Portfolios need to be reshaped for a new reality

As usual, I start with my long held view that the short term for investment markets is much harder to forecast than the long term. Therefore, I outline our expectations of the outlook for 2020 with some trepidation. However, further out we have much more confidence in suggesting that the world will steadily grow and investors in growth assets will be rewarded – as they always have been.

That is not to suggest that the present economic climate, as the starting point, is not without its difficulties. Interest rates are historically low and will remain low for a sustained period. The world is experiencing low growth and it will remain low for a longer period than normal. A trade war (a proxy for an enduring great power rivalry) exists between the largest economies in the world. Societal instability and unease with political leaders is high and there are few encouraging changes in the offing.

However, speculating further into the future I predict that visionary political leaders will appear, as they always have, and they will replace the ageing incumbents.

"Investing in this current low yield period it has become clear that from a growth perspective - investment horizons must be extended longer to capture the returns that will flow from world growth and particularly the emergence of developing world economies."

In the shorter term, a focus on purposeful asset allocation and on yield is essential. Over the longer term the compounding of returns will reward patience, but will require active management across and inside asset classes. Asset managers will encounter increasing levels of price volatility and they must be active to ensure that adequate returns are generated.

As always, a watchful eye for the seeds of financial crisis must be diligently maintained, but we must resist the human urge to jump at shadows. On this point, we perceive that the risk of a market or financial calamity is low because interest rates are low and unlikely to rise. The offset is that investment returns will be lower than the historical norm.

It is our view that it will take a sharp re-calibration of long term risk-free interest rates to cause a financial correction of significance. The potential cost of such a correction for investors can be offset by sensible, balanced asset allocation, a sharp focus on quality companies and a fundamental understanding of risk, both of the market and for the individual.

Today’s investment climate is managed aggressively by central banks which remain active and alert with quantitative easing (QE) in their arsenal.

Whilst it is hard to fully understand how the tools of monetary policy have maintained economic stability since the GFC, it is also clear that these tools have struggled to generate meaningful growth.

So the choice for the developed world is clear. Low growth and low investment returns flowing from the managed stability of negative real interest rates and zero-bound risk free returns. Or, the alternative of economic volatility that naturally flows from actively managed higher interest rates.

The developed world has succumbed to the first alternative – at least for the next few years.

Reflecting on the past year

A year ago, during the December quarter of 2018, equity markets were experiencing a sharp decline. The active market players who set daily prices were either selling aggressively or shorting equity positions in anticipation of more interest rate rises throughout 2019.

The uncertainty stoked a strong bond market rally as asset managers moved allocations from riskier growth assets (e.g. equities) into lower risk but low yielding assets (e.g. bonds). The rally in bond markets was fueled by the trade dispute between the US and China, as it was elevated by President Trump and threatened to destabilise world growth.

In the second half of 2018 it was generally perceived that the US Federal Reserve would continue with its monetary tightening even if its central bank peers in Europe and Japan were moving in the opposite direction.

What then followed in early 2019 caught many by surprise. The Federal Reserve reversed its policy settings and guided to a lowering of interest rates as it became increasingly concerned with the synchronised slowing of world growth.

By late 2018, bond yields had already begun falling. US ten year bond yields that had touched 3.4% in late 2018 rallied to 1.6% in mid 2019. German bonds that were yielding 0.7% rallied to a remarkable (if not ridiculous) yield of negative 0.7%. Meanwhile Japanese ten year bonds entered negative yield territory again.

The oversold equity market took off and rewarded investors who had taken the view that the US Federal Reserve would not adopt policies that would drive the USD higher and therefore slow US growth.

Whilst the world economy has endured a slowing of growth through out 2019, it has not entered recession. The fears of a global financial shock remain omnipresent, yet equity markets have ground higher. As stated earlier, we believe that these fears are not supported by economic analysis. Importantly, the US equity market continues to make new all time highs that reflect both low risk-free rates and the undeniable growth of the US economy and the profits of its major companies. Profit growth is clearly superior in the US to that of Australia.

