The six months of 2021 have delivered some decent returns to investors, not least due to double digit returns from global equities, small positive returns on high yield bonds and some alternative investments. Meanwhile, big chunks of the global bond markets have delivered no returns – or small losses.
The bottom line going into the second half of 2021 is that the valuation of most asset classes remains extremely expensive, implying very poor longer term return outlooks.
Nominal bond yields are at a record low and real interest rates are negative in most developed countries and have not been lower since the inflation surprises of the 1970s. Buy inflation linked bonds today and you are guaranteed negative real returns in several developed fixed income markets for the next 5-10 years.
The outlook for most corporate bonds is just as poor, with yields and yield spreads at record lows despite weaker credit scores than a few years ago. As an example, yield to worst, which is lowest possible yield from a bond that doesn't default, for European investment grade and speculative grade bonds are as low as 0.25 percent and 2 percent according to S&P.
Only EM bonds are capable of delivering positive real yields, as several central banks within the investment universe have started tightening their monetary policies.
Public and private equities and other parts of the alternative investment universe are also very pricy based on different metrics as forward price/earning, the cyclically adjusted-Shiller P/E or EV/Ebitda.
So, where to invest and gain some further returns for investors? What should be done, not least with Nordic and European fixed income instruments delivering zero to negative returns after costs, both in nominal and real terms?
Will funds be closed? Will more portfolios for especially low risk and/or shorter time horizon clients be closed or stopped being recommended? Will the allocation to alternative investments be lifted further? Will more speculative, illiquid, leveraged investments become more popular? How much will investors lift their risk budgets in their search for returns?
And what about product costs, both passive and actively managed? Will they be cut further in coming years as returns sour?
And how about foundations? How much will their payout opportunities be hurt if yearly returns dwindles to a third of historic returns as expected by finance professors Dimson, Staunton and Marsh? Or even lower in a period?
The beginning of the end of financial repression?
To be brutally honest – the corona crisis has been a huge gift for the asset management business. USD 10trn dollars in central bank money printing and quantitative easing in 16 months has lifted global asset prices to new highs.
Combined with a huge spike in household savings rates and zero to negative interest rates on cash in pension and deposit savings it has triggered a huge inflow of retail money with great asset management margins.
This is a continuation of a decade of financial repression, just on steroids and much bigger than anything I've ever seen before. However, the dark side of easy money is getting clearer by the day. Housing bubbles and unaffordable housing, enormous wealth transfers, rising inequality, leveraged companies, a global debt tsunami and zombie firms are just some of the worst problems.
Day by day, more central bank governors and economists and academics are switching sides and starting to advocate for tightening of the most expansionary monetary policy ever seen in the history of financial markets. So far, the people at the helm of the biggest and most influential central banks have resisted significantly change their view , but as the cost of easy money increases by the day, things are changing rapidly, and a change of course seems more and more likely in coming months.
Several emerging markets have started to tighten their monetary policy and pressure is mounting on developed markets, not least the Federal Reserve in the US, to start cutting down their enormous stimulus packages. The argument for the monthly purchasing of USD 40bn in mortgage bonds while house prices are rising exponentially to record highs seems hard to defend.
So, how will the asset management industry perform if the monetary policy begins to slow and returns flatten out or start to fall as soon as the second half of this year?
Could much lower returns re-awaken the interest for active investment management and fund managers and slow the surge in passive investing? Will more investors look out for tactical asset allocation and absolute return solutions?
How to deal with inflation?
The last decade since the Great Financial Crisis has seen lots of asset inflation but very little genuine consumer price inflation. However, changes have emerged this spring with inflation rates jumping from 0-1½ percent to 3-5 percent in several countries including the US, UK and Germany.
The jury is still out on whether the jump in inflation will be transitory, i.e. only persisting for 3-9 months (the definition of transitory by some central bank executives), or more permanent, with rising commodity prices and supply chain chocks feeding into producer prices, then consumer prices and finally higher wage demands.
The risk this is not just something transitory is increasing. But has the world really become more inflationary, or is the backdrop still deflationary, due to the extreme amount of debt in the global economy?
This creates several challenges for asset managers.
Firstly, how to strike the right balance between hedging the risk of inflation and the risk of deflation given that most assets performing in a deflationary scenario – long duration assets - are extremely expensive and would deliver very mediocre returns if inflation strikes.
Secondly, they need to ask what assets really provide inflation protection in a portfolio context and how expensive they are. Inflation linkers by nature will offer protection, but they are extremely expensive and deliver negative real returns by certainty.
Commodities and commodity-related equities and corporate bonds could help, and some alternatives like ILS or property and infrastructure investments offer built in inflation protection. But how about your equity portfolio, how much should you divest out of expensive growth and quality stocks like big tech? Is the reversal in the decade long downtrend in value vs. growth stocks sustainable?
Thirdly, managers need to consider how to deal with rising correlations. If we enter a more inflationary period, correlations between stocks and bonds will rise significantly. We have seen this dramatic effect already in recent months and it means portfolio risks and max losses will rise. There's a dramatic double whammy effect if returns fall at the same time.
Will investors increase their risk budgets, or will they lower their expected returns significantly? In the latter case we’re back to the issues raised above.
Consistency in ESG and sustainable investments
Finally, there’s the problem of how to deal with ESG and sustainable investments in a consistent manner. A lot has been written about lack of consistency in ESG ratings,but other issues have risen to the forefront during the first half of this year.
Will investments in black and carbon intensive companies like big oil be the new green? If anything goes in investments, how can ESG-conscious investors feel certain about their sustainable investments?
Is it ok and consistent to exclude certain companies in the equity portfolio, but invest in the same companies in the fixed income portfolio?
How come trillions of dollars are pouring into ESG and sustainable investments and yet less than 20 percent of global listed companies are aligned with the Paris agreement? How will you deal with that as an investor ahead of the COP26 in Glasgow this fall?
Is it time to boost investments in carbon credits as an investor?
How come producers of coal, oil, weapons and tobacco are seen as bad guys and excluded, while producers of unhealthy foods and soft drinks or addictive tech are not? Why are carbon emissions and lung cancer worse offenses than obesity, the surveillance society, screen addicted children and teenagers and propagation of fake news and extremes on social media?
And finally, if Brazilian government bonds are excluded from your portfolio due to the Bolsonaro-governments deforestation of the Amazonas, what about Swiss government bonds, now that the population of Switzerland have voted no to an important climate law? Who should decide what is ok and what is not – and how should they do this?
How about crypto currencies?
A big issue for investors is crypto currencies. Let me end this column on a brief note saying that I have no strong views how to deal with them as investments. I can't get my head 100 percent around the subject and my feeling is many other investors feel the same way.
99.9 percent of me thinks that what we're witnessing is a big ponzi scheme and investment bubble like tulip mania and the IT-bubble and other manias and that billions of dollars will go up in smoke in the end.
However, there's this little feeling that maybe something bigger is going on that will prevail. Maybe not bitcoin, but something else about decentralized finance that will prevail after authorities have entered the arena to regain control of credit creation and cleaned up some of the mess.
To be continued.