It was decades ago that the hero of MAD magazine, Alfred E. Neuman, uttered those words in response to the statement, “I can’t believe you’re so unconcerned with all the problems in the world today.” In fact, in 1959 a 45 rpm called “What, me worry?” was released. What’s a 45 rpm? is the question on the lips of most readers under the age of 50, and it’s the way to refer to a vinyl record..
One wonders how Alfred would respond to the same statement being asked today, given that:
- The US and China are in a trade war that threatens global economic growth;
- Britain’s parliament is in a constitutional crisis as it tries to execute Brexit without destroying both the British and European economies;
- More than $17 Trillion USD of government debt is offered with negative interest rates*; there appears to be no shortage of buyers.
- Many stock markets are at or near record levels and the 10-year trailing Cape Shiller Index is higher now than it was in both 1929 and 2007.
- Current fires in the Amazon Rainforest are exacerbating the impact of deforestation; bringing more attention to the need to decarbonize our global economy as climate change continues to wreak havoc worldwide.
- The current US economic expansion is a record at currently 123 months. At some point in the near future we would expect to experience a recession.
Beyond these, we could add: Japan /Korea relations, India / Kashmir, 2020 Presidential Election and the rapidly rising price of gold.
GMO, a very successful US asset manager, publishes a report several times a year in which they make their own prediction about expected returns in various asset classes over the next seven years, after inflation. The chart below is from their March report. It does not look promising.
So Alfred, are you worrying now?
Let’s look at each of these items one by one and see how each might cause investors to change their portfolio.
Global Trade: China vs. the US
The world has benefited in many ways from expansion of global trade and reduction of trade barriers. President Donald Trump has taken it upon himself to negotiate better trade deals for the US because he is certain that the US has a larger overall global trade deficit than most, if not all, other countries who are therefore taking unfair advantage of the US and they will now have to reap the whirlwind.
As we have seen from past events Trump’s actions rarely speak as loudly as his words. The recently negotiated USMCA between the US, Mexico, and Canada is marginally different than the old NAFTA.
In addition, China has been a bad actor in a number of economic and geopolitical areas. Up until now, chastising it for its actions does not seem to have had much of an impact. Does the Donald hold the solution to getting China aligned with other countries? His style and ego leave much to be desired but he just might end up being an example of where the ends justify the means.
Britain’s version of the Donald, Boris Johnson, is now the Prime Minister and within months could easily be out of a job, without having ever been elected for the job as the leader of the conservative party. As I write this, Johnson has lost his first of only two votes so far in the Commons. He cannot allow the UK to leave the EU with his “no deal” Brexit without asking for an extension of the October 31st deadline until next year. He also has been blocked in calling an election before that deadline.
Events will unfold but as of now much of Europe is experiencing declining economic output (including Britain) and Germany is close to the official definition of a recession. Given the economic interdependency, you would expect calmer heads to prevail and they still might. While a hard Brexit will cause some significant economic damage to the short and medium term for both Britain and Europe, both will eventually recover; as they have from countless economic calamities that have occurred in the past.
Negative Interest Rates
Many years ago, I decided to buy the book below on the history of interest rates, by Sidney Homer and Richard Sylla, designed to be read by those with limited social lives. The book goes back as far as possible in recorded human history and makes no mention of any period of time when lenders paid borrowers to take their money.
Today is certainly a brave new world with respect to borrowing. As of now, total government debt that has negative interest rates totals $17 Trillion USD and individuals can borrow and be paid for their troubles as this latest news from Denmark shows. You can ask the bank for a 1 Million Krone ($200,000 CAD) as a mortgage on a new home; they will pay you 5000 Krone per year ($1000 CAD) to take that money off their hands. It was about 38 years ago this September that the 10-year US Bond Rate peaked at 15.05%. Since then, it has been on a slightly interrupted but constant bull market as a result of yields falling from that lofty perch to just over 1.5% today. This has been a blessing for bond holders proving a 38 year total return for government bonds of 8.3% annually or about 5% more than inflation annually. That is far higher than historical inflation-adjusted bond returns of just under 3%. The current 10-year bond yield is negative after inflation and the US has higher rates than all of Europe, much of Asia, Australia, and Canada.
