During the last 30-40 year investment period, investors have been spoilt by an unusually favourable period for investments and asset prices. Following the high inflation and low growth period of the 1970s – when stocks and bonds did very poorly – inflation pressures finally subsided as did high interest rates. Furthermore, we had a massive period of peaceful prosperity and globalisation, enabling lower prices and greater economic efficiency. This created excellent conditions for most asset classes to flourish and with it growth orientated static Strategic Asset Allocation (SAA) portfolios and low-cost index funds.
Given inflation and interest rates gradually came down from very high levels over decades the entirety of the lived investing experience for nearly all investors is influenced by these very favourable conditions. Making money was easy. Because most current professional investment managers were merely young kids, or hadn’t even been born in the 1970s, they haven’t lived through investing in a macroeconomic or geopolitical climate like today. Unfortunately, most have also never bothered to learn, yet alone heed, the lessons of the past.
Today, many investors are extrapolating their experiences and still believe the world will be like the last 30-40 years by continuing to advocate for passive investing or “pretend active”, which has come to dominate the world of investing. If nothing else, it's cheap and easy. So, it must be good, right? The rationale used is that based on the last 30-40 years all you need to build a good portfolio is mostly equities with a smattering of bonds or property. The story is that equities always outperform and that asset prices always go up, and if they don’t bonds will protect the downside.
These investors are not only extrapolating but they seem to have totally ignored the fact that the world and markets have fundamentally changed. Unfortunately for investors following this low-cost static SAA approach will likely be problematic as we have already entered a period of challenged stock and bond prices, which could well last for years.
Brad Jones, Assistant Governor at the RBA said recently: “The great moderation is behind us. The global economy now appears more vulnerable to stagflationary supply shocks, including from the rewiring of globalisation, geopolitical and political economy tensions, and energy shocks from climate change (and related policies).”
In June 2023 the US Federal Reserve released a paper titled the End of an Era in which it says: “the decline in interest rates and corporate tax rates over the past three decades accounts for the majority of the period’s exceptional stock market performance. Lower interest expenses and corporate tax rates mechanically explain over 40 percent of the real growth in corporate profits from 1989 to 2019. In addition, the decline in risk-free rates alone accounts for all of the expansion in price-to-earnings multiples. I argue, however, that the boost to profits and valuations from ever-declining interest and corporate tax rates is unlikely to continue, indicating significantly lower profit growth and stock returns in the future.”
The different macro environment requires a different investment approach. The Future Fund, one of Australia’s best known and most respected investment managers says in their paper The Death of Traditional Portfolio Management: “War, deglobalisation, inflation, and rising interest rates have quickly coalesced in ways never seen before. These structural forces are challenging many of the assumptions underpinning the way investors have generated returns over the last three decades. Investors need to consider this risk and assess whether their traditionally constructed portfolios will successfully navigate this environment, as well as the other plausible paths that could eventuate. Refreshed portfolio planning and dynamic positioning are likely to supplant set and forget approaches.”
Blackrock – the world’s largest fund manager - says in its piece on New Regime, New Opportunities: “Higher macro volatility is translating into greater divergences in security performance relative to broader markets. That calls for much greater selectivity and more granular views.”
These all echo our thoughts first published in our article "Why Strategic Asset Allocation has a Bleak Outlook this Decade" from December 2022.
To overcome these challenges portfolio management needs to be more active, tilting asset allocation meaningfully to avoid pitfalls or take advantage of distortions, to seek better than base market returns, include alternatives such as hedge funds, private equity, commodities and precious metals.
At Dynamic Asset this approach is what we do best. Our mandates not only seek returns but to also protect capital during periods of market bubbles and extremes. To balance these mandate objectives, we dynamically change our portfolios to better suit the times. This active approach means at times our performance will be different to the mainstream and is slightly more expensive than the passive approaches, as there is more work involved, but we do the work because we believe it is absolutely necessary to best serve our investors’ interests.
We share below a quick summary of why we think investment conditions have changed and why we believe taking a more active and diversified approach will reward investors:
- Inflation has come off the extreme lows and is likely to remain a persistent problem. Indeed, we believe higher and more volatile inflation is set to remain with us not just for months, but for the rest of this decade due to important changes in the world economy. This means that building a portfolio which mainly benefits from lower inflation and interest rates like has been done in decades past is a very naïve if not foolish way to invest. Instead, we need to include assets which help protect against inflation. We need to think about commodities and other alternatives in addition to bonds and equities. If we are to be protected against higher energy prices, we need to include energy assets (such as uranium, which is massively undersupplied) in a portfolio.
- Equity valuations are higher. The starting point matters. In his most recent article "When the Bough Breaks" John Hussman says: “Over the coming decade, from current valuations, we expect the total return of the S&P 500 to lag Treasury Bond returns by about -6.5% annually”. US equities trade on 20 times earnings and offer no (equity risk) premium to bonds. Bonds have lost money for nearly 3 years, and yet still appear simply fair value at best for current inflation levels. For these reasons we have said for years now that gold is a better asset than bonds, and not only has this proven to be the case but it is likely to continue to remain the case. So not only do we need to have energy commodities in a portfolio, but we also need precious metals. Furthermore, we need the amounts of these assets in a portfolio to be meaningful to protect us against the risks of continuing failure of both bonds and stocks. Simply put, simply having bonds and stocks won’t do.
- Geopolitical risk is here – and extreme. We have consistently highlighted the risks in the current social, country and political setup we find ourselves in today. Russia may be a small economy globally but geopolitically it is a powerhouse and highly impactful. We hope it hasn’t, but a world war could have already started in the Middle East. Our concern is that conflict will not only continue but could get worse in the coming years. And this means that building a portfolio simply for peaceful times doesn’t work anymore. Again, we need precious metals, again we need commodities, and again we need alternatives that don’t rely on markets going up to make money.
At Dynamic Asset we’re not assuming that asset prices can continue to grow to the sky and ignore the world around them, and neither should you. Although some will argue its risky to be different from the consensus and mainstream, we suggest that never before has it be so risky to be with the crowd. We need to be humble in a world like today and build a portfolio with different assets to traditional portfolios to protect against known and unknown risks, not a portfolio that relies upon glory days continuing when they have so obviously already disappeared. It is not only desirable, but it is absolutely necessary to actively manage the risks of a massively changing and more adverse world. And that is what we do.
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