Expected Returns in a Bear Market
With the main release of data for October and the Xi`s opening speech at the party congress behind us, the world is in an unpleasant situation. The Fed, ECB and the BoE seem to want to keep tightening until it hurts, or until something breaks at home. For those with a bullish view, this means more pain as the ECB and the Fed reduce liquidity and hike rates. For those with a bearish view, the pain comes from the risk and threat of accelerated central bank intervention. This has again been illustrated by the Bank of England and by the wider British establishment which looks increasingly confused and lacking in leadership. Should the BoE's example spread to other central banks we could get an early turnaround from the Fed as well. This is not what we expect, but it is nevertheless a risk to our defensive positioning.
Another risk to the outlook is China. The Chinese economy has clearly slowed down more than the leadership is willing or admit. At the same time, we now have confirmation from Xi Jinping's opening speech at the party congress Sunday the 16th of October that he is satisfied with the development of the last 5-years and that no main policy goals and measures are to be changed. The way to widespread prosperity still goes through the undisputed leadership of the party, he is quoted saying. We don’t think that the 40 years of the economic miracle in China supports this interpretation of history or the idea that the Party should have as much influence in the next 5 years as it has had in recent years. We therefore warn that in our interpretation, Xi is not looking for a status quo or even an easing of centralised power. He is looking for a continued tightening of his grip. These are only the first days of the congress, but in our view these signals are not favourable for the long-term development of local or global markets.
From the UK we got a reminder of the lack of responsibility of populism and the damage it causes in European political circles, when the new government and its now former Chancellor of the Exchequer delivered a “mini” budget with big plans for spending and no matching cost control. Roughly speaking, this is the equivalent of fielding a sports team without any defence. This naïve move forced the Bank of England into a round of emergency interventions in the bond market. But the markets remain unimpressed. Yields have moved back up and it will be extremely difficult for the UK to avoid a recession. Nor is it clear whether the BoE will be able to stay out of the market, even though they say the recent programme has ended. One area of additional intervention could be US mortgage rates. These have increased fast in 2022 and are therefore a potential trigger for a market move as this could lead to changes in Fed policy.
Turning to Europe, the Finish Prime Minister, Sanna Marin, made clear her view on a solution to the war in Ukraine by stating that “The way out of the conflict is for Russia to leave Ukraine. That is the way out of the conflict”. Such clarity may well stem from the fact that Finland has lived under the threat from Russia’s empirical ambitions for hundreds of years. Or perhaps the former schoolteacher is thinking of Ukrainian children being bombed by supposedly Nazi fighting Russian soldiers, who kill and mutilate them from a safe distance. Those who focus on the supposedly historic rights of Russia, and on saving Putin’s reputation, should perhaps consider what exactly the children in Kharkiv owe to Putin and history. For markets, the problem is that the French president has strongly promoted the idea that it is necessary to avoid humiliation for Putin and that the money to build up Putin’s power and military came from the income derived from a deliberate German policy of accelerated reliance on Russian gas. Can France and Germany, with such a lack of strategic foresight, be trusted to take the Eurozone forward? Or even to organise the next fiscal plan to avoid a collapse of the EMU, if and when a new recession takes hold and peripheral bonds spreads widen further? With the Chinese president Xi Jinping celebrating his limitless presidency and befriending the mad man from Moscow, right now we are not tempted to buy either Chinese assets or European equities.
All said, the fact is that the world has been through cruel wars and repeated recessions before, and that returns on investment normally recover despite such events. The same holds true for periods of inflation spikes and increasing interest rates. We will take a closer look at all this below, where we try to put the current bear market into the perspective of 10, 30 and 100 years of investment returns. We also show the simple fact that for long-term investors, equities are often the least risky asset class. In our view, however, at present this is not the case, and we therefore remain defensively positioned across our funds and mandates while we wait for the foundation for the next bull market to be formed. Specifically:
In our dynamic allocation strategies, with up to 100% equities, we hold an equity allocation of 10-30%, with a US overweight. This position is to a large extent unhedged in our Euro portfolios.
In our balanced multi-asset strategies, we are maintaining stable equity allocations of between zero and 20%, in addition to making allocations to short duration high grade bonds.
Across our Global Fixed Income Opportunities portfolios, we are holding short duration high grade bonds, cash and 10%-30% high yield bonds, depending on the relevant risk profile.
