I didn’t want this week’s educational segment to be about the U.S. election, though it’s hard not to be, so I’ve added a twist to get you to consider not trying to time markets but rather to think about better, more robust portfolio construction.
Most asset markets are expensive in many respects. For this week’s uncertainty, the U.S. fiscal outlook is worst under a red sweep (very possible), less bad under a blue sweep (very unlikely), and best under a split (most likely), and it doesn’t matter much what colours.
Gridlock is generally good for markets. The cost of capital (discount factor) is virtually certain to get worse over time with debt/gross domestic product (GDP) in the U.S. over 100 per cent and rising rapidly.
The unsustainable cost of the debt and impact of future growth has been highlighted by U.S. Federal Reserve Chairman Jerome Powell, and many others have remarked that the fiscal path is unsustainable. To be clear, for the reserve currency of the world, the new debt will always clear the market, the discussion is at what yield (price) will it clear?
In recent weeks, the long end of the bond market has sold off in part due to an expectation of a red sweep, the notion that the Federal Open Market Committee (FOMC) may be losing control of the long end of the curve.
This is due to the massive amount of new debt that is needed, and a higher for longer series of economic data points. Over the past two years or so of quantitative tightening (QT), or the shrinking of the Fed’s balance sheet, the U.S. Treasury has funded most of that with the issuance of bills.
It’s inevitable that the issuance of bonds needs to rise and that will negatively impact the cost of capital and equity multiples. Today, the equity market is priced more for a soft landing and benign inflation. Markets will ignore these longer-term concerns for extended periods.
What is more certain, is that the FOMC will likely cut rates by 25 basis points (bps) on Wednesday, but the forward guidance is less certain. The best outcome for the long end of the bond market is a hawkish forward guidance.
The markets have walked back the aggressive rates cuts priced in following the 50-bps cut seen at the last meeting in September. More recent growth and inflation data shows that the FOMC should probably slow the pace of rate cuts.
With the election out of the way, we think that is a higher probability, but Powell is a dove and likely doesn’t do that. Note the uncertainty in my comments here – it’s too close to call.
For your portfolios, most investors should not be trying to guess what might happen with outcomes like this and build portfolios better suited for longer-term outcomes. Historically, that was a balanced 60/40 kind of public portfolio.
We have talked about broadening out your personal portfolio to look more like what pension funds do with Canadian pensions by using investment strategies that have less correlation with the uncertainty of how public markets and uncertainty are priced.
In the long run, it should not be about market timing (this coming from someone that is seeking alpha) but more about longer-term outcome-oriented portfolio construction that gets us through periods like this of higher uncertainty.
The era in thinking around the generic public market 60/40 balanced portfolio for most investors needs improvement. The truth is, we can’t forecast with certainty what will happen over short periods of time (like this week).
But we do know with certainty over long periods of time as growth drives earnings and earnings drives returns that staying fully invested matters far more than market timing. Canada Pension holds a robust globally diversified basket of assets for Canadians that has done a much better job smoothing returns over periods of uncertainty than the typical balanced portfolio.
The equivalent U.S. Social Security Trust Fund holds an IOU from the U.S. taxpayer (know as a special issue Treasury note) and no real assets.
That said, looking in the rearview mirror, the top 10 stocks in the world (excluding Berkshire Hathaway due to the double counting and summing the two classes of Alphabet), are almost 20 per cent and one massive bet on technology (artificial intelligence, social media, productivity and obesity).
They have done great over the past five years to be sure. All the benefits from the 60/40 public portfolio have come from these names and from little else. Public bonds have been a disaster.
Looking ahead, as one should, over ninety percent of the investable universe of equity is not listed on a stock exchange. As impressive as the growth has been on these companies in recent years, some of the best and fastest growing companies are not public yet.
The private markets are compelling from a long-term perspective and should be an increasing part of your retirement savings.
If you are going to make a trade this week, make it in favour of better diversifying your portfolio. Unfortunately, access to the private markets to DIY investors is limited, but the good news is that it’s improving quickly.
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