Mill Creek’s Chapin: Take More Risk With QE3
September 12, 2012
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Ludwig: That said, corporate balance sheets are looking quite good, no?
Chapin: Yes. We had record-level S&P 500 earnings—the second quarter was all-time high. Dividends are rising; total payouts are high. Corporate balance sheets are strong. If you’re a major corporation, and you can't make more money by borrowing long term at these kinds of rates, then maybe you shouldn’t be in business. So yes, corporations are in great shape. Unfortunately, unless they start seeing some top-line revenue growth, they won't be able to increase earnings.
Ludwig: So, when you think about these three legs in various states of repair or disrepair, are you of the mind that some of the more traditional asset allocation concepts might be fresh for reinterpretation? Or are you much more, “Let’s not get carried away. It’s still about basic asset allocation, depending on your age, regarding equity and debt balances”?
Chapin: Well, we like to allocate client assets and recommend asset allocation based on forward-looking market assumptions. And, you know, you can derive all those in terms of what you think corporate profits and dividends and valuations will be on the equities side, and look at that and say, “OK, it takes only reasonable expectations to get decent real returns in equities. And maybe they're not 12 percent or 10 percent, but maybe they're 7 to 8 percent, which, in a low inflationary environment, is a good return on your money.”
But equities can be volatile. So you want to hold some amount of less-volatile assets like fixed-income securities in your portfolio. I think normative expectations for clients and for asset allocation models are 5 to 7 percent returns on fixed income, and we don’t see these securities producing returns anywhere near that in the years just ahead. We’re talking about this possible outcome a lot with clients.
Ludwig: We’re looking at financial repression right now, pretty much, right?
Chapin: Good old financial repression, yes. Record-low levels of nominal yields and negative real yields, and the Fed has said it will hold them down for a few more years. But at some point they’ll have to go up because investors will demand a real rate of return on their money. And rates going up from here mean flat or some negative returns on your fixed-income investments. And how does that get you closer to your retirement savings goal?
Ludwig: So do you think outside the box, like maybe a bigger commodities-related-type allocation—either through equities or futures-type instruments—is needed?
Chapin: Yes, I think you have to look outside the box at nontraditional asset classes and strategies. And that’s the sort of discussion we’re having with clients as well, to say, “Recognize that the returns on fixed income aren't going to be as great. So you need to either tiptoe out—or even waltz out—to take more risk if you want to hit your overall return targets. And what is the right amount of risk for you? Does it mean that you have a lot more in traditional assets, like equities? Do you need to get some commodities exposure? Do you need to get into other alternative investments and strategies?”
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