“Well, here’s another nice mess you’ve gotten me into!”
– Oliver Hardy to Stan Laurel in ”Another Fine Mess” (1930)
“I’ve suffered a great many catastrophes in my life. Many of them never happened.”
– Mark Twain
There is an interesting juxtaposition between the critical comments of Oliver Hardy to his partner in crime (as they found yet another way to get into trouble) and the musings of Mark Twain that most of our worries amount to very little in the long run.
How will the current financial crises that surround us play out? Perhaps that depends on whether we are concerned about the immediate future vs. long term impacts.
It used to be that we could rely on having one perhaps two economic maladies occurring at any particular time but today we have a cornucopia of crises that make it more than a little challenging to stay focused on the key principles of building and maintaining en effective investment portfolio.
Let’s examine but a few of our current economic challenges:
- The Eurozone Crisis
- U.S. deficits and a gridlocked political system
- Equity markets (shaky, volatile and more or less where they were almost twelve years ago)
- Housing Bubble in China (is Vancouver next?)
- Global government liabilities created by an aging population and health and pension benefits promised with no funding
The Eurozone Crisis
At the top of the list would be the Eurozone crisis. As of today (November 17, 2011) interest rates on 10-year bonds are at unsustainable levels – Greece, Ireland, Portugal, Italy and Spain have now crossed the Rubicon as their long term rates approach 7%. Germany is insisting that any additional funding to these countries or elimination of their debt come with significant reductions in government spending. (This would normally create an increase in unemployment which in turn would reduce government revenues and exacerbate deficits – an interesting Hobson’s choice).
There are many who felt (Milton Friedman for one) that a monetary union such as the Euro would never work if it did not include a fiscal union as well. If a central government could not impose reasonable limits to debts and deficits, then eventually some members would abuse their ability to borrow at low (subsidized) rates to artificially improve their standard of living.
Greece is a great example, as are Italy and Spain. If you compare the performance of their currencies between 1950 and 1999 (when the euro was created) to that of Germany or Switzerland (two countries with hard currencies, cold climates and herculean work ethic) you see a long-term trend of constant devaluation of their currencies in order to remain competitive (see “Keeping Pace with German Efficiency”).
First table shows the exchange rates in 1949 and 1998 (just prior to the Euro in 1999) in U.S. dollars. The chart shows how much each currency varied against the German Deutschmark in that 50 year period. So prior to the euro, Greece, Spain and Italy needed to devalue their currency by 80% + to stay competitive with Germany.
For the last twelve years they have been completely unable to do that. And to make matters far worse, they are now paying a multiple of German borrowing costs to fund their debts (although at the beginning they were able to borrow at virtually the same cost). Given the history, it is hard to see how this story could have turned out much differently than it has so far.
Consider how much differently this all works in Canada. We have a federal government that can set and collect tax rates on all of our citizens and it can then reallocate those taxes to any part of the country it feels it needs to – “have not” provinces – in effect subsidizing them with revenue from “have” provinces. So in the past we might have grumbled about Newfoundland fisherman getting UIC 40 weeks a year, but we accepted it.
(Now, of course, Newfoundland is a “have” province with a lot of oil and other resources. Ontario, on the other hand, is now a “have not” province. Perhaps the new poster child for needy citizens will be former hedge fund managers from Toronto.)
But I digress… back to Europe.
This fiscal inequality allowed them to import goods and run trade deficits with an overpriced currency in relation to their productivity and simultaneously run large government deficits to fund pension, work and health benefits that were never going to be sustainable (such as the apocryphal Greek hairdresser who can retire on a full pension at age 50 – dangerous profession don’tcha know – and get paid for working 14 months a year).
The ultimate Ponzi scheme that makes Madoff look like a piker.
Of course, Germany and France had a major hand in all of this as well – especially Germany. With incredible Teutonic efficiency, their factories churned out world class goods for the rest of the world to buy and created huge trade surpluses. In addition, Germans are good savers and over time German and French banks found themselves the proud owners of a great deal of PIIGS debt. Since this debt was issued by Sovereign entities it was considered safe. So, indirectly, German and French citizens were willing to fund their more profligate cousins even when they knew they were living beyond their means.
Is this not a repeat of the story in the U.S. when American lending institutions convinced anyone with a heartbeat and a minimum wage that they could afford to buy their own American dream? Will this crisis turn out any better than that episode did?
If we want to add to this problem, much of the issues in Europe are also the result of an aging population and relatively poor demographics when compared to the rest of the developed world. For decades, warnings about unsustainable levels of pension and health benefits on a universal basis have been ignored. Now we are coming to that point where people will have to accept some combination of the following outcomes:
- Much later retirement ages (based on age 65 being the standard in 1935 when Social Security first appeared in the US one could easily argue for a normal retirement age now of 70-72)
- Increased taxes (should they be based on consumption or wealth?)
- Reduced government funded benefits (such as means testing or co-pay for health care)
These are not just changes that will have to occur in Europe. They will need to happen in the entire developed world.
Reduce Debt or Print More Money?
