From: aditya rana
Date: Sat, Jul 16, 2016 at 1:25 PM
Negative real interest rates across the developed world pose a dilemma for investors as expected returns on most traditional asset classes are correspondingly low. So what should investors do regarding asset portfolio allocation under this type of an environment. The ever thoughtful and insightful Chris Brightman, the CIO of the financial advisor Research Affiliates , provides a helpful framework with which to approach this key question (http://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/562_Death_of_the_Risk-Free_Rate.aspx?_cldee=YWRpdHlhQHJhbmE2MC5jb20%3d) . To summarise:
-The risk-free rate is central to modern finance and investment methodology, and given that the world today is so far removed from positive real rates it is critical to adapt to the new environment to make informed decisions on optimum portfolio allocations. The key here is to appreciate that managing volatility is a detriment to achieving portfolio return objectives.
-Given that there is an increasing likelihood of direct money creation (“i.e. helicopter money”) by central banks , long term inflation expectations should be adjusted higher.
-Fears of deflation have resulted in the cheapening of inflation hedges such as commodities, bank loans, high-yield bonds, REITs and emerging market equities, thereby providing a unique opportunity to improve expected returns by investing in these assets.
-Money’s traditional role of a unit of account, medium of exchange and a store of value is increasingly being challenged by technology and persistent negative real interest rates (i.e. a storage cost) – calling into question whether other instruments and technologies can serve the same purpose.
-For example, virtual currencies using blockchain technology could eventually provide an alternative unit of account , and the ability to link credit card or a mobile payment app with a securities brokerage account together with a transaction sweep account, potentially obviates the need for cash or bank deposits as a medium of exchange.
-Holding liquid real-assets in place of bank deposits, provides us with positive long-term real expected returns and a superior store of value when compared to cash and government bonds which pay negative real rates.
-When investors start substituting real capital assets for cash and government bonds, the traditional method employed by central banks to manage the economic cycle by changing interest rates become difficult. This is because changing rates (i.e. the value of a currency) causes a change in the prices of real assets denominated in that currency without changing the value of the real asset.
-However, central banks still perform the crucial function of a lender of last resort to provide liquidity to the market during crises. But continued attempts to boost employment and real economic output increases the risk of long term inflation. So far, unorthodox policies have not created inflation as the central bank has been purchasing securities from banks rather than directly creating money – but if they start doing so then inflation could soon follow, as history has shown us.
-Negative real rates on cash and government bonds cannot even preserve purchasing power over the long run, let alone provide a real positive return over time to meet our investment objectives. This raises the question whether default-free negative real rates are really risk free?
-While the higher short-term volatility of a diversified portfolio of real capital assets is higher than that of T-bills, are they really riskier from the perspective of long-term wealth accumulation? Over a 10 year time horizon, the most of the return dispersion of a well diversified portfolio of real assets is higher than that of T-bills, begetting the question whether a guaranteed failure to meet return objectives can be viewed as low risk?
-While cash and government bonds should continue to play the important role of pre-funding near term commitments, cash also plays the important tactical function of providing an option to invest later at a lower (or higher) price.
-Commodities, bank loans, high-yield bonds, REITs and emerging market equities have traditionally provided a hedge against inflation by providing a positive correlation of returns to inflation (see chart below).
-With current fears on deflation, these inflation hedge assets have cheapened substantially and an equally weighted portfolio comprising these five assets provide a large pick-up in current real yield over the traditional 60/40 portfolio (see chart below).
-Higher starting yields have historically proved to provide higher future returns, and analysis currently shows that T-bills provide an expected 10-year real return of -0.6%, a 60/40 portfolio of 1.2% versus 4.0% for the equally-weighted inflation hedge portfolio. Higher expected returns imply higher volatility, with T-bills at 1.5%, 8.6% for the 60/40 portfolio and 12.2% for the inflation hedge portfolio.
-However, the higher volatility does not necessarily imply higher risk over the longer term. Looking at the dispersion of real returns for the different asset classes, a 95% confidence band for annualized 10-year real returns is -1.1% to -0.1% for T-bills, -1.6% to 3.9% for the 60/40 portfolio and 0.1% to 7.9% for the inflation hedge portfolio (see chart below). A near certainty of exceeding the long-term real returns of T-bills should not be viewed as higher risk.
-Central banks have engineered negative real rates by directly purchasing securities from the market and the corresponding creation of bank reserves. Given the increasing possibility of them moving to the next step of direct money creation, it would be prudent to shift a portion of an investment portfolio towards higher yield inflation sensitive assets like commodities, bank loans, high-yield bonds, REITs and EM equities to improve future returns.
-Brilliant piece of thinking and analysis which makes the salient point that longer term investors should embrace higher volatility by investing in a diversified portfolio of higher yielding assets to improve returns over the long term. This is a recurrent theme of this newsletter, and a portfolio weighted towards EM equities (over 8% expected real return over the next 10-years), EM US$ bonds (3.1% return) and local currency bonds (4.4% return), commodities (1.3%), European and Japanese equities (6.3% return) and developed country high-yield bonds (3.1% return) is likely to provide higher returns over the ensuing decade. Adding on sharp market downturns, and taking some cash off the table on upturns to provide the option to buy cheaper later, would be a sensible strategy to follow over the coming years.
