The capital markets continued their road to recovery in the third quarter, albeit with some gut churning volatility. Investors who were able to withstand the quarter’s instability, were rewarded with decent growth in their portfolios. A gradual reopening of global economies and continued support from governments for the private sector, coupled with very accommodative monetary policy were all contributing factors to the market recovery. While the third quarter GDP numbers for the US have yet to be finalized, they will possibly be the largest quarterly growth in history. As we’ve mentioned in the past, markets discount the current environment, and trade off future expectations. The biggest mistake many investors make is bailing out of the markets during a crisis. This mistake has historically had a significant negative impact on one’s net worth.
Many of our clients have had similar queries over the past several months: our views on the upcoming US election, the impact of massive government debt, and how their portfolios are being positioned. We’ll take this quarterly update to provide our thoughts on these questions.
Historically, elections have not had long term impacts on stock markets. To shift long-term portfolio allocations because of potentially short-term market volatility is not warranted in our opinion. That’s not to say that one shouldn’t be prepared for some market volatility, as the odds are high that it will occur. There are certain variables that the markets have already started to price in, regardless which party wins the election. If the current administration is re-elected, the markets may negatively price in an even more aggressive approach to China. If Biden wins, the risk to corporate America through higher corporate taxes and increased regulations will also be viewed as a negative for the markets. While these are some of the issues the markets may concern themselves with, the biggest short-term risk is a disputed election result. If in fact the election is disputed, there’s a high probability it will carry on well past November 3rd.
Massive government debt is another concern our clients have and the potential negative impact. While fiscal spending has certainly been on a rampage over the past 6 months (for good reason), we don’t believe there’s any end in sight for at least the balance of 2020, or longer. There’s no appetite for fiscal austerity globally at the moment. In the U.S., both political parties are moving in a more populist direction, which usually leads to larger budget deficits. The UK government last week unveiled a fresh round of economic and fiscal measures. In France, the government announced a 100-billion-euro stimulus plan. European leaders are moving forward on a euro area-wide, 750-billion-euro stimulus package. China also continues to stimulate its economy. In Japan, the new Prime Minister Yoshihide Suga said that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The bottom line is that Canada and the rest of the world are awash in debt. The question is, how dangerous is this? While we are concerned about the potential long-term consequences of the accumulating global debt, the short-term impact will be fairly benign.
While overall debt burdens are certainly increasing in many countries, actual interest payments are declining as a percentage of GDP. As long as interest rates remain low, interest payments will not become a burden. The U.S. provides us with a great example. While total debt has grown considerably, net interest payments as a percentage of GDP have actually declined to a level not seen in six decades. The bottom line is that accumulating debt burdens are not an issue for the foreseeable future, as long as interest rates remain below GDP growth.
Given the potential market volatility that we may experience in the coming months, how are we currently positioning client portfolios? That question usually comes in the form of “are you decreasing equities, and adding to fixed income and cash” to lower portfolio risk in the advent markets do experience more volatility? To answer that question, we’ll digress somewhat and talk about TINA.
TINA is the acronym for “There is no Alternative”, which has been bandied about our industry for the last several years, and for good reason. “No alternatives” refers to the fact that outside of the stock market, investment options are rather underwhelming. In Canada, the yield to maturity on the broad Canadian bond Universe (which is heavily weighted towards government bonds) is currently yielding 1.3%, very similar to what the broad US bond market will provide. What does this mean? Well, if you hold that investment for the next 8 years or so, you’ll have made approximately 1.3% per annum. Not very inspiring. Want to get more from your fixed income investments? You’ll then have to invest in higher yielding (junk) bonds, which also comes with increased risk. So, for those seeking higher returns, it may be hard to argue with “TINA”.
The main reason that we at Kinsted underwent a major evolution of our investment platform was to provide our investors with direct exposure to asset classes beyond just stocks and bonds. This was due to the recognition of the following:
Once the shackles of operating within a constrained investment universe (i.e. stocks and bonds only) are removed, one recognizes that in fact there are multiple alternatives and TINA no longer applies.
So back to the question: “How are we positioning your portfolios in anticipation of market volatility during the upcoming election”? Over the past year, we’ve already made significant changes to client’s portfolios that will in most circumstances help their portfolios withstand the short-term volatility inherent in market moving events like the upcoming election. The reality is that outside of recently taking profits from equities and reallocating to real assets, private equity, private debt and market neutral strategies, we have not had to make significant short-term changes.
When investors think of portfolio volatility, they tend to equate it to the stock markets. The higher the exposure to stocks the more volatile their portfolio will be. The vast majority of Kinsted client portfolios have close to 50% less exposure to stocks today than they did this time last year. That in itself will drastically reduce portfolio volatility. The reduction in stock exposure was done for several reasons: expected returns for stocks over the next decade is mediocre, and there are other investible asset classes that offer significantly better risk adjusted profiles than stocks.
Last year, global equity return expectations for the next decade was between 5.5% and 6.5%. We believe that over the next quarter, we’ll be seeing these assumptions come down by probably 0.5%, or more. Investors must change their mindset around portfolio construction where growth can only come from publicly traded stocks. There are alternatives - the returns we are expecting from Kinsted investments in private equity, private debt, infrastructure, agriculture and other difficult to access investments exceed what broad equity market returns will provide, while also providing diversification benefits from an overall portfolio context (i.e. lower risk!).
If you think about what drives asset prices, you will come to appreciate having exposure to non-publicly traded assets. What does the U.S. election have to do with the value of the Abu Dhabi pipelines that provide natural gas to the rest or the UAE? What does the U.S. election have to do with the price of almonds or maple syrup? Should the U.S election have an impact on the value of a desalination plant in the Caribbean? If these private investments held by Kinsted were all publicly traded, they would behave like other publicly traded stocks in the midst of market volatility. By being institutionally managed by professionals with long-term outlooks and non-publicly traded, this reduces the volatility while still providing stable cash flows and long-term price appreciation.
Over the past year our clients have experienced the benefits of having exposure beyond stocks and bonds. We’ve certainly been tested by the market volatility due to COVID this year and have demonstrated exceptional risk-adjusted returns. We continue to research new investment opportunities on a daily basis for our clients which will only enhance what we already believe is the premier investment management platform in Canada.