To my clients:
It was a mixed week for North American stock markets with the Canadian TSX finishing down 0.2%; the U.S. Dow Jones Index finishing down 0.2%; and the U.S. S&P 500 finishing up 0.5%.
As promised, today I will discuss the challenge that ultra-low interest rates are imposing upon traditional “balanced” portfolios. But before doing so, I’ll offer a quick summary paragraph of the highlights of the week.
Early in the quarterly reporting season, 83% of U.S. companies have exceeded earnings forecasts. Select large U.S. banks have been particularly buoyant in both their reported earnings and outlooks. Anecdotal though this observation surely is, if the U.S. economy were indeed bordering on recession, it’s difficult to imagine how JPMorgan, the largest U.S. bank, was able to deliver robust earnings growth across nearly all of its divisions, or how its CEO would be able to assert that the consumer “continues to be quite strong”. Moving to the economic front, I’ll note that the 3 month to 10-year portion of the U.S. yield curve (the portion of most interest to RBC in our recession watch) “un-inverted” this week. To be sure, the “re-version” (yes, I’m stretching for terminology here) is not particularly significant, and the entire yield curve remains on knife-edge. But it is no longer inverted. While yield curve inversion is widely considered the best economic indicator of recession, it is unquestionably the case that the unwind of years of quantitative easing followed by negative interest rates throughout much of the developed world are distorting the U.S. yield curve and are possibly making it less reliable than in the past. This is not to completely dismiss the yield curve as a worthy indicator, but it is likely the case that blind adherence to its signal might best be tempered this time around. Our (my and RBC’s) second most watched indicator – the trend in weekly jobless claims – continues to show no hint of concern. Bottom line: no recession remains our base case expectation and, as such, portfolios are positioned close to the long-term equity (i.e. stock) target set in the Investment Policy Statement of individual clients.
Ok, so with bond (and GIC) rates so low, what should a prudent investor (or friendly Portfolio Manager) do when constructing a balanced portfolio? It’s a tricky question, and I’m not sure there is a “right” answer. But I think it’s important to discuss, and for clients to consider. So let’s get to it.
First, I’ll plug one last time the Globe and Mail article that I first linked two weeks ago (direct link here). It is an eye-opening read. If you’d prefer not to follow the link, here’s my “Coles Notes” version:
The popular narrative suggests that today’s ultra-low interest rates will eventually revert to “normal”. Well, what is normal? When I began in this industry just over two decades ago, 5-year GICs were yielding above 6%. About a decade ago (just prior to the Great Recession), call it 4%. Now? Just a bit more than 2%. The fact is that rates have been in near steady decline since the early 1980’s. In other words, rates have been dropping for about 40 years, and perhaps the ever-looming return to normal that I’ve been consistently hearing during my career simply won’t materialize any time soon.
Why? The article makes a very compelling argument that the drop in rates is driven by demographics, and it highlights the Japanese experience to compare and illustrate. It makes the broad (and accurate) assumption that older people have more money than younger people. Younger people, with less money saved, need to borrow funds to acquire life’s assets (houses, cars, businesses etc.). Older people, with more money saved, are content to lend out their surplus funds and receive the interest income. Prior to the 1990’s, the baby boom generation was still young and in “borrowing mode”. Being such a large demographic cohort, borrowers therefore greatly outnumbered the older generation of savers. In 1993, the population ratio was roughly 2.5 borrowers for every saver. The competition for loans amongst the greater number of borrowers allowed the savers/lenders to charge higher rates of interest. But then the baby boomers started turning grey, and the number of savers began to increase, while the number of borrowers began to proportionately decline. The ratio now stands at about 1.5 borrowers for every saver. As the trailing edge of boomers turns grey, the ratio is expected to decline further to about 1.3 to 1 in 2023. And then the ratio is expected to stay at that level for some long while after. The Canadian experience specifically, and North America in general, is very closely tracking what Japan experienced, just about two decades later (18 years is what the article asserts). In other words, beginning two decades earlier, Japan experienced nearly the same demographic shift in borrowers to savers, and interest rates in Japan fell nearly identically to what North America is now experiencing. Frankly, the correlation is quite stunning. Again, please read the full article if you have a moment.
