‘Six per cent is the new 8 per cent'

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‘Six per cent is the new 8 per cent'

We’ve moved light years beyond this conversation.

Now it is all about managing an increasingly multi-dimensional and much expanded opportunity set. And importantly, it is about acknowledging the new norm of lower return markets we face – the likely reality is that simple balanced investing in traditional asset classes is not going to deliver what it once might have for investors. 

Simply put, there is a growing body of evidence suggesting that the long-term trend for real and nominal growth will be below rates the world has experienced in recent decades.

And that is going to weigh on investment returns. We are investing in a world where effectively “6 per cent is the new 8 per cent”, meaning that investors are going to have to lower their return expectations. 

There are four drivers presenting structural challenges driving this trend to lower returns, namely demographics, deleveraging, divergence and directives.

Demographics: Across the developed world, the fall in working age populations is creating a major economic headwind. Globally, sluggish labour force growth and an ageing population are putting a speed limit on growth, implying lower nominal and real interest rates ahead. The relative bright spot is the US, where population growth remains positive, but only just.

Deleveraging: Post the great financial crisis, private sector debt burdens have shifted to the public sector. As a result, attention has been focused on the need to reduce debt-to-GDP levels, leading to fiscal austerity which has restrained growth. Meanwhile, although the financial sector has largely deleveraged, other segments have not and debt levels have risen above 200 per cent of GDP globally. 

Divergence: Differences in the direction of travel in monetary policy (i.e. the US Federal Reserve tightening with their counterparts such as the Bank of Japan easing) engenders fragility and dents confidence. For example, excessive policy divergence was, in part, a driver of tighter financial conditions early in 2016, which contributed to market turmoil. Market sentiment is now hypersensitive to policy tightening, creating a damaging feedback loop. 

Directives: This can function as a constraint on credit formation, holding back growth. In many ways, increased regulation following the financial crisis has been needed and welcome, but it has not come without economic implications. Thus far, the clearest consequences can be seen in the financial sector, where the impact has been slower lending and lower earnings for financials. 

These macro factors in combination have significant implications for policy rate normalisation and the degree to which it will (not) be accompanied by higher bond yields. The process of markets trying to work this out has already begun. What was a period of relatively easy post-crisis years for balanced investors, in which markets were virtually universally carried upwards by a sea of abundant liquidity from central banks, have given way to dicier conditions as investors start to reprice liquidity. 

A practical example can be found in the increasingly unreliable correlation between asset classes. As shown in the chart below, at various points, the conventionally and dependably negative stock/bond correlation has confounded historical norms and turned positive.  

In essence, investors cannot trust asset classes to behave. This batters the notion that a simple long-only, stock/bond balanced portfolio still constitutes true diversification and underscores the need for investors to reassess where their diversification is coming from and the stability of that source.  

Relying on long-only beta to deliver returns may not be enough. It will become increasingly necessary to tap into a mix of sophisticated strategies such as relative value, derivatives, and dynamic hedging strategies – to diversify away from less attractive traditional asset classes and to deliver positive returns across both up and down markets.

Broadly speaking, the same paradigm holds true in the increasingly fraught hunt for income. It is well known that in a yield-starved world, traditional sources of “risk-free” income have dried up. The pain is particularly acute for post-Brexit UK savers. They face a toxic cocktail of crumbling rates offered by banks and building societies combined with the likelihood of rising inflation from the weaker currency. That will cause stagnant returns. 

To avoid the dreaded savings erosion and beat inflation, investors need to exploit a wider band of income sources, but at the same time, not fall into the trap of blindly chasing yield with no regard to risk.

Multi-asset income strategies able to tap into globally diversified income streams can help maximise risk-adjusted returns. That may sound like a sales pitch, but it’s an important point if we step back to think about current market sentiment. We’re more than six years into a bull market in equities and 30 years into a bond bull market. Even acknowledging the post-crisis risk aversion, that’s had an impact on investor mentality. Many investors are thinking first about chasing yield and return, with less attention on the risk. Chances are riskier assets can continue to do well – we remain positive on them overall – but it’s not going to be smooth sailing. 

There’s another reason multi-asset income funds are particularly relevant to the low return world. They are increasingly being used to replace what was previously the “low risk” part of investor portfolios. What once would have been a traditional bond allocation today is nearly unfeasible. Bonds are incredibly expensive and provide little income – no surprise given the whole point of quantitative easing has been to push investors further out on the risk spectrum by making the returns of so-called “risk-free assets” de minimis. Higher-risk assets are the only game in town, so it makes sense that multi-asset income funds able to incorporate these opportunities while balancing the volatility inherent in higher-risk exposures are becoming more accepted as a portfolio foundation. 

The next 12 to18 months is going to be a challenging time for multi-asset investors – whether they are focused on total returns or on income – particularly as the efficacy of monetary policy is being called into question. As monetary policy is gradually forced to take a back seat to fiscal easing, investors should brace themselves for continued asset volatility. And they should be aware that relying on traditional balanced portfolios in tomorrow’s low return future simply isn’t going to cut it. 

Talib Sheikh is portfolio manager, Multi-Asset Solutions, at JP Morgan Asset Management