Forstrong CEO says low bond yields have presented a critical portfolio dilemma for advisors – how to conserve wealth by taking more risk
WP has teamed up with Forstrong Global CEO and CIO Tyler Mordy for a weekly series highlighting and analysing seven macro super trends for 2021. In part one, he explained why a fiscal revolution is here, while, for Super Trend 2, he analysed the inflation landscape and its investment implications. Here, in part three, Mordy delves into the low bond yields and the subsequent 'income famine'.
The world has inescapably changed. Video conferencing is the norm, sport is happening without fans and live shots of Mars appear daily on my news feed. Within the world of investing, there has been an even more fundamental shift; we are in the midst of an income famine.
At a time when Boomers, the largest demographic cohort in history, are retired or nearing retirement, interest rates and bond yields are at their lowest point. It leaves these investors in an unenviable situation. Do they take on more portfolio risk, eat into capital or scale back their lifestyle? None of which are particularly palatable options for retirees.
Tyler Mordy, Forstrong Global CEO and CIO, told WP many are leaning back on “legacy investment management architecture”, or in layman’s terms: the way it’s always been done. Back test the 60-40 approach over the past 40 years – as interest rates and inflation have been declining - and the numbers look good.
But now that the 40% bond sleeve no longer offers a reasonable income stream, many are replacing that allocation with dividend-paying North American stocks.
Mordy said: “The issue is you've totally changed the nature of risk in your portfolio. You’ve gone from fixed income, which has lower volatility, to equities, which has higher volatility. Dividend-paying stocks are normally more defensive in market downturns but that doesn’t change the fact that they're still stocks, and they'll still get hit during bear markets.”
This taps into how the mindset of a typical Boomer in their sunset years has changed. When they were establishing themselves in the 80s and 90s, they looked to advisors to “make me rich”. In late 1981, 10-year U.S. treasuries were in the process of dropping from an all-time high of almost 16% and a bond bull market of unimaginable length was under way. Investors received outsized returns, and over time, an unintended consequence was a growing tendency to treat fixed-income investments as the set-it-and-forget-it portion of a portfolio.
As Boomers aged, expectations changed from “make me rich” to “keep me rich”. Surveys have shown that, for the first time in a very long time, investors now prioritize capital preservation over capital growth.
It’s an attitude likely to be compounded by growing longevity. For financial professionals, they will have to find a way to satisfy that conservatism by paradoxically taking on more risk, all while managing clients’ expectations.
What reinforced this trend, Mordy said, was 2020’s “hinge moment” in history. Aside from the social impact on health, travel and retail, the most obvious – and most telling – casualty of the COVID-19 pandemic has been the bond market. Initially, bonds did rally as COVID-19 made its way into the public consciousness. Yet by mid-March, bonds sold off along with stocks. Then, when equities tanked again in September and October, bonds promptly sold off again. In short, they did not perform as per their role in the portfolio.
“This is a crucial development,” he said. “Nearly all diversified portfolios run by pension funds and big institutional money are constructed on the assumption that bonds will provide refuge during crisis. Admittedly, this is a far easier proposition when bonds have positive real yields - often as high as 4% over the past four decades. It is a very different proposition when real yields are deeply negative as they are today.”
Most investors, he added, have no living memory of bonds underperforming during inclement environments. Yet there is precedent. During the 1960s and 1970s, U.S. bonds provided persistently horrific returns, earning the title “certificates of confiscation”.
One might argue that rising yields last year were an anomaly given the enormity of stimulus directed at resuscitating global economies. Or that rising yields this year are simply recognizing the growing prospect of a return to normal economic activity, courtesy of mass inoculation.
The OECD’s leading indicators are, indeed, forecasting full-throttled economic growth ahead, while the IMF also expects the strongest year of global growth since the early 1980s. This could even be too conservative if encouraging signs of vaccination programs continue.
“All fair points,” Mordy said. “But looking ahead, everything hinges on the nemesis of bonds: inflation. In the short run, U.S. core inflation is likely to exceed the 2% target in the March/April period due to the annual base effect. The issue is what happens after. The big surprise will be that inflation remains higher than the past decade.”
As we, therefore, peak out of a 40-year period of disinflation, losing investments will be those that have been bid up on the “lower forever” inflation thesis. This includes high-duration growth stocks, which thrive on low discount rates, and, of course, Western government bonds.
Faced with this income famine and with many portfolios reaching into more risky equity territory, what’s the solution? Forstrong takes a global view when assessing new possibilities for generating income. One area is emerging markets fixed income, along with other global yield sources. Unlike developed market policymakers who have employed extreme measures during the coronavirus crisis, the monetary and fiscal policy response of emerging Asian economies was quite small.
Mordy explained: “Already, the legacy of this pandemic is that Western countries have deeply negative real yields and bloated national balance sheets, while Emerging Asia offers positive real yields and attractive fiscal positions. What’s more, many EM countries have overwhelmingly favourable conditions for growth, with younger demographics, growing urbanization and burgeoning consumer economies.
“Emerging Asian debt offers very attractive yields with very positive risk characteristics for investors who understand the market.”
Currency management can also be an important weapon for investors when managing risk and return. The global currency market is the largest, most liquid in the world and among the most non-correlated and volatile since the Global Financial Crisis. Being currency inert – either hedged or unhedged – means missing opportunities in the EM market, as well as those related to the expected long-term secular downtrend of the U.S. dollar.
High yielding global dividend-paying stocks, meanwhile, offer a valuable hedge against inflation, while active management – and the skill that requires – should come to the fore as more investors venture outside their risk comfort zone.
Whether advisors choose traditional or non-traditional approaches, or some combination of each, Mordy believes the set-it-and-forget-it era of income generation is most definitely over. His firm believes the new way forward is to look further afield for income sources from around the world, and put these yield-oriented asset classes together in a diversified income approach.
He said: “Growing risks associated with heightened economic, geopolitical, social and environmental uncertainties will require investors to pay attention and be ready to act. Investors will have to be very selective about their exposures in a rapidly changing world. Managing fixed income passively off the corner of one’s desk may well become a dangerous strategy once rates begin to normalize.”
Change has arrived and while it’s safe to sit back and watch as the NASA rover roams the desolate Mars landscape, doing nothing to your “balanced portfolio” invites danger.