Past Decade of strong returns unlikely to be repeated

The current return assumption for the average US public pension fund is 7.25%, according to the National Association of State Retirement Administrators (NASRA), highlighted in a recent CFA Institute Blog: Global Pension Funds the Coming Storm.

This compares to the CFA Institute’s (CFA) article expected return for a Balanced Portfolio of 3.1% over the next 10 years.  A Balanced Portfolio is defined as 60% Equities and 40% Fixed Income.

Therefore, the article concludes that a 7.25% return assumption is “overly optimistic in a low return interest rate environment”.

The expected low return environment will place increasing pressure on growing pension liabilities and funding deficits. This is over and above the pressures of an aging population and the shift toward Defined Contribution (DC) superannuation schemes e.g. KiwiSaver.

This environment will likely require a different approach to the traditional portfolio in meeting the growing liabilities of Define Benefit (DB) Plans and in meeting investment return objectives for DC superannuation Funds such as KiwiSaver in New Zealand.

The value will be in identifying and implementing the appropriate underlying investment strategies.

 

Past Returns

For comparison purposes an International Balanced Portfolio, as defined above, has returned around 7.8% over the last 10 years, based on international fixed income and global sharemarket indices.

A New Zealand Balanced Portfolio has returned 10.3%, based on NZ capital market indices only.

New Zealand has had one of the best performing sharemarkets in the world over the last 10 years, returning 13.5% per annum (p.a.), this compares to the US +11.3% p.a. and China -0.7% p.a.. Collectively, global sharemarkets returned 10.2% p.a. in the 2010s.

Similarly, the NZ fixed income markets, Government Bonds, returned 5.4% p.a. last decade. The NZ 5-year Government Bond fell 4.1% over the 10-year period, boosting the returns from fixed income. Interestingly, the US 5-year Bond is only 1% lower compared to what it was at the beginning of 2010.

 

It is worth noting that the US economy has not experienced a recession for over ten years and the last decade was the only decade in which the US sharemarket has not experienced a 20% or more decline. How good the last decade has been for the US sharemarket was covered in a previous Post.

 

In New Zealand, as with the rest of the world, a Balanced Portfolio has served investors well over the last ten or more years. This reflects the strong returns from both components of the portfolio, but more particularly, the fixed income component has benefited from the continue decline in interest rates over the last 30 years to historically low levels (5000 year lows on some measures!).

 

Future Return Expectations

Future returns from fixed income are unlikely to be as strong as experienced over the last decade. New Zealand interest rates are unlikely to fall another 4% over the next 10-years!

Likewise, returns from equities may struggle to deliver the same level of returns as generated over the last 10-years. Particularly the US and New Zealand, which on several measures look expensive. As a result, lower expected returns should be expected.

The lower expected return environment is highlighted in the CFA article, they provide market forecasts and consensus return expectations for a number of asset classes.

 

As the article rightly points out, one of the best estimates of future returns from fixed income is the current interest rate.

As the graph below from the article highlights, “the starting bond yield largely determines the nominal total return over the next decade. So what you see is what you get.”

 

US Bond Returns vs. US Starting Bond Yields

US Bond Returns vs US Starting Bond Yields

 

In fact, this relation has a score of 97% out of 100%, it is a pretty good predictor.

The current NZ 10 Government Bond yield is ~1.65%, the US 10-Year ~1.90%.

 

Predicting returns from equity markets is more difficult and comes with far less predictability.

Albeit, the article concludes “low returns for US equities over the next 10 years.”

 

Expected Returns from a Balanced Portfolio

The CFA Article determines the future returns from a Balance Portfolio “By combining the expected returns from equities and bonds based on historical data, we can create a return matrix for a traditional 60/40 portfolio. Our model anticipates an annualized return of 3.1% for the next 10 years. That is well below the 7.25% assumed rate of return and is awful news for US public pension funds.”

