The World Has Changed
Most informed investors, and all investment managers, know that the investment landscape has significantly changed. New economic and investment risks have developed over the past few years but so have new investment opportunities. In order to safely navigate your portfolio through all of these significant economic and investment risks, and to make smart investment choices to maximize your risk adjusted returns, we believe it is essential for you to understand all of your risks and opportunities.
Today’s Major Risks
Investment returns are driven by many influencing factors but two of the most important ones are business cycles and interest rates. Both of these inputs currently present major risks, and potentially negative effects, on both stock and bond markets.
Business Cycles: the economic cycles of all nations must be understood in order to avoid destructive downturns and be ready to ride the recovery cycles that inevitably follow. There are really only two cycles that drive nation and world economies: 1) the normal business cycles; and 2) the longer-term debt cycle.
Currently the world’s largest developed economies including the United States, Europe, Japan and Canada are in a position where massive consumer and government debt has been accumulated over the past two decades. Spending on consumer durables and government programs using borrowed money creates short-term prosperity and the illusion of sustainable economic growth while it’s accumulating. But, ultimately when the borrowing capacity is reached, these debts must be serviced - and repaid - one way or another. Either by our generation or future generations.
The subprime mortgage crisis of 2008 marked the turning point where unrestrained borrowing was called into question. This likely marked the beginning of what many leading economists and money managers describe as the period of de-leveraging. In an era of de-leveraging, consumers no longer have a growing capacity to borrow and spend, and drive corporate earnings. And, governments have a diminished capacity to spend on projects and programs because cash flow is being eaten up on interest payments.
In the context of investment returns for stocks globally, it is hard to make a case for high returns when the world’s largest economies are facing an extended period of de-leveraging (perhaps 10-15 years). Deleveraging has a very negative affect on the shorter business cycle so one might expect that we may be facing many years of relatively slow growth, punctuated by short and longer-term recessions. We expect that the returns on broader stock indexes might be mid to high single digits at best. After accounting for investment management fees and inflation, these returns are surely going to be much lower than historical returns, when debt accumulation was fuelling economic growth.
Interest Rates: interest rates and consequent cycles are very important to all investments. Whether they are growth-oriented investments such as stocks and real estate or fixed income investments such as GIC’s, government and corporate bonds.
In an era of global de-leveraging, governments will do everything in their power to keep interest rates relatively low. Should interest rates rise, either due to lower credit ratings or due to government intervention, these rising rates would be a double-edged sword for investors. Rising interest rates - especially if they rise quickly - would be devastating to highly indebted consumers; indebted nations (like Greece); and longer-term bonds and stocks.
In a rising interest rate environment, corporate earnings usually suffer and bong prices usually fall. Traditional investment portfolios comprised of only stocks and bonds would not perform well. Layer in investment management fees, inflation and taxes, and it is easy to see that returns would be very low and capital could be at risk (particularly if one was extracting regular income from their portfolio). Although higher interest rates are appealing to new buyers of GIC’s and bonds, the process of getting there would not be painless for most investors.
Industry Overview Summary
Today’s interest rates are historically low, and we don’t expect them to rise for some time. So the fixed income portion of balanced mutual funds and most traditional investment portfolios is likely not going to perform well. With MERs (Management Expense Rations) and the current inflation rate both higher than short and mid-term rates it is currently impossible to make positive real returns on many traditional fixed income investments. Add in taxes, and the after-tax real returns, and it will surely be negative for investors holding these low-yielding deposits and bonds.
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