is a value bias part of the answer in navigating today’s low interest rates?

The Value Factor (value) offers the potential for additional returns relative to the broader sharemarket in the years ahead.

Exploring an array of different investment strategies and questioning the role of bonds in a portfolio are key to building a robust portfolio in the current low interest rate environment.

There will also be a need to be more dynamic and flexible to take advantage of market opportunities as they arise.

From this perspective, a value tilt within a portfolio is one investment strategy to consider in potentially boosting future investment returns.

The attraction of Value

Evidence supporting a value tilt within a robust portfolio is compelling, albeit opinion is split.

Nevertheless, longer-term, the “Rotating into Value stocks offers substantial upside in terms of return versus the broad market” according to GMO.

GMO presents the case for a value tilt to navigate today’s low interest rates in their Second Quarter 2020 Letter, which includes two insightful articles, one by Ben Inker and another by Matt Kadnar. 

Value is at cheapest relative to the broader market since 1999, based on GMO’s analysis.  Value is in the top decile of attractiveness around the world, as highlighted in the following figure.

Spread of Value for MSCI Regional Value Factors (GMO)

As of 6/30/2020 | Source: MSCI, Worldscope, GMO

Is Value Investing Dead

As mentioned, the opinion on value is split.

A research paper by AQR earlier in the year addressed the key criticisms of value, Is (Systematic) Value Investing Dead?

For a shorter read on the case for value Cliff Asness, of AQR, Blog Post of the same title is worth reading.

AQR’s analysis is consistent with GMO’s, as highlighted in the Graph and Table below.

The Graph below measures the Price-to-Book spread of the whole US sharemarket from December 1967 to March 2020.

This spread was at the 100th percentile versus 50+ years of history on the 31 March 2020 i.e. value is at it cheapest based on 50 years of data.

Price-to-Book Spread (AQR)

Asness’s Blog Post highlights “expensive stocks are sometimes only <4x as expensive as the cheap stocks, the median is that they are 5.4x more expensive, but today they are almost 12x more expensive.” (March 2020).

It is the same story when looking at different measures of value for the US sharemarket, as highlighted in the Table below.

Value is at its cheapest on many measures (AQR)

‘Don’t ask the barber whether you need a haircut’

This quote by Warren Buffett springs to mind when considering the analysis from GMO and AQR, both being value orientated investors.  As Asness states, AQR has a horse in the race.

However, as outlined in his Post, he undertakes the same analysis as above and controls for, just to name a few:

  • Excluding all Technology, Media, and Telcom Stocks
  • Excluding the largest stocks
  • Excluding the most expensive stocks
  • Industry bets
  • Industry neutrality
  • Quality of company

Analysis is also undertaken using other measures of value, Price-Sales, P/E, using trailing and forecast earnings (these are in addition to Price-Book).

The attraction of value remains based on different measures of value and when making the adjustments to market indices as outlined above.

Asness argues value is exceptionally cheap, probably the cheapest it has ever been in history (March 2020).

The AQR analysis shows this is not because of an outdated price-to-book nor because of the dominance of highly expensive mega-cap stocks.  Investors are paying more than usual for stocks they love versus the ones they hate.  There is a very large mispricing.

The AQR research paper mentioned above, looked at the common criticisms of value, such as:

  1. increased share repurchase activity;
  2. the changing nature of firm activities, the rise of ‘intangibles’ and the impact of conservative accounting systems;
  3. the changing nature of monetary policy and the potential impact of lower interest rates; and
  4. value measures are too simple to work.

 Across each criticism they find little evidence to support them.

Are we there yet?

We do not know when and how the valuation gap will be closed. 

Nevertheless, the evidence is compelling in favour of maintaining a value tilt within a portfolio, and certainly now is not the time to give up on value.

This is not a widely popular view, and quite likely a minority view, given the underperformance of value over the last ten years.  As clearly demonstrated in the Graph below provided by Top Down Charts.

However, from an investment management perspective, the longer-term odds are in favour of maintaining a value tilt and thereby providing a boost to future investment returns in what is likely to be a low return environment over the next ten years.

It is too early to give up on value, news of its death are greatly exaggerated, on this, Asness makes the following point, value is “a strategy that’s “worked” through the 1920s – when a lot of stocks were railroads, steel, and steamship companies – through the Great Depression, WWII, the 1950s – which included some small technological changes like rural electrification, the space race and all the technology that it spanned – the internet age (remember these same stories for why value was broken back in 1999-2000?)………. Value certainly doesn’t depend on technological advancement being stagnant! But in a time when it’s failed for quite a while (again, that just happens sometimes even if it’s as good as we realistically think it is), it’s natural and proper that all the old questions get asked again. Is now different?”

I don’t think so.

Please see my Disclosure Statement

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

The reality is that asset allocations can only do so much

It is estimated US public pension plans would need to leverage a Balance Portfolio of 60% equities and 40% fixed income by 47% to achieve their 7.25% actuarial return target in the years ahead. 

Such is the challenge facing all investors in the current low interest rate environment.

Investors face some very tough decisions in the future and may be forced to consider significant asset allocation shifts.  Increasing the tolerance for risk and illiquidity are likely actions required to boost future investment returns.

Investors are going to have consider something different, from a return perspective, buying bonds is not going to cut it.  Likely actions may include considering substitutes to fixed income to provide portfolio stability and some diversification during periods of equity market weakness.

The reality is that asset allocation decisions can only do so much.

