Investors need Diversity, Equity and..Income.
The following article was published on Livewire. As we get more integrated into the new New Normal, asset markets are returning to their previous roles - Fixed Income and high yiled equity for Income and Equity for capital growth and real returns. Cash meanwhile will regain its role as arisk management tool. After a decade or more of 'living in the upside down', world of QE, investors need to adjsut their portfolios accordingly.
We are in a new, New Normal as we like to describe it and investors need to rethink how to negotiate it as the era of cheap money and low inflation disappears. One way to think about it we would suggest would be to borrow from that new ubiquitous centralised corporate policy of DEI, or Diversity, Equity and Inclusion and now concentrate on our own version; Diversification, Equity and Income.
Diversification - an alternative to alternatives?
Diversification was famously referred to by the late Harry Markowitz as the only free lunch in investing as it reduces risk while improving returns and yet after more than a decade of QE, many investors find themselves increasingly less diversified than they were previously, or indeed is optimal. For some, the lack of diversity is simply geographic; home country bias is always strong, but whether it is Chinese Family Offices seeking to diversify away from China risk or Australian Super funds needing to diversify away from their home market, the new New Normal makes a strong case for a Global approach. However, there is also an issue of asset class diversification. The poor yields available on cash and fixed income over the last decade have driven investors into a range of alternative assets, which, while seemingly diverse, all tend to share common characteristics of leverage and illiquidity. While some, such as Private Equity, Venture Capital and Private Credit are illiquid by design, many of the others, such as Property, infrastructure and leveraged loans are now finding themselves illiquid, not unconnected with the additional problem that they all now present very different return profiles with a new, ‘normalised’ cost of capital. Meanwhile, the disappearance of cheap and available liquidity is also presenting a challenge to other strategies in FX, commodities and managed futures. Thus as well as being more Global, the new New Normal also suggests a diversification back into more liquid areas and markets as an alternative to alternatives.
Equity - normal conditions apply.
The fact that more than a decade of Zero Interest rates produced asset price inflation but goods and services dis-inflation - as the boost to supply from cheap capital for businesses far outweighed the boost to demand from cheap borrowing for consumers - means that higher interest rates will, equally perversely, produce more high street inflation than previously thanks to lower supply and the end of dis-inflation. In the upside-down world of the old New Normal, Equities were held for income, while bonds were held for capital gain. In this new New Normal, order is being restored and the role of Equity now is more about maintaining real returns over and above inflation as the end of dis-inflation means retail price inflation moves from a 0-2% band, to a 2-4% range. Importantly, this environment also allows a number of companies to make better returns on capital as competitive forces ease, as the ‘normal’ cost of capital not only removes zombie companies and startups selling below cost of production, but also shifts the emphasis on returns being generated from operations, rather than from balance sheet manipulation. Attributes such as Quality, Cash flow and sound balance sheets will come back into fashion, as will understanding that asset turn and margin enhancement as key drivers of return on capital do not necessarily require high levels of headline GDP growth. This also means that a number of companies and sectors that have done very well out of the balance sheet growth of the last decade will now struggle to prosper, highlighting the importance of being in the ‘right’ parts of the market.
Income - from the bond curve and some equity
With short term interest rates having been hiked so far and so quickly, cash has become an obvious source of diversification for many, as it now offers a meaningful nominal return. As such it is crowding out longer dated fixed income from returning to its traditional role, as cash is currently offering a higher return than that available on longer dated bonds (the inverted yield curve). However, we do not see this as sustainable and many fixed income investors are focussed on when, rather than if, to extend duration, if only to avoid re-investment risk at the short end. Of course, most buyers of fixed income currently buy it because that is their mandate, so their only option is where on the curve they are going to sit. Currently we are seeing these long term investors buying the dips as nominal yields stray outside of the expected inflation range, ie at around 4%. In a few markets, such as Australia, there is still a franking credit that makes equity dividends very attractive to tax paying investors, but even without this, a lot of high quality, dividend paying companies with sound balance sheets are currently offering yields at or above those on longer dated bonds, with the added upside of being better hedges against inflation, as dividends can grow.
Overall then, investors need to restructure their portfolios and their thinking back to ‘the old days’, before QE and the New Normal turned everything on its head. Illiquidity and Leverage, the hidden source of so much historic return need to be traded for clean and simple, higher liquidity, products with clear line of sight to cash flows and earnings. In particular, cash flows need to come from the business model rather than the balance sheet. Concentration risk, at the country, sector or stock level needs to be diversified away for a ‘free lunch’ and Equity and Fixed income need to be restored to their proper roles in portfolios. As James Bond almost said ‘No(w) Time to DEI.’