Subsequent 10-Year Annualized Return for Traditional 60/40 Equity/Bond Portfolio

Subsequent 10 years annualized Return for Traditional 60 40 Equity Bond Portfolio.png

 

This is a sobering outlook as we head into the new decade.

Over the last decade portfolio returns have primarily been driven by traditional market returns, equity and fixed income “beta“. This may not be the case when we look back in ten-years’ time.

 

This is a time to be cautious. Portfolio strategy will be important, nevertheless, implementation of the underlying strategies and manager selection will be vitally important, more so than the last decade. The management of portfolio costs will also be an essential consideration.

It is certainly not a set and forget environment. The challenging of current convention will likely not go unrewarded.

Forewarned is forearmed.

 

Global Pension Crisis

The Global Pension crisis is well documented. It has been described as a Financial Climate Crisis, the risks are increasingly with you, the individual, as I covered in a previous Post.

As the CFA article notes, the expected low return environment adds to this crisis, as a result deeper cuts to government pensions and greater increases in the retirement age are likely. This will led to greater in-equality.

 

This is a serious issue for society, luckily there is the investment knowledge available now to help increase the probability of attaining a desired standard of living in retirement.

However, it does require a shift in paradigm and a fresh approach to planning for retirement, but not a radical departure from current thinking and practices.

For those interested, I cover this topic in more depth in my post: Designing a New Retirement System. This post has been the most read Kiwi Investor Blog post. It covers a retirement system framework as proposed by Nobel Laureate Professor Robert Merton in his 2012 article: Funding Retirement: Next Generation Design.

 

Lastly, the above analysis is consistent with recent calls for the Death of the Balanced Portfolio, which I have also Blogged on.

Nevertheless, I think the Balanced Portfolio is being replaced due to the evolution within the wealth management industry globally, which I covered in a previous Post: Evolution within Wealth Management, the death of the Policy Portfolio. This covers the work by the EDHEC-Risk Institute on Goals-Based Investing.

 

In another Posts I have covered consensus expected returns, which are in line with those outlined in the CFA article and a low expected return environment.

In my Post, Investing in a Challenging Investment Environment, suggested changes to current investment approaches are covered.

Finally, Global Economic and Market outlook provides a shorter-to-medium term outlook for those interested.

 

Please note, I do not receive any payment or financial benefit from Kiwi Investor Blog, and a link to my Discloser Statement is provided below.

 

Happy investing.

Please read my Disclosure Statement

 

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

How good will the next decade be for Investing?

“Adjusted for risk—or, more precisely, the volatility stock investors had to bear—gains in the S&P 500 index since Dec. 31, 2009, are poised to be the highest of any decade since at least the 1950s.” as outlined in a recent Bloomberg article, The Bull Market Almost No One Saw Coming.

Who would had thought that back in 2009?

 

As the Bloomberg article highlights, it has been a relatively smooth ride of late; equity market volatility has fallen in line with the sharp decline in interest rates over the last ten years.

Also assisting the smoother ride in US equity markets has been the lower volatility in US economic activity. The US economy has expanded by 1.6% to 2.9% in each of the previous nine years, a similar level of economic activity is expected in 2019. According to Bloomberg, based on standard deviation, that’s the smallest fluctuation over any 10-year stretch in data going back to 1930.

 

In fact, the 2010s were the first decade without a bear market, defined as a 20% drop from any peak.

For the record, US equities:

  • experienced six separate 10% corrections over the 2010s (to date!); and
  • In total have returned 249% in the past 10 years, about 1.2 times the historical average.

The US is amid the longest bull market ever (longest period in history without a bear market).

These gains have come when least expected.

 

They also follow a -20% decline over the previous decade (2000 – 2009). Which includes a -52% decline of the Great Recessions (Global Financial Crisis (GFC) – measured over the period October 2007 – February 2009. As at October 2007 the S&P 500 Index had only climbed 11% since the beginning of the decade.

 

How Good has it been?

As Bloomberg note, based on the Sharpe ratio, which tracks the performance of equity markets relative to Government Bonds, adjusted for the volatility of equity markets, the current Sharpe Ratio of the S&P500 is the best among any decade since at least Dwight Eisenhower’s presidency.

