For at least 60 years, it has been an article of faith to invest one’s assets along the lines of 60 percent stocks, 40 percent bonds. This formula was originally coined by the Ford Foundation; they advocated the allocation to endowments and large charities who previously had invested only in bonds. The idea was that the stocks would provide rising dividends, which would preserve the purchasing power of the portfolio, while the bond portion would provide stability to the values of the total investments. In effect, the two categories were to offset each other.
The performance of financial markets, both in this country and abroad, so far this year points to an unsettling uniformity of performance. Bonds have gone down in value with the talk of increasing interest rates by the US Federal Reserve and their equivalent in other nations. Bonds with the longest duration (i.e., longest time to maturity) have declined the most in value.
At the same time, stock indexes have declined with the indexes representing the longest duration stocks (i.e., highest price/earnings ratios) going down the most. Since these two categories are supposed to offset each other in order to reduce the portfolio’s fluctuation (technically known as reducing volatility by holding non-correlated assets), their declining in unison is not a good thing. Ditto for the declines occurring world-wide, which blows a hole in the risk reduction that is supposed to come about from international investing.
The reason for the uniformity of the declines is that low interest rates helped support both asset classes. Reversing low rates has caused both categories to take on water. As interest rates are expected to increase for some time to a level far higher than now, stocks and bonds as asset classes are both expected to be under pressure.
There is not much bonds can do to escape the carnage that awaits them. All bonds are essentially contracts to pay money, usually every six months, then the principal at maturity. It is hard to distinguish between debt. One bond does not pay in greener dollars than another. Bonds are sometimes categorized by default risk, with riskier bonds paying relatively more in interest than less risky issues. With years of low interest rates, the return between more- and less- risky bonds have compressed to the point where almost no bond issue pays more than inflation at any level of risk. Most bonds pay a lot less. This is in contrast to 1980, when government agency bonds paid interest in the range of 16 percent, while inflation was trending down from 13 percent.
So if stocks and bonds as a group are slated for less than projected returns for the next decade, where are the assets that, as asset allocators like to say, do not correlate in terms of their returns? Enter the rabbit hole of alternative asset classes.
To salvage asset allocation, enter alternative assets. As the name would suggest, “alterative assets” covers a broad spectrum, including commodities, real estate, collectibles, hedge funds, and private equity (to name a few). The common thread is that all these investments are not very liquid; this means that they are not bought and sold with the regularity of stocks or bonds, and thus the cost of buying and selling is far higher in terms of transaction costs, assuming a transaction can be arranged.
If not traded often, how are such assets valued? Usually by appraisal. The accuracy of such appraisals varies, and they are usually no match for an actual transaction. Then there is the matter of selling to raise funds should such be necessary. It can take a long time to find a buyer for an illiquid asset at a price quoted by appraisal.
What is the solution? For income, conservative value stocks with strong and rising dividends to offset inflation can address the need for cash flow. Smaller companies that can grow and be taken over can assist in preserving the purchasing power of one’s holdings. Both categories are volatile, but volatility is not necessarily risk. Sufficient cash should be set aside for funds needed in the short term with this approach.
For smaller portfolios, there are ETFs that can represent these areas. Investors with larger asset positions can purchase the same investments directly and avoid the expense of packaged financial products. Investors with very large sums of money, like endowments and foundations, can best invest a portion in alternatives directly because they can, through their sheer size, acquire assets whole at lower cost as well as have the staff to oversee the investments.
Either way, it is important to acknowledge that the past is not prologue for the future. As Dorothy once said, “…we’re not in Kansas anymore.” An asset allocation formula that was adopted 60 years ago when inflation was trending down will not work when inflation and interest rates are trending up. Choosing investment assets is a different matter than choosing asset categories. Categories is the role of an asset allocator. Investing is the matter for portfolio management. Woe to the person who confuses the two.
The Economy
The economy, while strong, continues to gear down from last year as the stimulus funds make their way through the financial system. Economic growth in 2021 was 5.7 percent after inflation. This year it is expected to be about three percent, and down to two percent in 2023.
The greatest economic variable is Ukraine. If Russia chooses to invade, the economic upheaval in Europe, Russia, and the US will be material. The price of oil and other commodities will likely go through the roof given the supply disruption expected from such a conflict. Much of Europe is dependent on Russia for natural gas. For the last twenty years, Germany has been dismantling its nuclear program with no strategic alternative power source. On the other hand, Russia will become insolvent quickly without the sale of oil and gas and the foreign exchange it provides. The Russian people are not enamored of fighting in Ukraine, but Russia is not a democracy. It will be interesting to see how this plays out.
Interest Rates
Interest rates are rising. The question is how much.
The projected time rates officially rise seems to be in March, when the Federal Reserve meets. As usual, there is a parlor game of how much interest rates will be increased. Right now, the betting is between three and five quarter-point increases. Much will depend on the economy and its ability to absorb such increases without sliding into a recession.
Of less focus but perhaps greater impact is the decision to begin reducing the government’s bond portfolio. Such a reduction would serve to take money out of circulation, in theory reducing inflationary pressure in the process. As the amount of bonds held is about $9 trillion, a reduction of $200 billion per quarter for about ten years would be enough to eliminate this prior source of stimulus. As many of the bonds are made up of mortgages, the government may be able to reach this target by simply letting the bonds mature and not purchase new bonds with the proceeds.
Inflation
Everyone seems to have a story of higher prices. Such pricing pressure, brought about by demand for goods, seems to be a world-wide phenomenon.
Like the economy, the course of inflation in the short-term hinges largely on Ukraine and the Russian decision whether or not to invade. If a decision is made to invade, the disruption of supplies of energy and commodities will be felt all over the world. On the other hand, a reduction in tensions between Russia and Ukraine would lead to some reduction in European energy prices and the price of other materials as well.
Labor shortages are also international in scope. Demographics are changing in most parts of the world as populations get older and fewer children are raised. This is expected to become a more embedded source of inflation going forward.
The Stock Market
While overall indexes have declined, there are companies and industries that excel in this environment. Firms that pay dividends, cater to the general public, and are not overvalued are the drivers of the current market. Stocks of those who are richly valued, pay no dividends, and need years of earnings growth as far as the eye can see to justify their current prices are at best going to tread water going forward.
Warren M. Barnett, CFA
February 1, 2022
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