How might all of this play out? A few months ago we reviewed John Mauldin’s new book “End Game: The End of the Debt Supercycle and How it Changes Everything” which addresses both the causes of the current debt supercycle and some of the possible outcomes, which basically fall into one of two camps: deflation and hyperinflation. There are good arguments for both but I admit I fall into the deflationist (or at least disinflationary) camp for the following reasons:
- Countries that have followed a hyperinflationary approach to eradicating debt have almost always ended in far worse financial positions than before their crises began and often end up civil unrest and war. The world has survived deflationary periods either very well (the U.S. and the U.K. for much of the 19th century for example) or with a Depression. In the case of the 1930’s, there was a devastating financial impact on many people, but for the most part, governments, currencies and institutions survived.
Some can point out the Depression only ended as a result of WWII, but one can also argue that its genesis was in the crushing impact of the reparations of WWI which eventually led to the hyperinflation of the Weimar republic and the ultimate rise of Hitler.
- Deleveraging involves the repayment of debt. This, in turn, is a form of saving and removes this money from being used for consumption. Generally, that tends to suppress prices of both goods and services.
- Aging Boomers will need to save more than they have because they will live longer and likely have less in the way of government funded benefits to rely on. Higher savings rates also means less spending.
- The developing world still has millions of people under- or unemployed. Over time, standards of living between rich and poor countries will narrow and this huge global labour pool will make it difficult for many workers to obtain inflationary wage increases. Future rises in income will need to be accompanied by real improvements in productivity.
Speaking of the developing world, the charts below illustrate a strong reason for why when it comes to sovereign debt, the best place to put your money maybe in those countries that have strong growth prospects, better demographics and less overall debt.
We have discussed with our clients on many occasions what we feel constitutes a good portfolio and why asset allocation may be far more important than the actual choice of individual securities or funds. Below is our asset allocation we recommend for our balanced portfolios.
Translating an economic projection into tangible investment results is no easy task. It is a delicate challenge that involves more than just “picking the right stocks,” which is why we take a further step back to look at asset allocation models and examine their performance.
We went back to 2000 and measured how this asset allocation would have performed (after fees) if ETFs or low cost mutual funds had been chosen and compared it to the same approach, but with a more traditional and typical asset allocation of 60% stocks and 40% bonds. The traditional approach has created a net result of 3.1% per year after fees from January 2000 to September 2011 compared to 5.5% per year from a much more diversified portfolio that focuses on cash flow. Over that same period, our approach has yielded clients a 6.7% annual return.
However, a lot of things have changed since 2000. And while we believe that a diversified cash flow portfolio will do well in the future, there are a few financial hazards that need to be considered.
- In 2000, government 10-year bond yields were more than three times the dividend yield of the S&P 500. Today they are about the same or slightly less (except for the market nadir in 2009 that has not happened since the 1950’s).
- We have been in a long term secular bull market for bonds since 1981 (see chart “The Tortoise and the Hare”). Over the last 30 years, high-grade corporate bonds have outperformed equities (even considering the huge bull market in stocks up until 2000). The Tortoise has won!
- However, the second chart below shows what happened in the eight years between 1973 and 1981 with bonds. Over that time frame, they lost an average of 5% per year after inflation. Rising interest rates are a death spiral for long-term bond holders.
The only way that 10-year government bonds could earn a 3-4% real return would be for us to experience cumulative deflation of just over 10-20% in the next decade. Given the current inflation rate is about 3% that seems very unlikely.
Where To Find Cash Flow
While there are a lot of factors already mentioned that are deflationary in nature, there are also more than a few that are inflationary including monetary and fiscal policy. Other choices that exist have investment risk, but they also offer much higher potential returns and higher current cash flow. Below we will try to summarize the yield, growth potential, tax status and risk of these alternatives.
We have written about these before, but in this environment it never hurts to remember what is likely to work best.
- High Yield Bonds – Volatile markets can increase credit spreads and hurt HY Bonds as they did in 2008, but corporate balance sheets have never been better and current yields over government bonds are about 4-5% for good quality bonds.
- Preferred Shares – They still offer blended yields in the 5% range and with about 50% of the tax for a non-registered account they are the equivalent of a 7.5% pre-tax yield
- Mortgages – Good risk-adjusted returns and relatively short duration so future rising interest rates are not a significant issue. First mortgages would yield about 2.5% over government bonds while seconds would be closer to 5-6% more.
- Prescribed Annuities – While these are not practical for most people under 60, they are a very attractive, safe form of income with very low taxation for personal non-registered accounts. Can be used with and without life insurance to create high-yield, low-risk income streams.
- Stock Yields and Distributions – While it is true that the average yield of both the S&P 500 and the TSX is about 2.1%, one can put together a portfolio of much higher-yielding stocks that also have the opportunity to increase their future distributions unlike bonds. Over the next ten years, I would much rather own a portfolio of companies distributing a current yield of 4% (in many cases taxed at half the rate of interest income) with a good chance of future inflationary increases, than 10-year bonds that can only ever pay out 2%.
- Real Estate – And finally, of course, there is income-producing real estate which we will cover in greater detail in a future newsletter. For us, it is an important part of a cash flow generating portfolio and has certainly been a strong anchor over the last ten years.
We worry about many things when it comes to our finances and in most cases we have no control over events that affect the short-term and intermediate value of our assets. However, the fundamentals of long-term wealth building rarely change and if we get them right, then Mark Twain’s comments about the “catastrophes” in front of us are spot on.