The last decade has not been all plain sailing and includes the following market events: May 2010 flash crash, Europe’s sovereign debt crisis in 2011 and ’12, and China’s currency devaluation in 2015.

A previous Post covered these market declines: Equity Market Declines in Perspective

More recently global markets have had to endure an ongoing trade and technology dispute between the US and China.

Central Bank actions, including the lowering of interest rates and quantitative easing (i.e. buying of market securities, mainly fixed income) has helped ease markets anxiety. This is reflected in the decline of market volatility indices, such as the VIX Index.

 

What does the next decade look like?

The sharemarket and economy are linked.

Generally a bear market (i.e. 20% or more fall in value) does not occur without a recession (a recession is often defined as two consecutive quarters of negative economic growth).

Currently there are no excesses within the US economy, that normally precede a recession e.g. elevate inflation, excessive house prices, and high household debt levels.

This would tend to indicate that global equity markets can move higher.

 

Nevertheless, US equity market valuations are high, as are those of global Fixed Income markets.  This environment has resulted in many reporting the death of the traditional Balanced Portfolio (60% listed equities / 40% fixed income).

There are growing expectations that returns over the next decade will be lower than those experienced over the last ten years, as highlight in a previous Post: Low Return Environment Forecasted.

That Post has the following Table, GMO’s expected 7 year returns as at 31 July 2019. They estimated the real returns (returns after 2.2% inflation) for the following asset classes as follows:

Share Markets Annual Real Return Forecasts
US Large Capitalised Shares -3.7%
International Shares 0.6%
Emerging Markets 5.3%
Fixed Income Markets
US Fixed Income -1.7%
International Fixed Income Hedged -3.7%
Emerging Debt 0.7%
US Cash 0.2%

As GMO highlight, these are forward looking based on their reasonable beliefs and they are no guarantee of future performance.   Actual results may differ materially from those anticipated in forward looking statements.

 

It is very rare for decade of strong returns to be followed by a similar like decade.  Only time will tell.

Nevertheless, there is little doubt that a challenging investment environment is likely in the not too distant future. This Post outlines how to prepare and consider investing for such a challenging environment: Investing in a Challenging Investment Environment.

 

Happy investing.

Please read my Disclosure Statement

 

For a historical perspective of previous sharemarket corrections and bear markets please see my previous Post: History of Sharemarket corrections – An Anatomy of equity market corrections

Meanwhile, this Post, Recessions, Inverted Yield Curves and Sharemarket Returns, outlines the inter-play between the economic cycle and sharemarket returns.

 

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

 

Global Economic and market outlook

For those looking for a balanced, rational, and insightful view of the global economy and outlook for financial markets, this article is worth reading.

 

I don’t normally post economic views on Kiwi Investor Blog as they are readily available. The quality of these views can also often be questioned.

It is also easier to find articles of doom and gloom, as they are more often promoted by the mainstream media, they attract more headlines.

 

This interview with Peter Berezin, of BCA, is the exception to the rule.

BCA’s Chief Global Strategist, Berezin, is not worried about the current weakness of the global industrial sector. If anything, he expects the global economy is going to see a revival in growth over the next few quarters.

As the article outlines “Falling interest rates and the service sector which is cooling but still expanding give Berezin grounds for optimism. He considers the trade dispute to be the greatest risk. But he believes that both the US and China have an interest in reaching a deal before the next US presidential elections.”

“Berezin prefers equities to bonds. In the longer term, he expects painful losses for the latter because central banks underestimate inflation risks……..”

I’ll quickly summarise Berezin’s thoughts below, nevertheless, the article is well worth reading so as to form your own view and to be informed.

