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Rough Seas or Callus Times!

Sept. 22, 2022, 3:16 p.m. |Portfolio Allocation |Intermediate

The next ten years will be rough seas for all savers, but the best strategies of the past are looking like they will produce a rotten journey therefore structural change in portfolio allocation may be the only way to avoid callous times.

Ship in storm

High inflation has always been a worry for savers, but it’s been 40 years since we have had to contend with inflation. Inflation has been stable at around 2% and has not risen above 4% in the past 30 years. Inflation below or above the U.S. target of 2% is good for savers.

When inflation is low savers benefit from real purchasing power. For example, if your portfolio returned 6% and inflation is low at 2%, your real purchasing power is 4%. However, where inflation is high, it currently is around 7%, and your portfolio returns 6%; the real return is -1% a year, leading to a severe reduction in your purchasing power. You still feel happy with a 6% return but the reason you buy something other than a low yield government bond is to have a higher return to preserve your purchasing power.

So, what is inflation, and what does it mean if we want to protect savings and preserve our purchasing power?

Inflation is the rise in the prices of the goods and services we use and the fall in the purchasing power of our money. Inflation begins with a period when the annual change in the headline consumer price index (CPI) rises to 5% or higher. It ends when the annual change falls below 50% of its trailing 24-month peak.

This chart from JP Morgan shows how dramatic the change in CPI has been this past year. In June of 2020, global inflation averaged 1.3%; it is now averaging 7%. Again, no debate; we are in an inflationary period.

Headline Inflation - Sep 2022

Inflation impacts our savings because inflation forces central banks to raise interest rates as they try to slow down the movement of money. Too much money means we chase prices higher on the goods and services we want. Central banks' increasing interest rates raise the cost of money and lower its speed.

How does this impact our savings? As interest rates rise, money costs more for companies we invest in and lowers their future earnings. Lower corporate profits lower the prices of stocks because it brings uncertainty about companies' prospects. Investors seeing these lower profits can panic, sell stocks, and cause a bear market. Higher interest rates also cause the value of our fixed income investments to fall as new money can take advantage of the higher yields. At the same time, rising rates slow down our spending, typically tipping the economy into a recession, and lowering corporate profits.

You may hear comments about inflation coming from the supply chain; supply chain issues are usually a good excuse for politicians to blame outside influences, but inflation is about too much money chasing too few goods. Politicians like to blame the supply chain since they are the ones that have likely created too much money in the system. It may have been for a good reason, but it is much easier to blame an outside issue. Regardless of who is to blame, central banks raise rates when they want to slow down the speed of money. 

Included is a link to an excellent paper written by Jack Carr in 1976. At the time, the Canadian government was citing supply chain issues as the primary cause of inflation and put in controls to limit wage increases, in general, to the 8 percent to 12 percent range and allow prices charged by firms to increase only when the firm's costs increase. 

It is hard to imagine such a world, but we may be faced with the government making these same decisions to tackle today’s inflation. This is an age-old problem, the article states, "The use of wage and price controls by the government to fight inflation is not a novel approach. The first recorded example of wage and price controls dates to 301 A.D. At that time, the Roman Emperor Diocletian put a price ceiling on over 900 commodities, 130 different grades of labour and on a large number of freight rates." These attempts to control the supply chain by governments did nothing to slow down inflation in the 70s and forced Paul Volker to increase interest rates in the 1980s.

https://www.fraserinstitute.org/sites/default/files/wage-and-price-controls.pdf

A period of higher inflation and higher inflation beliefs, like the one that arose in 1976 and currently in 2022, has important implications for saver's outcomes, especially if inflation is likely to stay high for years. 

For the last 30 years, a balanced portfolio of 60% stocks and 40% bonds has been a saver's delight. Not only was it easy to construct it became much cheaper with the growth of index investing and handily beat the pants off any other type of portfolio allocation. Unfortunately for savers, a period of inflation, especially stagflation where you have both high inflation and a recession, is excruciating for the 60/40 portfolio allocation. After 30 years as the winning portfolio allocation, it is probably safe to say most savers have a 60/40 portfolio allocation and are going into a period of stagflation with a portfolio allocation that could be abysmal to their wealth.

