The previous column explained the big trends in the “new normal” investing environment. Investors who naively assume the future will be like the past are in for a rude surprise. Smart advisers, and the clients they educate, recognize the likelihood of the new normal and adapt.
Slower economic growth will mean slower earnings growth, and consequently much more modest returns from stocks. That secret is slowly being acknowledged by investment managers and manifested in higher volatility.
Capital gains will become rarer and smaller. As the title of my book, written with co-author Riaan Nel, says, “It’s the Income, Stupid!” Dividends don’t lie: companies can’t fake the cash they pay out. Investments that are designed for income, like many alternatives, will grow in popularity (and rise in price, deliver capital gains as a bonus).
Although bonds and other fixed income assets like CDs have been retirement staples, their usefulness is vastly reduced in the new normal. First, interest rates are infinitesimal, so bonds are offering what James Grant calls “return-free risk.” Second, after years of debt monetization by central banks, inflation will follow. Any investment (like bonds) that offers a fixed nominal return will get creamed. Interest payments to bondholders will have diminishing purchasing power. As rates rise to compensate for the inflation, they will depress bond prices.
Instead, income should be sought in equity/fixed income hybrids such as alternative investments.
“Alternatives” include both specific “pass-through” hybrid asset classes like REITs, MLPs, and BDCs, which are staples in advisers’ toolkits; as well as alternative strategies such as buy/write options and tactical asset allocation.
Investing in alternatives that are pass-through entities offer a double benefit: the high payout ratios they must provide to avoid corporate taxes; and rising prices as more investors seek them out.
Investors in developed countries should overcome their “home bias”—the common proclivity to geographically overweight portfolios toward domestic investments. Stocks in companies headquartered in advanced economies face slowing earnings and significant headwinds from inflation. Increasing your exposure to dynamic developing economies whose favorable demographics help them maintain monetary discipline will earn better returns (although with higher volatility).
Happily, investing in home country-headquartered firms can still provide some foreign exposure—if the company is a multinational. Companies like Microsoft, Boeing, and Coca-Cola earn well over 50% of their revenues overseas, as does much of the S&P 500. So with careful stock selection it is possible to enjoy both international growth with home country familiarity.
Likewise, all companies are not affected by inflation in the same way. Firms that have pricing power—whose strong competitive position and high market share allow them to raise their prices without seeing a significant loss of customers—can weather inflation, and even prosper from it.
Products that offer principal protection or hedge against longevity will become imperative to mitigate risk.
The 2012 book, also co-written with Rian Nel, Your Macroeconomic Edge, discusses these strategies in considerable detail.
The new normal will provide extra reasons for de-risking clients’ portfolios and migrating portions into income-producing assets. But your clients’ personals situation—aging, and their plans to stop working and begin relying on your assets for income—were moving in this direction already. Future columns will explain how to follow through.
Philip J. Romero and Riaan Nel are authors of “It’s the Income, Stupid! 7 Secrets for a Stress-free Retirement” (Post Hill Press, 2017).