Jean L. P. Brunel, chief investment officer at GenSpring Family Offices, says low interest rates have made the investment environment “radically different.”
By PAUL SULLIVAN
Published: March 16, 2012
Article from The New York Times
THE stock market seems to have found its footing lately, touching levels not seen since early 2008.
So I was surprised to hear Jean L. P. Brunel, chief investment officer at GenSpring Family Offices, tell me that he was preparing his clients for a sustained period of low investment returns. And further, he is counseling those clients — families with hundreds of millions of dollars — that they may need to spend less or change their estate plan.
If this is his advice for the wealthy, what does it mean for people with considerably less, who may simply be saving for retirement?
Mr. Brunel argues that the classic link among the return premiums for bonds over cash and stocks over bonds still holds, but they are substantially lower because of the low interest rates set by the Federal Reserve.
Here is how it works. The return on cash is typically the expected rate of inflation plus some real interest rate that is derived from the rate a central bank sets to promote growth. The return on bonds is cash plus some additional amount to account for the duration of the bond. The return on equities is the bond returns plus some premium for the risk associated with stocks.
He noted that cash typically had a return of 4 percent, putting bonds at 6 percent and stocks at 8 to 9 percent. With cash now yielding zero, that has lowered bonds’ return to 2 to 2.5 percent and stocks to 5 percent. The problem, as he sees it, is that too many people are stuck on the old numbers.
“I don’t want you to read into this that we have precise information on real returns,” he said. “I could be wrong. It wouldn’t be the first time. But whichever way you cut it, the environment is radically different.”
Sure, the stock market is off to a nice start this year. But 2011 also started strong — until the tsunami in Japan and the uprisings throughout the Arab world touched off a downward spiral. For the year, the Standard & Poor’s 500-stock index finished flat, unless you include dividends, which put it up 2.1 percent.
We’ll find out if Mr. Brunel’s gloomy take is right. But in the meantime, his forecast of low returns is worth thinking through.
LOWER EXPECTATIONS The consensus among other analysts I spoke with is that most people should plan for single-digit investment returns for a while. That time horizon ran from five to as many as 20 years, in the case of Jim Russell, regional investment director at U.S. Bank Wealth Management.
“If we’re able to generate returns above that, that’s a good problem to have,” he said. “Most clients think the worst is over, but most professional investors think the black swan event is possible.” (A black swan, a term popularized by the economist Nassim Nicholas Taleb, is the unlikely event that too few people plan for.)
Darrell Cronk, chief investment officer for the Northeast at Wells Fargo Private Bank, said the issue for many clients was the effect of negative real interest rates on their portfolios. This is often a hidden problem because, for example, a 10-year United States Treasury bond was paying 2.295 percent on Friday, but core inflation is around 3 percent. In other words, owning government bonds costs investors money.
“Over the past decade or two, we’ve had positive real rates of return,” Mr. Cronk said. “We talk about purchasing power risk, scarcity of income for portfolios and duration risk, but a negative real interest rate is a challenge for the bond market.”
Maria Elena Lagomasino, chief executive of GenSpring, said clients were not pleased with the implications when she talked to them about Mr. Brunel’s calculations. “The clients get mad when you say what we thought was true in the past may not be true in the future,” she said. “Maybe it won’t happen. But what if it does?”
HOW IT ENDS Mr. Brunel’s forecast is bleakest in how he believes the environment of low investment returns will end: global hyperinflation to reduce government debt burdens.
Given this gloomy time, he may well be overly pessimistic — the flip side of being overly optimistic when it seems that markets can only go up. (Mr. Brunel said that even his son was rooting against his end-game prediction.)
“A lot of our clients are worried about the after-effects of this global liquidity glut and what it will be” said Katie Nixon, chief investment officer for personal financial services at Northern Trust. “The world is awash in developed market currencies. You can inflate your way out of it or you can grow.”
She falls on the side of slow but steady growth.
Mr. Cronk said that the notion of using inflation to deal with too much government debt was an old one. While he agreed that anything was possible, he also said that he expected moderate inflation and moderate growth in gross domestic product.
“It won’t be 5 to 6 percent, but a positive 2.5 or 3 percent growth rate that would allow interest rates to move higher,” he said. “It would reinflate the value of risk assets so you’d get more normal returns.”
Growth that small, he said, probably will not quickly reduce the unemployment rate.
SOLUTIONS When, how and if returns on traditional assets return to old levels is not the immediate issue. Rather, the question is how people should plan for years of low returns, particularly when retirement may be near.
The easiest strategy is to spend less. But telling people to cut back is as difficult a conversation to have as telling people that the old model is broken.
“The day we do that is the day the relationship walks out the door,” Mr. Russell said. Instead, he shows clients portfolio simulations so they can see what the current return rates mean for the future.
If these return predictions are wrong, the worst that can happen is people have more money. (Mr. Brunel is more concerned, he said, with the overly optimistic return projections that many, often underfunded, pension funds are making, since they will have to pay out a set amount of money at some point.)
The other option, which the analysts I spoke to all agreed on, is for people to rigorously practice mental accounting — one of the main tenets of behavioral finance. By putting money in various fictional baskets or buckets, people can become more comfortable about the money they have. As long as the money for the next five years is safe, the thinking goes, clients are less apt to touch the money meant for after that.
Mr. Cronk suggested that investors consider a medium-term basket, which would be for securities that have an income stream. “You need to look for income in nontraditional sources — places where there is growth and income streams over time,” he said. He said he had been recommending real estate investment trusts, master limited partnerships and dividend-paying stocks for his wealthy clients. But these are all securities that most investors can buy.
For the money in the basket meant for growth, Mr. Brunel recommended securities that focus on global issues not tied to the economy of any one country: consumer demand, the need for more energy and technological innovation.
Of course, this is predicated on a long-term view — and an ability to wait. “Things do recover,” Ms. Nixon said. “It just takes time.”
Article from The New York Times
