Rory McPherson, head of investment strategy Psigma looks at the underwhelming prospects of traditional asset classes.
“Why bother?!” That’s not a cry for help by the way, but the question I believe investors should be asking themselves in today’s world, where traditional assets are expensive and growth rates are low. Add into the mix that bonds and equities could well start moving in the same direction at the same time (as they have done recently) and the question becomes ever more pertinent.
Phrases such as “we’re in a low return world” and “borrowing from tomorrow to pay for today” get hackneyed around far too often in the various outlooks currently doing the rounds. Both statements are factually accurate, but tremendously unhelpful from the perspective of an investor looking to make money. They do however cut straight to the nub of my “why should I bother?” question.
Traditional assets are expensive and growth rates are low. It follows that future returns are therefore lower with more risk involved (since you haven’t got the safety net of having bought something cheap in the first place).
Growth levels are low due to well-documented slow-downs in productivity, ageing populations and rising levels of debt. Increased spending by governments will help, but it won’t greatly change the tide. Valuations within conventional fixed income are eye-watering (yields at multi-hundred-year lows or near enough). Within equities, they are just plain old “expensive”. Unless you’d scooped down too much strong Belgian lager, it’s hard to argue they are “reassuringly” so.
Equity valuations are of course greatly skewed by the US market which accounts for circa 60% of the global stock market. It trades on over 17 times next year’s earnings and has endured five consecutive quarters of negative earnings growth. Hence you can forgive us for not wanting to hang too much weight on the ever bullish earnings’ growth numbers for next year (circa 13%!). Other areas of the equity market do represent good value and good opportunities for making good money over the next five years.
At Psigma, we have a quarterly meeting where we forecast future returns over the next five years. In a Goldilocks scenario, we struggle to see traditional assets giving much in the way of positive return and the returns are so paltry that we think it’s a fair bet that Goldilocks would be more fussed with the portion size than she would the temperature of the porridge! The main issue for us is that the conventional ingredients; traditional bonds and equities, have been exhausted to such a degree that they’ll no longer be able to pack anything like the same kind of punch. Our decisions and calls reflect a lot of analysis but perhaps the cleanest and easiest way to distill our thoughts on traditional assets is simply to say that trees don’t grow to the sky. A traditional “60/40” mix (with 60 being the % in equities) has yielded a return of nearly 8.5% a year for the last 35 years against a backdrop of a 2.6% inflation rate. That translates to an increase in capital value of over 17 times before inflation and almost 7.5 times in real terms: this can’t go on forever.
Our expectations for future returns before and after inflation are below:
Traditional assets are tired and so is a traditional approach to allocating to them. Much of the life (in terms of return) has been sucked out of these assets. However, what really turns the fan a darker shade of brown is the breakdown in traditional relationships between these assets. Over the last month we’ve seen bonds moving in the same direction as equities (correlations are higher than they were in the taper tantrum of 2013). This means there is no natural protection for portfolios and diversification gets replaced by di-“worse”-ification! We have sought alternative means of protection for our portfolios, but more on that another day.
Once you’ve added in the increased risk that traditional assets now hold (on account of high valuations and increasing correlations) your natural response to “why bother?” is, “I won’t bother” (lumping all your money in them). We would firmly agree. Our solution is to make a break from tradition. To protect portfolios and tilt much more greatly towards less traditional investments that stand a much better chance of gaining good returns over inflation over the next five years – who’s not bothered about that?