Past investment performance is not an indication of future returns. For an executive at one of the world’s largest investment management firms, that traditional investment disclaimer provides a stark warning for the new financial landscape.
Ed Devlin said at a CFA Vancouver event, “Investors have to realize that they’re not going to get the double-digit returns they’ve had in the past. This is probably one of those environments where you really have to have a forward-looking framework. You can’t just look at history, buy stocks for the long-term, buy and hold and close your eyes. The new normal is not that kind of environment.”
Devlin is executive-vice president and head of Canadian portfolio management for Pacific International Management Company LLC (PIMCO), which has more than $1.1 trillion in assets under management. It has forecast a “new normal” in the global economy created by the financial crisis, which has created structural changes that will profoundly affect markets and asset prices.
A trilogy of fundamental changes underlies PIMCO’s argument.
“Our forecast for the next three to five years is below-trend growth,” said Devlin. “We don’t think that credit-fuelled private-sector growth is going to happen and public-sector growth is going to retract.”
The first trend is global re-regulation, which Devlin said will likely slow the creation of credit. The second is a stronger push toward trade protectionism, leading to some de-globalization of trade, further reducing international economic growth. One of the key changes, however, is the end of a 20-plus year “super cycle” of borrowing and consuming in the developed world.
“We’re in a multi-year period where two large segments of the economy have to de-leverage,” Devlin said. “One is the financial system, which means credit is going to be harder to obtain, and second are households.”
While much has been said about household debt of U.S. consumers, Devlin noted that Canadian households are not much better: Canadian household debt-to-GDP ratio is at 94%, higher than U.S. households' 93%.
“I think the Bank of Canada should be happy about that to some degree,” said Devlin. “When you’re lowering rates closer to zero, you’re encouraging people to borrow so you can bring consumption forward, so it worked out as it was supposed to, because the Canadian banking system and credit creation process wasn’t as broken as it was in the U.S. But that’s also why the Bank of Canada is tightening rates, because it’s time to tap on the brakes.”
Increasing uncertainty about the sovereign financial solvency will also persist over the next three to five years. He said at least two or three significant countries could default over the next few years. The problem in the U.S is just as acute as several American states face rising deficits and growing debt.
“The real question is will Uncle Sam bail them out, or will they pull down Uncle Sam.”
But Devlin provided a glimmer of optimism for investors. He said Canada’s strong financial system and fiscal balance sheet will make the country’s market an attractive safe haven for international investors.
“Canada should be a relative winner in this new normal environment, relative to other G7 countries. It means more capital inflows into Canada, which means lower real rates. With a flight to quality coming from oil producers in the Middle East and currency manipulators out of Asia, they’re all going to look to buy some Canadian dollars. It’s not going to be a flood, and it’s not going to happen tomorrow, but it’s going to trickle in as the U.S. has abused [its] privilege of providing the reserve currency to the world.”
However, Canada is going to be affected by the economic challenges in the U.S., so investors should expect continued volatility in Canadian debt and equity markets as funds flow in and out of the Canadian market.
In a world with lower expected returns, Devlin noted it’s even more important for investors and their advisers to have their entire portfolio working to earn extra risk-adjusted active return on investment (alpha) and not simply rely on the stock portion of a portfolio.
“You can be more active in the marketplace and get your fixed income to work, because it’s going to be very hard in the new normal to just keep it under the mattress. Higher volatility is the friend of an active investor and we think that creates a pretty good market for creating alpha, and we think you should be looking at alpha across all sectors in this new normal.”
While the Canadian market should be relatively strong over the next few years, much of the world’s economic growth will be in emerging markets, especially in the key BRIC countries: Brazil, Russia, India and China.
“Think of emerging markets as a bigger piece of your portfolio, think of debt and preferred shares as a bigger piece of your portfolio and think about your age more. Older investors should not be heavily involved in stocks.”