-As pointed out previously, US investors selling into the stock market rally this year (with the S&P up 17% from its Feb lows) has reached near record levels as the chart below illustrates. So the question to ask is what is driving this rally?
-As the chart (from Matt King of Citibank) below illustrates, it is the surge in global central bank purchases (the highest since 2013) which is driving the global rally in risk assets driven by an acceleration of purchases by the ECB and the BOJ, and a reversal of the previous decline in EM FX reserves (see second chart below on the correlation between CB purchases and global risk assets). King expects this rally should continue going forward given the “potential for a further squeeze in risk assets driven by a broadening out of mutual fund inflows from IG to HY, EM and equities; the second lowest level of positions in our credit survey (after February) since 2008; and prospects of further stimulus from the BOE and perhaps the BOJ”.
Health Benefits of a Plant-based diet:
-To follow-up on last week’s summary of a guide to a plant-based diet published by the Permanente Journal a (a US based a peer-reviewed journal of medical science, social science in medicine, and medical humanities), I thought (on the suggestion of a reader!) it will be useful to present the relevant details of the guidelines which contains some very helpful information relating to the benefits of a plant based diet with links to the underlying research (for those interested). The article will be serialised in the following few newsletters.
SUMMARY OF HEALTH BENEFITS:
-Plant-based nutrition has exploded in popularity, and many advantages have been well documented over the past several decades.1 Not only is there a broad expansion of the research database supporting the myriad benefits of plant-based diets, but also health care practitioners are seeing awe-inspiring results with their patients across multiple unique subspecialties.
-Plant-based diets have been associated with lowering overall and ischemic heart disease mortality; supporting sustainable weight management; reducing medication needs; lowering the risk for most chronic diseases; decreasing the incidence and severity of high-risk conditions, including obesity, hypertension,
hyperlipidemia, and hyperglycemia; and even possibly reversing advanced coronary artery disease,
and type 2 diabetes.
-The reason for these outcomes is two-fold. First, there are inherent benefits to eating a wide variety of health-promoting plants. Second, there is additional benefit from crowding out—and thereby avoiding—the injurious constituents found in animal products, including the following:
– Saturated fats: Saturated fats are a group of fatty acids found primarily in animal products (but also in the plant kingdom—mostly in tropical oils, such as coconut and palm) that are well established in the literature as promoting cardiovascular disease (CVD).
The American Heart Association lowered its recommendations
for a heart-healthy diet to include no more than 5% to 6% of total calories from saturated fat, which is just the amount found naturally in a vegan diet (one consisting of no animal products).
-Dietary cholesterol: Human bodies produce enough cholesterol for adequate functioning. Although evidence suggests that dietary cholesterol may only be a minor player in elevated serum cholesterol levels, high intakes are linked to increased susceptibility to low-density lipoprotein oxidation, both of which are associated with the promotion of CVD.
Dietary cholesterol is found almost exclusively in animal products.
-Antibiotics: The vast majority (70% to 80%) of antibiotics used in the US are given to healthy livestock animals to avoid infections inherent in the types of environments in which they are kept. This is, therefore, the number one contributor to the increasingly virulent antibiotic-resistant infections of the type that sickened 2 million and killed 23,000 Americans in 2013.
-Insulin-like growth factor-1: Insulin-like growth factor-1 is a hormone naturally found in animals, including humans. This hormone promotes growth. When insulin-like growth factor-1 is consumed, not only is the added exogenous dose itself taken in, but because the amino acid profile typical of animal protein stimulates the body’s production of insulin-like growth factor-1, more is generated endogenously. Fostering growth as a full-grown adult can promote cancer proliferation.
-Heme iron: Although heme iron, found in animal products, is absorbed at a higher rate than nonheme iron, found in plant-based and fortified foods, absorption of nonheme iron can be increased by pairing plant-based protein sources with foods high in vitamin C. Additionally, research suggests that excess iron is pro-oxidative and may increase colorectal cancer risk and promote atherosclerosis and reduced insulin sensitivity.
-Chemical contaminants formed from high temperature cooking of cooked animal products: When flesh is cooked, toxic compounds are produced which are
compounds carcinogenic, pro-inflammatory, pro-oxidative, and contributive to chronic disease.
-Carnitine: Carnitine, found primarily in meat, may be converted in the body by the gut bacteria to produce a toxic compound (
TMAO). High levels of TMAO
are associated with inflammation, atherosclerosis, heart attack, stroke, and death.
-N-Glycolylneuraminic acid: This compound is found in meat and promotes chronic inflammation.
Here’s to crowding out animal products from your diet and replacing them with healthy plant-based foods! I will be travelling for the next three weeks and the newsletters will recommence on August 20. Wishing my readers an enjoyable and restful summer!
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