Faithful Investor

By Paul Hancock, CFP®    July, 15, 2014

Summary

• 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

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 14.3%. To put this number into context, a 14.3% average annual return is twice the normal rate of return for the global stock market, which has returned 7.2% 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 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 and to 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 Washington Post Op-Ed that one of the goals of the Fed buying government bonds was to increase the stock market.  The chart below shows how correlated the stock market has been with the growth of the Federal Reserve’s balance sheet.

Figure 3: 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 a rough bogey for returns on cash.  The market is forecasting the Fed Funds rate 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 4).  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 4: Global Debt

Source: PIMCO

PIMCO also cites that the historical Federal Funds policy 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 5).

Figure 5: Likely Returns in a Low-return World (real returns after inflation)

Source: Credit Suisse

Investment Conclusions

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.  Seek 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.

In the bond market, look for individual bonds or bond mutual funds that provide enough yield to compensate for the potential for rising interest rates in the developed economies.  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 unless you are comfortable with the possibility of added volatility.

Consider other asset classes and strategies to complement core stocks and bonds that may provide added diversification in an era of low interest rates.  For those worried about risk assets, 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.  This part of the portfolio can also serve as downside protection in a possible scenario where markets turn south.  Seeking out active management for this portion of the portfolio is a key.  It’s important to weigh the risk/return potential versus the increased cost associated with non-traditional asset classes.  Finally, as mentioned above, try not to get carried away with allocating capital away from core stocks and bonds into these strategies.

The policies of Central Banks has 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.”

REFERENCES

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 in tandem 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.

INDEX DESCRIPTIONS

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not reflect fees or expenses.

The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. As of June 2009 the MSCI ACWI consisted of 45 country indices comprising 23 developed and 22 emerging market country indices.

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. This world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. An investor cannot invest directly in an index.

The Russell 3000 Index® measures the performance of the 3,000 largest U.S. companies based on total market capitalization.

The Russell Midcap Index ® measures the performance of the 800 smallest companies in the Russell 1000 Index.

The Russell 2000 Index ® measures the performance of the 2,000 smallest companies in the Russell 3000 Index.

The MSCI® EAFE (Europe, Australia, Far East) Net Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indexes, representing the developed markets outside of North America.

The MSCI Emerging Markets Index SM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of June 2007, the MSCI Emerging Markets Index consisted of the following 25 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

The Dow Jones Composite REIT Index measures the performance of Real Estate Investment Trusts (REIT) and other companies that invest directly or indirectly through development, management or ownership, including properties.

The Dow Jones-UBS Commodity Index is composed of futures contracts on physical commodities and represents twenty two separate commodities traded on U.S. exchanges, with the exception of aluminum, nickel, and zinc.

The Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indexes that are calculated and reported on a regular basis.

The Barclays U.S. Treasury Index is U.S. Treasury component of the U.S. Government index. Public obligations of the U.S. Treasury with a remaining maturity of one year or more.

Treasury bills are excluded (because of the maturity constraint). Certain special issues, such as flower bonds, targeted investor notes (TINs), and state and local government series (SLGs) bonds are excluded. Coupon issues that have been stripped are reflected in the index based on the underlying coupon issue rather than in stripped form. Thus STRIPS are excluded from the index because their inclusion would result in double counting. However, for investors with significant holdings of STRIPS, customized benchmarks are available that include STRIPS and a corresponding decreased weighting of coupon issues. Treasuries not included in the Aggregate Index, such as bills, coupons, and bellwethers, can be found in the index group Other Government on the Index Map. As of December 31, 1997, Treasury Inflation-Protection Securities (Tips) have been removed from the Aggregate Index. The Tips index is now a component of the Global Real index group.

The Barclays Short Treasury Index includes aged U.S. Treasury bills, notes and bonds with a remaining maturity from 1 up to (but not including) 12 months. It excludes zero coupon strips.

The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Remarketed issues, taxable municipal bonds, bonds with floating rates, and derivatives, are excluded from the benchmark.

The Barclays U.S. Corporate Investment Grade index is the Corporate component of the U.S. Credit index. Publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.

The Barclays U.S. Corporate High Yield index covers the universe of fixed rate, non-investment grade debt. Eurobonds and debt issues from countries designated as emerging markets (sovereign rating of Baa1/BBB+/BBB+ and below using the middle of Moody’s, S&P, and Fitch) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-EMG countries are included. Original issue zeroes, step-up coupon structures, 144-As and pay-in-kind bonds (PIKs, as of October 1, 2009) are also included.

The Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian government, agency and corporate securities, and USD investment grade 144A securities.

The Barclays Emerging Markets USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. The index is broad-based in its coverage by sector and by country, and reflects the evolution of EM benchmarking from traditional sovereign bond indices to Aggregate-style benchmarks that are more representative of the EM investment choice set. Country eligibility and classification as an Emerging Market is rules-based and reviewed on an annual basis using World Bank income group and International Monetary Fund (IMF) country classifications. This index was previously called the Barclays US EM Index and history is available back to 1993.

DISCLOSURES

Past performance is no guarantee of future results.  Diversification does not assure profit or protect against a loss in a declining market. While we have gathered this information from sources believe to be reliable, we cannot guarantee the accuracy of the information provided.   The views, opinions, and forecasts expressed in this commentary are as of the date indicated, are subject to change at any time, are not a guarantee of future results, do not represent or offer of any particular security, strategy, or investment and and should not be considered investment advice.  Investors should consider the investment objectives, risks, and expenses of a mutual fund or exchanged traded fund carefully before investing. Furthermore, the investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals.

International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.  Small and mid-cap stocks carry greater risks than investments in larger, more established companies.  Fixed-income securities are subject to interest-rate risk. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds.  Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. There are several risks associated with alternative or non-traditional investments above and beyond the typical risks associated with traditional investments including higher fees, more complex/less transparent investment strategies, less liquid investments and potentially less tax-friendly. Some strategies may disappoint in strong up markets and may not diversify risk in extreme down markets.

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