In summary Berezin made the following comments and observations:

  • He does not see the global economy heading for a recessions, as noted above if anything, he expects the global economy is going to see a revival in growth over the next few quarters. Financial conditions have eased significantly over the last six months largely due to the decline in government bond yields. Historically, easier financial conditions tended to translate into faster growth.
  • Provided that the trade war doesn’t heat up significantly, the global manufacturing sector is going to rebound later this year. That’s going to drive global growth higher.
  • He does not see any glaring imbalances in the US or globally that gives concern to a recession, noting the private sector globally is a net saver.
  • The trade dispute between the US and China is the biggest risk to his view. China is stimulating their economy.
  • He believes both parties have an incentive to cool things down – Trump so it does not do damage to the economy and his election changes. China – likewise so not to damage their economy, also they don’t like the prospect of negotiating trade if Trump does win the election and also if he doesn’t win the election – the Democrats are likely to be tougher on trade than Trump.

 

The above provides a taste, the article also covers the outlook for oil, inflation, and risk of regulatory impact on the large US technology companies.

 

What should investors do?

Berezin recommends investors to overweight equities relative to government bonds over the next 12 months. “Stocks are not particularly cheap, but they are certainly not very expensive either. The MSCI All Country World Index is trading at around 15.5 times forward earnings which is not too bad. Outside the US, stocks are trading at close to 13.5 forward earnings which is actually pretty cheap.”

Looking forward, his preferred regions are away from the US and towards the emerging markets and Europe.  This is subject to a pickup in the global economy.

In relation to Fixed Income (bonds), he sees “an environment in which government bond yields are rising”. This is a negative environment for bonds (as yields rise, bond prices fall).

 

It is worth noting that 2019 is turning out to be good year for investors, particularly those invested in a “Balanced Portfolio”, 60% Equities and 40% Fixed Income. Global equities have returned around 18% since 31 December 2018, likewise returns on New Zealand and Global Bonds have been around 8-10%. This follows a very hard year in 2018 in which to generate investment returns, with the possible exception of New Zealand equities.

Returns on a one year basis include sharp declines in global equity markets over the final three months of 2018. These negative returns will start to “unwind” out of annual returns so long as equity markets remain at current levels.

 

Happy investing.

Please read my Disclosure Statement

 

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

2018 was a shocking Year

Well its official, 2018 was a shocking year in which to make money. Not for some time, 1972, has so many asset classes failed to deliver 5% or more in value.

In terms of absolute loses, e.g. Global Financial Crisis (GFC 2007/08), investors have incurred far worst returns than 2018, nevertheless, as far as breadth of asset classes failing to deliver upside returns, 2018 is historical.

 

Here is a run through the numbers:

International Equities were down around 7.4% in local currency terms in 2018:

  • The US was one of the “better” performing markets, yet despite reaching historical highs in January and then again in September, had its worst year since the GFC, December was is its worst December return outcome since the 1930s.
  • The US market entered 2018 on a record run, experiencing it longest period in history without incurring a 5% or more fall in value.  This was abruptly ended in February.
  • During the year the US market reached its longest period in history without incurring a Bear market, defined as a fall in value of more than 20%. Albeit, it has come very close to ending this record in recent months.
  • Elsewhere, many global equity markets are down over 20% from their 2018 peaks and almost all are down over 10%.
  • Markets across Europe and Japan fell by over 12% – 14% in 2018
  • The US outperformed the rest of the world given its better economic performance.
  • The New Zealand sharemarket outperformed, up 4.9%!

Commodities, as measured by the Bloomberg Index, fell over 2018. Oil had its first negative year since 2015, falling 20% in November from 4 year highs reached in October. Even Gold fell in value.

Hedge Fund indices delivered negative returns.

Global credit indices also delivered negative returns, as did High Yield

Emerging Market equities where negative, underperforming developed markets.

Global listed Property and Infrastructure indices also returned negative returns.

Fixed Interest was more mixed, Global Market Indices returned around 1.7%:

  • US fixed interest delivered negative returns for the year, as did US Inflation Protected fixed interest securities. US Longer-term securities underperformed shorter-term securities.
  • NZ fixed interest managed around +4.7% for the year.

