Three Reasons to Moderate Your Optimism

by Niels Clemens Jensen, CIO, Absolute Return Partners

Optimism is the madness of insisting that all is well when we are miserable.
– Voltaire

Three major challenges in front of us

Some investment challenges are virtually set in stone. Take for example the demographic outlook. Whether we like it or not, the populace at large is ageing quite fast, and there is little we can do about it. In this Absolute Return Letter, I will focus on a few such issues and what the implications are, namely:

1. The (excessively) high returns of recent years, and why that will result in lower returns going forward.

2. The new world order which is forming in the wake of Russia’s invasion of Ukraine and the rise of China, and what that implies for investors.

3. The ageing of the populace at large, and why future equity returns will be lower as a result.

It may surprise you that I have made no mention of inflation. While I do believe inflation will prove stickier than most think, I also believe that the problem can be addressed through various policy programmes; however, that is stuff for another day. This month, I will focus on issues that are next to impossible to address.

Concern #1

Let’s begin with #1 and why the high returns of yesteryear will lead to lower returns going forward. If you have followed my work for some time, you will be aware that I believe household wealth – particularly US household wealth – is elevated when compared to GDP. For reasons I have discussed numerous times before, in the long-term, one cannot grow faster than the other. The long-term mean value in the US is approx. 380%, i.e. total US household wealth should be approx. 380% of US GDP for the system to be in balance. Now, as you can see in Exhibit 1 below, as of the latest count, US wealth-to-GDP is 562%, almost 50% above its mean value.

Household wealth consists predominantly of pension savings, property holdings and various direct investments. In the US, the latter comprises mostly of public equity investments and investments in family-owned businesses. In certain other countries, bonds account for a much bigger share of household wealth than they do in the US, where the exposure to bonds comes mostly through pension savings.

Unfortunately, the economic theory underneath says nothing about how the balance will be re-established. Nor does it say anything about timing. Having said that, I need to bring a recent paper from Vanguard, the second largest asset management firm worldwide, to your attention. In the paper, which you can find here, Vanguard argues that annual returns on most risk assets will be much lower over the next ten year than what we have enjoyed over the past ten years (Exhibit 2).

Vanguard’s forecasts are based on the March 31 running of the Vanguard Capital Markets Model®. As Vanguard points out, their return forecasts reflect a 2-point range around the 50th percentile of the distribution of probable outcomes. This implies that more extreme returns are possible.

One way for the balance between wealth and GDP to be re-established is for the numerator to grow more slowly than the denominator for an extended period of time. This is essentially what the researchers at Vanguard believe will happen. According to them, following an extended period of very robust returns, investors should expect some leaner times in the years to come.

Concern #2

About 13 months ago, we added Globalisation 2.0 to our list of megatrends. If you subscribe to ARP+ and have read the paper, you will be aware of our logic.  If you haven’t read it yet, you can find it here. For non-subscribers, allow me to summarise our findings.

In short, international trade creates economic growth everywhere, and international trade is stalling after years of expanding.  It all started in the autumn of 2008, post-GFC. From November 2008 to October 2016 some eight years later, protectionist measures adopted by members of the G20 reached a new all-time high of 5,560. This created a huge increase in the number of trade frictions worldwide (Exhibit 3). Consequently, international trade started to slow.  WTO estimate that the volume of global trade in goods and services grew by only 1.7% in 2016, significantly below the growth rate of the global economy, and that has remained the case every year since then.

It is easy to blame Russia for the slump in international trade more recently but, in reality, it was a process started by the G20 more than ten years ago. There can be no doubt that Russia’s acts have further destabilised an already delicate balance, but it would be wrong to blame it all on the Russians. Sovereign interests in the western world combined with a bout of COVID-19 have also played a role.

The last time globalisation went into reverse in a major way was during the Great Depression in the 1930s.  The most important lesson learnt from that episode was that self-isolation harms everybody.  With self-isolation follows reduced economic growth and lower corporate profits, and with that comes lower equity returns. Countries prepared to go the other way and form new alliances stand to benefit, as new trade patterns will be established. In that context, most EM countries look better positioned than the average G20 country does.

Concern #3

Most people change the composition of their portfolio in favour of bonds, as they get older. Not that long ago, we went through a period of excessively low interest rates, but that has changed again. Bonds are back in favour, and that is particularly the case amongst senior citizens.

Meanwhile, investment advisers across the board encourage investors to increase their allocation to bonds as they grow older. Take for example T. Row Price who advocates a 0-10% allocation to bonds in the early stages of your career.  It is then recommended that you gradually raise the allocation to bonds as you move through your 40s and 50s only to end as high as 60% when retired (Exhibits 4a-4c).

My concern is the following: Most wealth is created when people are in their 40s and 50s, i.e. that is when there is most capital to invest. Adding to that, US private investors are major equity investors, in fact much bigger equity investors than European private investors are. If you combine those two facts, it is suddenly less of a mystery why US equities have performed so much better than European equities over the last decade. Quite simply, demographics have had a meaningful, and positive, impact on equity returns. Now, the biggest cohort – the baby boom generation – is no longer 40-60 but 60-80 years old, i.e. an awful lot of people are busy switching from equities to bonds.

It is therefore no wonder that equities are beginning to struggle.  For a few years, the struggle was tempered by the fact that the near zero return on bonds gave retiring investors no option but to stay invested in equities, but that is no longer the case. I think the 2020s could easily turn into a decade-long low-return environment for equities.

Final few words

Vanguard states on its website that “our research shows that the average Vanguard investor’s portfolio holds 63% stocks, 16% bonds, and 21% cash. We also found an interesting difference in the way investors approach their asset mix based on their age. If you’re under age 39, your portfolio is more likely to be heavily weighted towards stocks. In fact, this age group allocates nearly 90% of their portfolio to them. By comparison, people over age 55 only hold about 66% of their assets in stocks.”

This is broadly in line with the findings of T. Row Price and supports my thinking.  In fact, for at least a year or two, the impact could be even more dramatic than you would have thought.  Because of the extraordinarily low interest rates of recent years, there is a fair amount of catching up to do, as many investors are ‘behind plan’ in terms of switching from equities to bonds. Precisely how big the impact from the catch-up will be is next to impossible to say, but I would recommend a cautious approach, given how out-of-sync wealth-to-GDP is.

Niels C. Jensen

1 July 2023

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