Maximizing Your Returns in a “Return-Free Risk” Market

If you find yourself struggling in the current “risk on”/”risk off” market environment to make a decent return on your portfolio, you may find solace in the fact that you’re not alone. Even the professionals, meaning large institutional investors, are struggling to achieve positive real returns. The German newspaper, Der Spiegel, recently interviewed Yngve Slyngstad, the chief investment officer of Norway’s wealth fund. Slyngstad is responsible for managing $558 billion largely earned from the country’s oil revenue.

In the article, he states, “In the past we searched for risk-free returns… today we know that what we mainly have are investments with return-free risk.” It’s clear that many investors attempting to insulate themselves from further volatility have looked to sovereign bonds as a place to hide. Unfortunately, given the generational lows in interest rates, investors in most government bonds are facing negative real returns and undeniably “return-free risk.”

In the book, This Time Is Different, economists Carmen Reinhart and Kenneth Rogoff conduct an overview of financial crises going back eight centuries. By reading the book, you realize that financial crises have been a part of financial markets since the beginning.

The earliest crises were typically caused by a monarch who overstretched his finances in a time of war and then debased the coinage by reducing its gold or silver content to fund the budget shortfall. The advent of central banking has made the currency debasement process much more advanced, but the principles remain the same. The easiest way for modern-day politicians to deal with huge government debt loads is through direct monetization, which typically results in higher rates of inflation. Thus, investors, especially those nearing retirement, need to remain focused on real rates of return.

With the US 10-year Treasury currently yielding 1.63% and inflation at 1.7%, investors are barely maintaining the purchasing power of their investment, let alone generating a positive real return.

Although it appears irrational to lock in a marginally negative real return, investors are simply reacting to the continuing crisis in Europe and recent spate of negative data points coming out of the US. From my perspective, it’s highly likely that the US is heading into another recession.

The year-over-year change in real personal income growth provides an example. Lakshman Achuthan of the Economic Cycle Research Institute notes that “personal income growth has never remained this low for four months without the economy going into recession. At least in the last 60 years.”

Additionally, the June ISM data came in at 49.7, reflecting contraction in the US manufacturing sector. More importantly, it was the first below-50 print since July 2009. With the rush of recent negative economic news, we’ve seen this story before. In prior slowdowns, central bankers were able to successfully pull back the global economy from the brink of recession through coordinated monetary interventions (QE2 in 2010 and LTRO in 2011).

At this point, Wall Street and many investors believe that this pattern can continue indefinitely. Furthermore, it would be unwise to bet against another round of monetary heroism by the world’s central bankers.

However, it’s clear that with each round of quantitative easing, the impact on the real economy becomes ever more fleeting. Thus, investors find themselves in a difficult situation – either facing negative real yields from “secure” sovereign debt or placing their faith in an equity market that continually needs new doses of monetary stimulation. What, then, is the right course of action for one’s investment portfolio?

You probably already know about the benefits of investing in the resource sector and owning gold. However, there is another highly valued asset that can help boost your real rate of return while minimizing volatility in the current market environment.

High-quality dividend-yielding stocks have proven to outperform the overall market with less risk over long periods of time. A study done by Standard & Poor’s found that A-rated stocks outperformed C&D-rated stocks by 3.8 percentage points from 1968 to 2004. In addition, the A-rated stocks produced an annualized return of 13.1% with half the standard deviation of the C&D-rated stocks.

Although high-yielding US equities are a good place to start your search for investments offering positive real returns, a carefully selected portfolio of high-yielding international equities offers the added benefit of providing currency diversification and the potential for much higher yields.

The chart below displays current dividend yields for the major developed markets globally. The dividend data are based on iShares MSCI country ETFs and derived on a TTM (trailing twelve month) basis. Interestingly, the US equity market currently offers the lowest dividend yield among all developed markets.

The dividend yield for the Spanish market jumps out on the graph, but it’s clear that this is due to the ongoing bear market in Spanish equities. In this instance, the high-dividend yield signals the possibility of future cuts in dividends, beginning with the undercapitalized banking sector.

The Singaporean equity market, on the other hand, offers an attractive yield combined with a currency that has the potential to appreciate relative to the US dollar. Unique investment opportunities can be found in the current market environment – it’s just a matter of starting your search in the right market.

For instance, I recently uncovered a Singaporean company for World Money Analyst that offers exceptional free cash flow, a stable recurring revenue model, and reasonable upside potential at current price levels – not to mention a 5% dividend yield. Additionally, in the upcoming July issue of WMA, I’ve highlighted an opportunity to invest in preference shares that are senior to common equity, available to retail investors and offer a 4.4% dividend yield.

In the current “return-free risk” environment, international equities remain one of the few investment options that have the potential to maintain your purchasing power and generate positive real returns.

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