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Equities

Valuations are at all- time highs – is it time to sell? T.I.N.A. says no!

By Brad Creighton
Portfolio Strategist - Dynamic Markets Sydney, Australia

Constructing a portfolio that can weather uncertainty and provide secure income in retirement has never been easy, but arguably today it is more challenging than ever.

Stock markets are trading at all-time high valuations, government bond yields are close to all-time lows, inflation looms on the horizon and some of the major tailwinds that have supported comfortable retirement lifestyles in the past are unlikely to persist well into the future.

So where can investors turn? And what does the post-COVID economy look like for investors saving for retirement?

The implication for investors

A retiree in 1985 could earn 13.5% on a 10-year Australian government bond (a proxy for the defensive allocation in a balanced investment portfolio). Today, that figure is more like 1.7%1.

The forty-odd year journey from 13.5% to 1.7% is another important and often overlooked drive of historical portfolio returns. Not only has that fall in interest rates caused bond prices to rise (as yields fall), but it has also supported equity prices and the broader economy by making it cheaper to borrow and service existing debts and boosting the net present value of future earnings on which equity valuations are based.

A government bond would play the decisive diversification role when a crisis struck, sometimes falling several hundred basis points; offsetting loses on equity holdings and concurrently providing an incentive to economic actors to invest and take risk again as interest rates moved lower.

From a starting point of under 2% on today’s 10-year Australian government bond, those three levers of income, diversification, and a catalyst for green shoots, are not what they were.

As a result of these dynamics, a new acronym has entered the financial lexicon: TINA, short for “There Is No Alternative”. TINA refers to investors’ reliance on equities to achieve their return objectives. It is part of the reason valuations have been pushed higher over time.

While some observers are quick to conclude that equities are in a bubble, one can also make a case that so long as bonds provide a limited income, with only modest diversification benefit and prospects for capital gains, persistently higher equity valuations are going to be a fact of life. Our concern, however, stems from the fact that investors (retirees in particular) are now more exposed to equity risk than they have ever been.

If equities were to either suffer a severe correction and fail to recover swiftly or deliver meagre capital gains for several years, maintaining a comfortable standard of living in retirement would be challenging.

Portfolio construction: then versus now

In 1995, an investor seeking a 7.5% expected return could hold 100% of their portfolio in government bonds. By 2005, they needed a 50:50 mix of bonds and equities. By 2015, to hit 7.5% return, bonds could only be 12% of the portfolio2.

The takeaway should come as no surprise: the same return has required taking more risk. In risk terms, the 2015 investor should expect 2.87 times more portfolio volatility per annum than the 1995 investor1.

In the current environment it can be easy to conclude that everything will work out in the end. After all, policymakers have done an exceptional job at supporting both asset prices and the economy over the course of the COVID-19 pandemic. Rather than reflect purely on recent successes, however, it is also worth reflecting on how financial markets got ‘here’ in the grand scheme of things. Here we note a few of the major tailwinds supporting investment outcomes over the past four decades.

Dwindling tailwinds?

Equity and bond markets have been underpinned for decades by several supportive tailwinds:

  • Alignment and openness on global trade
  • Price stability - major central banks have managed inflation tightly; hiking in anticipation of higher inflation rather than waiting for actual evidence of it
  • Interest rates have been steadily declining
  • Corporate tax rates, especially in the US, have been steadily declining

Life after COVID-19

A lot has happened over the past twelve months which started with the confirmation that Moderna, Pfizer-BioNTech and AstraZeneca/Oxford had developed viable COVID-19 vaccines and trillions of dollars in government stimulus approved with a focus on the environment and addressing social inequities.

Whereas the Global Financial Crisis (GFC) recovery relied heavily on supporting asset prices through easy and unconventional monetary policy (quantitative easing or ‘QE’), the COVID-19 recovery has seen fiscal policy play a vital role in the form of enhanced unemployment benefits, furlough schemes, and direct cash payments in various countries. One of the biggest critiques of QE was its lack of transmission to the individual which has been addressed this time around. While it’s hard to quantify the exact impact these policies have had on the recovery, a strong argument can be made that without them far higher rates of delinquency, default and long-term unemployment would have ensued.

But there are some bigger picture implications too.

US gross government debt to GDP rose to 107% as at 31 December 2020 – it hasn’t been this high since 1947 . US corporate debt to GDP is similarly high. Globalisation, measured by the percentage of global exports to global GDP, is falling as nations turn inward to address national security concerns and socio-economic imbalances. US corporate tax rates, which have been falling for over 50 years, and offshore tax arrangements, are coming under increasing scrutiny as governments seek solutions to some of the above-mentioned developments4.

Further evidence of policy misalignment can be seen in China’s dogged credit and regulatory crackdown in the face of a global recession and stands in stark contrast to the expansionary policy deployed by China in response to the GFC.

Inflation here to stay?

Until recently, the transitory inflation camp has held sway in global markets. Price rises were mainly being seen in housing, used cars and durable household goods — big ticket, non-recurring purchases.

That may be changing. Over the past 12 months, cattle futures are up 20%, corn futures are up 35%, coffee futures are up 100% so it’s clear these cost pressures have the potential to move beyond used cars and industrial metals and into the everyday supermarket items5.

It will take time to flow through. Companies do not want to alienate customers so are slow to raise prices but once they see higher costs entrenched, they will pass it on in a smoother manner.

Much of these price pressures though can be attributed to the current supply chain disruptions - an unintended consequence of the massive amounts of stimulus channelled directly to households at a time when global manufacturing hubs were unprepared for a sudden restart, while also attempting to manage the risk of COVID-19 infection to workers.

It’s a situation that should resolve itself over coming months, but it may also serve as evidence to how easily prices can rise when the supply chain is motivated by more than the lowest cost of production (higher wages, higher energy and material costs, and potentially lower profit margins).
Implications for investors

Where does all this leave us?

The starting point for retirees today is more challenging than it was in prior decades. The levels of interest rates were higher and the tailwinds of falling interest rates, falling tax rates, the ability of governments to borrow, and a favourable geopolitical environment laid the foundation for strong investment returns. Those tailwinds are not headwinds however one must consider if they are lesser tailwinds and whether it is reasonable to expect that today’s retirees can enjoy the same level of financial security as those in the past.

Second, there may well be no alternative to today’s retirees running a higher equity allocation than prior cohorts, but there are some good alternatives to government bonds that can substitute for the income generation and diversification benefits afforded by government bonds of yesteryear.

Those alternatives include activities like tail hedging - buying assets that can rise in value when other assets fall – as well as private equity, private debt, niche hedge fund strategies, high yield credit and distressed debt. Our modelling showed that by combining these alternatives into a 50/50 Growth/Defensives portfolio a retiree’s income stream, measured in years, can be increased by 13%.
For most investors, this will require using a specialist investment manager to get access to these assets which are structured with retirement goals in mind.

1 Bloomberg
2 Wall Street Journal
3 Trading Economics
4 US Bureau of Labor Statistics
5 Bloomberg

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Brad Creighton, Dynamic Markets - Portfolio Strategist
  • Equities
  • Goals-Based Investing
  • Investment Strategies
  • Retirement
  • SMSF News
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