There are really two things which need to be in place for any investment: price and value. Price is what you pay, and value is what you get. Sounds simple, yet it is so complicated when we are in the world of future returns for investors. When trying to create a portfolio, most managers look up historic performance and then correct their future expectations into this average.
Let’s start with the chart alongside this article, from the CFA Institute, which has averaged out the long-term forecasts of JPMorgan, Northern Trust and BNY Mellon.
The expected return then needs to be adjusted. For example, US inflation is nowhere close to the 2 to 5 per cent range which will lower nominal return. Furthermore, two additional changes need to be made: The outperformance in the past seven years under low interest rates – in real buying terms borrowed money has been almost costless – needs to mean-revert to its long-term mean and growth top-line is also lower than norm. Doing all these corrections, Boston-based GMO, one of the world’s largest fund managers, have produced forecasts for their returns for the next seven years – clearly the fat seven years seems to have been replaced with seven lean years.
If GMO is right, the traditional portfolio is under attack – whether it’s equal weighting for stocks and bonds or a 70 per cent weighting for stocks and 30 per cent for bonds, the expected return is pretty much zero. However what few people seem to realise is that over time the next return is correlated more to the “illiquidity” premium of the asset than any other determining factor. This means the less liquid the product trades the higher the expected return – hence treasury bills have zero risks and zero returns. Now government bonds have zero risks and zero returns as well, which means you need to access less liquid markets so as to achieve returns higher than zero over the medium term.
Here, the emerging-markets fourth-quarter theme of Saxo Bank, where I am the chief economist, plays in. Emerging markets is the only asset class in stocks where both price and value are deeply cheap. A study by Kyle Caldwell of the Daily Telegraph found the cheapest nine markets to be: China, Russia, Pakistan, Turkey, Hong Kong, Greece, Poland, Spain and Japan – all markets that we agree offer unique price and value. The reason for our newfound optimism is kind of “negative”; the failure of the US Federal Reserve to start a normalisation cycle will create another leg of pretend-and-extend, which means doing nothing for longer. But it most importantly also delays any potential Fed hike into the second quarter or third quarter of next year, hence creating a cheaper US dollar and time to pass.
Emerging markets are “hated” by most managers because of China and Asia overall: big built-in debt (China’s debt quadrupled from US$7 trillion in 2007 to $28 trillion by the middle of last year, according to the McKinsey Global Institute) and lack of exports combined with low energy prices. But Asia and emerging markets are now priced to imperfection, failure even, and with a monetary policy of stimulus from the European Central Bank and the Bank of Japan, plus a hesitant Federal Reserve, will create carry trades. And here not only the above markets, but also emerging markets overall comes to mind. To short emerging markets is very expensive – the 12-month yield is +233 basis points in iShares MSCI Emerging Markets, a big exchange-traded fund (ETF). ETFs are passively managed investment funds traded publicly on stock exchanges in the same manner as traditional stocks.
How do we combine all of the above: price, value, future expectations and economic outlook?
I believe the rest of this year is fair sailing but that by the first quarter next year, the non-change, lack of reform and no mandate for change will have Europe but also the United States close to recession, which means lower overall interest rates levels. This, combined with stubborn inflation expectations and expected returns profile, creates my choice of portfolio: Thirty per cent in gold, silver exchange-traded funds (tickers: GLD, SLV), 15 per cent in broad emerging markets (ticker: EEM), 10 per cent in Japan (Fidelity funds), 35 per cent in US bonds with maturity tenor of between seven and 10 years. (ticker: IEF) and 10 per cent in emerging markets bonds (ticker: EMB).
My choice of portfolio is overweight on metals due to lower real interest rates, and the stabilising of the US dollar and commodities. My investments in emerging markets are due to carry trades and also because they are cheap or of good value. Meanwhile, Japan-Fidelity is a play on the initial public offering of Japan’s postal system, which I believe will change the landscape and allocation to stocks in Japan. The IEF bonds I expect to be lower for longer due to the actions of the major global central banks. Finally, my investment in the iShares JPMorgan Emerging Markets Bond fund is because I expect countries will see less pressure from inflation as the currency stabilises.
This is my portfolio for the year end and past the new year. When things have normalised in emerging markets and Japan, I will rotate to neutral.
Steen Jakobsen is the chief economist of Saxo Bank.
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