The US dollar was stronger over 2018, this provided some relief for those investing outside of their home currency and maintained a low level of currency hedging.

The above analysis does not include the unlisted asset classes such as Private Equity, Unlisted Infrastructure, and Direct Property investments.

 

Two last points:

  • Balance Bear, under normal circumstances, fixed interest, particularly longer-term securities, would perform strongly when equity markets deliver such negative returns as experienced in 2018. This certainly occurred over the last quarter of 2018 when concerns over the outlook for global economic growth became a key driver of market performance. Nevertheless, over the year, fixed interest has failed to provide the usual diversification benefits to a Balanced Portfolio (60% Equities and 40% Fixed Income). Many Balanced Portfolios around the world delivered negative returns in 2018 and failed to beat Cash.
  • Volatility has increased. Research by Goldman Sachs highlights this. In 2018 the US S&P 500 Index experienced 110 days of 1%+ movements in value, this compares to only 10 days in 2017.

 

Happy investing.

 

Please see my Disclosure Statement

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

 

Recent Market volatility and end of year market and economic forecasts

There are lots of economic and market forecasts at this time of the year. Many are easily accessed on the internet.

Does anyone care about these forecasts? Or do we place too much emphasis on these forecast? These topics are covered in a recent Institutional Investor article. Some good points are made.

 

The current market volatility is likely to be front of mind presently for many investors. Others may be seeing it as an opportunity.  What ever your view of 2019, a longer term perspective should always be maintained.

Either way, it has been a tough year to make money .

 

Most likely, your view of the current market volatility is closely tied to your forecast for 2019.

On this note, there are number of reasons to be “relaxed” about the current market volatility as outlined in the recent Think Advisor article.

 

Why should we be relaxed about the current bout of volatility? The most pertinent reasons from the article are as follows:

The US economy is still strong

US Economic growth accelerated in 2018 while the rest of world slowed. Global growth is expected to moderate in 2019 from the current pace in 2018.

Albeit, the US economy is still strong with unemployment at its lowest level since 1969, consumer and business confidence remains healthy, forward looking indicators are supportive of ongoing economic growth.

Although growth is slowing in Europe and China the environment remains supportive of ongoing economic expansion.

Global sharemarkets appear to have already adjusted for a more moderate level of global economic growth in 2019.

 

Stock Fundamentals are okay

Global corporate earnings are forecast grow over the next twelve months, supported by the economic backdrop outlined above.

As alluded to above, value has appeared in many global markets given recent declines.

 

Yield curve inversion

Markets are pre-occupied with the possibility of a US inverted yield curve. This appears overdone. Yield curve Inversion is when the yield (rate of interest) is lower on longer dated fixed interest securities compared to shorter dated securities. Under normal circumstance longer dated securities have a higher yield than shorter dated securities.

As highlighted previously  an inverted yield curve is a necessary but not sufficient pre-condition to recession. Not every yield curve inversion is followed by a recession .

There is also a considerable time lag between yield curve inversion and economic recession. A period of time in which sharemarkets have on average performed strongly.

Lastly, the traditional measure of yield curve inversion, 3 month yield vs 10 year yield, is not inverted!

 

Of the reasons provided in the article, the above are the most relevant and worthy of taking note of.

Nevertheless, global trade is a key source of the current market volatility and is likely to remain so for sometime.  Likewise it may take time for markets to gain comfort that global economic growth has stabilised at a lower rate of expansion. Therefore, continued market volatility is likely.

Alternatively, a pause in the US Federal Reserve raising short term interest rates would also likely provide a boost to global sharemarkets.

 

PIMCO, as recently reported, highlight that the risk of a recession in the US has climbed in 2019.

This prediction is made in the context that the US is nearing a decade long period of economic expansion, the longest period in its history without experiencing an economic recession (defined as two consecutive quarters of negative economic growth).

PIMCO note “The probability of a U.S. recession over the next 12 months has risen to about 30 percent recently and is thus higher than at any point in this nine-year-old expansion, Even so, the models are flashing orange rather than red.”

