July 15, 2014
- Global stocks rallied during the second quarter led by emerging markets. The S&P 500 climbed to an all-time high aided by low interest rates, low inflation, slowly improving economic growth and continued expansive policies from the Federal Reserve.
- Global bond markets also performed well during the second quarter as interest rates fell driving bond prices higher. Most bond sectors have posted positive returns in 2014, led by municipal bonds and emerging market bonds.
- Economic growth remains low in the US and other developed economies despite highly accommodative policies from central banks. The winds of change are blowing as the growth model of the past 35 years of larger deficits and more debt in the developed economies is possibly coming to an end. Central bank actions in the next 3-5 years will have major impact on future market returns.
- Investing in this environment is difficult. Following time-tested, core building blocks of portfolio construction is a great place to start.
Escape velocity is a physics term used to describe the speed that is needed to “break free” from the gravitational field without further propulsion. In economics terms, “escape velocity” refers to the need for an economy to grow at a rate high enough to escape recession and return to normal economic growth. In the United States, despite massive interventions from the Federal Reserve, economic growth is around 2% per year, one-third below the long run average of 3% for the past 50 years.
Despite sluggish economic growth, the stock market has continued hitting all-time highs. The MSCI All Cap World Index, a proxy for the world stock market, rose 5% in the second quarter and is up by 6.2% in 2014 at quarter end. Over the past five years, the global stock market has risen at an annual rate of 14%. To put this number into context, a 14% average annual return is twice the normal rate of return for the global stock market, which has returned 7% over the past 113 years.
Why has the market been so strong in the face of weak economic growth? In short, central bank policies around the world continue to support the market and risk assets worldwide.
Central banks such as the US, UK, Europe, and Japan, have developed policies of low short-term interest rates and quantitative easing (buying bonds) in the hopes of avoiding deflation. These policies aid their respective economies in exiting recession and achieving “escape velocity." Total assets on central bank balance sheets have ballooned since the global financial crisis (figure 1).
Figure 1: Central Bank Assets
Source: Cumberland Advisors
These policies have led to a period of slow growth and low inflation, which is highly stimulative for the stock market. Many investors have been pushed into riskier assets like stocks and high yield bonds as many feel there is no alternative to making money. In fact the former chairman of the Federal Reserve, Ben Bernanke stated in a 2010 Op-Ed in the Washington Post that one of the goals of the Fed buying government bonds was to increase the stock market. He describes what the Fed has done by lowering interest rates and buying bonds...
This approach has eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth.
And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Investors took notice as the market has strongly correlated with the growth of the Federal Reserve’s balance sheet since 2009 (figure 2).
Figure 2: Correlation of the S&P 500 and the Fed Balance Sheet
Source: Zero Hedge
Investors on Edge
Some market participants have are taking a more cautious stance during the current market environment. Specifically, some are wary of the actions taken by central banks. Steve Romick of FPA Capital said in a recent letter to investors,
“Central bankers say they have everything under control, but that isn’t helping us sleep at night.”
Other managers are surprised at how far the market has run in in the absence of less-than-appealing fundamentals, uniformly bullish investor sentiment, and complacency in risk-return expectations.
Questions remain. What happens when central bank policies start to normalize? When and at what speed will short-term interest rates rise? What impact will this have on economic growth rates? What impact will this have on bond and stock markets globally? Make no mistake, I possess no crystal ball. These questions are complex and are hard to decipher, especially since we are dealing with such experimental monetary policy. However, the fact remains that many investors have become complacent and used to low interest rates and low volatility. Does that mean markets are headed straight down? Does that mean we are headed for another recession? Again, difficult questions with no clear answers.
The New Neutral
The folks at PIMCO have attempted to answer these questions with what they are calling the “New Neutral”. PIMCO believes that short-term interest rates will remain low over the next 3-5 years, much lower than the market expects.
The interest rate they focus on is the Federal Funds rate which the market is forecasting to rise to as much as 4% over the next five years, to a “normal” interest rate. However, PIMCO believes the Fed Funds rate cannot rise higher than 2% over the next 3-5 years. Central Banks cannot be too aggressive in raising interest rates with so much debt built up over the past 35 years. While the private sector has modestly paid down debt, the total stock of public and private debt worldwide is at an all-time high (figure 3).
If rates rise too quickly, too fast and if there is no government balance sheet to buy bonds, economies have little chance to achieve “escape velocity”
Figure 3: Global Debt
PIMCO also cites that the historical Federal Funds rate from 1900 - 1980 was around 2% in the US and UK and around 0-1% for Europe and Japan.