A picture is worth 1000 words and a chart from a recent paper by AQR Capital titled New Rules of Diversification highlights the expected return of a 60/40 portfolio allocation facing inflation, low growth, Fed hiking – or all three?

This graph shows the average return of a U.S. 60/40 portfolio since 1900. The average return has been 4% with periods of expected returns as high as 11% and 8%. The current expected return is 2.1%, a historic low, for a U.S. 60/40 portfolio and 2.2% for a Global 60/40 portfolio. If inflation persists at even a 5% level that means a -3% loss of purchasing power.

AQR 60/40 - Jun 2022

The paper also looks at impact of stagflation on the investment performance of traditional assets and liquid alternatives. This graph measures the vulnerability a portfolio allocation has to poor performance during a stagflation period from January 1972 – June 2022.

Stagflation - Sep 2022

The Global 60/40 portfolio allocation is highly vulnerable to poor outcomes for savers during any period of stagflation, but this current period could go down in history as one of the most painful for savers with a 60/40 portfolio allocation. Stocks are coming off one of the best bull markets in history and are not cheap by any means, and bonds have just finished their most outstanding bull market in history, a 40-year run. On September 30, 1981, the 10-Year U.S. Treasury note yielded a record high of 15.82%. Yields have continued to fall over the last four decades.

These two key challenges facing your savings during current stagflation, expensive stocks, and the most expensive bonds in history, may warrant taking action to change the tools you use to invest. Moving to different approaches with the money we need for our retirement savings should always be looked at with some skepticism, but with the prospect of stagflation looming upon us for the first time in 40 years, it is time to seek out significant changes.

How can we position our saving away from the possibility to provide pain for the next ten years and to move from pain to gain? Fortunately, savers have a solution. Over the last ten years Factor investing has established itself as a third pillar of investing, offering investors a complementary approach to traditional active management and newer passive index investing.

Factor investing favourably combines the best elements of these two approaches and chooses investments based on specific positive characteristics like a traditional active manager but also uses a rules-based approach like an index that eliminates the cost for a traditional portfolio manager.

Factor investing came from rigorously studied investment papers and work by academics that identified specific characteristics and quantifiable features of investments that can help improve portfolio outcomes, reduce volatility, and enhance diversification.

The arrival of advanced quantitative techniques that made these scientifically built portfolios available and has created an unprecedented growth of these strategies as the largest institutional investors quickly adopted them worldwide. Numerous ETF providers including the world's largest ETF providers are building scalable, systematic, rule-based portfolios based on factor strategies.

ETFs, primarily index-based and passive-based investments, are taking money away from traditional mutual fund managers in the U.S. and have now grown to 40%, over $4 trillion dollars of the money managed in equities in the U.S. in the last ten years.

ETFs have seen tremendous growth, but Factor ETFs have grown at an even more incredible pace in the U.S. ETF assets account for 4 trillion dollars, but 23% of that amount, over 1 trillion, is in Factor-based funds. In less than ten years, they have taken over a vast percentage of the assets used to grow the wealth of all investors and savers.

Factor investing has many advantages, but a recent paper pointed to three critical characteristics of the returns from these types of portfolio allocations:

  • Economic recessions or expansions do not impact a saver's average returns in a factor portfolio. The returns of a factor portfolio seem to be independent of economic impacts, which can significantly hurt both passive and actively managed funds. 
  • A saver's average returns in factor portfolios are practically the same during inflationary and non-inflationary times. 
  • The average returns a saver enjoys in factor portfolios are the same for optimistic and pessimistic states of the ISM Purchasing Index. 

Factor investments are not a hedge against inflation, but they provide returns that seem independent from the three major issues confronting all savers. If you are concerned about how a recession, inflation or corporate pessimism will impact your savings, then Factor investing should be a significant part of your portfolio allocation. 

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