“The last few months have given us a sense of the types of risks that are out there, that both the economy and markets are going to face in 2019,” ….. “At a minimum, like we have seen this year, expect ongoing volatility and that’s true across all segments of the financial markets.”

 

Happy investing.

 

Please see my Disclosure Statement

  

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

It has been a tough Year to make Money

2018 has been a tough year in which to make money.

2018 is “The worst time to make money in the markets since 1972” according to a recent Bloomberg article.

“Things have not been this bad since Richard Nixon’s presidency”.

Research undertake by Ned Davis Research, who places markets into eight big asset classes, everything from bonds (Fixed Interest) to US and international stocks and commodities, not one of them is “on track to post a return this year of more than 5%, a phenomenon last observed in 1972”….

As they note, in terms of absolute loses, think Global Financial Crisis (GFC 2007/08), investors have incurred far worst returns in 2018, nevertheless, as far as breadth of asset classes failing to deliver upside returns, “2018 is starting to look historic.”

Nothing has worked this year.  Year to date: global equities are down, as are emerging markets, hedge fund indices, global commodities (even oil), International Credit, Global High Yield, US Fixed Interest, US Inflation Protected Bonds, while Global Aggregate Fixed Interest have eked out a small gain.  Investments into unlisted assets have been more rewarding.

 

“That’s all but unique in history. Normally when something falls, something else gains. Amid the financial catastrophe of 2008, Treasuries rallied (increased in value). In 1974, commodities were a bright spot. In 2002, it was REITs. In 2018, there’s nowhere to run.”

 

Outcomes are a little better if you are a New Zealand (NZ) based investor, Cash is on track to return around 2%, 6 month Term Deposits 3.5%, NZ Fixed Interest is up around 4%, and the NZ Sharemarket is currently up 3%.  Still they are all short of 5%.  Meanwhile the recent strength in the NZ dollar has detracted from offshore returns.

 

It has been a tough year, global equities reached all-time highs in January, fell heavily in February and March, only to recover up to October, with the US Sharemarket reaching a new historical high.

Since October yearly gains have been erased due to a number of factors, some, but not all, of these factors are briefly outlined below.

 

In short, as highlighted by a recent Barron’s article markets appear to be panicking over everything.

Recent market drivers in brief:

  • Primarily concern for Sharemarkets has been a reduction in global economic growth expectations. Global investor sentiment toward the pace of global economic growth in 2019 has become more cautious over recent months. Global sharemarkets have adjusted accordingly. Albeit, the sharmarket adjustment does appear to be overdone relative to the likely moderating in global growth in 2019, which has also  largely been anticipated.
  • Global Trade concerns continue to negatively impact global markets e.g. Australia and commodities, primarily the ongoing negotiations between the US and China are a source of market volatility and uncertainty.
  • Brexit more recently. The UK are going to have to pay a price for leaving the EU, why? too stop other countries ever considering leaving the EU as a viable option. Unfortunately, while Brexit is an important issue and will be a source of volatility, the negative consequences will largely sit with the UK rather than the rest of the world.
  • There has been considerable oil price volatility, the price of oil fell by over 20% in November.
  • There has also been uncertainty as to likely pace of increases in the Federal Funds Rate by the US Federal Reserve (US Central Bank).

 

Inverted Yield Curve

Lastly, markets have also latched onto the inversion of the US Yield curve.

Inversion is when the yield (rate of interest) is lower on longer dated fixed interest securities compared to shorter dated securities. Under normal circumstance longer dated securities have a higher yield than shorter dated securities.

An “inverted” yield curve has been useful, though not perfect, in predicting economic recession and equity bear markets (when sharemarkets fall in value of over 20%),

 

On this occasion the market has focused on the three year security versus the five year security.

Normally, the market focuses on the three month versus the 10 year security as the best predictor of economic recession.  For a further discussion see Risk of Economic Recession and Inverted Yield Curve and US Recession warning. An inverted yield curve is a necessary but not sufficient condition in predicting a recession, and there is often a lag.

