Insights

Summary:

• In the current environment, there are three issues that affect the ability of investors in constructing robust portfolios:
  • • • Extreme valuations,
      • A continued belief in omnipotence of Central Bankers (CBs) and their propensity to resort to QE, and
      • Low and declining interest rates.
• Persistently declining interest rates experienced over the past forty years have conditioned market participants into believing that interest rates have an inherent tendency to decline.
• The persistent decline in interest rates combined with the an ever increasing willingness of CBs to cut interest rates on every equity market decline resulted in happy outcomes for portfolios that combined equities with bonds.
  • • • The result, not surprisingly, was the rise of 60:40 and risk-parity portfolios.
      • The idea made for an easy sales pitch. Combine risky assets (equities) with riskless assets (bonds) and voila! You could now have the best of both worlds.
• Interest rates, as of this writing, were near their 700 year lows. Importantly, such low interest rates did not compensate investors for the very first component of required returns, i.e., a compensation for inflation-risk.
  • • • Of course, the idea of compensation for the other components didn’t even arise.
      • Bonds were poorly priced and posed significant risk to investment portfolios.
• To make matters worse, equities were priced for poor long-term returns.
  • • Such mark-up of equity prices creates a significant risk of repricing downwards.
• Constructing sensible portfolios in such an environment requires one to disengage from fancy models such as mean-variance optimization. Instead, investors should combine assets that are likely to do well during periods of debt deflation with assets that perform well during periods of goods and services price inflation.

N.B.: This note was sent to our investors as part of our Q3 2021 letter which was circulated in October 2021.

“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas. ” – Warren Buffett

As discussed in our 2020 annual letter, three issues affect an investor’s ability to construct robust portfolios in the current environment. The issues highlighted were the equity valuations, the tendency of Central Banks to resort to QE and therefore the low current yields on Fixed Income instruments. Each of these issues is relevant to one’s portfolio construction process and requires careful consideration. This note discusses the impact that declining interest rates over the past forty years have had on investment returns, investor expectations, and portfolio construction.

The chart below shows the behavior of interest rates in the US since 1962, i.e., the past six decades. While rates rose between 1962 and 1981 in three periodic spurts, they have been persistently declining for the last forty or so years. Forty years is a long enough time to condition market participants into thinking that interest rates will continue to decline in all future periods. This thinking is further encouraged by a belief in the omnipotence of Central Bankers.

Figure 1: Interest rates and equities

In the discussion below, we divide the timeframe in Figure 1 into three periods and discuss the investment outcomes during each of these periods.

A favourable period: 1980 – 2000

The peak of the interest rate cycle also coincided with the start of a secular bull market for US equities, which lasted until 2000. Keep in mind that as rates decline, bond prices rise. With this information, think about those forty years beginning from 1981 again.

During the first twenty years of that period, equity markets were in a secular bull market, compounding at about 14% per annum[1]. During this same period, 10-year bond rates fell from about 15% to sub 6% levels, i.e., bond prices also rose. Indeed, bond returns compounded at nearly 11% between 1980 and 2000[2]. In that time frame, inflation averaged about 3.8%. A favourable period indeed!

The chart below shows a 60:40 portfolio combining the S&P 500 (60% weight) and 10-year treasuries (40% weight). Note that these are inflation-adjusted returns, i.e., real returns. As is seen, this was an excellent period for the 60:40 portfolio as it returned nearly 10% inflation-adjusted return with very low volatility.

Figure 2: The 60:40 portfolio during 1980 to 2000

The Fed has your back: 2000 – 2020

The next decade saw two bear markets. One, the tech bust, and two, the global financial crisis. The response of the Fed during both these bear markets was to cut rates. So what that meant is that just as equity markets fell, Fed’s actions caused bond prices to rise. Indeed, the GFC saw rates getting pegged to zero. Except for a brief period in the middle, we continue to be stuck at the zero bound.

The impact of the rate cuts during equity bear markets was to provide a boost to bond prices. The result is that the 60:40 portfolio enjoyed another period of advantageous outcomes. Over the last twenty years, the 60:40 portfolio has compounded at nearly 5% per annum on an inflation-adjusted basis. Not as strong as the previous period, but a healthy return indeed.

However, not all was rosy during the period. In fact, between 2000 and 2009, the 60:40 portfolio generated an inflation-adjusted return of 0.6% per annum while experiencing elevated volatility. Investors, who were conditioned by the experience during the 1980-2000 period, were surprised by this lost decade.