We will not experience that bond bull market again. What we do know is that if over the next decade the 10-year yield on Government of Canada Bonds (presently yielding 1.4%) rose to only 3%, the total return on those bonds from this point forward would be below zero for most of those 10 years before providing a pre-inflation return of 1.4% at maturity; after inflation almost certainly negative, especially if taxable. The results would be considerably worse if rates rose that much in three years. Those same bonds would then be trading at about 85 cents on the dollar and still paying a 1.4% interest rate for another seven years.
We’ll consider alternative approaches in part two of this newsletter.
We have been speculating for several years that equities (we’ll use the S&P total return as a proxy for stocks) have been expensive. However, they continue to defy gravity as they have tripled in value, total return including dividends, since the nadir of the great recession in March 2009. According to the Cape Shiller Index, which measures trailing 10-year price-to-earnings ratios of the S&P 500, the Index is higher now than it was in October 1929 and November 2007. In case memories are fuzzy, the first date was followed by a four year 80% decline in the market and a depression while the second date was followed with an 18 month 46% decline in equity prices plus the greatest recession since the 1930s. We have looked at the 14 recessions that have occurred in the US since 1929 and, on average, equity markets returned 43.6% for the three years prior to the recession, over 13% annualized, and only 28%, just over 8% annualized, for the three year period after the recession started. We have not had a recession in the US since 2009 (123 months) which is a record expansion for the US; common sense would suggest we are due for one. So whether one feels stocks are expensive or that a recession will trigger a bear market, some reduced exposure and an overall defensive approach to equities is warranted.
Why do stocks keep rising in light of all of this data? Let me suggest a few possible reasons:
- As of now the economy is doing well, unemployment is almost at record lows, and inflation is well contained.
- Company profit growth, while slowing down, is still rising.
- As of September 2019, the dividend yield of the S&P 500 is 1.91% vs. 1.6% for 10-year US treasury bonds. It has been more than 60 years since the last time the dividend yield on stocks was higher than 10-year bonds, aside from a brief exception during part of 2008. If investors believe low rates are here to stay, there is logic in owning stocks that can pay that level of dividend. It should be noted that European dividend yields have been higher than 10-year bond yields for quite a few years. Right now most European 10-year bonds are either close to zero or negative yields.
On balance, I would suggest that the margin of error for equities is narrow. More on options we are using in this environment to come.
Climate Change and Decarbonization
It seems to be a sad but necessary observation of the human condition that we need to be in a crisis before we develop the capacity to overcome the inertia of old habits or models. Perhaps the Amazon rainforest fires, or ever more powerful hurricane seasons, will shake us out of our lethargy. It will likely take many more decades to completely wean the world off fossil fuels but I believe that the outcome of this battle is inevitable for several reasons:
- Technology has already brought the cost of many renewable energy applications below those of incumbent fossil fuel delivery systems. These technologies know no boundaries and will be available to all countries. Since most countries must import fossil fuels, they have the most to gain from accelerating the switch to renewable and sustainable energy.
- The impact of global warming on a carbon economy is clear enough now. When that cost is also factored in then it will likely be driven more by concerned citizens than politicians. The general population must lead the changes in our approach to energy creation and delivery.
- While battery technology is needed, and improving, there is great promise in the use of hydrogen as a clean form of renewable and mobile energy.
- These changes to eliminate fossil fuels as the primary source of energy globally have started slowly and with much resistance, much like prior technologies that fundamentally changed our world and how we live in it (the steam engine, electricity, internal combustion engine, telephony, personal computers etc.). Many firms have tried and failed to deliver workable and marketable solutions. We are likely at a tipping point in both economic justification and political motivation to see renewable energy, and the attendant products it will create, becoming a new major industry globally. The chart below is helpful in explaining how most real innovation is eventually adopted.
Given all of this, should we agree with Alfred and not worry or do we need a more proactive approach? I would suggest both make sense at the same time.
When we invest, we need to remember that our results will be impacted more by our own behavior than by events around this. In addition, when a crisis depresses the prices of certain assets it also means they can be acquired more cheaply and will generate more cash flow per dollar invested.
In other words, a good crisis often puts assets on sale and gives us better opportunities to rebalance.
So what specific action steps should one take in this current environment?
For long-term readers and clients there is not much new in my advice. For more than 20 years we have taken an asset allocation model that reduces exposure to publicly traded markets of bonds and stocks. As of now, our Nicola Core Portfolio Fund is just under 50% in private assets such as mortgages, real estate infrastructure, private equity, and alternative strategies.