A Bear Market like no other
We are in a bear market like no other seen since the last fight against inflation in the early 1980's. High grade bonds denominated in the world's reserve currency have been declining in value for almost two years and the losses in medium duration paper matches those of global equities. And last month has been dreadful even for supposedly safe short duration German government bonds. To understand the dynamics unfolding and what future opportunities this brings it is important to recognise the sell offs correlation with duration. Long duration assets have suffered independently of asset class. The least liquid like private equity has until now suffered the least, liquid equities crypto and Chinese tech, have suffered the most. All of this has happened before we even have an official recession, (although the Chinese economy is contracting). As we explain below, what we have seen is in retrospect a shift back towards reality of bond yields, which In USD rates now positive in both nominal and real terms (using inflation expectations weighted by economic influence). This means that we can expect bonds to give decent returns in the coming years and equities to most likely deliver even more, meaning something like 7%-8% nominally. This is slightly less than in the last 120 years, but enough for capital invested in equities to quadruple in the next 20 years.
How good investment returns come about is a bit of a mystery, but some elements are clear after all. As global financial markets move from boom to bust, the business cycle plays its role, intertwined with the monetary policy cycle. Technological innovation delivers growth in invested capital over the longer run with spiked in the form of various industrial revolutions. Financial innovation typically helps to amplify effects of such innovation and often creates its own opportunities and problems. Larger political changes domestically and internationally send countries into booms and catch-ups like those seen in China and India in recent decades. In between there are darker sides of human history, which also scare financial markets, such as WWI and WWII, Russia and the Soviet Union after WWI, and Mao’s China after WWII. Millions of people lost their lives and bond, and equity holders often lost all the money they had invested in countries losing wars or turning communist or implementing other forms of autocratic regimes. Leaving aside the possibly dramatic consequences of the affinity of Xi Jinping and Putin, possibly encompassing an act of nuclear madness, history also has a few positive lessons for us. One is that it pays off to invest, particularly long term. The other is that while equities are very volatile, they are a good way to preserve real purchasing power and to grow wealth across decades and generations. Another lesson is that it is worth looking at the main differences from one boom to another. This can help as a guide of what will happen and to identify when things could stabilize. One example is technology stocks. Leading technologies have almost by definition offered great long-term return, but great things can still come at too high a price. Railways stocks dominated global indices in 1900, but they were not necessarily a great investment afterwards. Nearer to the present day, technology peaked in 2000. After that, the Nasdaq index declined for more than 2 years and accumulated a 75%+ fall, after which the index value again rose dramatically. Seen in retrospect, everyone knows that both valuation numbers and matrices were wrong back in 2000. Much the same way as many can now see that there was a housing bubble in 2007. In the same way, a yield of 0.5% or 1% on a 10-year US government bond was way too low. It is clear from Figure 1 that US government bond yields declined in one long trend from 1982. This led to continuous high returns. As central bank rates declined to lower and lower levels, it probably also led to excessively optimistic perceptions of how low the risk of investing in these assets was. Even this year, the consequences of a normalisation of yield levels have shocked markets and central banks alike. Probably because of the extent of the losses with negative returns of 15%-25% over the last 6-12-18 months in traditional fixed income asset classes like government bonds, investment grade credit and emerging market bonds. These losses have led people to question the usefulness of bonds for investments. It has also led to talk about the end of multi-asset investing and particularly of the 60%/40% portfolio. We don’t agree with this scepticism as the sell-off has made these bonds inherently more compelling as investments, since there is now a much higher yield to be had from investing in them.
Figure 1: Long term US government Bond yields
Looking at the long-term history in Figure 1, the question arises if this sell-off in bonds is over. The truth is that we don’t think anyone can know for sure. What we do know is that buying and holding a US 10-year bond from here to maturity in 10 years will provide a return equal to the market rate (close to 4% per annum depending on markets on the day of purchase). This is several percentage points higher than in recent years and it is about 1.5% above market implied inflation, as expressed in the market for inflation-linked government bonds seen in Figure 2. With USD cash yields heading above 3.5% and the US 2-year yield above 4%, a similar USD return can be locked in for most points of the curve over the next 10 years.
