The next decade will be a very challenging one for the typical portfolio of 60% equities and 40% bonds.
This mix has done well since the 1950s. The logic is that over a decade, these two assets should each generate positive returns.
But the current situation is different, which means we must look for moneymaking opportunities elsewhere. Let me explain…
Flat to Negative Returns
Equity values have already brought forward much of the earnings for the next decade by shifting the discount factor to near zero.
This means that unless companies show fantastic growth rates in earnings, stock prices have probably already discounted the future stream of earnings, or at least a good chunk of them. The mere hint of higher rates will send stocks tumbling.
Accordingly, I expect stock indices to waffle about for the next decade, chopping around without a prospect for great growth. Of course, there will be exceptions, just as we’ve seen over recent months, but the overall tendency will be for flat to negative returns.
Stocks will be primarily vulnerable to two things: higher rates, and any sort of setback in growth rates. Yes, there are other risks as well – political is one for sure – but these two are plenty.
Bonds have also brought forward a lot of their future gains by lowering the discount factor from 2.5% to 0%. They are a long duration asset, and higher rates will also drive their prices lower.
So the 40% of the portfolio that is supposed to be an asset actually behaves more like a liability. It has asymmetrical downside risk!
Don’t Expect Any Moves in Interest Rates
The bond prices can only go higher if we shift to negative rates. But will rates go negative here in the U.S.? Unlikely. The Federal Reserve may be a bit reckless, but they are not keen on this idea.
We can see what negative rates do to help an economy by looking at Europe and Japan… And the answer is not much. In fact, it hurts the banks’ earnings significantly, which in turn forces them to tighten up their lending criteria.
So, the fact that rates can’t really go lower destroys the 40% of the portfolio that is supposed to be a balancing asset with a steady cash flow.
But what about higher rates? That brings us back to something I wrote about last week:
Given the extreme sensitivity to higher interest rates in stocks and bonds, the Federal Reserve is in a box.
Unless there is a surge in inflation – which is highly unlikely given the 30 million people receiving some form of unemployment benefits – the Fed can’t move on rates.
Moreover, with the massive fiscal deficits, it is unlikely that the Fed will be in a mood to raise rates, since that would simply raise the cost of funding for the government.
In short, the political pressure to hold rates steady will be enormous. Plus, we have already seen how much Fed chief Jerome Powell cares about the value of his own portfolio – which could be hurt by higher rates.
So we should not expect any moves by the Fed to lift rates for many years.
Where the Opportunities Will Be
The Fed has been largely stripped of its traditional role of managing the economy by using interest rates to make necessary adjustments. Instead, its main job will be to continue monetizing the ever-growing federal deficit.
This was largely the job of the Fed during World War II, so it is not without precedence. This limited function will probably persist for close to ten years.
But the big question is: Where does it all lead?
To answer that, take a look at the chart below. It shows the average annual inflation rate by decade since 1913.
You can see there was a long-term cyclical fall in inflation, followed by another rise, and yet another fall.
Also notice how, starting in the 1910s, and then again in the 1970s, we had decades of high inflation. These giant trends tend to last for about sixty years, so I believe we’ll see the next surge in inflation starting around the end of the 2020s.
In other words, I don’t expect inflation to rise right away. First, I believe we’ll see a blow-off phase of deflation between now and 2030. After that, we should be ready for a sharp pick-up in inflation once again.
That means that over the coming years, interest rates may not move, except in the bonds with longer durations. But global differences in growth, inflation, and policy paths will still yield massive levels of volatility.
As I wrote last week, that volatility will show up in the currency markets in particular, but also in some commodity markets. In fact, we will have a new Golden Age for trading in currencies and currency-like products such as gold and Bitcoin.
Editor, Money Trends
Like what you’re reading? Send your thoughts to [email protected].