The Business Cycle, Geopolitics and Retirement Investing

Art by Julien Posture

Sitting down with PLANADVISER for a wide-ranging discussion about the global equity and fixed-income markets, Jim McDonald, executive vice president and chief investment strategist at Northern Trust Asset Management, said he does not expect the trade conflict underway between the U.S. and China to be meaningfully resolved.

“This will be a headwind to global growth for the long term, we believe,” McDonald says, adding that it’s very possible the U.S. and China will be fighting a low-intensity trade war for decades to come. “Taking a step back, we anticipate about 1% slower annual gross domestic product [GDP] growth in the U.S. and Europe over the next five years, which will lead to lower returns in risk assets. In addition, interest rates are lower today than they have been in the last five years, adding another challenge for retirement investors.”

Wrapping all of this together, Northern Trust and other investment managers are voicing a more cautious outlook for returns over the next five years. According to McDonald, over the last five years, a balanced 60/40 portfolio of equities and bonds has generated a return of about 6.2% annually. He expects that will fall to 4.7% over the next five years.

“There will be a lot of noise about individual agreements to try and resolve the trade issue,” McDonald predicts. “Maybe China will buy more U.S. agriculture in a given year, and maybe we will hold back on some tariffs on certain products. But as a general matter, I don’t see the fundamental disagreements going away. The inherent issues are really intractable. What we want from China will significantly hinder their ability to continue to advance their economy in the same way they have. Therefore, they are going to be unwilling to make the major concessions.”

Reaching some similar conclusions, the Natixis 2019 Midyear Strategist Survey suggests portfolio outcomes for the coming years will be “more muted as markets grapple with a number of downside scenarios and little in the way of upside surprises.”

According to the survey, a “messy Brexit outcome” is the most likely downside risk in the eyes of professional money managers, while a rebound in growth driven by new central bank policy ranks as the most likely upside. The survey also identifies a more bullish outlook for U.S. sovereign bonds, emerging market equities, global real estate investment trusts (REITs) and emerging market bonds—due to accommodative central bank policy.

“The survey results clearly show that, in aggregate, our respondents don’t see a lot of positive market catalysts on the horizon—nor do they see a recessionary worst-case scenario as very likely in the near term,” says Esty Dwek, head of global market strategy, dynamic solutions, Natixis Investment Managers. “It’s a kind of a ‘muddle through’ outlook.”

Trade Tensions and Interest Rates

McDonald says the global trade tensions are “really important,” but it is also critical to understand these tensions are coming to the fore against the backdrop of a global economy that is slowing on its own because of age demographics and also because of the amount of outstanding debt held in developed economies.

“With slower growth and lower inflation, we don’t see a case for interest rates to meaningfully rise from here,” McDonald says. “The positive aspect of this is that investors won’t see accounting losses on the bonds that they hold. The negative is that the real return possibility remains relatively low. Our expectation for an investment grade bond portfolio is 2.5% to 3%, which is still better than inflation but remains low by historical standards.”

In his experience, McDonald says, one of the main misconceptions of investors is that they are going to lose money on bonds if interest rates go up.

“If you buy a bond today and you hold it, you are going to get the par back at maturity, so in this sense the risk of rising interest rates is really the reinvestment risk—which is just to say that you would have been better waiting and buying when rates were higher,” McDonald explains. “Our view is that investors should not be hesitant to put fresh money to work yearly, based on the interest rate environment that is in place right now.”

McDonald does not expect to see rates increase any time soon on the long side of the yield curve. He actually thinks long rates could come down further. Currently the 10-year Treasury yield is around 1.75%, but Northern Trust’s expected range over the next six to 12 months is lower, between 1.25% and 1.75%.

“So, we think rates are really at the top end of where they are likely to reside,” McDonald says.  “For this reason, we aren’t hesitant to buy medium- to long-maturity bonds right now.  This is where there is a disservice done by some of the media commentary that gets published about ‘losing money in bonds.’ What they are talking about is really an accounting loss as opposed to an economic loss. It’s an important distinction for individual investors to understand.”

Reaching for Late-Cycle Yield

At this point in the business cycle, McDonald worries about participants “reaching for yield.”

“Any time you have a financial crisis, it is caused in principal by excess,” McDonald says.  “Everyone is asking what the next crisis will be, and while predicting it is impossible, one possible contributor I believe will be that interest rates have been as low as they are for so long.  We need to be cautious about where too much money has gone without sufficient forethought and due diligence.”

McDonald cites the examples of private companies that have raised “absurd amounts of money” by private backers, but then the public markets wouldn’t support those valuations.

“The lesson here, we believe, is that investors have to be more selective and cautious about the credit assets they are buying,” McDonald says. “Our current view on credit quality is that it actually remains pretty good—the aggregate statistics absolutely support that view.”

Scott Donaldson, a senior investment analyst in the Vanguard Investment Strategy Group, also worries about participants reaching for yield in the current market environment.

“In a low interest rate environment, trying to juice returns on the fixed-income side means moving into higher yielding alternatives other than, say, government debt or even investment-grade credit,” Donaldson says. “Greater return potential may be there, but there are tradeoffs to doing this. The pros of course are that, yes, you may get an increase in yield for a period of time. The negative tradeoff is significantly lower diversification for the whole portfolio and higher risk concentration. The more credit you get into, generally, the higher correlation your portfolio will have to the equity markets, should something go wrong.”

Pursuing that higher level of yield makes sense for some people, but investors have to be willing to gain the higher yield by having a higher concentration in similar types of securities—lower quality bonds that are more correlated with equities.

“This means that, if something goes significantly wrong and the business cycle turns to a contraction, that extra 50 basis points you tried to squeeze out of the market may pale in comparison to the downside you could experience,” Donaldson explains.

In terms of specific holdings, Donaldson says, Vanguard invests sizably and believes strongly in the diversification potential of high quality non-U.S. government bonds. He freely admits these are actually even lower yielding on a local basis than the U.S. fixed income market.

“Instead of seeking higher yielding instruments, we feel that a strategic asset allocation of having non-U.S. bonds with another 30 or 40 countries is highly valuable even when their rates are low and even when they are, in some cases, negative,” he says. “Our strategy involves hedging the currency exposure to lower the volatility of those fixed-income instruments. In this sense, we’re not really giving up yield, we argue; we’re just getting it differently in an equivalent total return.”