Figure 2: Market implied inflation expectations for US government bonds
While the implosion in the fixed income bubble and increase in yields undermined multi-asset investment strategies this year, it also makes their nominal returns less risky in the future, not only due to the higher nominal yields but also because these higher yields make it much more likely that yields will fall in the next recession. It is precisely these positive bond returns that most multi-asset portfolios are set up to benefit from, when the economy moves from expansion to contraction, and when high grade bond yields move down as risk aversion increases inversely to the decrease in growth. Framing this argument in terms of the business cycle, one can say that this year we have seen growth decline, but there has been no recession yet and, specifically, there has been no recession strong enough to cool down inflation and inflation expectations significantly. The positive portfolio effect of high-grade bonds has therefore been absent in multi-asset portfolios since it was dwarfed by the bond bubble implosion. The popping of this bubble led to correlated losses across bond markets, which also provoked declines in equities, private equity, venture capital and liquid equities alike. A truly terrible experience, but one which is unlikely to repeat itself after this business cycle.
Figure 3: Total return for S&P 500 and for a 60% equity 40% bond portfolio
Triumph of the Optimists
To get more perspective, it is worth looking at the basic lessons to be gleaned from historic market data in order to underpin the long-term outlook. Some of the best quality data is presented in the book Triumphs of the Optimists,by Elroy Dimson, Mike Staunton, and Paul Marsh. This book was first published in February 2002, well before the bottom of the market and while the mood was bleak, the title back then seemed a bit misguided. As history shows, it was not such an inappropriate title after all.
Figure 4: Max drawdown for US market (the rest of the world mostly did worse)
Figure 3 shows the historic returns from early 2002 until today and, as can be seen, both the 60/40 portfolio and US equities have paid invested capital back multiple times. More important and more significant, the work by Dimson, Staunton, and Marsh relied on 101 years of history, including one cold war and two world wars. This set of data has since been updated annually and the 2022 edition of the Annual Return Yearbook, as the three professors now call it, found that US equities have delivered a real return of 6.7% annually for the 122-year period. Fixed income has delivered closer to 1% annually after inflation. The problem for this period was that the drawdowns were substantial in both types of portfolios. See Figure 4. While this historic experience now looks manageable, many investors panicked in the middle of the negative market behaviour. Possibly because there seemed to be no plan for how to stop the drawdowns, either from politicians, central bankers or portfolio managers, some investors even liquidated positions and missed out when markets recovered.
Today’s market in a historic context
Comparing today’s markets, where we are down approximately 25% on US and global equity indices (S&P 500 and MSCI World), to recent history, we see that this corresponds to March-April 2001 where MSCI World was nurturing losses of approximately 25% from the peak in 2000. An investor buying at that time would have made a return of about 8% annually until the end of 2007 (the next bubble ending) and about 7.5% until the end of 2021. Similarly, investing in MSCI World after the first 25% decline from the peak in 2007, that is to say, near the middle of the great financial crisis, would have generated a return of 9% annually by holding these equities until end of 2021. A return which would have declined to 7.5% by now (10th of October 2022).
Summing up in respect of the expected return on equities, a 7%-8% equity return seems to us to be a good neutral expectation over a period of a few decades. Actual realised inflation could obviously come out higher than market-priced implied inflation, leading to higher risk premiums. But with inflation at, for example 3%-4%, companies will continue to grow their profits in the long run and, assuming 7-8% nominally returns, the implied real return of equities would then only be around 3%-4%. This is only half the real return from 1900-2022 for US equities. As such, it is not a demanding level in historic terms. Where inflation also was above 2%. Though it close to the average for the similar period for global equities Ex-US (4.5% after inflation).
As we have argued before, we do not think inflation will be as persistent as many central bankers are preparing for and many commentators are asserting. The main leading indicators are showing easing price pressure. M2 continues to decline, USD QE is being scaled back, yields are up, commodity prices are down, housing activity is declining, freight rates are down, microchip prices are down, etc. Still, if we set aside our view and use the current market yields from figure 1 and the implied break-even rates from Figure 2 also for bonds, the asset class implication of this is likely to be that the US 10-year yield stabilizes around 3%-5%. If the economy continued to have cycles this also implies that yields again become cyclical, which means that their diversification benefit will return.
