The Comedy Illuminating Florence featured above is the most famous fresco by Domenico di Michelino, located on the west wall of the Cathedral of Saint Mary of the Flowers in Florence. The canvas is divided, like Dante Aligheri's The Divine Comedy, into three parts: Inferno (Hell), Purgatorio (Purgatory), and Paradiso (Paradise or Heaven). Dante is in the center of the fresco wearing a red robe and holding a volume of his poem The Divine Comedy. With his right hand Dante points to a procession of sinners being led down through the nine circles of Hell. Behind Dante in the center are the seven levels of the Mount of Purgatory, with Adam and Eve at the top standing in the Earthly Paradise. Above them, the sun and moon and seven planets represent the Heavenly Paradise. On the right is Dante’s home city of Florence illuminated by rays emanating from his poem, hence the title - The Comedy Illuminating Florence.
The Divine Comedy tells the allegory of Dante's journey through these three realms of the dead, lasting from the night before Good Friday to the Wednesday after Easter in the spring of 1300. Conscious of his self-destructive behavior and feeling that he has fallen into a "low place" (basso loco), Dante is rescued by the Roman poet Virgil author of Aeneid and Trojan Horse legend. Virgil guides Dante through Hell and Purgatory and sends him on his to Paradise.
All hope abandon, ye who enter here! Dante Alighieri
In its third quarter of 2016 Quarterly Newsletter, investment management firm GMO's Ben Inker describes the torturous parallel of the "mortal comedy" of investment management today in his article entitled, "Hellish Choices: What's An Asset Owner To Do?" Inker somberly explains the dilemma investors face with today's loathsome investment opportunity set:
Given today’s low yields and high valuations across almost all asset classes, there are no particularly good outcomes available for investors. We believe that either valuations will revert to historically normal levels and near-term returns will be very bad (Purgatory scenario), or valuations will remain elevated relative to history (Hell scenario). If valuations remain elevated indefinitely, near-term returns will be less bad but still insufficient for for investors to achieve their goals. Furthermore, given elevated valuations in the long term, long-term returns will also be insufficient for investors to achieve their goals.
It would be very handy to know which scenario will play out, as the reversion (Purgatory) versus no reversion scenarios (Hell) have important implications both for the appropriate portfolio to run today and critical institution-level decisions that investors will be forced to make in the future. Unfortunately, we believe there is no certainty as to which scenario will play out. As a result, we believe it is prudent for investors to try to build portfolios that are robust to either outcome and start contingency planning for the possibility that long-term returns will be meaningfully lower than what is necessary for their current saving/ contribution and spending plans to be sustainable. (explanations/emphasis added)
In the Purgatory scenario that Inker outlines we'll obtain the "salvation" of future higher risk-adjusted investment returns only if we "purge" today's high valuations. With the Hell scenario, there is no saving grace from a redemptive correction in valuations. We'll remain in this high valuation and tormentingly low risk-adjusted return environment potentially for the rest of our mortal existence.
The chart below highlights GMO's view of Purgatory and Hell scenarios over their seven year forecast period (click image to link to article and larger image). GMO's standard forecasting approach in the Purgatory scenario is that high valuations will gradually dissipate such that seven years from now valuations will have reverted to historical norms. GMO's Hell scenario assumes valuations do not mean revert but instead remain at historically elevated levels. Inker states:
Our standard assumptions for long-term asset class returns are that equities deliver 5.5 - 6.0% above inflation in the long run, bonds 2.5 - 3.0% above inflation, and cash 1 - 1.5% above inflation... The assumptions for Hell are 1.25% lower equilibrium returns across the board. In other words, in Hell the equilibrium return on cash is 0% real and risk premia are otherwise left unchanged.
The second chart below depicts GMO's mean variance optimized portfolios for the Purgatory scenario (left column) and Hell scenario (right column). Note the marked differences in asset allocation depending on whether you expect a valuation purge or not. There is a substantially lower weighting in risk assets (equities) in a Purgatory forecast with cash representing 50% of assets while the Hell forecast has 58% weighting in risk assets because there is no dread of a valuation purge. Also note that Emerging Market (EM) equities carry a 17% weight in both the Purgatory and Hell scenarios given the asset class has GMO's highest expected real return in either scenario. Inker states in a footnote to the article that he "put limits on asset classes." We believe he has likely constrained emerging market equities to 17% of the portfolio in both scenarios.
