Low Return World
October 24, 2020
"Be willing to suffer a lot of agony by buying equities and riding out the declines." Charlie Munger
In 2019, markets were grinding higher as the economy pushed forward with the longest economic expansion in history. Many people warned that an economic downturn would occur in the not-to-distant future. None of these warnings included a worldwide pandemic that has resulted in a very unusual economic crisis even when judging by 2020 standards. No two economic downturns are the same but historically they have shared several common features. Let’s take a look at them compared to the current environment.
“Normal downturn”
After a long period of economic prosperity, lenders tend to lower their standards which inevitably leads to the following…
- Bad loans result in losses which cause lenders to become discouraged and pull back on lending activities.
- Risk aversion rises and along with it interest rates due to tighter lending standards and availability of credit.
- With less money available, only the most qualified borrowers can refinance their loans. Companies starved for cash default leading to a wave of bankruptcies.
- The process continues as pessimism reinforces the economic contraction.
- Panic selling drives asset prices lower as investors can only see bad times ahead.
- Eventually asset prices bottom and the next recovery begins.
2020 Version
- Credit remains plentiful as lenders widely grant payment holidays or offer short term loan modifications.
- Interest rates went to zero and investors lined up to provide loans to the most troubled industries. Rather than a credit crunch, a record amount of money is available. This so far has saved airlines, cruise lines and others from sure bankruptcy.
- Pessimism is absent, in fact most are optimistic that better times are ahead.
- The panic selling only lasted for about three weeks, an unusually short period of time as people accepted the recession would end, and the next recovery would begin in short order.
- With rates at zero investors cannot afford to be risk averse and they have rushed to buy risky assets like stocks driving asset prices to all-time highs.
After comparing the present environment to downturns of the past, I question whether we can even call 2020 a recession. As I wrote at the outset of the pandemic this is a health crisis first and it must be solved before the economic issues can fully heal. That was prior to unprecedented government intervention. From late March to mid July, the amount of money the Federal Reserve Bank injected into the economy was 20x larger than the amount it supplied during the entire 18 month financial crisis in 2008-2009. While we continue to work on solving the health crisis, the economy has been doped with morphine.
Where does that leave us?
+ Asset prices are full
+ Risk seeking behavior by investors chasing higher returns is commonplace
+ Elevated external risks remain from the pandemic and geopolitical tensions
= The lowest prospective returns in history
The prospective return outlook is 0% for cash, 2% for investment grade bonds, 5% for junk bonds and 5-6% for stocks. We are faced with a low return world, that does not mean we are in a bubble or a major downturn is imminent. It just means we are not being compensated for risk like we have in the past. Risky asset prices are set by low risk alternatives. With government bonds near zero in the US and negative throughout Europe it is not surprising to see stock valuations higher pushing future prospective returns to the lowest level in history.
Why the stock market has risen in a weak economic environment
Think of investments as a hot air balloon, interest rates as the air inside of the balloon and the Federal Reserve Bank as the flame that heats the air. When the Federal Reserve decides the economy needs support it injects money and as the supply of money goes up the price (interest rates) falls to meet demand. Investments have an inverse relationship with interest rates, low rates push valuations up and high rates push them down.
Back to balloon analogy, the Federal Reserve injecting money is like heating up the air in the balloon causing it to rise. If done correctly, we will have a nice ride the air will slowly cool (interest rates slowly move up) and we will land safely. However there are physical limitations to how high the balloon can go. The Federal Reserve only has so much power, it cannot use its flame endlessly because it will run out of fuel. Also, if the Federal Reserve pushes the balloon too high with stimulus, the balloon will face turbulent conditions at high altitudes. This is what we would call an asset bubble and if the balloon pops, suddenly we are plummeting towards the ground and the Fed will be powerless to stop it.
What should you do
There are only a few options and the best option is based on personal preference and needs.
- Invest as you normally would and expect the same historical result. I advise against this as it will probably lead to disappointment.
- Invest as you normally would and accept a lower return. This is preferable to #1 after all the key to a happy life is low expectations.
- Reduce risk because we are not being fully compensated for it and accept even lower returns.
- Go to cash and wait for better opportunities. Never do this.
- Increase risk and chase higher returns. I would advise against this as well as it violates Buffet’s aphorism to “be greedy when others are fearful and fearful when others are greedy.” Presently, I do not see fear in asset valuations.
I am using a combination of #2 and #3, I have low expectations and moved a portion of my assets to cash and safe short-term bonds. I chose this path to have the flexibility to seize an attractive opportunity when it arises. If retirement is far off #2 might be the best option and if you are near retirement and reliant on your investments for income #3 should be considered. If you need assistance choosing the right path, I am always available to help.
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market result is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
