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 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.

Optimism tempted by uncertainty

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

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

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

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

Economic Conditions

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

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

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

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

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

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

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

Vaccine

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

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

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

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

Working remotely, property sectors, and social impacts

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

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

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

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

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

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

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

Effects of the enormous government and central bank policy response

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

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

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

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

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

US Elections

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

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

US China relationship

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

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

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

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

Energy Sector

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

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

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

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

Happy investing.

Please see my Disclosure Statement

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



We will get through this – coronavirus

One of the better discussions available on the coronavirus is the CFA Institute interview between Laurence B. Siegel and Andrew “Drew” Senyei, MD.

The most important point to take away is the concluding remark “the advances in medical knowledge and molecular biology, especially in the last decade, and with the full focus of the world on this one challenge — we will get through this.”

The discussion is wide ranging and will help in providing clarity on several issues e.g. the importance of testing, how the virus impacts on the body, and the trade-off between preventing or slowing the spread of the disease at all costs versus the cost on the economy and people’s mental health, including what testing is required to get people back to work.

 

The interview begins by acknowledging that although our knowledge of the virus is increasing there is still lots to learn about it. It is evident that this coronavirus is different from previous coronaviruses.

One important unknown is how lethal it is. This relates to the case fatality rate (CFR). This is the number of people who die of the disease, expressed as a percentage of the number of people who have it.

As you may be aware, there are a number of problems in measuring this currently:

  • More testing is needed to know how many people who have had it, especially asymptomatic patients – tested positive for the virus but showed no symptoms.
  • The reporting of deaths has also been problematic, did they die because of the virus or was there an underlying ailment e.g. cancer or heart disease. The difference between died with and died from.

The best estimate currently is that the CFR of the coronavirus is higher than the flu, but it is unlikely to be as high as SARS.

Also, the CFR for the coronavirus is likely to fall as further testing is undertaken, this was the experience with SARS.

The experience on the cruise ship, The Diamond Princess, provides an insight into the likely CFR, and interestingly, over half those tested were asymptomatic. This is discussed in more detail in the article.

The issue of incomplete statistics is highlighted in comparing the outcomes between Italy and South Korea. This comes down to the level of testing and the variations in the way different countries are testing.

Social distancing is having a positive impact. Particularly from protecting the health care system. Ideally, we want “the density of new cases presenting in any geographic area at any given time to be as low as possible and over as long a time period as possible to prevent a surge on the health care system.”

There is a great discussion around the issues with testing. There are a lot of variables.  At the risk of sounding repetitive we need lots of testing, “We need to know how much of the disease is out there so we can have the health care resources and physicians to respond to that surge, where and if it occurs.”

 

Economic Trade-off

The latter half of the article covers the issue of the trade-off between preventing or slowing the spread of the disease at all costs versus the cost on the economy and people’s mental health.

The argument being, should we ease up relatively quickly on policies that discourage work and income and social interaction, otherwise we will severely injure the economic life.

Is there an optimum or balance between the two extremes?

 

Initially, given the unknows, erring on the side of caution would appear appropriate.

Nevertheless, there is an argument for considering “a rational middle ground and that is: We have to first understand if this is peaking. And remember when you look at new case rates, you’re actually lagging by two weeks.”

Understanding more about the virus will help in getting the economy back up and running.  More testing is needed.

“I would look at those [new case rates], and then at hospitalizations and intensive care utilization, and see if that’s peaking because that is the most pressing problem. Then I would look at the rates by population density and see where the wave is happening more locally and usher resources there.”

The discussion comes back to more but different testing, to get a better sense of who’s had the infection, who’s over it, and who’s protected at least for a while.

This is an interesting discussion and highlights a likely path to getting people back to work. .

The key is to identify those individuals already immune and not likely to get infected or infect others back to work.

Protecting the elderly is important, therefore it is suggested “to look at the density of the elderly and make sure resources are adequate for that particular region — not just equipment and supplies, but personnel.”

Senyei concludes “I would invest really heavily in the basic biology and in vaccine development which is two years out. I think you’re going to need a vaccine and you’ll probably need a new vaccine like you do for the flu every year. This virus will mutate.”

“Now all that takes money, time, and coordination — but people are working on it and I think, if we did that, we could sort of get back to the economy being an economy.”

As highlighted above, they conclude by acknowledging that we will get through this.

 

Stay safe and healthy.

 

Happy investing.

Please see my Disclosure Statement

 

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

 

 

 

Sobering low return estimates

AQR has updated their estimates of medium-term (5- to 10-year) expected returns for the major asset classes.

Their expected real return for the traditional U.S. 60/40 portfolio (60% Equities / 40% Bonds) is just 2.4%, around half its long-term average of nearly 5% (since 1900).

It is also down from 2.9% estimated last year.

 

AQR conclude that medium term expected returns are “sobering low”. Their return estimates are after inflation (real returns) and are compounded per annum returns.

“They suggest that over the next decade, many investors may struggle to meet return objectives anchored to a rosier past”.

“We again emphasize that our return estimates for all asset classes are highly uncertain. The estimates in this report do not in themselves warrant aggressive tactical allocation responses — but they may warrant other kinds of responses. For example, investment objectives may need to be reassessed, even if this necessitates higher contribution rates and lower expected payouts. And the case for diversifying away from traditional equity and term premia is arguably stronger than ever.”

 

The AQR estimate for a Balance Fund return are similar to those published recently in a CFA Institute article of 3.1%.

 

AQR update their estimates annually.  They manage over US$186 billion in investment assets.

 

Return Estimates

Reflecting the strong returns experienced in 2019 across all markets, particularly US equities, future returns estimates are now lower compared to last year.

This is Highlighted in the Table below.

Medium-Term Expected Real Returns

Market

2019 Estimate

2020 Estimate

US Equities

4.3%

4.0%

Non-US Developed Equities

5.1%

4.7%

Emerging Markets

5.4%

5.1%

US 10-year Government Bonds

0.8%

0.0%

Non US-10 Year Government Bonds

-0.3%

-0.6%

US Investment Grade Credit

1.6%

0.9%

 

Bloomberg have a nice summary of the key results:

  • Anticipated returns for U.S. equities dropped to 4% from 4.3% a year earlier.
  • U.S. Treasuries tracked the move, with AQR predicting buyers will merely break even.
  • Non-U.S. sovereigns slipped deeper into negative territory, with a projected loss of 0.6% a year.
  • Emerging-market equities will lead the way, the firm projects, with a return of 5.1%.

 

This article by Institutional Investor also provides a good run down of AQR’s latest return estimates.

More detail of return estimates can be found within the following document, which I accessed from LinkedIn.

 

Lastly, AQR provide the following guidance in relation to the market return estimates:

  • For shorter horizons, returns are largely unpredictable and any predictability has tended to mainly reflect momentum and the macro environment.
  • Our estimates are intended to assist investors with their strategic allocation and planning decisions, and, in particular, with setting appropriate medium-term expectations.
  • They are highly uncertain, and not intended for market timing.

 

In addition to the CFA Article mentioned above, AQRs estimates are consistent with consensus expected returns I covered in a previous Post.

 

Although AQR’s guidance to diversify away from traditional equity and fixed income might be like asking a barber whether you need a haircut, surely from a risk management perspective the diversification away from the traditional asset classes should be considered in line with the prudent management of investment portfolios and consistency with industry best practice?

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 term outlook for those interested.

 

Happy Investing

Please read my Disclosure Statement

 

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

 

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.