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Less Than Great: How 2020 Will Be Nothing Like 1990.

Summary paragraph: From aiCIO Magazine's September Issue: Aran Darling looks ahead to the volatile 'new normal,' and discusses what an asset owner might do about it.

To see this article in digital magazine format, click here. (

I assume the larger portion of our readership is unfamiliar with the musical stylings of NYC's gangster rappers. In trying to come up with an introduction for this article on investing in the post-2008 era, however, I couldn't find a more fitting quote than the following lyric by the Harlem hip hop artist Cam'ron: "When the grape gets dry, I hope you enjoy the raisin."

With negative real yields on 10-year and shorter US Treasuries, and negative nominal yields on certain "safe" European two-year government bonds, the financial grape has officially shriveled. The period of relatively steady economic growth and stable markets that lasted from the early 1980s to the mid-2000s, which has come to be known as "The Great Moderation," is over. And while the period we've entered is still taking shape, most indicators confirm that it will be characterized by increased volatility, tail-risk, and desiccated yields.

Curt Custard, Head of Global Investment Solutions with UBS says, "Investors can expect the next decade to look more like the 1970s than the 1990s." But what did the 1970s look like? "From 1970 to 1979," Custard says, "the annualized real return on the S&P 500 was negative 1.4%, and Treasuries yielded negative 1.7%." Custard believes the present global imbalances in trade and debt levels have created the same kind of policy uncertainty and unfavorable macro environment that caused asset prices to struggle throughout the 1970s.

"At this point, policy makers are out of options," Custard says, "which, combined with the demographic reality and increased volatility, points to more risk overall." The demographic reality to which Custard is referring is the generational divide between the under-35s who will be the next engine of growth in the US, and the 85 million retiring baby boomers (with $3.7 trillion in retirement assets) who desire to maintain the investment returns to which they became accustomed during the Great Moderation.

But booming boomer yields have not held up. Stock indices that grew 5% or 6% when GDP was consistently above 4% have been trading flat for a decade. The inimitable Jack Bogle once said that people who are uncomfortable with the idea of losing 20% in the value of their portfolio shouldn't be in the stock market. The new reality would probably see upwards of 25% (a two standard-deviation event) replace that already intimidating number.

Custard's view: "As a result of the increased volatility many investors and asset managers have shifted from seeking to achieve a return on capital to a return of capital." This is why the inflation considerations are relevant again now. "If investors," Custard says, "demand a real return of 2% and inflation is 2% they need a nominal return of 4%. But if inflation climbs to 4% and investors have the same demands, they will require a 6% nominal yield." A consistent 6% return today is not very easy to come by, especially if there are credit-rating criteria to adhere to, as is often the case with pension assets.

According to Custard, the admittedly uncomfortable solution to the challenge of investing in the post-Great Moderation period is for investors to learn to love risk. "Because of the leverage and regulatory issues in today's environment, people need to recalibrate their goals and expectations," he says. Custard believes investors can learn to love risk by viewing it as opportunity: "Dislocations provide instances for the forward-looking investors to reap gains."

For instance, Custard sees promise in emerging markets boosting global growth by strengthening their domestic consumption. He cautions, however, that "the transition period will be choppy and investors will need to weather discomfort to participate in the returns." In this type of market, fortune favors the brave.

"The primary guiding behavioral principle in finance today is that people hate loss more than they like gain," he says. Therefore, utility curves are path dependent. "Everyone is scared because of what has happened over the past few years," he says. "But the answer is definitely not to become less risk tolerant."

When I asked Custard what investors with a longer-term horizon should be thinking about buying, he recounted a story wherein he advised his father to consider taking a position in certain European equities. "I'll buy them when things get better over there," the Mr Custard Senior replied. "This won't work of course," Custard told me, "because by then my dad will be buying after the market has rallied."

Kyle Bass, Managing Partner of Hayman Capital Management, LP, says one of the most insightful essays for understanding the post-2008 world is The Black Swan of Cairo by Nassim Taleb. "In the same way that dictatorial regimes like Mubarak's smoothed social and political variability in their countries, central bankers in the world's advanced economies repressed volatility in the markets," Bass says. As Taleb's article shows, the problem is that when Tahrir Square finally gets occupied, or financial panic sets in, the turmoil is even more catastrophic because of the build-up.

For Bass, the macro risks in the present era should be a primary consideration in any investment strategy. "The G8 Central Bank balance sheet trajectory has reached $15 trillion," he says, "and governments have shown a willingness to print money before, during, and after crises." Bass adds that "total credit market global debt has gone from $80 trillion to $200 trillion in just 10 years (a compound annual growth rate of 11%). If you take a few steps back, you see this is the end of a debt supercycle that is 70 to 100 years in the making and has culminated in superpowers' debt loads ballooning to 200% to 250% of GDP." Bass adds that historically, countries with such debt levels would go to war.

Bass' view is that "the money multiplier isn't working and the debt overhang remains oppressive, so restructuring is likely the only way out." He thinks other nations which are even further from a period of moderation than the US may provide a roadmap for what's to come. "Japan is the most indebted nation on earth," he says, "and they will show us what a quadrillion yen restructuring will look like."

Asset allocation has had to change in light of this shift in the markets. Bass explains: "Institutional investors used to generate two-thirds of their bogie through fixed-income assets whereas, today, the equity book has to return 600 to 700 points to meet the benchmark." However, he cautions, "one can't even think about the cyclical nature of markets before a major restructuring occurs." So where do you put your money if you want to stay afloat? "US dollar assets are a good place to invest while this happens because the period is forcing people to make the wrong decisions at the wrong time." He sees the US dollar as "a way not to lose purchasing power by being in the wrong place."

The suppression and re-distribution of volatility that occurred under the Greenspan-era Federal Reserve has been replaced by a new reality -- one with significantly elevated risk. Being aware of the forces driving the current "Less Than Great" period is a step in the right direction. Additionally, investors need to embrace certain risks and be willing to leave their comfort zones with the positions they take on.

Investors can also focus on domestic markets due to the advantage that comes with holding assets denominated in the global reserve currency. Finally, it is worth remembering that this period, like the one that came before it, will end. And while one can't eat relative returns, raisins can tide you over until your next meal arrives.

-- Aran Darling
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Date:Sep 1, 2012
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