Future Returns: Ex Nihilo or Bust?

February 4, 2015 8:46 pm Published by

By Wilfred Hahn, Chairman & co-CIO

Asset managers always stress-out on the question of future portfolio returns. Just where will these come from? In the early innings of 2015, this angst is more acute than ever. The year has started with a bang. Some of our balanced (yes … balanced) portfolio mandates are up over 10% in the month of January alone. Can it continue? Just what can policymakers do for an encore?

When global interest rates — both short- and long-term — are at the lowest levels in recorded history, it is a foregone conclusion that interest income will also be at the lowest level on record. If so, we may reasonably ask again just from where might future returns come from?

We start with an uncomfortable fact: Historically, periods of low interest rates have always led to low investment returns overall. If not from interest or dividends, returns must increasingly come from capital gains (ex. Currency effects). As it is, asset managers have been highly reliant upon capital gains in generating returns of late. The chart on this page shows the 5-year rolling share of capital gains as a percent total returns of a balanced U.S. portfolio (50% stocks, 50% equities). Clearly, it shows an extreme reliance upon capital gains of late.

Global Return Components: Income and Capital Gains —Rolling 5-year % annualized
Source: World Government Bond Index and MSCI Developed World Index in local currencies.

capital gains

As is said, one should not look a gift horse in the mouth. Realized returns of any kind are welcomed, not shunned. But back to our question: For how long can investment returns be dependent upon capital gains? Answer: Actually, there are two; one theoretical, and one practical reality.

First to the theoretical answer: There is no limit. It depends on human behavior and beliefs. For example, an investment mania (or even a coordinated collusion) can serve to keep marking up the prices of investment asset and will surely produce gains on paper. This — theoretically — could be done indefinitely

But, as is well known, neither financial models nor human behavior are bound by “theory.” For one, financial returns that are disproportionately dependent upon capital gains do not prove to be sustainable (according to the annals of financial history). Invariably, at some point the connections between the “real” and “financial” economies become unglued. Profits and underlying wages no longer show themselves to be the anchor of asset values.

As well, long periods of capital gains (especially so when paired with low volatility) ultimately give rise to giddiness and complacency. Then, speculative finance runs hot, thereby magnifying the consequences of any following instability or disruption. Ultimately, these imbalances contribute to a downside phase … one that is usually hair-raising with or without hair.

Therefore back to our question. When the interest rate on a 10-year German bond is 0.32%, 0.33% in Japan, 1.31% in the UK and only 1.70% in the U.S., just how could one reasonably expect to earn investment returns much greater than 1% or 2% over future years? In fact, surveys show that general return expectation amongst professional and private investors alike is around 8% annually. Is that reasonable today?

As it is, currently-negative real bond yields and near-zero nominal rates will barely cover financial service fees.
To hit those 8% return expectations, investors need to keep capital gains coming. But, will financial markets heed investor’s beck and call? Usually, markets tend not to do what investors may want or expect. And, to add some perspective here, it is a fact that historical returns of U.S. equities over the past century were split roughly 50%/50% between capital gains and dividend.

To then believe that capital gains will continue to drive returns, one must endorse the idea of ex nihilo — namely, something coming from nothing … or at least, from very little. Back in the Klondike Gold Rush eras and that of the California 49ers, the same implicit sentiment prevailed. There were dreamy and unfounded expectations of returns. As legend had it, wealth literally was to be found in fist-sized nuggets laying on the ground (as it is in financial markets again today metaphorically). The famous placard of the California Gold Rush of the mid 1800s read “California or bust.” Apropos to today — “ex nihilo or bust.”

But let’s not fall prey to old lore. It indeed is a different world today for a host of reasons. And, if so, just what other scenarios could one consider sustainable today? For the sake of mind-broadening perspectives, let’s consider some new ideas.
We pose four frames of view:

1. Anti-Matter of Financial World: As bizarre and woolly as are monetary policies at this point of history, we may have seen nothing yet. It indeed is a new era and everything is new; perhaps one that has only just begun. The Guardians of the Mammon Temple (central bankers) have engineered negative interest rates (both in real and nominal terms). Effectively, that means that inert investment capital (deposits) is being diminished by paying “anti-interest.”