20 years ago private assets were less than 30%1. Since 2000, this model has outperformed Morningstar’s Canadian Neutral Balanced model by almost 2.5% annually, after fees; overall generating a 5% net return after fees and inflation.
It is likely that private assets will continue to increase as a percentage of our recommended asset allocation. Here are some of the reasons:
- Well over half of the world’s wealth is held in private assets including real estate, private debt, and private equity.
- The cash flow per dollar invested is considerably higher with private assets than public ones in these markets. Cash flow (especially when distributed in the form of rents, interest, and dividends) forms a significant percentage of total returns over time.
- Public markets are shrinking. In the last twenty years or so almost half of all publicly traded companies in the US and Canada have been delisted, usually as a result of M&A activity. The number of choices we can make has reduced significantly.
- Private debt offers a premium coupon over public debt where the credit risk is similar. This is usually because of the lower liquidity of private debt. However for many investors liquidity is not required on a daily or even monthly basis. This is especially true for registered plans such as RRSPs, TFSAs, and IPPs.
- While private assets may have less liquidity than publicly traded assets, much of that can be mitigated using large pools that diversify single-asset risk and improve overall liquidity.
- Gold is a good hedge, for now. I have not been much of a supporter of gold as a long term investment strategy. I prefer to know my assets earn income and not just rely on capital appreciation to create a return; however, this unprecedented low and negative interest rate environment changes that view. Gold does not pay interest either but it is also not negative and it has been a very reliable inflation hedge (bonds except for Treasury Inflation-Protection Securities (TIPS) are not inflation protected).
- Environmental, Social, Governance (ESG) Investing. Lastly, we are currently creating a new investment pool for our clients that will focus on sustainable and clean technologies in energy, transportation, and manufacturing. As with all emerging technologies, many companies will fail, but the overall sector is likely to grow at a multiple of the greater economy. Plus, the benefits of this type of investing include more than just a return.
So let’s give Alfred some credit for not worrying. Most of the crises we face we have little control over and, in the case of asset prices; we need to remember that all markets have cycles. They may be emotionally hard to adjust to (especially when prices fall 30% or more) but at the same time present a rare opportunity to acquire more assets and better returns through rebalancing.
I definitely have concerns with both economic and geopolitical headwinds that we face and fully expect both a recession and likely a bear market in publicly traded equities in the foreseeable future.
So perhaps our best approach is to blend words from the Lion King song Hakuna Matata with the Boy Scouts motto, “No worries for the rest of your life—– by being prepared.”
1. The Nicola Core Composite returns represent the total returns of Cdn. dollar denominated accounts of all fee-paying portfolios with a Nicola Core mandate. The composite includes clients who are both fully discretionary and nondiscretionary. Historical net of fee composite performance returns are calculated using individual realized time-weighted client returns net of fees and is presented before tax. The Nicola Wealth inclusion policy is based on clients’ weights at calendar month end. The composite returns are asset-weighted based upon ending monthly market value. The Nicola Core mandate may change throughout time. Additional information regarding policies for calculating and reporting returns is available upon request. The composite returns presented represent past performance and is not a reliable indicator of future results, which may vary. Nicola Core Portfolio past performance is not indicative of future results. Returns are net of fund expenses. Please refer to the Nicola Wealth Funds disclosure document for additional details and important disclosure information. The Nicola Core Portfolio Fund Asset Mix takes into consideration only the primary asset class of the aggregated funds but does not take into consideration the underlying fund’s holdings of other asset classes. For example, the Nicola Primary Mortgage Fund is allocated in its entirety to “Mortgages” even though it holds some “Cash.” Nicola is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. Client returns are net of Nicola Wealth portfolio management fees.
* This is a proprietary index developed by Morningstar Canada based on the CIFSC Fund categories (www.cifsc.org). This index includes funds which meet the following criteria: Funds in the Canadian Neutral Balanced category must invest at least 70% of total assets in a combination of equity securities domiciled in Canada and Canadian dollar-denominated fixed income securities and between 40% and 60% of their total assets in equity securities.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only and is not intended to provide legal, accounting, tax or specific investment advice. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. This investment is generally intended for tax residents of Canada who are accredited investors. Some residency restrictions may apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Effective January 1, 2019 the Nicola Core Portfolio Fund changed its name from the NWM Core Portfolio Fund.”