Foresight - Winter 2019

Looking backwards and forwards

As 2019 comes to a close, what may we expect from our portfolios in 2020, given the current global economic cycle and a bull market deep into its 10^th year? Various snapshots in recent time show that global stock markets provided a lot of volatility to portfolios without really going anywhere until recently.

 Looking forward, global GDP growth is forecasted to be similar to 2019 …. in the 2.6% range, with regional disparities.

% Growth forecast	US	Europe	China	India
2020	2.3	4.1	6.1	6.8

The US continues to have the best corporate earnings momentum; however it also continues to command a healthy Price Earnings (P/E) multiple premium compared to other global markets.      

2020  12 month estimated Forward P/E

	US*	Europe	UK	Japan	Emerging
	17.7	14.8	12.5	13.8	12.2

*Corporate America has embraced a share buyback strategy since the 2008/9 bear market. This automatically increases the earnings per share of US companies as a result of  the now-lower number of shares outstanding.

Although we are in the late stages of a very old bull market and robust economic cycle, fears of a global recession in 2020 are dissipating. There are well-reasoned forecasts that see equities rising 25% in 2020. The year before a US Presidential Election is generally good for US stocks (up on average 9% over the last 14 Presidential elections). Globally, stocks are not overly expensive on a 12 month forward P/E. With US stocks making up 56% of the Global MSCI Equity Index and already trading at a premium to regions with higher growth potential, in the coming year we will look to Europe, the Global Emerging Markets and Japan for greater stock performance in 2020. With bond yields remaining stubbornly low, it will not take much growth for stocks to handily outperform bonds in 2020. And if the bear market does surprise us in 2020, we finally will be able to rebalance portfolios by selling bonds and buying stocks “on sale,” setting up for the next economic cycle. 

 Lets reflect upon a longer perspective of historical real returns in the World equity sector: Geometric real returns (%), by decade 1900-2000, for World equity markets

World	1910	1920	1930	1940	1950	1960	1970	1980	1990	2000
Equity	5.4	-3.7	13.0	1.7	1.0	17.1	5.5	0.9	13.5	5.4
Inflation*	1.9	6.8	-0.9	-1.8	4.5	2.4	2.6	7.6	6.2	2.2

  *Canadian

The nominal equity return that we would be familiar with in the News is approximately the sum of the real return plus the corresponding-period inflation rate. Note that North American inflation data were benign, compared to much of continental Europe in those world war decades.

Each decade has its own story-lines in the history books, and the relative severity of each set of events may be debated. The low decade equity returns were of course the war decades of 1910-20 and 1940-50. Two of the big decade equity returns (1930 and 1960) were both post-war, as the world set about reconstructing the global economy previously destroyed by global conflict.

Ten year investing periods may seem like a long time. If we were to present charts of the annual returns in each year of all of those decades, the data would appear more heart-stopping, with way more fluctuation than we see in the ten decade-points of data in the table. Our mantra is to focus on long term running compound portfolio performance. 

Running-decades compound geometric real returns, by decade 1900-2000

World	1910	1920	1930	1940	1950	1960	1970	1980	1990	2000
Equity	5.4	0.8	4.7	3.9	3.3	5.5	5.5	4.9	5.8	5.8

 Canada’s 100 year inflation rate was 3.2%. Thus, the 100 year nominal return on world equities was approx. 9.0%.

It is interesting to note how the ups and downs of major economic events smooth out to a great extent, even within any decade, for the patient, long-term investor. “Patience” is a state-of-mind and “long term” is a state-of-perspective. Much wealth today truly will carry forward multiple generations into the future.

BOND TALK

It is an investor’s inclination to view bonds, aka fixed income, as the “safe”, “bedrock” part of a portfolio. Investors historically have liked bonds because they provide regular guaranteed income cash flow source (be it monthly, quarterly, semi-annually or annually) and they provide safety of capital.

As such, we don’t need to keep an eye on them, compared to our equity investments. That said, there are borrowers out there (eg non investment grade bonds, or “junk” bonds) who may keep us awake at night because they may not show up to make those regular interest payments, and/or return our capital at some maturity date in the future.

The concept in Finance is that the interest rate we are prepared to accept on a bond notionally includes a) some reward for parting with our money for a period of time, at the cost of deferred enjoyment from spending the money today b) an “insurance” premium to cover inflation, meaning that when we get our money back, what we want to buy now costs more and c) a risk  premium to compensate that the borrower may not show up on repayment day, thus losing our initial capital, in whole or in part.

Let’s reflect upon a longer perspective of historical real returns for Canadian bonds. 

Geometric real returns (%), by decade 1900-2000, for Canadian bonds

	1910	1920	1930	1940	1950	1960	1970	1980	1990	2000
Decade	0.2	-7.6	7.3	7.5	-0.6	-2.1	0.1	-1.6	6.4	9.3
Running compound	0.2	-3.7	-0.2	1.7	1.2	0.7	0.6	0.3	1.0	1.8

 Historically, lenders are not particularly well rewarded in “real” terms….meaning after experiencing cost inflation. If you started out as an investor in 1980, and looked at this chart, it would seem a hard sell to even entertain becoming a lender…from 1900-2000, there was no cumulative compound period where the real return reached 2%. However, the middle-aged investor today has fixed income investing experience over the two decades through 1980-2000 of 6.4% and 9.3% real returns. The following two decades to 2020 have fallen off a cliff by comparison.