Whether or not the preceding analysis is entirely accurate, the fact is that, at present, bonds issued by both Canada and the U.S. yield substantially less than 2% for any duration out to 10 years. Such yields are NOT what traditional balanced portfolios were predicated upon. Once upon a time, when 5 to 10-year yields were in the 4 to 6% range (let’s call it 5% for simplicity), and perhaps conservative dividend-paying stocks might generate 8%, a traditional balanced portfolio allocating 40% to bonds and 60% to conservative equities might be expected to generate a 6.8% return [consisting of 2% from the bond portion (40% x 5% = 2%), and 4.8% from the equity portion (60% x 8% = 4.8%)]. A stellar annualized return it is not – but it’s not bad either. Further, the 60/40 split would generally see bond prices zig when equity prices zag thereby reducing overall volatility (or, if you prefer, increase the stability of the portfolio).
But now, with yields so low, does the math still makes sense? Should an investor otherwise disposed to holding a 40% allocation to bonds still be doing so? Quite frankly, I’m not sure.
On the one hand, at least most of the time, bonds should still zig when equities zag, so a measure of stability remains in maintaining the bond exposure. But on the other hand, if the U.S. (and presumably Canada) continue to adhere to the concept of the “zero bound” for bond yields – meaning neither country is intent on following the European and Japanese precedents into negative yields – then even the portfolio stabilizing function of bonds is diminished because existing bonds can only rise in price so much before they too begin to yield negative returns (the math here gets a bit complex, and I don’t want to lose the audience, so just trust me on this). In other words, in the current environment, both the return generated from bonds and the portfolio stabilization they offer are both diminished. That is if North America resists the global trend into negative rates. Should we in North America follow the path to negative rates then we are dealing with another problem entirely – one I don’t wish to get into this week.
Another problem arising from the present low yield environment is how this impacts my decision as a Portfolio Manager to distribute the assets held by clients across their various accounts. The reflexive and widely followed industry practice is to allocate securities generating fully taxable interest to tax sheltered registered accounts such as RRSPs and RRIFs, and to allocate securities expected to generate tax advantaged capital gains or dividends to non-registered taxable accounts. The thinking is that this is the efficient way to distribute investment assets for an optimal after-tax outcome.
Well, clients have likely noticed that I have not adhered to this practice since obtaining my discretionary Portfolio Manager license several years ago. Instead, in most cases (not all) clients own the same mix of stocks and bonds in their registered accounts as well as their fully taxable non-registered accounts. And this positioning is not because of a lack of sophistication on my part. The reason I’ve chosen to do this is because tax sheltered registered accounts offer both tax sheltered compound growth of assets, as well as a shelter from the tax payable on interest earned in a given year. And if one is earning only about 1.5% interest (roughly the Government of Canada 5-year bond yield at present), and one were to pay 50% tax (higher than the highest marginal tax rate), the client is only saving $750 on a $100,000 investment – which would now be worth $101,500 at year end. Alternatively, the client could be investing in conservative equities that might, over time, generate the all-in return I previously asserted of perhaps 8%. Or, if fully blended to the balanced 60/40 mix, the previously asserted 6.8% rate. The point being, saving a very modest amount of tax in the current environment at the expense of longer-term tax sheltered growth is not the good trade-off it might once have been when rates were higher.
About a decade ago I once read an excellent online piece that explores the math of this phenomenon in a very friendly and accessible way. I’ve tried in vain to find that article so I could link it to the “Curated Library” section of my website, but I just can’t track it down. In any event, there are other online analyses of the subject, although all venture much too far into the weeds even for my liking. I’ll keep looking and post a suitable link should I ever find one.
Anyway, as a concluding thought, I'd like clients to consider the implications presented here. As I've said, I'm not sure there is a one-shoe-fits-all-solution to the dilemma. But the topic might be worthy of discussion when we meet for annual reviews early in 2020.
That’s it for this week. All the best,
Nick Scholte, CIM, FCSI
Vice-President & Portfolio Manager
Scholte Wealth Management
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