 

As the Barron article highlights: “Since 1965, the three-year yield has been higher than the five-year on seven different occasions. In 1973, the stock market had already sunk into a recession. In the other six instances, the median distance to a recession was 25 months—or more than two years. The S&P 500 went on to gain a median 20% over the 24 months following such an inversion. “Historically, not only have returns tended to be very strong, but the bear market has generally been years away,”

 

Happy investing.

 

 

Please see my Disclosure Statement

 

 

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

 

How long will the record US equities bull market run continue for?

An interesting view from JP Morgan.

The US Equity market is within a month of recording its longest ever bull market.  Many are expecting it to continue well into 2019.  The US economy will reaches its longest period of economic expansion in modern history July 2019.

History of Sharemarket corrections – An Anatomy of equity market corrections

 

JP Morgan view.

www.bloomberg.com/news/articles/2018-07-19/jpmorgan-says-record-breaking-bull-market-could-run-until-2020

 

Happy investing.

 

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

 

Please see my Disclosure Statement

Risk of Economic Recession and an Inverted Yield Curve

There has been a lot of discussion recently about the prospect of an inverted US yield curve.  (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months).  A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Historically an inverted yield curve is a powerful recession sign.  John Williams, who will take over the helm of the New York Federal Reserve Bank of New York in June, said earlier in the year a truly inverted yield curve “is a powerful signal of recessions” that has historically occurred (italics is mine).

The US yield curve spread (difference in yield) between the 2 year and 10 year US Treasury interest rates has recently reached its narrowest in over a decade.  Thus the heightened discussion.

As can be seen in the graph below the US Treasury yield curve inverted before the recessions of 2008, 2000, 1991, and 1981.

It should be noted that the US yield curve has not yet inverted and there is a lag between inversion and recession, on average of 1 to 2 years.  See graph below.  I am not sure I’d call the Yield Curve still “Bullish” all the same.

At the same time, the risk of recession does not currently appear to be a clear and present danger.

Much of the flattening of the current yield curve (i.e. shorter-term interest rates are close to longer-term interest rates) reflects that the US Federal Reserve has increased shorter-term interest rates by over 150 bpts over the last 2 years and longer-term interest rates remain depressed largely due to technical factors.  Albeit, the US 10 year Treasury bond recently trade above 3%, the first time since the start of 2014.  Therefore, the current shape of the US yield curve does make some sense.

Inverted yield curve.png

 

The picking of recession is obviously critical in determining the likely future performance of the sharemarket.

As a rule, sharemarkets generally enter bear markets, falls of greater than 20%, in the event of a recession.

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

See the graph below, as it notes, since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

bear market recessions.jpg

 

Statistically:

  1. The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  2. The average Bear Market period lasted 1.3 years with an average loss of -41%
  3. Historically, and on average, equity markets tend not to peak until six months before the start of a recession.

The current US sharemarket bull market passed its 9 year anniversary in March 2018.  The accumulated return is over 300%.

 

Mind you, we have to be careful with averages, I like this quote:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 

Assessing Recession Risk

Importantly, investors should not use the shape of the yield curve as a sole guide as to the likelihood of a recession.

The key forward looking indicators to monitor include an inverted yield curve, but also a significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders.

Tightening of financial conditions is also a key indicator, particularly central banks raising interest rates (or reducing the size of their balance sheet as in the current environment) e.g. US Federal Reserve, but also tightening of lending conditions by the large lenders such as the commercial banks to consumers and more particularly businesses.

Lastly, equity market valuation is important.

Happy investing.

 

Please see my Disclosure Statement

Shortcomings of Target Date and Life Cycle Funds

Target Date Funds, also referred to as Glide Path Funds or Life Cycle Funds, reduce the equity allocation in favour of more conservative investments, fixed interest and cash, as the investor gets closer to retirement.

