Most Americans are familiar with “Black Friday,” the day after Thanksgiving that marks the beginning of the Christmas shopping season. Hoping to get a jump on holiday sales, many retailers drastically slash prices and offer extended hours, with stores opening in the wee hours of the morning. The opportunity for deep discounts, often for a variety of the most popular wares and sought-after gifts (not the typical clearance of last season’s leftovers), creates massive interest with bargain conscious shoppers lining up around the block. By the time doors open, shoppers overwhelm the store, its employees, and often each other. The first day of the shopping season sadly brings out little spirit of sharing. Pushing, shoving, fighting, and trampling are commonplace. Such is the effect of dramatically lower prices; they create an almost frenzy-like rush to buy.
The capital markets are very different from Best Buy. The investment business is one of the few businesses in which deep discounts drive away customers. Falling prices are met with a mass appetite to return, not buy, merchandise and get the heck out of the store. Such is the effect of dramatically lower prices in investments; they create an almost frenzy-like rush to sell. Some of the biggest “sales” in the investment world have occurred on another black day of the week, Black Monday, most famously in October 1929 and October 1987, with some admittedly smaller examples recently (such as August 8, 2011, after the U.S. debt downgrade). While certainly no Black Monday, the second quarter of 2013 was filled with relatively sharp drawdowns for just about every asset class outside of U.S. equities. In this issue, we’ll explore recent events across the asset allocation spectrum.
Recent “Pillar” Performance
Most long-time readers of this publication know Research Affiliates’ views on projected long-term inflation, economic growth, and capital market returns. The CliffsNotes version is that over the next couple of decades the “3-Ds”—deficits, debt, and demographics—will produce a very different backdrop than the one to which most of us are accustomed. The developed world will have to monetize its burgeoning and eventually unsustainable debt burden via reflation and financial repression. Further, economic growth is likely to disappoint because of demographics alone. Baby boomers, already at peak productivity, will begin to leave the workforce without a large roster of young adults—those ready to make rapid incremental productivity gains—available to replace them. Sadly, the two main pillars of portfolio construction over the past 30 years—mainstream stocks and mainstream bonds—now offer very little in the way of yield (and therefore future returns) to compensate for these risks.
For these reasons, we have suggested investors build a sizable “Third Pillar” of assets that diversify equity risk and can perform better in a reflationary regime. The size and scope of this Third Pillar hinges on multiple issues. How willing are investors to shift from traditional portfolio approaches (and incur the inevitable maverick risk that comes with such a decision)? How much do they believe in the thesis of lower economic growth and higher inflation over the long-term that we and others assert?1 The ultimate scope of such a Third Pillar is open for debate, but it’s fairly obvious most investors are woefully short on inflation protection and equity diversification. Look no further than the 401(k) marketplace. The second largest provider of target date funds, Vanguard, has its 2020 target maturity fund invest exactly 0% in Third Pillar assets and contains over 90% of its risk budget in stocks!
Since about 2010, we’ve been urging investors to remain alert to buying opportunities for building a more robust Third Pillar. When will this opportunity arise? These alternative markets become cheap when investors are more concerned about deflation than inflation (deleveraging and demographics are often used to argue that deflation is the main risk). Building an inflation hedge is far less expensive when people are not concerned about the risk of inflation than when inflation is already self-evident. These markets become cheap when there’s a “flight to safety,” out of the unfamiliar “Third Pillar” assets and into the familiar first and second pillars. What a wonderful opportunity!!
Table 1 outlines a sampling of asset classes with Third Pillar strategies highlighted in blue and an equally weighted blend labeled “Third Pillar” near the top of the table. Note how these categories provide some diversification benefits relative to equities (all have correlations below 0.8 to the S&P 500 Index) as well as a measure of inflation protection (all are more positively correlated to inflation than mainstream stocks and bonds). Nearly all Third Pillar assets suffered mightily in the second quarter of 2013. We can see these strategies declined by –4.7% for the quarter, worse than the bludgeoning that Second Pillar assets (mainstream investment grade bonds) received at the hand of rising rates.
For Third Pillar assets, these losses came after a lackluster first quarter. In some cases, the year-to-date returns have turned downright nasty, especially from a historical perspective. Through June 30, the year-to-date return of the JPM Emerging Market Plus Index was –9.4%. If this result holds for the year, it will be virtually the same calendar-year loss as the asset class experienced in the 2008 Global Financial Crisis! The year-to-date return for TIPS, as measured by the Barclays Global Inflation Linked US TIPS Index, stood at –7.4%, far and away the worst calendar year (again assuming the result holds through year-end) of performance since the index’s 1997 inception.
These and other losses seem all the more acute given the robust performance of mainstream equities in 2013. Through June, the S&P 500—riding a bull market driven by hope, hype, and Uncle Ben’s printing press—was up 13.8%, while an equally weighted portfolio of Third Pillar assets was down –3.7%, a whopping gap of 17.5 percentage points. We would have to go back 15 years to 1998 to find such a double-digit shortfall.