The third GMO chart below presents the Purgatory Portfolio and Hell Portfolio under two scenarios - Purgatory (a purging to normal valuations occurs within the seven year forecast period), and Hell scenario (no purging). Inker summarizes the differences in expected investment outcomes:
And while the two portfolios have similar expected returns if Purgatory turns out to be the correct forecast, the difference between the two in Hell is 1.3% per year for seven years. Another way to look at it is if you pick the Purgatory portfolio and it turns out we are in Hell, you will only break even with a more traditional 60% stock/40% bond portfolio. If you run the Hell portfolio and it turns out we are in Purgatory, you are taking almost twice the volatility and expected loss in a depression, and almost three times the portfolio duration for no benefit in expected return.
Inker concludes his investment article by stating that
...we believe the basic point is that from today's valuation levels, there are no good outcomes for investors.... we can hope that valuations fall to historically normal levels, because only if that happens will the institutional business models and savings and investing heuristics that institutions and savers have built still be valid.
Given Inker's sober investment outlook one must ponder whether there are any alternative paths for long term investors. Perhaps Dante's trials in Purgatory may provide useful allusions for today's investor. Purgatory is the second part of Dante's The Divine Comedy. Dante and Virgil ascend out of the depths of Hell to the Mountain of Purgatory on the far side of the world. The Mountain is on an island that is the only land in the Southern Hemisphere. This aspect of the poem has a distinct emerging market angle as we see in this global map below with Organization of Economic Corporation and Development (OECD) countries in blue and non-OECD or developing countries in gray and mostly in the Southern Hemisphere.
In addition, Dante's Purgatory Mountain has seven terraces rising one above the other which correspond to the seven deadly sins - Lust, Gluttony, Greed, Sloth, Anger, Envy, and Pride. The terraces are inhabited by souls doing penance as expiation for their sins - the conversion of the soul from the sorrow and misery of sin to the state of grace. One could imagine Dante finding a slothful soul running a penitential marathon while shouting with zeal, "Go Cubs Go" as if the Chicago Cub would ever have a snowball's chance in hell of winning a World Series. This aspect of the story suggests taking a contrarian view as well as a longer term perspective (up to 108 years for a Cub fan's salvation). These literary allusions led us to consider whether one possible asset class to enhance portfolio returns for investors was emerging market equities and debt (securities akin to some investors as lovable losers like the Cubs).
We found some potentially confirmatory views of higher expected returns for emerging market equities in the Purgatory scenario in recent forecasts of 10 year real returns by Research Affiliates as of October 31, 2016. Much like GMO, Research Affiliates' standard return forecast approach assumes that today's high valuations will mean revert to normal valuations at some point over the course of their projection period of 10 years (compared to GMO's 7 year forecast period).
As depicted in the following chart, Research Affiliates forecast 10 year real annual returns of 7.3% for emerging market equities compared to GMO 7 year Purgatory return of 3.7%. Research Affiliates' expected return is comprised of 2.7% from yield, 1.3% growth, 1.5% valuation, and 1.8% foreign exchange (weaker dollar). In addition, Research Affiliates' forecasts higher real returns for emerging market debt in local currencies of 3.8% over 10 years compared to GMO's 0.3% over 7 years. Lastly, Research Affiliates' forecasts higher real annual returns for international developed EAFE equities of 5.9% compared to GMO 7 year Purgatory return of 0.5%. Research Affiliates' return is comprised of 3.4% from yield, 1.3% growth, 0.0% valuation, and 1.2% foreign exchange (weaker dollar). Research Affiliates approach to foreign currency forecasts is summarized here. For the month of November, the U.S. dollar appreciated about 3% compared to a trade weighted basket of other major currencies.
