August 11, 2009
A New Normal is coming into focus, providing a glimpse of the slow growth and higher inflation that may soon characterize the U.S. economy. Warnings about this alarming prospect have been articulated by Bill Gross of PIMCO and by his colleague Mohammed El-Erian.
PIMCO’s new paradigm is not, in fact, that new. Many of its themes are described in detail in El-Erian’s book, When Markets Collide. In it, El-Erian warned investors to prepare for an increasing economic shift of power to emerging markets and increasing correlations between major asset classes
Under the New Normal, investors should prepare for lower equity risk premia. If economic growth slows, it stands to reason that equities will deliver lower average returns than many investors expect (see here). Lower returns are also likely to be accompanied by substantially higher volatility than we have experienced in recent decades—though less than the very high volatility of late 2008.
If this view is correct, what should investors do? I will examine the implications of this New Normal for asset allocation and financial planning by stress-testing some well-known asset allocations to see how well they will serve investors in the forecast environment.
Back in June 2008, I analyzed some model portfolios that had been proposed by Paul Merriman and Ted Aronson, both very experienced commentators on global markets. Paul Farrell, who writes regularly about so-called ”lazy portfolios,” proposed that those asset allocations would be an effective way to deal with stagflation — low economic growth coupled with significant inflation risk. My analysis at the time suggested that was not really the case. The portfolios in question had low exposure to asset classes that tend to weather inflation (such as commodities and REIT’s) and fairly high Beta, which meant that they derived most of their returns from price increases in the S&P500. At about the same time, I analyzed a model portfolio proposed by Mohamed El-Erian in When Markets Collide that was designed to account for the forces anticipated by the New Normal world view, and I found that my Monte Carlo projections were in broad agreement with his analysis.
Gross suggested that firms with strong consumer franchises — like Coke (KO) and Procter and Gamble (PG) will tend to do well in the New Normal. In July, Gross wrote the following:
…the outlook for risk assets – stocks, high yield bonds, and commercial and residential real estate will involve just that – risk. Investors should stress secure income offered by bonds and stable dividend-paying equities.
And earlier this month he offered a related insight:
An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low-yielding returns for government and government-guaranteed assets at the bottom end.
In Monte Carlo analysis, companies like Coke and P&G are attractive in volatile environments because they are fairly low volatility and low-Beta. Low volatility means that they can help to mitigate overall risk in the portfolio. Low volatility is also related to low default risk — something I have shown using credit ratings and Monte Carlo simulations. These companies seem like a good place to put money in times when the default risk of firms is elevated. Monte Carlo analysis makes the link between investments with high market risk and default risk quite clear.
I have argued for years that companies like KO and PG provide low-Beta portfolio enhancements. I have also noted that Dividend Aristocrats, a set of stocks that have maintained or raised their dividends for at least twenty-five years, as a group tend to provide this portfolio impact, and our simulations suggest that this will continue to be the case. Dividend Aristocrats tend to be both low volatility and low Beta. High volatility assets will not thrive in an economic environment of high volatility and low growth — conditions that are at the heart of PIMCO’s New Normal. High Beta assets rely on price appreciation for their returns, and price appreciation is driven by expectations of earnings growth. In a low-growth environment, a larger portion of returns will be provided by dividends, as opposed to price appreciation.
An additional theme that Gross does not discuss explicitly is the likelihood that correlations between asset classes will remain high for quite some time, reducing the effectiveness of traditional asset allocation. (El-Erian, on the other hand, does discuss this issue in his book.) One of the last refuges of low correlation is a selection of Blue Chip stocks. This, all by itself, has important implications because it challenges the idea that investors are well-served by buying the entire market-cap weighted index.
Key themes that emerge from the New Normal model that are entirely consistent with the projections from Monte Carlo simulations (using Quantext Portfolio Planner) are the following:
- Dividend Aristocrats and similar stocks are a good choice for equity exposure.
- TIPS should make up a considerable portion of bond exposure to protect against inflation.
- High volatility / high Beta asset classes will be too risky for many investors—even at moderate allocation levels.
- Emphasis on international equity exposure is necessary to protect against a weaker dollar.
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