Figure 5: Wealth accumulation, 2.5m investment, 60/40 portfolio, 120k annual spend
This is true even if the future nominal return will not be as high as in the 40 years until 2021, since there will not be the same tail wind as in the previous 40 years. This means that even if bonds are looking the most dangerous when considering recent history, they are becoming increasingly attractive as a long-term investment. This holds true both as a standalone and a portfolio building block proposition. It is probably too early to take advantage of this and buy duration now, but when the Fed and other central banks regain their composure, such a new (unstable) equilibrium or market range can probably be established. From then on, we expect that a balanced portfolio as the one seen in Figures 3 and 4 with 60% equities and 40% government bonds, would deliver a total return of 82% over a 10-year horizon (before fees). Holding on to such a portfolio and benefitting from the power of compounded returns, such a return could amount to a meaningful total return of 500% over a 30-year period.
Figure 6: Wealth accumulation, 2.5m investment, 100% equities, 120k annual spend
For an investor with a starting value of USD 2 million and a monthly consumption of USD 10k, the likely wealth distribution is shown in Figure 5. The expected accumulated capital after 30-years, with 120k annual spending, is 100% or a total of 2.5 million on top of the initial 2.5 million. The less comforting fact is that even with the use of normally distributed returns, there is an expected 5% chance that there will be nothing left already after 20 years (where the lower black line crosses the zero axis). Not only does the investor face the fact that real consumption gradually declines with inflation, but there is also a less than trivial chance of running out of funds. Bearing in mind the way in which our industry focusses on volatility as a measure of risk, someone may have the idea of reducing the “risk” of a shortfall of capital in the long term on the basis of reducing the volatility of the short-term portfolio by reducing the equity exposure to 30% equities, for example. But that is a bad idea. For long-term investments, volatility is a poor risk measure and drawdowns are mainly relevant as a measure of how large the losses may be and how deep the declines the investor is prepared to accept along the journey. What matters most is to remain invested, to avoid larger drawdowns, to stay the course and to invest enough in high return assets to have a high probability of achieving the targeted return in the long run.
This is not only a theoretical consideration, but also what led the late David Swensen, a great investor, to set up the Yale Endowment portfolio to invest primarily in high risk assets and strategies, capable of achieving his ambitious long-term return goals. For affluent investors, the best way to lower the probability of running out of capital in the long run is therefore to find the optimal balance between a portfolio not leading to unbearable stress in recessions and during the bursting of market bubbles, while at the same time investing enough in asset classes with returns similar to equity. Initially this most often means allocation to listed equities. As wealth and experience increases, more advanced strategies with less liquidity will be appropriate, which means that more can be allocated to various private markets and illiquid strategies, primarily Private Equity, Venture Capital and similarly leveraged exposure to real estate and infrastructure. Such strategies are for truly multi-decade investing, but tactically it is worth noting that they are inherently getting more attractive as the world economy and markets deteriorate, so the coming quarters and years are also likely to be presenting good opportunities in private markets.
Figure 7: Edge Sustainable Growth total return vs MSCI World total return
For those investors wishing to protect themselves against excessive drawdowns, as in 2007, 2018 and 2020, we offer our Dynamic Allocation Portfolio techniques. In our view, one particular risk in the current environment and probably more so in the eventual recovery, is for investors to be caught with overweight in sectors with redundant or unloved business models. Such sectors and companies often trade at low valuations with high cyclical gearing and can be leaders of an initial recovery. In our view, however, there is also a high risk of such sectors and companies turning out to be less prepared for the continued, if gradual, revolution in sustainable investing.
Figure 8: Edge sustainable Growth Drawdown vs MSCI World drawdown
To mitigate this risk, we offer our globally diversified investment strategy Edge Sustainable Growth with its bias towards technology and growth stocks with carbon emission levels 40-50% below global averages and high ESG scores.
As seen in Figures 7 and 8, this strategy has delivered a solid performance relative to MSCI World, both in the upward cycle and in the recent downturn. As we work our way through the coming months of market turbulence, we expect that with its dynamic movements between 100% to 20% equities, this strategy will offer a better risk return trade-off both in absolute and relative terms. As yields have now moved closer to reasonable levels for government bonds, it also provides a better absolute protection to the downside than what we have seen in 2022. For investors not yet ready to take exposure to our dynamic allocation process, these portfolios are also available with fixed allocations of equities and bonds. Finally, for investors looking for truly low risk investments, we offer single name fixed income buy and hold portfolios with short duration and with ethical and sustainable investment filtering at individual company level to secure a higher level of compliance with personal preferences.
Best regards,
Mads N. S. Pedersen
Managing Partner and CIO