Carl Otto, co-founder and chairman of Cordiant Capital Inc., passed away on April 19, 2012. The following is his final article, which appeared in Perspectives – a newsletter that he issued regularly. He began his final Perspectives in the hospital and his colleagues put the finishing touches on it when he was unable to continue. Past issues of Perspectives can be found online at cordiantcap.com.
Investors have, by and large, structured their portfolios around one simple belief: in the long-run, equities will always produce higher returns than safer assets. Fixed income assets round out a portfolio to offset the volatility of equities and, together, these asset classes allow pension funds to meet their fiduciary responsibilities. The second half of the 20th century did much to reinforce this cult of equity as valuations skyrocketed. The equity risk premium was high and investors poured their money into equity markets accordingly, despite the obvious paradox that high valuations are bound to ultimately produce low returns.
This paradox has become painfully clear to pension funds. At 8.3%, the equity risk premium was at its highest during the 40 years between 1940 and 1980; today it is calculated at less than half that figure.
Many pension funds counted on equities continuing to rise, and are now in deficit as a result of the economic downturn in developed economies and significant dissipation in the markets. The Tokyo market, for instance, remains an astounding 75% below its apex in 1989.
Pension funds have been further hampered by low fixed income returns and are falling well short of the target needed to meet their liabilities. Funds will either need to increase contributions or reduce benefits. In the case of government plans, this would mean increasing taxation, which is never a politically attractive option.
A recent paper by Maria Belen Sbrancia of the University of Maryland, called Debt, Inflation, and the Liquidation Effect, looks at the period following WWII and notes the parallels to today’s economic circumstances. In both eras, public debt escalated precipitously. Investors anticipated a lengthy economic slowdown and high levels of unemployment.
At the end of WWII, allied leaders gathered at Bretton Woods to regulate the international monetary system. What followed was a period of financial repression intended to relieve large debt burdens.
The 2008 crisis has similarly created a situation where several countries are at risk of defaulting on their debt and many more are struggling with the economic and political change needed to reduce debt to more sustainable levels. Sbrancia notes that many of the present regulatory changes share elements in common with the policies that characterize the Bretton Woods period, a period marked by negative real interest rates. She indicates that the yield on 10-year treasuries is lower than the market’s expectation of inflation over the next decade. Negative real interest rates are similarly found in China, Europe, Canada and the United Kingdom and they pose a serious threat to the real value of bond portfolios.
Given the recent escalation of public debts, governments across the developed world have a shared interest in maintaining rates below the level of inflation.
In this century, high dividend markets have performed most solidly. Pension plans would be wise to replace some of their traditional fixed income investments with dividend growing equities and floating rate loan instruments of high credit rating in order to protect the real value of their bond portfolios.
It is notable that the debt to GDP ratio remains much healthier in emerging markets where, despite having to deal with high capital flow volatility, high growth has been sustained.
Pension funds remain overtly preoccupied with liquidity, though most have a duration of two decades.
Most foundations and endowments, for their part, have infinite terms. They have positive cash flows and little operational needs for liquidity. Investors, however, continue to be married to the idea that liquidity is important in order to facilitate change and turnover. In the 2010 SBBI Yearbook, Ibbotson shows that the opportunity lost by restricting a long-term portfolio to highly liquid assets is substantial.
From 1972 to 2009, Ibbotson determined that, of all stocks traded on the NYSE, AMEX and NASDAQ, the least liquid quartile returned 16% with a standard deviation of 20%, while the most liquid quartile returned 8% with a standard deviation of 29%.
It is in the investor’s interest to look for investments that will provide long-term steady returns that are well above the rate of inflation. This is far more important to the health of a portfolio than liquidity.
Over the last decade, the roles of advanced and emerging economies have clearly reversed, yet few pension funds have changed the structure of their portfolios to reflect this new reality.
History proves that government debt levels of over 90% of GDP necessarily generate long periods of slow economic growth, high unemployment and, ultimately, financial repression. As such, it is interesting to note that, by 2016, emerging markets will produce 38% of world output but hold only 14% of world debt. This is in stark contrast to projections for the U.S., the U.K., Japan and the eurozone.
Value-oriented active investing based on skilled bottom-up fundamental analysis is critical to the success of any emerging market investing. Floating rate instruments that can provide stable, long-term returns have earned their place in the prudent portfolio where quality and true value will always represent the best investment decisions.
Carl H. Otto was co-founder and chairman of Cordiant Capital Inc. cordiantcap.com.
Reproduced with permission from Cordiant Capital Inc.