Purgatory or hell–no matter who the president is. That’s the future investors face over the coming years given today’s low yields and high valuations, according to GMO Portfolio Manager Ben Inker.
“Either valuations will revert to historically normal levels and near-term returns will be very bad [purgatory] or valuations will remain elevated relative to history [which means]… near-term returns will be less bad but still insufficient to investors to acheive their goals [hell],” writes Inker in the firm’s latest quarterly letter.
In the long run hell is worse for investors because disappointing returns will persist for longer, according to Inker.
“The nature of the problem is different in Purgatory and Hell,” writes Inker. “In the Purgatory scenario returns for the next seven years will be inadequate but after that the world reverts to a normal pattern and the old rules apply,” writes Inker. There isn’t such a reversal in his hell scenario, as the chart below illustrates.
In the first seven years, a traditional 60/40 stock/bond $ 1 million portfolio with returns far below 5% real return would lose about 36% in the purgatory scenario and closer to 30% for the hell scenario, according to Inker’s calculation.
But after those first seven years or so, the portfolio in the purgatory scenario would stabilize while in the hell scenario it would continue to lose money.
“For someone saving for retirement the required savings rate has just risen markedly because not only is the pot of retirement savings going to be growing more slowly than expected but the safe spending rate for given pool of savings in retirement has just fallen,” writes Inker.
An institutional fund such as a defined benefit plan fully funded at a 7.3% rate of return, with a duration of 15.5 years and payouts over 30 years would be left with only 80% funding in the purgatory scenario and just 67% in the hell scenario, according to Inker.
“Both Purgatory and Hell are bad outcomes for investors,” writes Inker. But over time “the lower cash flows associated with higher valuations bite more and more.”
“The investment landscape today is an unprecedented one,” writes Inker. “It is not so much that asset prices look mispriced relative to one another … but that almost all asset classes are priced at valuations that seem to guarantee returns lower than history.”
Inker concludes that it would be “irresponsible” for investors and institutions not to at least contemplate the possibility of hell in building a portfolio. “Hell will creep up slowly” with relatively small losses building up year after year, resulting not only in disappointing annual returns but also a slow shrinking of next eggs and inadequate retirement savings,
“Now is exactly the time we need to start building our battle plans for the challenges we will be facing in the coming years.”
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