The story of long term economic growth trends

The following three graphs highlight the significant growth the world has experienced over the last 50 years. Included is an intermediate point snapshot of the world’s distribution of growth that captures China’s emergence some 20 years ago.

Looking at history and appreciating the reasons for trend lines helps us understand current growth trends. Importantly, they help us comprehend the effects of non-conventional monetary policy and the excessive fiscal largesse of recent decades. They also capture some aspects of an ageing population in the developed world.

In 1969, the world economy was a mere US$2.6 trillion in size, with the US representing 40% of the world’s economy and the Soviet Union some 15%.   

By the turn of the century, the world had grown to US$32 trillion with the US representing 30%. Over the 30 year period, Japan had rapidly emerged to be the world’s second largest economy. Japan had grown 25 fold over the period, compared to the 9 fold increase of the US. Germany’s growth matched that of the US, and the Soviet Union effectively collapsed.

Australia and India represented just 1% each of world GDP. China was three times bigger than Australia, but just 25% of the size of Japan.

   

China’s emergence and Japan’s stagnation from 1999 to 2018 is clearly evident. The Chinese economy grew 13 fold over this 20 year period, whilst Japan barely grew at all.

Australia recorded a 4 fold increase over the 20 years, and actually grew at twice the rate of the US. This is indicative of our rapid growth in population – the fastest in the developed world.

The 5 fold increase in India’s size over the 20 year period shows that India’s growth potential (compared to China) remains largely untapped. With the population of both countries approximating 1.4 billion people, we can see that India’s per capita GDP is still very low.

Today, the world’s GDP is US$85 trillion – some 40 times larger than it was 50 years ago. Throughout this period, it is the US that has been the consistent and dynamic driver of world growth. The recent emergence of China and the stagnation of Japan gives us an insight into the future.

In China’s case, it has been population growth combined with per capita income growth, driven by trade, that has accelerated growth. Japan was a standout beneficiary in the 1970s and 80s. China has been the standout beneficiary for the last 20 years. The US has maintained its place as the dynamic growth economy of the world, while Australia has benefited through its population growth and unique resources, and India is rapidly emerging.

The question in this analysis is, why is this important? Our next section deals with the answer to that question.

Unconventional monetary policy and Quantitative Easing (QE)

Japan’s stagnation is a critical case study. By analysing Japan’s experience with an aggressive use of QE over the last 15 years, we can draw some conclusions for the outlook for the developed world if it adopts similar aggressive monetary policies.

Japan was the first of the developed countries to acutely feel the effects of a rapidly ageing population (low birth rates) which accentuated a fiscal (debt) problem. The Japanese government excessively stimulated its economy in the 1980s and built no fiscal buffers to protect against a slowdown.

As clearly shown above, Japan’s growth compares poorly with China, which has leveraged its population growth with labor productivity improvements with trade to generate massive economic growth.

Observations of many of the the developed world economies which have adopted similar policies and are burdened with low birth rates, suggests that they have entered a ‘Japanification’ type economic cycle. Such a cycle is noted by its low growth, mild economic downturns followed by mild recoveries, low sustained interest rates and low investment returns.

‘Japanification’ – what it means

The QE experiment, which commenced over 15 years ago by the Bank of Japan, still endures today. To some extent it has been adopted across the western world - through Europe, the UK and the US. It will likely come to Australia at some point.

However, we must put Japan’s economic performance into proper context. Since 2010 Japan’s working age population has contracted by around 0.5% a year whilst GDP has increased by an average of 1.3% a year and over the last 12 months by 1.7%. GDP per capita has increased by an average of 1.5% a year. Through this period, Japan has endured mild growth with mild recessions. A review of its economic cycles suggest that QE has worked to hold its highly indebted government and economy together.

Another observation of Japan, which is common across other QE driven economies, has been that its labour market has become resilient. Unemployment is running at record lows and the participation rate is rising, meaning that overall employment has never been higher. The high employment rate has been offset by low rates of productivity growth and thus wage growth. Therefore, inflation has become entrenched at extremely low levels.