Why were those two decades of bond returns so high? We have to stop here and go back to Bond School (which we have written on at length in the Foresight Library). The “current” annual return on a bond for any given year is the sum of its yield-to-maturity rate and its temporal gain (or loss). As we have written before, the sum of these annual temporal gains and losses will, by definition, net out to zero over the life of the bond.

The early ‘80s were infamous for insanely high interest rates. Part of that was related to taming inflation, which ran at 7.6% and 6.2% over the decades 1980-2000. As the following two decades played out, interest rates had only one direction to go, and that was down, as Central Banks have focused on managing inflation around 2% over the last twenty years. Falling interest rates impact bond pricing, giving rise to temporal gains, and notionally higher bond returns.  

2019 bond returns

We had started to see the expected rise in interest rates a year ago but then, surprisingly, interest rates fell back again between January and September, impacting the current market valuation of bond portfolios.

Here are two client portfolios that own the same strip bond: an Ontario June 2/2023. The first client had a January 31, 2019 report date; the second had a September 30, 2019 report date.

Valuation date	Yield to maturity	Unrealized gain	Interest	Current yield
January 31st	4.22%	$10	$541	3.96%
September 30th	4.28%	$341	$563	6.45%

 While their two yields to maturity are almost exactly the same, the impact of falling interest rates between February and September caused the September return to jump from 3.96% to 6.45%, all reflected in the temporal unrealized gain difference in the chart. Rolling forward another month to October 31, 2019, that same bond now yielded 7.01%, up from 6.45% the month prior. So, this Fall, we have gone back to where we were in 2015, when the overall portfolio return was getting notable lift from temporal gains from the bond portfolio.

Bond yields in 2020 are expected to remain low but rising...eg the US 10 year Treasury yield is forecast to rise from 1.75% to 2.2%. This would take away the 2019 temporal bond gains above and negatively contribute to overall portfolio returns.

All of our clients have an “Asset Allocation Plan”, which drives the portfolio’s long term success and volatility. The key aspect of that Plan is the allocation between fixed income and equity. It is insightful to view this allocation as a PARTNERSHIP between those two asset classes, as they each share the load in building your financial future. The success or failure of each over any period of time is the product of the complexities of the world’s events and commerce.                    

Trivest’s Annual Report provides an overall portfolio rate-of-return, including the current year, and the three, five and ten year annual compound, and, lastly, annual compound return since inception with us. We have always said that, for the wise investor, long term compound return is the most important. Ideally, it can be referenced back to a formal Financial Plan that you might have had prepared, which included in its 30-35 year forecast, an average long term compound return that drives the forecast of your financial future.

Our annual rate of return calculation is derived with painstaking precision, drawing from our accounting roots...the “A” in “AFT”. Our annual calculation is determined for the portfolio as a whole. The components of income include: cash payments from interest (from fixed income) and dividends (from equity) and capital gain appreciation/loss (from both). Interest and dividends arrive as cash into the portfolio at various times in the year. Capital gain/loss has two components: realized (meaning something was disposed) and unrealized (meaning something you still own has gone up /down in value over the period). “Realized” creates cash into the portfolio; unrealized does not.

Historically, the fixed income partner has born the lion’s share of responsibility to produce cash flow into the portfolio. Equity responsibility was to produce appreciation more than cash flow. But with bond coupon rates dropping from 18% in the early ‘80s to less than 2% today, the fixed income partner is not carrying that responsibility. On the other hand, companies are paying healthy dividends, which come with valuable dividend tax credits in non-sheltered accounts. 

We recently “dissected” in detail the rate of return of the two partners in a sample portfolio:

	Interest	Dividends	Cash Return %	Gain	Gain Return %	Total	Total Return %
Fixed Income	$8,846	n/a	2.24	$1,501	0.38	$10,347	2.62%
Equity	n/a	$22,054	3.09	$11,855	1.66	$33,909	4.75%

The denominator in each partner’s return calculation is the capital invested respectively in fixed income vs equity holdings. We see that the cash return of dividend income on equity (3.09%) exceeded that of interest income on fixed income (2.24%). And, for the period, the equity market rose, adding a further 1.66%.  The overall portfolio return, weighted by the allocation between fixed income (40%) and equity (60%), was 3.98%.

Note that the ratios of cash income to appreciation was approx. 70/30 over the twelve months ending September 30, 2019. Elsewhere, we have tracked quarterly returns for a particular account for thirteen years. The long term 13 year mix between cash income and appreciation is notably different at almost exactly 50/50. The inter-play of stock market returns with temporal fixed income gains over rolling 12 month periods is always interesting.

Our average portfolio returns from October through December 2018 were slightly negative. The average returns from January through September 2019 were all modestly positive. Our most recent October 31, 2019 reports have averaged 8.62%.