Capital is therefore being depreciated relative to spending power. Returns on capital are being squeezed relative to labor. And, given that capital is held disproportionately by the elderly, this amounts to what may come to be known as the Great Intergenerational Financial Transfer (or GIFT). This is the new world of “anti-matter” interest — the mirror image of positive returns. And, this GIFT could keep giving for quite some time given the unprecedented nature of the of the world’s demographic shifts underway.

2. Perpetual Wealth Machine: As long as key long-term interest rate levels are above zero, then theoretically there are also nearly limitless gains to be had just holding bonds. No matter how low interest rates may already be in nominal terms, any further decline will generate a capital gain. In fact, the closer that interest rate levels approach the zero-bound, the greater the lever on capital gains.

As long as this process can be kept free of high volatility, then bond markets will continue to re-price to the upside. This in turn will boost the valuations of all income flow types, especially also equity market prices. In conclusion, this Perpetual Wealth Machine scenario can continue for a time longer … but only if tightly managed and free of high volatility. And, not to forget: U.S. rates are still quite high relative to the rest of the world. In the 10-year space, they are still 170 basis points above zero.

3. Deliberate Pied Piper Economics: The above two perspectives depended on causal technical arguments and suggested that these could yet (maybe) continue for some time. This next explanation stoops to conspiracy, hearsay and the possible manipulations attributed to certain elites. (We don’t know who they are, although we are sure they meet in “smoke-filled upper rooms.”) The problem is simple. Populations are aging and a bulge of “baby boomers” are entering retirement. Pension plans likely cannot deal with this burden. What to do? Inflate financial assets and create the illusion that real wealth is being created. It’s a matter of practical political economy. At all costs, policymakers playing by this rule book must always push the inevitable as far into the future as possible.

Now renown economist, Thomas Picketty, predicts that private capital will continue to increase relative to income. By his estimate, private capital will increase to 700% of income by the end of the century, up from a current 450%. Practically, what that means is that there will be lots of capital, but a shortage of income. The “Global Income Crisis”, a term we coined a decade ago, continues and has yet far to run. An aging population will be desperately chasing income. As such, the cost of retirement will continue to soar.

4. Retro View: As the saying goes, “everything old becomes new again.” As such this perspective looks to the past (and classical theory) for answers. What conclusions does history offer? Busts always follow manias. Unrealistic expectations and flawed beliefs eventually are uncloaked. What is unsustainable will prove itself to be something that cannot continue forever. Ergo, the Perpetual Motion Machine of financial gains eventually blows its head gasket. History therefore teaches strong odds on this fourth explanation.

Which of the above scenarios will it be … and for how long? It depends in part on the necessities of political economy and the desperation of investors (and, eventually, perhaps the “madness of crowds.”)

The conclusion is this: Scenarios #1, #2 and #3 outlined above still can play out some rope. “Anti-interest,” GIFT the Pied Piper and ex nihilo gains can continue. At the same time, it is becoming a white-knuckle ride and volatility should be expected to again increase. After all, perspective #4 skulks about. It eventually — and at any time — can invoke its natural economic laws.

There is much that is new and unprecedented at the current time. But that doesn’t mean that risk should be neglected. By many measures, risk appears overpriced. The problem, however, is that the only way to lower risk is to accept negative real interest income. Hardly anyone is willing to accept this price for lower risk.

As such, risk must be lowered in non-traditional ways … i.e. not necessarily by raising cash weightings. An emphasis on dividends and income remains the lowest risk strategy. Avoiding cyclical and growth risk is also key. As such, the Twilight Equity Cult has no reason to stop just yet. Companies with low dividend pay-out ratios and solid returns on capital continue to be incentivized to buy back shares.

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This post was written by mstockburn