Japan has shown that governments can issue local currency bonds at very low rates of interest and can sustain surprisingly large debt burdens. This gives government leverage to keep fiscal policy loose in order to sustain demand and maintain full employment. Warnings that large debts will inevitably lead to fiscal crises have not transpired. Whilst the Japanese government has gross debt that approximates 240% of GDP, the interest bill is a mere 1% of GDP and does not expose the Japanese budget to the need to aggressively raise taxes. Thus, there is no imperative to change fiscal course at this point.

Our conclusions on global growth and risk markets

The Japanification growth cycle will play out differently for individual economies. For instance, whilst US growth is projected to be below its historic averages, its economy will benefit from being at the entrepreneurial technological frontier. Countries that grow employment, focused on services, do not have a similar growth profile as their productivity is not high. Australia falls into this category, as do many European countries. An offset is population growth - and Australia, being an attractive migration destination, does have an advantage in this respect.

Meanwhile, it is the emerging world that continues to have the growth potential and will drive world growth. Over the past couple of decades, the pace of catch-up by the emerging or developing world has been impressive. Emerging economies have been responsible for around two-thirds of global growth since 2000, and their income levels have increased by an average of 6% a year.

The standout opportunity is India, with a large underutilised and lowly rewarded population. Meanwhile China clearly has a long growth cycle ahead of it with its per capita income still just 25% of that of the US.

From the above and reflecting on the Japanese experience we conclude that passive investment returns for much of the developed world will be lower than historic norms. Risk asset returns, notably a passive index of equities, will not generate their historic annual returns of 8%. A lower return is likely over the next few years with volatility heightened as market prices over and under-shoot a low return band. To generate historic returns on equities an investor needs to be active and utilise volatility in prices to their advantage.

Other asset classes will succumb to a similar fate, with returns a few percent below historic readings. In low risk asset classes (for example bonds) returns could be negligible but with the same price volatility as risk assets. Investment undertaken with a reasonable expectation of investment outcomes and with a balanced approach to risk will generate acceptable returns. Importantly, returns will be superior to inflation and the low yields presented on bonds or bank deposits.

The utilisation of QE and other supportive monetary policy tools will act to sustain developed world economic growth - but it will not accelerate it. It will be the continued emergence of the developing world, admittedly checked by trade frictions, that will sustain world growth. The global economy will grow, but at a slower rate for the foreseeable future.

The outlook for 2020 and recommendations for portfolios

Taking all of this into account, what are Clime’s recommendations for portfolios in this letter?

Our main conclusion on the global outlook is that the developed world has entered or fallen into a period of Japan-style low growth. Consequently, we expect the following:

1. Generally lower than normal world economic growth with developed economies drifting through mild growth and mild downturns;
2. Bond yields will stay low, but price volatility will develop. Whilst the yield on quality assets will be appropriately bid lower, a similar move in the yields of lower quality assets will be seen and become a risk issue for central banks and regulators;
3. Equities are likely to remain well bid (PER expansion) as required returns decline and the time horizon is extended in valuing high growth opportunities; and
4. As always “quality companies”, measured by sustained growth in incremental ROE and funded by superior internally generated cash flows will generate the best returns.

In this environment, we believe that the maintenance of a diversified portfolio of investments is critical to successful investing. 

 In fact, we believe more than ever that asset allocation will be the major determinant of investment performance. 

Ensuring your portfolio is invested across a range of asset classes will be critical in managing increased volatility, as each asset class will perform differently in different market conditions. Importantly, whilst we perceive that Australian Government bonds will likely rally under a QE program, we now see them as trading assets rather than proper long term investments.

Within individual assets, particularly Australian and global equities, active investing will be a critical consideration. A key focus for an active manager will be to generate adequate capital returns, created with less than market volatility, whilst maintaining a healthy focus on delivering income and realised capital gains. Price volatility is something that an active manager, even if value and quality focussed, must access. Constrained mandates that restrict cash holdings and the logical protection of a portfolio against price volatility, will simply encourage the rotation of securities and a drift away from risk management.

2020 in our opinion will be a volatile ride for passive investors. Whilst that may not be a concern those in the accumulation stage of their life, for pensioners reliant on sustaining capital and generating income, the requirement to be active or to find active asset managers should be a primary focus.