THE LONG VIEW: The biggest threat investors face now? A stagnant market

U.S. money manager GMO's forecasts for market returns, widely followed by investment professionals, are now decidedly downbeat. (Richard Drew/AP)
U.S. money manager GMO’s forecasts for market returns, widely followed by investment professionals, are now decidedly downbeat.

IAN McGUGAN The Globe and Mail

One of the biggest unacknowledged threats that investors face now is the possibility that nothing happens.

That’s nothing as in a stagnant market, not just for a year or two, but for a decade or more to come.

It’s one of a couple of scenarios that Ben Inker worries about as he surveys an investing landscape where just about everything appears expensive. The co-head of the asset allocation team at money manager GMO in Boston says that while many people worry about a market crash, few ponder an equally dangerous alternative – the possibility that we are entering an era in which long-term returns may persistently fall short of expectations.

If interest rates and bond yields were to remain stubbornly low, the time-honoured notion that pension funds and other astute investors can generate a return of “inflation plus 5 per cent doesn’t work,” Mr. Inker said in an interview.

It’s one reason he thinks people should be more cautious than usual despite the stock market’s recent string of record highs. “You’re not being paid as much to take risk as in the past, so it makes sense to take less risk than in the past,” he said.

Mr. Inker is not as well known to Main Street investors as his colleague Jeremy Grantham, but he has emerged as an equally compelling voice in his recent commentaries. Among other things, he’s argued that “U.S. small caps seem to offer the stock equivalent of a case of salmonella.”

Such brutally frank assessments are rare in the investing world but common at GMO, which has built a reputation for outspoken bluntness. The money manager, which oversees about $124-billion (U.S.) in assets, sounded the siren before both the dot-com crash and the U.S. housing bubble.

Its forecasts for market returns are widely followed by investment professionals and, right now, are decidedly downbeat. “There’s not much for an investor to get excited about,” Mr. Inker says. According to GMO’s economic models, both U.S. stocks and bonds are likely to lose money, after inflation, over the next seven years.

That grim outlook rests on the assumption that today’s rock-bottom interest rates will climb off the floor and revert to something like their normal levels over the next few years as the economy improves. Rising rates would hurt bond prices, which move in the opposite direction to yields. They would also make stocks less attractive as an investment alternative.

Even scarier, though, is what happens if the opposite occurs and rates don’t go up in the next few years. In the short term, low rates might provide fuel for even more market gains, but they would also imply an economy plodding along with minimal growth.

In such a scenario, the long-term returns from both stocks and bonds would disappoint. Many pension funds base their forecasts on the notion that a balanced portfolio can be relied upon to produce a 5-per-cent annual return over inflation. But that assumption dies in a low-return world. Instead, investors may be left scrambling to produce a 3.5-per-cent real return – and that’s before taxes and fees.

In effect, portfolios are in for a tough time no matter what, according to GMO. If rates go up, there will be the immediate hell of short-term losses in stocks and bonds. But if rates stay low, there will be the purgatory of lacklustre results for years to come.

So what can an investor do? “It would be tempting to sit on the sidelines, but the cost of sitting on the sidelines is higher than it was in the past,” Mr. Inker says. With cash and high quality bonds yielding so little, anyone seeking higher returns has to devote at least a small part of their portfolios to alternatives that are less obvious.

He believes emerging markets can offer decent value, especially if you venture beyond popular sensations such as Alibaba and look at cheaper sectors – South Korean industrial conglomerates, for instance, or Chinese banks, Russian oil companies and Taiwanese information technology firms.

Such stocks involve risk, but a diversified portfolio of them is less dangerous than one might think, he argues. “Lots of bad things can happen to any one of these companies, but the same bad thing is unlikely to happen to all of them.”

Mr. Inker also sees some appeal in European value stocks and in U.S. high quality companies – those that can churn out high profits throughout an economic cycle and that have little debt. But he is unimpressed with large energy producers despite their apparently low valuations.

“It costs more to find a barrel of oil now than it did in the past, so these companies’ true economic profit is usually less than their accounting profits. An oil company trading at six times earnings is not as cheap as it appears.”

Follow Ian McGugan on Twitter: @IanMcGugan

Posted in Investment