A balanced portfolio alternative
In recent weeks, analysts have argued forcefully that the spectre of deflation looms large with capitalism returning to its “19th century roots” of deflationary booms and busts. They point to the wide dispersion of weak prices and recently added a twist by highlighting weak silver prices as a reliable predictor of price declines. The next question is whether price signals point to a world economy that faces an ugly bust driven by debt-deflation dynamics or could it be an old style generalised deflationary boom?
A “good” deflation would result from productivity gains, derived in particular from new hydrocarbon extraction methods and revolutionary automation practices. Since industrial debt tends to be concentrated with producers which are subject to intense creative destruction, much of the core industrial system faces an existential threat. There will be winners and losers in this scenario but the economy as a whole should thrive as consumers will get more for less.
The headache for investors is that even as the US appears to be enjoying a virtuous deflationary cycle, much of Europe continues to face a bad deflation. Last week’s poor eurozone PMI numbers did nothing to dispel this notion. Hence a portfolio orientated for good deflation would require an overweight in the US market, but with protection in the shape of bonds to protect against a deflationary shock.
But what about alternatives? One suggestion would be to consider US high dividend yield plays. Over the long run, a collection of high dividend yield stocks (as tracked by MSCI) offers a similar return profile as a balanced portfolio. In particular, US high dividend plays are typically well represented by: - Knowledge-intensive firms that have high levels of intangible capital that is often not captured by standard accounting treatment. - Consumer staples and utilities which have an obvious defensive nature and a performance profile which resembles that of bonds.
This is not to say that usage of high dividend stocks can fully replicate a balanced portfolio. Replacing bonds with equities increases volatility. Such a portfolio will underperform during crisis periods. Indeed, over the last five years, the best moment to enter a high dividend strategy in preference to a conventional balanced portfolio had been during crisis points. For those multi-asset managers seeking a deflation-beating strategy, relative valuations are clearly not yet compelling. However, for those managers with a dedicated exposure to equities and a worry about the impact of a disinflationary world, the pursuit of balanced portfolio-like returns makes sense. And for this group the high dividend approach is recommended.