The catalyst for Third Pillar losses has been declining inflation expectations as measured by the so-called Break-Even Inflation rate—the difference between 10-year TIPS and 10-year Treasuries. The 10-year “BEI” fell by 50 bps during the second quarter of 2013. Over the past 15 years, we’ve seen six quarters where inflation expectations dropped by more than 40 bps. Figure 1 outlines the results of an equally weighted portfolio of Third Pillar assets and a more mainstream blend of 60% S&P 500 and 40% BarCap Aggregate Bond in these three-month stretches.
Coincidentally, these periods are synonymous with crisis events, where investor risk tolerances shift in very rapid order and liquidity becomes king. This isn’t surprising as declining inflation expectations are typically associated with a slowing economy where investors turn their attention to recessionary possibilities. So Third Pillar assets, with their natural inflationary bias, shouldn’t be expected to produce solid absolute returns. And indeed they underperform 60/40 by about 2% on average in these instances. The 60/40 portfolio is buoyed by its 40% allocation to bonds and their natural inclination to rally on falling inflation expectations.
What’s different this time? Well, we again witnessed underperformance of the Third Pillar trailing 60/40 by a bit over 5% in the second quarter of 2013. But this time equities are winners; so, even with bleak bond market returns, 60/40 ekes out a small gain. During these crisis periods, equities have averaged a –11.0% return—hardly surprising given the tendency of inflation expectations to drop during crisis and recession, both of which aren’t associated with robust corporate earnings and stock surges. But in the second quarter, the remarkably resilient U.S. stock market produced a gain of 2.9%, the first time in any of these periods where it outperformed mainstream fixed income. And Third Pillar assets finished last. This result is frustrating for those who want better downside protection with these diversifying assets, but history suggests that it’s not unusual. U.S. stock market strength is unusual, and is clearly—at least in part—a function of global money printing by the central banks.
There’s a silver lining for net savers over the long-term. If we can buy assets that protect against future inflation, would we rather do so when people fear deflation, not inflation, and when inflation hedges are newly cheap? Or should we wait until inflation is a self-evident risk, and inflation hedges are expensive? Clearly, we should be pleased to see inflation hedges hammered down in price, as they are today, so that we can build a deeper and stronger inflation protection for the future.
When the market punishes inflation-hedging Third Pillar assets, we often see those assets outperform mainstream markets in subsequent periods. Why? Falling prices means rising yields and rising yields mean higher forward returns. Figure 2 outlines the subsequent three-year returns from these periods for both the equally weighted Third Pillar and the 60/40 blend. We find on average an excess return of nearly 10% cumulatively in the three years following these crisis periods of declining inflation expectations. Historically, the modest shortfalls that accompany economic crisis don’t last and investors have been better off by sticking with these out-of-mainstream assets for the long haul. In other words, a 2% short-term average give-up isn’t bad if we tend to recoup 10% over reasonable subsequent spans.
Who among us doesn’t have a long investment horizon? For all but a scant few, liquid assets will be invested somewhere for the next 10-plus years. But, human nature conditions us to not plan long-term; on the African Veldt, we often had to focus on the next 10 seconds, never on the next 10 years. Today, those with liabilities of only a year or two out are rare (and should be in ultra-conservative portfolios). The IRA of a retiring 65-year old, actuarially speaking, has nearly 20 years before the last dollar is likely to be spent. So we’re all long-term investors and we have some profound advantages, best captured by Andrew Ang of Columbia University and Knut Kjaer of FSN Capital:
Long-horizon investors have an edge. They have the ability to reap risk premiums that are noisy in the short run and only manifest over the long run. They can acquire distressed assets when investors with over-stretched risk capacity have to sell.2
Warren Buffett once said, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”3 Many investors today don’t view emerging markets or TIPS as quality merchandise. We do. They’re not concerned with eventual debt-induced dollar debasement or the near inevitability of demographic headwinds on economic growth. With most other assets, we must be. So we advise the long-term focused to bring their shopping carts and begin to add inflation protection. There’s no need to rush—nobody’s banging down the door, despite the deals. Investors, cognizant that market tops and bottoms are near impossible to predict, can take their time and carefully look at the very best bargains in a near-empty store.
Assets that add diversification to equity-centric portfolios, especially those that protect against inflation, have had an awful run in 2013. Meanwhile, U.S. equities have been an unexpected outlier, blissfully marching ever higher despite profligate money printing, declining inflation expectations, and high valuations. Given that U.S. equities are the largest allocation of many investors and overwhelmingly their largest risk exposure, this unusual circumstance should be most welcome. But this good fortune shouldn’t be squandered. At a minimum, it’s a marvelous rebalancing opportunity. We assert that now is the time to act like a long-term investor and go beyond rebalancing, by beginning to stock our carts with amply discounted quality Third Pillar merchandise.
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1. Gross, William H. 2012. “The Great Escape: Delivering in a Delevering World,” PIMCO Investment Outlook (April).
2. Ang, Andrew, and Knut Kjaer. 2011. “Investing for the Long Run.” In A Decade of Challenges: A Collection of Essays on Pensions and Investments, Thomas Franzen, Ed., Andra AP-fonden, Second Swedish National Pension Fund-AP2:94–111.
3. Buffett, Warren. 2009. “Letter to Shareholders of Berkshire Hathaway,” (February 27).