The Challenge to Generate "Safe" Returns in a Low Growth Economy
Last month, the topic for my newsletter was the long term benefits of a diversified investment portfolio. Generally, I choose to vary subject matters for each newsletter. However, due to perhaps the most challenging investment environment of my career, I feel compelled to share my views of the markets over the next several years and, most importantly, realistic expectations for investors over that time frame.
For those clients who have met with me over the past several months, much of this commentary will be redundant. For others, these views may be eye opening and even sobering.
Since the financial crisis of 2008, the central banks of the world (The Federal Reserve, Bank of Japan, European Central Bank, etc.) have embarked on a money printing campaign unprecedented in economic history. A primary objective of this massive expansion of the money supply was to create loan demand by depressing short term interest rates. Incredibly, this strategy has worked so well that some government bonds in Switzerland and Germany actually have negative interest rates. In other words, investors pay the government for the right to purchase sovereign bonds. Despite historically low interest rates in the US, money flows from Europe and elsewhere continue to invest in our sovereign bonds to take advantage of higher relative yields. This migration of funds has a direct economic impact to us on two fronts: the suppression of long term interest rates and the rapid appreciation of the dollar.
Meanwhile, our stock market has experienced its longest bull market in decades. It, too, has been fueled by investors in search of higher returns than offered by bonds. A widely used gauge of stock valuations, the cyclically adjusted price earnings (CAPE) devised by well known economist Dr. Robert Shiller, currently stands at 27 vs. a historical average of 16 dating back to 1871. In my opinion, the combination of the length of the bull market, high valuations, and the headwind resulting from the appreciating dollar makes it problematic that gains will continue in US equities.
So where are the candidates for growth? Well, many emerging markets stocks have price earnings ratios at half or lower than US stock indices as measured by the MSCI Emerging Markets Index. And for those investors with a higher risk preference, so-called frontier markets represent another opportunity for significant growth albeit accompanied by much higher volatility and risk.
Emerging markets debt presents an opportunity to invest in bonds with higher interest rates. And with some central banks in emerging markets reducing interest rates to combat an economic slowdown, bond prices appreciate. But the headwind created by the appreciating dollar is a risk that must be carefully weighed.
On the domestic front, investments in oil and gas had produced handsome returns to investors until the latter stages of 2014, but the precipitous decline in oil prices has halted, at least temporarily, any growth prospects.
My main point is that there seems to be few pockets of growth in the global economy and those that we can identify, are fraught with risk. I could certainly be wrong in my assessment. Jeremy Siegel, the well known and prescient finance professor at Wharton, recently predicted the Dow Jones Industrial Average at 20,000 by the end of 2015. As long as interest rates remain low and stocks represent a viable alternative to low yielding bonds, Professor Siegel may be accurate on his assessment of the short term prospects for the stock market. But all bets are off when interest rates begin to rise.
My view is that opportunities to earn reasonable risk adjusted returns can be viewed through the prism of central bank monetary policy. Those prescient investors who are quick to recognize opportunities presented by policy decisions should be the beneficiaries. A recent example is the significant appreciation of European equities. Another example is the discernible paths that energy, interest rates and currency have taken and the opportunities that have arisen to take advantage of these trends.
Due to my view of limited growth opportunities, I feel strongly that over the next several years, investors' expectations need to be dampened and they should be cognizant that markets are likely to be much more volatile as well. The key to success may be to identify trends and pockets of opportunities at their early stages. Perhaps most importantly, it is imperative that the portfolio be allocated in a manner that provides significant downside protection when markets deteriorate. In a low return environment, it will be critical to limit portfolio losses so that they may recuperate quickly after troughs have been established and the recovery process begins.
As usual, I appreciate any comments or questions you may have about this narrative or any other issue.
Clifford L. Caplan, CFP®, AIF®
In the News: In an article titled "Currency Oil Help Managed - Futures Funds" that appeared in the Wall Street Journal on April 7th, I commented on the benefits of employing momentum based strategies, particularly in the current investment environment.