Figure 3: The 60:40 portfolio during 2000 to 2020

The time when it didn’t work: The era of inflation

It’s not that the combination of equities and bonds has always worked. Indeed there was a time when it didn’t. It’s just that it occurred such a long while ago that most investors think that it won’t happen to them. As is seen in the chart below, the 60:40 portfolio’s return in the twenty years between 1960 and 1980 was just about 1%, and that result was associated with much higher volatility.

If we zero in on the period of 1968-1980, a period during which inflation averaged 7.3%, the 60:40 portfolio generated a negative inflation-adjusted return at a CAGR of -1.5%.

Figure 4: The 60:40 portfolio during 1960 to 1980

Risk-parity: Underappreciated risk

The poor outcomes of the 60:40 portfolio during the 2000s resulted in investors searching for “better” solutions. This is when the idea of risk-parity came to the fore. It wasn’t a new idea. It just was repackaged to sound exquisite and supported by quantitative models.

The fact that central bankers worldwide were responding to economic recessions and equity market declines by cutting rates means that as long as such a dynamic holds, combining bonds with equities will lower volatility. All that was needed now was to add some leverage to the mix. Note, however, that this whole idea depends on two basic premises. One, that bonds are much less risky than stocks. And two, that bonds act counter cyclically to equities.

Bonds – a high-risk asset class?

The question that an investor has to ask is whether it is indeed true that bonds are always a lower risk asset class. Can there be times when such an assumption may not be valid? To our way of thinking, risk isn’t fully defined by the experienced volatility. Indeed, risk in any investment is driven by the price paid and the value obtained in relation to that price. As seen in Figure 1, interest rates are close to the lowest that they have been in the last sixty years. Importantly, as seen in Figure 5, bond rates are at their seven-hundred-year nadir.

Figure 5: the 700-year history of bond rates

Source: Visual Capitalist[3]

Below, we reproduce a segment from our 2020 Annual Letter that highlights the risk embedded in bonds. The critical point is that rates at their current levels do not, in our opinion, sufficiently compensate investors for the risks assumed.

At its core, ownership of a fixed-income security like a bond is similar to lending money to a borrower. When we lend money out, we essentially forego current consumption in favor of future consumption. Foregoing current consumption requires an incentive, a compensation for accepting consumption in the future over the present. The required lending rates are composed of four components that can be segregated in two primary parts as below.

• Time preference component
  • Compensation for inflation
  • Compensation for foregoing current consumption
• Investment component
  • Compensation for credit risk accepted
  • Excess investment return

When interest rates are negative or close to zero, as is the case currently, the very first component of the required return, compensation for inflation itself, is questionable. When accepting such low rates, investors make an implicit assumption that inflation will stay close to zero or negative for extended periods. Of course, the idea of compensation for other components doesn’t even arise unless one is pricing a deep and extended deflation.

And therein lies the risk. Bond buyers aren’t being compensated for the risk that the future may be different from the experience of the past few decades. To the extent that investors have levered up their portfolios to earn higher returns in the name of risk-parity, they are carrying a much higher risk than they likely signed up for. What makes it a much higher risk exercise is that the second part of that combination, stocks, are also poorly priced.

Equities – priced for poor outcomes

The chart below is courtesy of Mr. John P. Hussman. The graph shows the ratio of market capitalization to the corporate value-added. As is seen, the ratio is currently in extreme territory, higher than even in 2000.

We think the construct of relating market capitalization to gross value added (GVA) is a sensible way of looking at the valuation of all businesses in a economy. GVA is the value of output created by all producers across the economy and avoids double counting of the intermediate sales used in the overall production process. GVA, in turn, accrues to all sources of production, including labour, capital, and government (taxes).

When the market value assigned to GVA rises substantially, one of two factors, or both, has to be true. First, that a more significant portion of the GVA is now accruing to the providers of capital at the expense of the share of labour and government. If true, the market value of GVA should indeed rise as the value of capital has increased. However, such inflation is a surefire recipe for social unrest. The second, which is most plausible, is that investors are assigning a higher value to output driven by a wave of speculative fervour.

The key understanding we believe is  that just because investors mark up the value of equity indices via financial transactions doesn’t mean that society is any better off than before with such a mark-up. Neither the overall production levels have changed, nor the cash flows earned by providers of capital have increased. The implication though, is that there is a significant risk of repricing equities downwards, as things eventually reprice within historical norms as economic surprises and risks manifest themselves.

