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 and affect our investment portfolios? Is this just a short-term mess? Is it a catastrophe? Perhaps that depends on whether we are focused on the immediate future or if we are taking a longer-term view.
It used to be that we could rely on having one or perhaps two economic maladies 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 an effective investment portfolio. Consider the range of our current economic challenges, which encompass everything from the eurozone crisis and the gridlocked political system in the US to shaky equity markets and a housing bubble in China (is Vancouver next?). Top it all off with global government liabilities created by an aging population and health and pension benefits promised with no funding.
Let’s take a look at some of these nice messes – and see how you can structure your investments so you need not worry about the catastrophes.
The Eurozone Crisis
At the top of the list would be the eurozone crisis. As of mid-November, interest rates on 10-year bonds were at unsustainable levels. Greece, Ireland and Portugal are already there, while Italy and Spain have recently crossed the Rubicon as their long-term rates approach seven per cent. Germany insists that providing any additional funding to these countries or eliminating their debt must come with significant reductions in government spending. (This would normally increase unemployment, which in turn would reduce government revenues and exacerbate deficits – an interesting Hobson’s choice). See table 1.
Many people, including Milton Friedman, felt that a monetary union such as the eurozone 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 of the union 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 a herculean work ethic) you see a long-term trend of constant devaluation of their currencies to remain competitive.
Keeping Pace With German Efficiency
Table 2 shows the exchange rates in 1949 and 1998 (just prior to the introduction of 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 more than 80 per cent to stay competitive with Germany.
For the last 12 years, these countries 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. See table 3.
Consider how much differently this all works in Canada. We have a federal government that can set tax rates and collect taxes on all of our citizens. It can then reallocate those taxes to any part of the country to subsidize the “have not” provinces with revenue from “have” provinces. So while we may have historically grumbled about Newfoundland fishermen collecting unemployment insurance 40 weeks a year, 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 some countries 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. (This includes the apocryphal Greek hairdresser who could retire on a full pension at age 50 – dangerous profession, don’t you know – and get paid for working 14 months a year.) This is 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 debt from the PIIGS (Portugal, Italy, Ireland, Greece and Spain). 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?
Adding to this problem, many 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 universal pension and health benefits have been ignored. Now we are coming to the point where people will have to accept some combination of the following outcomes:
- a much later retirement age (65 was set as the standard in 1935 when Social Security first appeared in the U.S., but one could easily argue for a retirement age of 70 to 72),
- increased taxes (should they be based on consumption or wealth?), and
- reduced government-funded benefits (such as means testing or co-paying 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? John Mauldin’s new book Endgame: The End of the Debt Supercycle and How it Changes Everything addresses the causes of the current debt supercycle and 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 in civil unrest and war. The world has survived deflationary periods either very well (the U.S. and the UK for much of the 19th century for example) or with a Depression. In the 1930s, there was a devastating financial impact on many people, but for the most part, governments, currencies and institutions survived. Some point out that the Depression only ended as a result of WWII, but you can also argue that its genesis was in the crushing impact of the reparations of WWI that eventually led to the hyperinflation of the Weimar Republic and the ultimate rise of Hitler.
- Deleveraging involves repaying debt. This, in turn, is a form of savings and removes money from being used for consumption, which tends to suppress prices of both goods and services.
- Aging boomers will need to save more because they will live longer and likely have less in the way of government-funded benefits to rely on. Higher savings rates also mean 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, tables 4 and 5 illustrate a strong reason for why, when it comes to sovereign debt, the best place to put your money may be in those countries that have strong growth prospects, better demographics and less overall debt.
So what makes a good portfolio given the current economic environment? Our approach sticks to the fundamentals. Indeed, our track record shows that asset allocation may be far more important than the actual choice of individual securities or funds. Asset allocation plays an integral role in our balanced portfolios. In particular, we advocate that portfolios should include only 30 per cent equities compared to the 60 per cent that is typical of other approaches. See table 6.
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 historical performance.
We went back to 2000 and measured how our suggested 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 per cent stocks and 40 per cent bonds. The traditional 60/40 approach would create a net result of 3.1 per cent per year after fees from January 2000 to September 2011 compared to 5.5 per cent 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. See table 7.
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, you would do well to consider the following financial hazards:
- In 2000, government 10-year bond yields offered 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 1950s).
- We have been in a long-term secular bull market for bonds since 1981. Over the last 30 years, high-grade corporate bonds have outperformed equities (even considering the huge bull market in stocks up until 2000).
- However, table 8 shows what happened to bonds in the eight years between 1973 and 1981. Over that time frame, they lost an average of five per cent per year after inflation. Rising interest rates are a death spiral for long-term bond holders.
- Going forward, the only way that 10-year government bonds could earn a real return of three to four per cent would be for us to experience cumulative deflation of just over 10 to 20 per cent in the next decade. Given that the current inflation rate is about 3 per cent that seems very unlikely.
Where to Find Cash Flow
While we have already mentioned a lot of factors that are deflationary in nature, there are also more than a few that are inflationary, including monetary and fiscal policy. Other choices 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 them 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 high-yield bonds as they did in 2008, but corporate balance sheets have never been better and current yields over government bonds are about four to five per cent for good quality bonds.
Preferred Shares – They still offer blended yields in the five per cent range, and with about 50 per cent of the tax for a non-registered account, they offer the equivalent of a 7.5 per cent pre-tax yield.
Mortgages – With good risk-adjusted returns and relatively short duration, future rising interest rates are not a significant issue. First mortgages would yield about 2.5 per cent over government bonds while seconds would be closer to five to six per cent more.
Prescribed Annuities – While these are not practical for most people under the age of 60, they are a very attractive and safe form of income with very low taxation for personal non-registered accounts. They can be used with and without life insurance to create high-yield, low-risk income streams.
Stock Yields and Distributions – Although the average yield of both the S&P 500 and the TSX is now about 2.1 per cent, it is true that 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 10 years, I would much rather own a portfolio of companies distributing a current yield of 4 per cent (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 per cent.
Real Estate – And finally, of course, there is income-producing real estate. For us, real estate is an important part of a cash flow generating portfolio and has certainly been a strong anchor over the last 10 years.
We worry about many things when it comes to our finances, yet 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, Mark Twain’s comments about the “catastrophes” in front of us are spot on.