These are the key conclusions from an article written by Rob Croce, PhD, of Mellon and Aaron Filbeck, that recently appeared in AllAboutAlpha.

The article covers three potential solutions for investors to consider in boosting future investment returns.

Meeting the Pension Fund Challenge

The above conclusions are determined in the context of the challenge facing US public pension plans.

On average US pension plans currently have target returns assumptions of 7.25% on average, this is down from 8% in 2000.

In the year 2000, US 10-year government bond interest rates were 6%.  Therefore there “was little headwind to meeting return objectives”….

However, with the dramatic fall in interest rates over the last 20 years, the “gap” between long-term interest rates and return assumptions has widened materially.  This is highlighted in Figure 1 below, from the article. 

The gap is currently around 6%, compared to 2% in 2000!

Figure 1: Difference Between Average Plan Actuarial Return Assumption and 10-Year US Treasury Yield

Source: NASRA, Bloomberg, CAIA calculations

What have US pension plans done over the last 20 years as the return gap has widened:

  • Reduced their allocations to fixed income;
  • Allocated more to equities; and
  • Allocated more to alternatives.

“ According to Public Plans Data, from 2001 to 2009, the average pension allocation to alternative investments increased from 8.7% to 15.7%, which only accelerated after the Global Financial Crisis (GFC). Over the next decade, allocations to alternatives nearly doubled, reaching nearly 27% by the end of 2019.”

The increased allocation to Equities and Alternatives at the expense of fixed income is highlighted in the following Figure also provided in the article.

Figure 2: Average Allocations for the 73 Largest State-Sponsored Pension Funds

Source: Pew Research. Data as of 2016

At the same time US pension plans remain underfunded. 

The challenge facing US pension plans has been known for some time, the article notes, “In general, pension trustees seem to be faced with two potential solutions – take on more (or differentiated) risks or improve funding statuses through higher taxation or slashing benefits.”

How big is the Pension Fund Return Challenge?

The article analyses potential solutions to “filling the gap” between current interest rates and the assumed target rate of return for US pension funds.

The first approach uses risk premia-based analysis, focusing on the amount of return that can be generated over and above holding just risk-free short-term US Government bonds.

Starting with a traditional Balanced Portfolio, 60% domestic stocks and 40% U.S. 10-year bonds, the analysis seeks to determine how much risk would need to be taken to reach the 7.25% return target. Assuming historical return premia, but with the current level of interest rates.

In relation to return assumptions, the Article notes “Since 1928, stocks have outperformed the risk free asset by 6.2% at 20% volatility and 10-year U.S. government bonds have outperformed the risk-free asset by 1.5%, for Sharpe ratios of 0.3 and 0.2, respectively. For cash, we have decided to use its current near-zero return, rather than its 3.3% average return during that period.”

The results, “there is effectively no unlevered portfolio of stocks and bonds that can reliably deliver many investors’ 7.25% target return over time. Because of the nature of the problem, the solution will likely force pension investors to consider taking on leverage.”

This reflects the low interest rate environment, returns on equities will be lower on an absolute return basis.  Although equities are still expected to earn a “premium” above cash, the absolute return will be lower given the cash rate is so low (0%). The 6% equity premium is earnt on 0%, not the average 3.3% cash rate since 1928. 

The article estimates, for the Balance Portfolio to achieve the 7.25% return objective it would need to be levered by 47%.  This would increase the Portfolio’s volatility to 17.75% from 12%.

As they note, this is not a sustainable solution.  Nevertheless, it provides an indication of how much more risk needs to be taken to achieve the 7.25% return target in the current low interest rate environment.

Therefore, the article highlights the return challenge all investors face.  The leveraging of portfolios is not going to be a viable option for most investors.

The Potential Role of Alternatives

The article looks at two “hypothetical alternative allocations as potential solutions for U.S. pension funds to hit their 7.25% return, one illiquid and the other liquid.”

  1. Private Equity (illiquid).
  2. Hedge Funds or Diversified Assets (liquid)

Their analysis seeks to achieve the return outcome of 7.25% with less volatility than the levered Balance Portfolio above of 17.75% with an allocation to Private Equity and Liquid Alternatives separately.

Based on their analysis, and assumptions, they conclude the inclusion of Private Equity and Liquid Alterative strategies could help in reaching the 7.25% return assumption.

They note that Private Equity and Liquid Alternatives are “two examples provide different solutions for the same problem”.

The article also notes that there are many strategies that do not make sense e.g. anything that takes them further from their return target for the sake of diversification or anything illiquid with an expected return below their target portfolio return.

Key insights

The article wraps up with some key insights, including “buying bonds isn’t going to cut it from a return target perspective today,”…..

They also demonstrated that to meet return targets US pension plans are going to have consider something different.  “And while each pension fund is different, risk tolerance and liquidity needs will need to be managed.”

“We think that the current, low yield environment could potentially open institutions up to the idea of using low-risk liquid absolute return strategies as substitutes for fixed income investments. We believe they will increasingly look for investments that provide portfolio stability values and some diversification during risk-off environments, similar to that of traditional fixed income, but potentially provide the return of fixed income two decades ago.”

Reading this article made me think of the following John Maynard Keynes quotes:

“The difficulty lies not so much in developing new ideas as in escaping from old ones.”

“When my information changes, I alter my conclusions. What do you do, sir?”

“It is better to be roughly right than precisely wrong.”

Please see my Disclosure Statement

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

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

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

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

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

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.