Tackling the 3 Ds of investing

As part of our annual review of the markets, the economy, and consequently our investment strategies going forward, Nicola Wealth Management organized two seminars whose theme revolved firmly around the impact of massive global government fiscal stimulus and the debt that goes along with it.

We discussed the questions that are on everyone’s mind:

• How will that debt be funded and eventually repaid?
• Will increasing government debt be inflationary or deflationary?
• What impact will demographics have on debt and deflation/inflation?
• How might that affect our asset allocation and specific asset selection?

For any answers to emerge, first let’s summarize the current government debt situation.

It would be kind to say the picture is not pretty, although the world has now split between what appears to be the profligate spenders of the developed world and the industrious ants of the developing world (see “Deeper in debt”).

Debt levels are rising, because countries are trying to mitigate the impact of the financial crisis that began in 2008. On average, the G20 nations will have a 2010 fiscal deficit equal to 8.6% (anything more than 3% is not considered sustainable in the long term) and a current debt-to-GDP of 100%, which puts them at the tipping point of default, according to a detailed analysis of government debt written by Carmen Reinhart and Kenneth Rogoff (This Time it is Different: Eight Centuries of Financial Folly).

Their observations about sovereign debt and the numbers are sobering—especially the fact that over the last 200 years it was far more common for countries to have defaulted on their debt than to have repaid it.

• 66 countries have represented 90% of global GDP since 1800;
• Only 17 have not defaulted;
• “Ne’er-do-wells” include France, Germany, China, Russia, Latin America, and Japan; Greece is a serial defaulter (according to Reinhart and Rogoff, it has been in default for 105 out of the last 200 years); and
• Default Virgins include Canada, Australia, Singapore, and the U.S.

Other countries are also facing a wall of resistance from the bond market regarding their never-ending deficits. Portugal has just experienced a reduction in its bond ratings; Britain, Spain, Ireland and even the U.S. may not be far behind.

To exacerbate this current fiscal mess, we have much bigger future problems with the joint unfunded liabilities of health care and pensions in an aging world.

• Global birth rates have declined from five children per woman to 2.5 today (replacement is about 2.1);
• Those rates will continue to drop to below two by 2050, at which time the global population will reach about 9 billion;
• While this is good for both the environment and limited natural resources, it also means we will be aging faster in the next 40 years than we have ever experienced (and not just in the developed countries);
• China is arguably the fastest aging country in the world as a result of its one-child policies, and the percentage of its over-65 population will rise from 12% of the working population to 38% within 40 years—far more than the U.S.

These unfunded liabilities are estimated to be in the range of 300% to 400% of GDP, or several times larger than all existing current debt (see “The cupboard is bare”). Our observation is that they are unaffordable and, as such, many of the promises made about funding health care and government pensions will be reduced. The bottom line is: we will work longer and be more directly responsible for our own health care—perhaps a better outcome and one more likely to lead to a healthier and more productive life.

Long-term effects

The prolonged effect of the recession—and what some observers are calling The New Normal—will likely cause:

• Unemployment to take longer than normal to recover to pre-recession levels;
• Interest rates to remain below normal for longer than most analysts expect;
• The secular bear market in equities to continue as ongoing personal (and eventually government) deleveraging takes place;
• BRIC countries (Brazil, Russia, India and China) to continue to outperform in relative terms, as do commodity-based countries such as Australia, New Zealand and Canada;
• The U.S. dollar to continue its downward spiral (although recent issues with the Euro may slow that down);
• Sovereign debt to find there are limits to government borrowing. When governments deleverage this will create a drag on economic growth in the short to medium term.

Investment strategies

The last decade was, in terms of making positive returns, the most difficult in well over a century (see “The negative noughties”). Ten-year returns for 10 different asset classes—a diversified portfolio of 10% in each category—would have netted about 2% per year after fees for the last decade.

While the importance of diversification can’t be stressed enough, our main focus is (and will continue to be) cash flow—through assets that generate a sustainable or growing income stream. That approach has worked very well over the last 10 years, especially when compared to traditional balanced fund approaches (typically 60% equities and 40% fixed income as represented by the Globe Peer Index (see “Diversification and cash flow”).

As we look forward to the next 10 years, we are reminded about how difficult it is for anyone to make accurate predictions this far out. How many people would have predicted a Canadian dollar over par in January of 2000 when it was trading at $0.69US, or that the noughties would provide the lowest return for U.S. stocks of any decade ever (including the 1930s) when for the previous two decades it had increased by 1,400%?

Our approach is to develop a strategy based on value principles, cash flow and diversification, and then look for good opportunities within each asset class.

Some of those opportunities could include:

• Life annuities (with or without life insurance) as an alternative to other fixed-income vehicles. Yields are excellent and for non-registered capital, as much as 60-80% of the income is tax-free;
• Preferred shares with adjustable medium-term rates; significant tax benefits on income received for non-registered and corporate accounts;
• Mortgages on income-producing assets; especially subordinated debt-to-low-loan-to-value first mortgages;
• Distressed debt in publicly traded companies (this we have done through our private equity LP with Maxam);
• Other private equity pools that are able to acquire assets at far better pricing than might exist in public markets;
• Income-producing real estate where the spread between cap rates (income yield) and mortgage rates is at least 2%; and
• Diversification out of the Canadian dollar to take advantage of its increasing purchasing power of foreign assets. (Specifically, we are looking at U.S. income-producing real estate and global bonds).

We remain in a challenging environment where the two main factors will be the deleveraging of both consumers and governments, and the political and lifestyle changes society will make as a result of aging populations. This does not mean that good investment opportunities will not exist. As usual it will take significant effort to find value.

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John Nicola is partner and financial advisor at Nicola Wealth Management.

John Nicola