They do this on the premise that as we get older we cannot recover from financial disaster because we are unable to rebuild savings through human capital (salary and wages).  These Funds follow a rule of thumb that as you get closer to retirement an investor should be moved into a more conservative investment strategy.  This is a generalisation that does not take into consideration the individual circumstances of the investor nor market conditions.

Target Funds are becoming increasingly popular.  Particularly in situations where the Investor does not want or can afford investment advice.  The “Product” adjusts the investor’s investment strategy throughout the Life Cycle for them, no advice provided.

 

All good in theory, nevertheless, these “products” have some limitations in their design which are increasingly being highlighted.

No, it is not that they are moving investors into cash and fixed interest at a time of record low cash returns and over-valued fixed interest markets.  This is an issue, but a topic for another Blog.  Albeit this is touched on below from a slightly different angle.

 

Essentially, Target Date Funds have too main short comings:

  1. They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration future income requirements or likely endowments, level of income generated up retirement, or the investors risk profile, appetite for risk, or risk tolerance.
  • They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.
  1. Additionally, the glide path does not take into account current market conditions.
  • Risky assets have historically shown mean reversion (i.e. asset returns eventually return back toward the mean or average return, prices display volatility to the upside and downside.
  • Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:
    • Delays in the pace of transitioning from risky assets to safer assets
    • May require step off the glide path given extreme market risk environments

 

Therefore, there is the risk that some Target Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income.

 

Target Date Funds, Life Cycle Funds, focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.

The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk.

As noted above, most target date funds don’t make revisions to asset allocations due to market conditions.  This is inconsistent with academic prescriptions, and also common sense, both of which suggest that the optimal investment strategy should also display an element of dependence on the current state of the economy.

 

The optimal target date or life cycle fund asset allocation should be goal based and multi-period:

  • It requires customisation by goals, of human capital, and risk preferences
  • Some mechanism to exploit the possibility of mean reversion within markets

 

All up, this requirements a more Liability Driven Investment approach, Goal Based Investing.

My first blog outlines the revolution required within the industry to Mass Customisations.

 

Please see my Disclosure Statement

US Equity Market 9 Years of Advancement

The US equity market recently celebrated 9 years of advancement without a bear market (a Bear market is defined as an equity market decline of greater than 20% from its peak).

This 9 year Bull market is closing in on the historical record of 9 years and five and half months.  The longest post-war Bull market stretched from 11 October 1990 to 24 March 2000.  To break that record the current Bull market will have to continue until the last week of August 2018.

The US equity market experienced a “correction” in February 2018 (a correction is defined as a fall in market value of between 10 and 20%) on inflation and higher interest rate concerns.  I wrote about this in this blog and also put into historical perspective here and here.  

 

Bull markets end with a Bear market.  Bear markets usually coincide with recession.  Very rarely has there been a Bear Equity Market without recession.  Nevertheless, there have been bear markets without a recession.

Fortunately the global economy has good momentum and recession does not look imminent. Most economic forecasts are for economic growth throughout 2018 and into 2019.

Albeit, the current Bull market does face some risks.  Key amongst those risks are:

  • Earnings disappointment in 2019. Earnings momentum is vulnerable this late in the economic cycle
  • Economic data disappoints – global equity markets are priced for continuation of the current “Goldilocks” economic environment, not too hot and not too cold.
  • Inflation data surprises on the upside
  • Policy mistake by a Central Bank given the extraordinary policy positions over the last 10 years of very low interest rates and Quantitative Easing, e.g. US Reserve Bank needs to raise short term interest rates more quickly than currently anticipated
  • Longer term interest rates rise much higher than currently expected

 

Therefore, lots to consider as the year progresses.

 

I enjoyed this quote from Howard Marks “there are two things I would never say (since they require far more certainty than I consider attainable): “get out” and “it’s time.”  It’s rare for the market pendulum to reach such an extreme that views can properly be black-or-white.  Most markets are far too uncertain and nuanced to permit such unequivocal, sweeping statements.”

Well worth thinking about when making portfolio investment decisions.

 

Please see my Disclosure Statement