Figure 6: Equity valuations

What to do?

Figure 7, courtsey of GMO[4], shows the 7-year expected real returns for various asset classes. As is seen, just about all asset classes are priced for poor investment returns.

There are hardly any easy choices here. First and foremost, one needs to disengage from  past investment outcomes experienced, either during the past ten years, a period during which central bankers have usurped the market’s price discovery function, or even the past four decades, a period that has been defined by a persistent decline in interest rates. We recommend that one should ensure that they shift their allocations, as much as possible, to the highest quality segments of the asses classes they allocate to. In constructing a sensible portfolio in such an environment, the most critical element is to ensure that you combine asset classes that will likely do well during periods characterized by debt deflation with assets that will likely do well during periods of goods and services price  inflation.

Figure 7: Forecasted 7-year real returns

Our approach: Highly selective assets

As a family-focused investment practice, we spend a considerable time on this issue. Indeed, our strategies are designed to construct resilient investment portfolios through economic environments, including “tail risks” of inflationary and deflationary episodes. To that end, we offer three primary strategies: a global equity allocation strategy, a global valuation-driven multi-asset allocation strategy, and a private credit strategy. Below we briefly summarize our approach in each one of these areas.

Equity allocation strategy. The GMF/GMI are our core equity allocation strategies. As we have highlighted previously, US equities are significantly more overpriced than international equities. Notably, the market capitalization weight of the US equities at nearly 60%[5] is much higher than its GDP weight of 25% (16% on PPP basis). Further, most investment portfolios are significantly overweight within their home countries.

To that end, we designed GMF/GMI as truly global equity portfolios allowing investors to reduce country concentrations within their overall equity allocations. At the same time, by being extremely selective about the quality of businesses that we invest in, we expect our businesses to survive & possibly thrive through all kinds of economic outcomes.

Global asset allocation strategy. The GSVF is designed to be a global asset allocation strategy. GSVF combines equities, fixed income, monetary exposures, and commodities within a well-designed mix to construct an investment portfolio that is resistant to economic shocks. Further, we take a very selective approach to building each one of the components of the portfolio.

The fund’s equities book is composed of the highest quality of asset and natural resource owners and operators. Note that our equity book at the GSVF does not include a core equity strategy. To that end, we recommend combining GMF/GMI with GSVF with the mix depending on the investor’s risk preference.

As bonds are unattractively priced, we are taking a different route to our fixed-income book; supplementing it with ownership of businesses with fixed income like cash flows and operating within high-quality regulatory frameworks. Please note that it requires us to take our eyes off mark-to-market changes and instead focus on the underlying cash flows of the businesses we invest in.

Our monetary position is largely comprised of gold as we consider gold to be the highest quality of “money” ( and currencies). We build our exposures here both via ownership of physical gold bullion (stored separately for us) and via ownership of the highest quality of goldminers.

Lastly, our commodity exposures are largely built via ownership of the highest quality of commodity producers spread across energy, uranium, metals, and agricultural resources.

Private credit strategy. In the world of financial repression, fixed-income investors usually have to settle either for poor returns or expose their portfolios to substantial credit losses. Even then, the pickings are rather slim. To that end, we set up a private credit strategy that lends against real assets. Our portfolios are currently focused on aircraft and realty assets. We lend monies only against assets that we carefully select, are of the view that they represent high-quality and highly desirable assets that will retain value even during the worst of a deflationary periods, and look for a substantial capital cushion to ensure that our capital is well protected. Our private credit strategies allow us to generate significantly superior fixed income returns and do so with much lower credit risk.

Summary

The experience of the past forty years has conditioned investor expectations in ways that may be detrimental to the construction of robust portfolios. As discussed, the premise behind constructing portfolios by combining equities and bonds may not hold going forward. Indeed, the leverage embedded in risk-parity or other forms of return enhancement strategies expose such strategies to much higher risks than investors may have bargained for. We suggest treading carefully and not falling for neat models.

Appendix

[1] CAGR for the S&P 500 between August 1981 to August 2020, price only.

[2] Data from Aswath Damodaran | https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

[3] https://www.visualcapitalist.com/700-year-decline-of-interest-rates/

[4] https://www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-august-2021/

[5] As evidenced by the MSCI All Country World Index wherein US had a 59.56% weight as of September 30, 2021.