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ACM Journal - Investment Management
13 Jan

Low Investment Returns Could Persist – Q4 2022 Newsletter

The S&P 500 had its worst year since 2008 and bonds just wrapped up their worst year ever. However, inflation seems to have rolled over and employment remains robust. Has the market bottomed? Is the Fed going to pivot shortly? Are better days ahead for investors? Perhaps. But for truly long-term investors, it probably doesn’t matter.

There are still head winds (deglobalization, demographics, a staggering level of sovereign debt, a likely secular rise in interest rates, the potential for a second spike in inflation, and even war) for both stock and bond market performance as we look further out toward the horizon, and these are not issues that will be resolved quickly. The end result is that investment returns will likely continue to be quite a bit lower than what we have come to enjoy historically. How low? A lost decade for the 60% stock/40% bond portfolio cannot be ruled out.

There are many factors that impact stock and bond market returns, but perhaps the two most important are corporate earnings and interest rates. Unfortunately, both point to a challenging future.

Interest Rates

Interest rates have likely entered a new long-term cycle. The graph below is from veteran technical analyst Louise Yamada. Interest rates have historically trended in 25 to 40-year cycles, and the spike down during the COVID shutdown was probably the endpoint of the last 40-year cycle. Rising rates, even if that rise is not linear, will impact both stock and bond returns perhaps for the next several decades.

Rising interest rates, by definition, mean declining bond prices. However, rising rates also impact stock valuations. At the core, it becomes more expensive for businesses to borrow money to fund operations and growth. That means fewer initiatives will be undertaken and growth will slow. But rising rates also impact what investors will pay for stocks even if growth is constant. Risky investments, such as stocks, are less attractive if satisfactory returns can be earned from higher yields on safer assets.

Corporate Earnings

The other major headwind comes from corporate earnings growth that likely won’t be as robust as in the past. Everyone is aware that technology stock growth is slowing down, and that sector has been a big driver of shorter-term earnings, but that is not the real problem. In fact, sector exposure may not matter over the long term. That is the finding of a study called The Level and Persistence of Growth Rates from 2001. The authors found that from 1951 to 1997 the median earnings growth rate was very close to GDP growth irrespective of industry exposure. Verdad Research recently extended the study to 2021 using the same methodology and found similar results.

If GDP is the primary driver of corporate earnings, the future may not be so bright. Economists Carmen Reinhart and Kenneth Rogoff found that when the national debt to GDP ratio for a country rises above 90%, economic growth slows. Data from World Economics shows debt to GDP of 119% in the U.S. and 240% in Japan. Many developed economies around the world are near or above the 90% threshold. Fiscal policy in a lot of the developed world is still very expansionary, meaning that debt levels will likely rise even further.
Common sense dictates that there are consequences to too much debt. An individual can only consume so much on credit before that consumption must slow down and the debt must be repaid. Ray Dalio, the founder of Bridgewater Associates, points out a similar dynamic at the macroeconomic level in his books, emails, and videos. He notes that deleveraging periods historically have been painful, such as in the U.S. during the Great Depression; England in the 1950s; Japan in the 1990s; and Spain, Italy, and Greece in the 2010s. All were periods when economic growth declined substantially. Periods of deleveraging almost by definition result in cost cuts, austerity, and slowed growth, weighing on the ability of corporate profits to expand.

Stock Market Valuation

To make matters worse, stock market valuations are still at fairly lofty levels when viewed historically, despite last year’s market drop. That means further losses cannot be ruled out.

There isn’t much that we as investors can do to change these dynamics. You can’t change the cards you’re dealt, but you can change how you play the game.

While no strategy works in every market environment, and we had our challenges during the latter phase of the
most recent bull market, we believe our portfolios are well equipped to weather what could be another bout of market turmoil.

Factor Investing

A study by Dutch asset manager Robeco found that factor exposures tend to outperform the overall stock market during periods when the market is weak (see table below). The table below, based on Robeco’s study, shows that a diversified factor portfolio performed particularly well during the 1970s and 2000s when overall stock market returns were anemic. Our factor-based investments have held up quite well over the past year, and history suggests they could outperform the stock market in the years to come.

Alternative Assets

Diversification is the other approach that we expect to help if stocks and bonds continue to disappoint. Certainly, we want to be diversified within our stock and bond portfolios, but we also want to diversify beyond stocks and bonds. Investing in “alternative investments” can be tricky since costs can be high, tax impact is often ignored, and lack of liquidity can be an issue. Nevertheless, there have been some very solid funds in the alternative space with repeatable methodologies that performed admirably last year. Funds using investments such as managed futures, private lending, private real Robecoestate, catastrophe bonds, and others have been quite defensive as stocks and bonds faltered.
Unfortunately, bear markets are a part of the investment experience. There is no way to avoid them and trying to sidestep them by timing the market has repeatedly been shown not to work. It is also expensive to sell out and pay capital gains taxes on many years of
built-up growth. The better approach is to build a portfolio that can weather downturns but still provide solid long-term returns. Using a mix of globally diversified, factor-based stock funds; low risk bonds; and truly diversified alternative investments, we expect that returns will be acceptable in the future, if not as strong as we’ve experienced since the last bear market.

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