Worldly fame is but a breath of wind that blows now this way, and now that, and changes name as it changes direction. Dante Alighieri
As we've stated in previous postings, there is no free lunch with emerging market equities or debt. Both asset classes are very volatile and prices are subject to rapid movement in global capital flows in and out of these much more thinly capitalized and less liquid markets. Emerging market equities were all the rage in the 2001 to 2007 period in the aftermath of the BRIC acronym (Brazil, Russia, India, and China) coined in 2001 by Jim O'Neill from investment bank Goldman Sachs in a paper entitled "Building Better Global Economic BRICs." Emerging market economies and equities enjoyed robust foreign capital flows and exuberant psychological tailwinds.
The winds of global capital flows changed subsequent to the global financial crisis and it has generally been a struggle for the former BRIC darlings. Emerging market equities have performed poorly on an absolute and relative basis over the trailing five and ten year periods. The emerging market asset class has disappointed investors so often many of its fans have adopted a Cub's like attitude, "Wait until next year." Meanwhile, S&P 500 large cap equities have become the Bronx Bombers of asset classes - winning return championship year after year through 2015. Through October 2016, the winds of global capital flows were in favor of the much maligned emerging markets only to abruptly reverse direction to U.S. shores with the wildcard Trump election.
We suspect that the global winds of capital flows will continue to change and as GMO's Inker has suggested portfolios must be robust to a possible purging of valuations, of which domestic markets are the richest. Portfolios also need to be responsive to changes in long term global capital flows, relative values, demographics, and economic conditions. A recent meeting with a China focused private equity firm provides some relevant anecdotes that suggest Western conventional wisdom on China is mostly wrong. China is making good progress in transitioning to a domestic consumption led economy with services accounting for 53% of GDP. China GDP growth was 6.7% for the first nine months of 2016. China's non-performing loan problem and corporate debt levels are manageable relative to the size of their economy.
The private equity firm's pending exits are mostly through sales to their local Chinese partners who are going long China's future. The Western view is that every Chinaman is seeking to get all of their wealth out of renminbi. Admittedly, wealthy Chinese are prudently diversifying their investments. Ironically, the perception of capital flight was erroneously promoted, in part, by the Chinese government encouraging Chinese companies to acquire real assets abroad with low cost government financing. The Chinese government would sell U.S. treasuries and replace these assets with financings of SOE's (state owned or controlled enterprises) purchases of real assets abroad. The Chinese government is changing course on this strategy.
As we've outlined above, Research Affiliates' expected real return forecasts are far more bullish for emerging market equities and debt than GMO's forecasts. Research Affiliates's forecasts are downright bearish on domestic equities. Running a portfolio optimization at a 9.5% volatility assuming a Purgatory scenario with Research Affiliates' on-line portfolio tools produces an expected real annualized portfolio return over 10 years of 3.7% compared to the 0.4% return with 5.3% volatility for GMO's 7 year portfolio optimization. The chart below summarizes this optimized portfolio's characteristics. The asset allocation is markedly different with 40% in equities (24% EAFE and 16% EM), 29% in government bonds (mostly short-term U.S. Treasuries), 14% in corporate bonds and bank loans, and 17% in alternatives (U.S. TIPs, foreign currencies, commodities, and REITs).
Much like Dante's journey through Hell and Purgatory, there is no easy path for investors today. GMO's analysis has demonstrated the considerable variability of investment outcomes depending on whether today's high domestic valuations are purged (Purgatory) or not (Hell). We've also shown with Research Affiliates analytical tools that there is considerable variability of expected return outcome across investment experts, particularly for emerging market equities and debt and developed international equities.
Already historically rich domestic equity markets are rising and signaling that investors believe President Trump will deliver them to the promised land of higher investment returns while he Makes America Great Again. We wish him well but believe the best salvation for investors in this high variability/risk environment is to think long term, contrarian, and pursue relative values. We believe investors should maintain robust portfolios comprised of globally diversified baskets of assets with a sufficiently meaningful position in emerging market and developed international equities while mitigating the volatility of these asset classes by being conservatively positioned with larger money market balances and overweight high quality fixed income allocations.
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