Investment themes for a ?Groundhog Day? world
Wall Street strategists and financial media pundits have spent much of the last several years foreshadowing a dramatically changing investment environment and telling people what to do about it.
> Despite these prolific predictions, the actual environment has been remarkably stable, featuring slow economic growth, little inflation, low interest rates, significant geopolitical tension and just about everything being slightly better in the United States than anywhere else.
> Eventually the backdrop for investors will change. However with slack labor markets, prudent government spending in most major countries and no apparent structural shortages of key commodities worldwide, change may not come anytime soon.
> Investors may have to confront the profound decisions Bill Murray’s character faced in the comedy movie “Groundhog Day.” If tomorrow is always very much like today, and you are not happy with the current positioning of your investment portfolio, you probably need to do something. But what?
Given the demographic profile of most investment strategists, financial reporters and portfolio managers, it is perhaps no surprise that these people all seem to expect constant change. Over the last 35 years, a barrel of crude oil has been $160 and it has been $10. Ten-year U.S. Treasury bonds have yielded 14% and they have yielded 1.5%. The Dow Jones Industrial Average has been below 800 and above 17,000. It is a logical fallacy, however, to base a forecast of the future only on one’s personal experience, even if that experience is lengthy and comprehensive. Consider these points:
> The recent stability of official interest rates, such as the Federal Reserve discount rate, is unusual since the 1970s, but it was fairly common prior to then. Also, large price movements in bonds that end up being fully repaid with interest are mostly a late 20th to early 21st century phenomenon.
> An environment where the dividend yields of established public companies are similar to the current yields of high-quality bonds has occurred before, most recently in the 1950’s. Although a typical forecast today is cautious on bond returns and only modestly positive on equities, the parallel 1950-1965 period saw bond returns that satisfied investor expectations and equity returns that were very strong.
> The concept of the United States being the world’s best overall financial market has recently re-emerged. Global diversification should always be considered, but don’t be overly deterred by all the flaws we see living everyday life in the U.S. or the recent strength of our stocks and bonds. The number of other countries with consensus AAA-rated government bonds, a dominant military and hundreds of years of democratic tradition is zero. Any one of these factors can have a material effect on investment returns, as you would notice if you have recently been long Venezuelan government bonds or Russian stocks.
Suppose we remain in a period where the pundits continue to be surprised by a lack of change? Which strategies proposed by the experts, based on their 30 to 40 years of experience, do we stick with? Which do we change?
> First and foremost, recognize that an environment of slow economic growth, low interest rates and minimal inflation is an above-average context for financial market performance. For the last five years, investors who have taken prudent risk and had a long-term strategy have been rewarded with strong returns and modest volatility. Unless we are nearing the end of our Groundhog Day story, operating with an unusually low-risk budget could be a big mistake.
> High-quality bonds are currently revered for their safety and reviled for their duration risk (the risk of a mark-to-market decline that would occur if similar new bonds were issued with higher coupons). Ironically, in a Groundhog Day world, neither of these points is central to the bond buy/sell decision. Highly rated bonds should provide their contractual returns, with limited price volatility and negligible default risk.
> While the point above may sound like a ringing endorsement for bonds if it is always going to be February 2, that is not the case. Owning a portfolio full of financial instruments that meet your expectations isn’t optimal if those expectations are low, or if you are missing out on other securities that would fit well within your risk budget and could perform substantially better. Many securities in today’s financial market, including common stocks, convertibles, master limited partnerships and the like, have yields similar to those of investment-grade bonds. If we stay in a favorable, lower risk environment, consideration of bond alternatives that have similar current income but potential for growth of income or capital will be critical to investment success.
> The world is a big place, and there will be financial instruments everywhere that deserve consideration. That being said, Groundhog Day is a uniquely American holiday. In today’s environment, our country is more insulated from geopolitical risk and better suited for business innovation and free commerce than any other large country. If you look at the common stocks of well-known U.S. companies in early 2010, after a significant recovery rally coming out of recession, and compare the prices then to the prices and dividend yields today, remorse may set in. If you’re thinking, “Darn! Why didn’t I buy some of those back then?” you may want to avoid similar regrets that might occur if the world looks largely the same a few years from now as it does today.
Getting back to Groundhog Day: In the movie, the lead character was initially despondent that time had stopped moving forward. He took actions that were at first silly, then very foolish. Later, when the world still didn’t change, he realized he could capitalize on the predictability of the environment for the benefit of himself and everyone around him. Eventually, this led to a very happy ending.
For today’s investor, there may be a degree of surprise or even frustration that the recent market environment has persisted. Bonds yield very little by historic standards, but to the chagrin of the bears, they are not plummeting in price. Stocks have moved much higher, but many solid companies pay safe dividends at higher rates than Treasury bond yields. Despite good performance, the volatility associated with these stocks has been moderate if not low. New income securities proliferate and perform well, despite being unfamiliar to many retail investors. We read about the gridlock and animosity within our federal government daily, yet the U.S. annual budget deficit is declining, interest rates are stable at low levels, and the dollar has been slowly strengthening.
Here are some strategies that have worked in the “Groundhog Day” markets of 2010 to 2014:
> Take a long-term view.
> Use your full, appropriate risk budget. Conservatism is a valid investment philosophy; fear is not.
> Pursue a realistic income goal with more than bonds. Common stocks and a variety of other corporate securities may yield as much as reputable bonds with greater return potential over time. The volatility of these bond alternatives has been very manageable.
> Take advantage of the best investment opportunities in your own backyard before you start thinking about attractive potential tax credits on Australian dividends, or how Eurobonds work. The new house, college education or good retirement you are saving for is probably priced in U.S. dollars. Someday, conditions may be different, but the checklist of what’s better for investors in the United States is currently a long one.
If change in the investing environment continues at its current, tortoise-like pace, strategies that were effective in the last few years deserve very serious consideration looking forward.
Happy Groundhog Day!
The views expressed are as of 1/5/15, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
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