It does appear that the growth model of the past 35 years of larger deficits and more debt in the developed economies is coming to an end. At some point, the debt needs to be paid off.
PIMCO would suggest that this means we are not headed for an immediate recession or a bear market. However, a resounding bull market is not in the cards either, but instead, a period of low returns yet less downside risk. Couple PIMCO’s call with recent strong performance from markets and modest returns do appear to be on the horizon.
Future Market Returns
The reason it’s so important to understand the future of the Federal Funds rate is that most financial assets are priced off of this rate. The Fed Funds rate is a rough approximation for cash returns or US Treasury Bills. The interest on cash/US Treasury Bills represents as close to the return of a risk-free asset as possible. The expected return on bonds and stocks should be higher than cash as investors require compensation for higher risk. Research from numerous sources suggest that the perceived “equity risk premium” is around 3-4% per year.
Therefore in a 2% PIMCO new neutral, risk assets should have lower returns as well, perhaps 3% for bonds and 5% for stocks.
A 3-5% return for bonds and stocks is a far cry from 8%+ returns from both bonds and stocks since 1980 (see figure 4).
Figure 4: Likely Returns in a Low-return World (real returns after inflation)
Source: Credit Suisse
How then should investors construct a portfolio in the face of possible low, future market returns? As always, each investor should construct a portfolio geared towards their own risk tolerance, income needs, and time horizon. However, following time-tested, core building blocks of portfolio construction is a great place to start:
- Hold a broadly diversified set of global asset classes.
- Hold stocks through good and bad markets, avoid trying to time markets.
- Use low cost investments as much as possible.
- Use actively managed strategies only where the risk-return reward outweighs the cost.
- Save and invest consistently month to month without fail.
- Rebalance as markets move up or down.
Beyond these core building blocks, there are other ways in which investors can combat the current investment environment.
Within the stock market
- Have a healthy mix of US and international stocks.
- Allocate a portion to countries that have younger, growing populations and are not constrained by heavy debt burdens.
- Look to markets that trade below or within reasonable levels of perceived fair value estimates.
- For those worried about declines in the market, utilizing low cost actively managed strategies that have historically taken on less risk is a good strategy.
In the bond market
- Look for individual bonds or bond strategies that provide enough yield to compensate for the potential for rising interest rates.
- Have a portion of your bond allocation dedicated to short-term bonds, but don’t sacrifice return carrying too many short-term bonds.
- On the flip side, avoid reaching for yield in riskier areas of the bond market like high-yield corporate bonds.
Consider other asset classes and strategies to complement core stocks and bonds that may provide added diversification in an era of low interest rates.
- GMO’s James Montier suggests owning what he calls “dry powder assets.” He suggests these assets should have three characteristics: liquidity, protect against inflation, and might generate a little bit of return.
- These strategies may also serve as downside protection in a possible scenario where markets turn south.
- Seek out active managers and weigh the risk-return potential versus the increased cost associated with non-traditional strategies.
The policies of Central Banks have and will continue to shape the future of markets in the years ahead. As President Robert F. Kennedy once said, “Like it or not we live in interesting times.”
JP Morgan Guide to the Markets, 2014. Available at jpmorganfunds.com.
Credit Suisse Global Investment Returns Yearbook, 2013. Available at credit-suisse.com.
Cumberland Advisors charts, 2014. Available at cumber.com.
Bernanke, Ben, 2010. What the Fed did and why: supporting the recovery and sustaining price stability. Available at washingtonpost.com.
Romick, Steve, 2014. FPA Crescent Quarterly Commentary 3/31/2014. Available at fpafunds.com
FMI Large Cap, 2014. Semiannual report 3/31/2014. Available at fiduciarymgt.com.
PIMCO Secular Outlook, 2014. The New Neutral. Available at pimco.com
Key Terms & Definitions
GDP: Gross Domestic Product which is defined as the market value of all officially recognized final goods and services within a country in a given year.
Correlation: the extent to which the values of different types of investments move intandem with one another in response to changing economic and market conditions.
Real Return: The return of a specified index after the effects of inflation. The return before inflation is typically called “nominal return.”
Central Banks: A central bank, reserve bank, or monetary authority is an institution that manages a state's currency, money supply, and interest rates.
Federal Reserve Bank: A Federal Reserve Bank is a regional bank of the Federal Reserve System, the central banking system of the United States. There are twelve in total, one for each of the twelve Federal Reserve Districts that were created by the Federal Reserve Act of 1913. The banks are jointly responsible for implementing the monetary policy set forth by the Federal Open Market Committee.
Monetary Policy: Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability.
Federal Funds Rate: In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis.