All-weather jackets and cockroaches
Brilliant spring sunshine, but still several degrees below zero in the capital. The snow has stayed around unusually late in the season, but the daytime thaw hints of warmer and lighter times to come. In this period of transition, I found myself thinking about the all-weather jacket. The ultimate piece of clothing, designed to withstand wind and rain but easily unzipped and opened up when the sun is shining or when you're working up a sweat. And this can be used as a metaphor in the hunt for the ultimate portfolio.
An industry colleague recently wrote about the benefits of a "cockroach portfolio". A portfolio that, like the cockroach, has evolved for survival almost regardless of the threat. The cockroach has become known for being the oldest living order of insects. They were around in the Carboniferous period, 300 million years ago. They can be found in any kind of habitat, from deserts to tropical rain forests, and their scientific name comes from the Latin blatta, meaning "an insect that shuns the light". They have a soft skeleton so they can hide in tiny cracks, and they can manage without water for up to two weeks or remain entirely submerged for 30 minutes. It is also claimed they could survive the radiation from a nuclear war.
In 2012, Dylan Grice designed a financial equivalent to this ability to survive – the cockroach portfolio – which uses equal allocations of equities, long bonds, cash and gold to stably create and maintain value over time. The stocks contribute underlying profit growth and inflation protection through real exposure, while gold is also a real asset but contributes to stability. The two liquid nominal assets are for periods of volatility or deflation.
Most portfolio managers active nowadays have been brought up in an environment of falling long-term interest rates, a cycle that has been going on for 36 years. During this period, we have gone from a society with major inflationary problems to the opposite, with key interest rates at their lowest not only during this period but probably also throughout the whole cockroach's existence. It is highly likely that this period of falling interest rates has had a very big impact on other related asset classes. Shares have been affected in two ways. The underlying companies have been stimulated by low interest rates in the demand for their products, and their financing. The low interest rates have also contributed to rising multiples for these companies as investors' required returns have fallen. It is easy to see how the well-being effect of rising stock markets in recent years has also created a strong consumption-driven economy, in which the trade in goods and services has flourished and added additional fuel to the fire.
How many people think back to the period before the fall in interest rates, when Sweden in the early 60s experienced a record year, with real GDP growth of about 5 percent on average and when Sweden was one of the world's richest countries measured as GDP per capita? At that time, industry accounted for 30 percent of the workforce and central union labour agreements were critical to the management of inflation. Investments in the following decade had to cope with the demands of an oil crisis, sharply rising interest rates, high inflation and a stock market that moved sideways, nominally, for several years.
If we were to invest today using the cockroach principle, or perhaps a little more pleasantly expressed, using the all-weather jacket as a metaphor, what would we consider? Low interest rates on both short and long maturities provide very low returns on the safe parts of the portfolio, while gold offers no yield at all. The only thing that contributes returns right now is the equity portfolio, but even here the yields are low after several years of strong stock market upswing. After such a long period of monetary stimulus, the risk of deflation feels lower, although it cannot be ruled out. However, protecting yourself by owning nominal bonds has limited effect today. Even if interest rates were to fall to zero, it would be difficult to compensate for weaknesses in equities in a deflationary scenario. However, there should be protection against inflation in the equities, but even here the market has chosen to take a lot in advance through high valuations of high profits that are very probably cyclical. The gold remains, but the current return is zero.
It is clearly difficult to create anything that provides a reasonable return without excessive risks. Everything that protects against wind and rain takes place at the high cost of the returns in sunnier times. All the signs suggest that investors need to cut their level of ambition in terms of the required return to make it work.
At Catella we often point out how difficult it is to predict the future, and we therefore advocate the importance of a balanced portfolio. In our current environment, low-risk products that aim to achieve absolute returns appear to be the most attractive. Especially if their correlation with other markets is low. As a stand-alone or as a complement in a broader portfolio, investors would hopefully then achieve a good balance between a positive required return and limited downside if bad weather hits the markets. If we dwell too much on the period of sunshine that we have recently experienced, with positive returns on both bonds and equities, we risk being caught out when the wind blows. It's better to put on the all-weather jacket in good time, and instead leave it partly unzipped.