The most important decision we make in investment, particularly in somewhat diversified portfolios, is the overall allocations to major risk categories. Traditionally, these are considered as equities, bonds, cash, property etc. More recently, the concept has moved to risk dimensions somewhat like those in the 3rd chart.
At a overarching level, it is absolutely clear that returns from bonds on an ongoing basis are not going to be good. Whilst it is arguable that real returns might still be positive, when the return to bonds is lower than the cost of locking cash up in a box and issuing certificates on it (sort of like callable deposits, a form of cash), you have hit the bond floor, particularly if the CBs are inflation targeting and credible enough not to hyper-inflate storage and admin costs. We are not seeing returns to duration risk being rewarded at all in large swathes.
There is a corollary to equities. Earnings still haven't done much and yet prices are moving ahead. Whatever you thought equities would do 'in the longer term' ten to twenty years ago, it is now a fair chunk lower. The debate really centers around how much lower. Answer: in all likelihood, a fair bit in the US. Nothing big looks particularly cheap, although many will argue that EM equities is cheap relative to DM equities at present.
Source: Credit Suisse (market implied real discount rate)
Note: Aust looks fair (relative to history), but our market is dominated by resources and financials.
Let's do some maths. Intergenerational report says Aust GDP will be 2.8%pa in the next 40yrs. Inflation is 2.5% per RBA target band. So-called equilibrium bond yield then works out to be about 5% per annum (sounds about right if the FOMC reckons the long term figure for the short end is 4%pa). The market implied return for Aust services and industrials is about 7.5%pa. That's a 2.5% risk premium over long term equilibrium bonds. Seems a little light. Do this for the US and you fall over.
To support high returns to equities, you need to rely on arguments like a productivity surprise when labour is returning from the doldrums (usually productivity shocks occur when everyone is losing their jobs) or that equities are going to become more expensive simply because it is the least stupid place to put your money at the moment pending a better idea. Or maybe the profit share of GDP swings even further to corporate, or the listed profit component grows at the expense of the unlisted. Stuff like that.
Assessable long term returns to long-only bulk beta just aren't what they used to be. It was made to be so by CB policy and a savings glut due to lack of confidence to convert fresh money into productive capacity and the effects are genuinely visible.
What now? $X bucks today doesn't buy the kind of retirement $X bucks bought two years ago, assuming no social security support.
There are other kinds of risk premia in the market besides equity, duration and credit. I think the way to adapt is by adding meaningful exposures to other kinds of risk premia which you can't buy-hold in a traditional sense and balancing things out. But you maintain exposure to by trading your portfolio in certain ways. Carry and momentum, which I wrote of in the forex threads, are examples.
This is where I am currently (sort of):
This is where I think I need to be going to (sort of):
Charts are from Harry Liem, Mercer. The segments represent proportion of portfolio risk, not physical allocations.
Risk is not having enough money to do what you needed to do with it. With lower expected returns from traditional buy-hold, other kinds of 'trade-to-hold-exposure' to extract other forms of premia become more viable as offsets to the tiring workhorses that have been equity risk premium and term premium.
I think someone moved my cheese.
When I started out over twenty years ago, it was deemed terribly risky to own anything other than direct property. Amazing when I look back at it. Some clients referred to equities as 'those gambling things'.
The key thing here is that investment is about buying cheap stuff. The innovation here is that this stuff is not just an asset, but an exposure to a kind of risk that looks like it has a reward in it. When the rewards to buy and hold appear much diminished, I feel compelled to look at alternatives.
I think, for example, the return to carry might re-assert in currency if cross border finance re-emerges as a phenomenon. Duration looks a really really bad bet with virtually no downside in many markets. Amazing. Equities won't give you the real returns that were once expected. May be this is as good as is possible to obtain and we need to adjust our expectations down. Maybe not.