- Conditions now parallel the late 1990s as inflation expectations plunge, emerging market currencies tumble, relative valuations of emerging markets versus U.S. stocks and bonds hit extremes, and the growth-stock bull market roars ahead while value stocks lag behind.
- The extreme parallels observed in both December 1998 and today are the drivers of future outperformance for the most hated asset classes as well as the drivers of disappointing return prospects for the most popular and comfortable markets.
- In the five and 10 years following December 1998, assets other than U.S. and developed-market equities and U.S. notes and bonds outperformed 60/40 by an annualized 8.8% and 6.2%, respectively. Today, the potential for a 1999 redux is palpable. We believe the real return–diversifying asset classes could improve on a traditional 60/40 allocation by approximately 3.5% a year over the next decade.
In nearly four decades of contrarian investing, I've learned that the markets reward neither comfort seekers nor performance chasers for long. Instead, experience shows that the correct long-term strategy is to cautiously pivot into out-of-favor markets, averaging in over time, because it is not possible to know when the turn will come. Executing these uncomfortable trades, such as tilting deeper into value or into diversifiers at the times when they are most shunned, goes against human nature. We all want more of what has given us comfort and profit, and less of what has given us pain and loss. But, the capital markets do not reward comfort. Buying what's unloved is, simply put, the most profitable way to invest, but it demands patience and staying power through the inevitable bouts of adversity.
Anyone with a passing familiarity of market history knows we have experienced this environment before. In fact, the late 1990s are strikingly similar along many dimensions, and they were far and away the most difficult years of my career; Jeremy Grantham—a superb contrarian investor—lost assets and credibility along with me and many other value investors. Julian Robertson, the legendary founder of Tiger Management, and godfather to legions of "tiger cubs" who subsequently launched their own hedge funds, famously closed his hedge fund in March 2000 at the exact end of the tech bubble!1
Such pain and angst is wasted if we don't learn from it. We are now seeing conditions parallel the extremes of the late 1990s. The following parallels can serve as the drivers of future outperformance for the most hated asset classes, as well as a body blow to the return prospects for the most popular and comfortable markets:
- falling inflation expectations
- tumbling emerging market currencies
- extreme relative valuations for EM versus U.S. stocks and bonds
- protracted growth-stock bull market and underperforming value stocks
The last time all four of these were at, or near, historical extremes was in December 1998. After 1998, an equally weighted mix of inflation-fighting and diversifying assets2 outperformed a traditional U.S.-centric 60/40 portfolio by nearly 9.0% annualized over the subsequent 5 years and outpaced 60/40 in 11 of the next 12 years. That's a lesson we remember.
The impact of these conditions is that, on the one hand, relative-return prospects for our inflation-hedging asset classes are now quite good. On the other hand, however, given their poor current yields, U.S. cap-weighted equities and nominal bonds are now offering poor real-return prospects.
Four Parallel Extremes
Let's compare current conditions with those that presaged one of the best-ever performance spans for inflation-hedging and diversifying markets:
Falling inflation expectations. When inflation expectations fall much below 2%, they tend to snap back in reasonably short order. After inflation expectations hit a basement low of 0.9% in December 1998, within six months they had jumped to 2.0%. Over the past three years, 10-year inflation expectations have plummeted by over 50% from 2.6% in February 2013 to 1.2% in early February 2016. Both lows (December 1998 and February 2016) were well into the bottom decile of historical inflation expectations. But by the end of March 2016, over just a matter of weeks, inflation expectations rebounded to 1.6%, as Figure 1 shows. We expect that as the impact of the crash in oil prices begins to fade from headline inflation over the coming months, a reversion toward much higher inflation expectations is very likely.
(For a larger view, please click on the image above.)