Since 1988, such shortfalls for diversification have largely been associated with crisis periods where massive uncertainty forces investors to first sell alternative markets, where perhaps risk is least understood. Parenthetically, there’s probably some “maverick risk” contributing as well—large losses in emerging market local currency bonds draw far more scrutiny than similar declines incurred in the S&P 500! As Figure 1 shows, the September loss for the 16-asset portfolio was exceeded only in key months during four noteworthy periods—the Global Financial Crisis of 2008, the 1998 Long-Term Capital/Russian Default, the 1990 Invasion of Kuwait, and the September 2001 terrorist attacks. Interestingly, these previous crisis periods all subsequently witnessed superior results—an average of 2.7% per annum over the 60/40 portfolio—in the three years post crisis, as shown in Figure 2.
Of course, every crisis is different. So what is driving the seeming failure of diversification this time? Revisiting Table 1, it is clear that the markets wholeheartedly abandoned the idea of inflation protection during the third quarter. Of the 12 asset classes that have historically been positively correlated with inflation, only TIPS (Treasury Inflation-Protected Securities) produced a positive return for the latest quarter, and that was more due to across the board bond yield compression overriding the negative impact from its inflation protection. The remaining 11 all posted losses—averaging 12%!2
Is Inflation Really a Non-Issue?
Unlike “the market,” we believe inflation will be a factor in the next decade or two because of the game-changing effects of deficits, debts, and demographics. Combined these three “Ds” could produce hurricane force headwinds to developed world growth and tailwinds to bursts of rising prices as debt levels are manipulated down to more manageable levels. Over the past two years, we have encouraged investors to place a greater emphasis on real return asset classes and the emerging markets (where our 3-D headwind is a relative tailwind). We also advocate using an expanded inflation-protection asset class toolkit and tactical management to produce substantive real returns in such an environment.3 Key tools in the toolkit: traditional real return asset classes (TIPS, commodities, and REITs) and what we have labeled “stealth inflation fighters” such as bank loans, emerging market local currency debt, high yield bonds, and convertibles—the same assets that were brutalized in the third quarter!
We have oft referred to a portfolio of these assets as the “third pillar” to be added to the mainstays of traditional stocks and bonds. Scaling the allocation of this third pillar is dependent on one’s view of the probability and magnitude of the 3-D storm. We obviously are strong believers and assert the third pillar should be the core—the largest and most central part of one’s portfolio mix.
But if these inflation-protection assets were savaged, then we must really be looking at a rapidly deflating price level, right? Wrong! Inflation is 3.9% and core inflation—inflation net of the basic things that dominate the spending of working families—is 2%. Compounding matters, inflation is calculated in a way that produces figures 2–4% lower than in the past. So, 3.9% inflation probably means 6–8%, using the old fashioned method. The difference? The old fashioned method simply asks how much prices are rising or falling. The new method asks how much quality-adjusted prices have risen or fallen. If an anti-lock braking system for a car was a $2,000 option, but it’s now standard equipment, and the car costs $1,000 more, then the car is presumed to be $1,000 cheaper. If a $1,000 computer has doubled in speed or capacity, it is presumed to have fallen 50% in price. This calculation provides little comfort to those squeezed by rising prices for basic necessities.4
Worse, the near-term direction for inflation is up, not down. The one-year inflation rate is a function of the difference between the new month’s data (coming in) and the year-old month’s data (going out). Rates for those soon-to-be-dropped months are 0.0–0.2%. That means year-end inflation will assuredly be above 4% and may even reach 5%… using the new method that systematically reduces our reported rates of inflation. Federal Reserve Chairman Ben S. Bernanke dismisses the one-year inflation rate as a temporary spike, because core inflation and three-year inflation rates are “well grounded.” Based on the year-ago months that are about to be dropped, one-year core inflation is likely to finish the year at about 3%. And, based on the three-year-ago deflationary months from 2008 that are about to be dropped, the three-year annualized inflation rate is likely to soar from 1.1% at mid-year to around 3% at year-end.
If we finish 2011 with 3% core inflation, 4–5% total inflation, and 3% three-year total inflation, the Fed’s ammunition will be tapped out. If the Fed runs the printing presses in the face of 6–10% true inflation, we are flirting with hyperinflation.
So, contrary to the prevailing current view, we are strongly inclined to believe the big issue for most investors over their relevant investment time horizon will be the wealth-eroding effect of inflation.5 As a result, the first and primary focus should be to locate and invest in asset classes that over a full market cycle (and beyond) are likely to generate superior real returns. Can some of these recently battered asset classes that meet this definition fall further? Of course. But averaging into the riskier markets, when recent markets have brought them to reasonable valuations, and accepting some downside risk if you’re early, is essential to successful asset allocation.
The First Steps to Building the Shelter
If we take the long view and focus on asset classes that are likely to excel over a 3-D dominated secular period, the recent sell-off is slowly beginning to create opportunities for establishing a meaningful third pillar within our portfolios. It’s not yet a clearance sale, but bargain-starved asset allocators are finally being offered the chance to buy some asset classes at below retail prices. Let’s review some that are currently interesting (based upon data as of September 30, 2011).
- Emerging Markets Debt sports attractive nominal yields of 6.7% (as measured by the JPM GBI-EM Global Diversified Index), a pretty attractive rate given their substantially higher capacity to service that debt.6 Emerging markets have 38% of world GDP, 81% of global population, 65% of its landmass, and 45% of worldwide energy consumption but only 11% of the debt.7
- Investment Grade Credit offers yields of 3.2% on the intermediate part of the curve (as measured by the Barclays Capital Intermediate U.S. Corporate Index), a spread of 2.2% above Treasuries, making it a far better low-risk option.
- Emerging Markets Equities have had higher dividend yields than today’s 3.2%8 only twice—during the Long Term Capital Management episode and the Global Financial Crisis. If we add in the historical excess return from the Fundamental Index ® strategy and a slight premium for earnings growth above the developed world, we can arrive at an expected long-term real return over 8%.
- High Yield Bond spreads are the cheapest since 1986. Nominal yields are 9.5%, which allows for decent forward-looking returns even after netting out a sizeable default risk.
For an asset allocator, the sweet spot is a combination of cheap assets and an improving economic backdrop. Today, we have cheaper assets and a deteriorating macro picture. Thus, the prudent course is to add incrementally to these exposures.
If you are buying some assets, you have to be selling others. The obvious sell candidate in a long-term inflationary environment would be developed world sovereign debt. See Figure 3, which plots the starting nominal yield of the Ibbotson Intermediate Government Bond Index (essentially a five-year Treasury) and its subsequent five-year real return. When starting government bond yields are below 1% (as they are today), subsequent five-year real returns are substantially negative—by an average of 5%! After incorporating our long-term 3-D forecast, buying and holding Treasuries is the equivalent of an islander sitting in his hut and never looking out the window for the duration of the hurricane season!