Recently, I attended a talk by Don Drummond, former Chief Economist at the TD Bank at an event organized by PWL Capital here in Ottawa. Here are some key points that Mr. Drummond make in his talk:

The 2008-09 Recession

The 2008-09 recession was unique in three respects: (1) Unlike previous recessions, this was the first time that world economic output decreased. (2) The synchronized recession meant that monetary policy across the globe was synchronized as well. (3) The global economic framework is changing. Between 1980 to 2026, emerging markets would go from accounting for 1/3rd of world economic output to 2/3rd of it.

The implication for investors: (1) Diversification across global stock markets does would not help much in this environment and (2) Investors need to have some exposure to emerging markets in their portfolios.

Modest Asset Class Returns

Mr. Drummond urged investors to be realistic about return expectations. In an environment with subdued inflation rates of 2 percent or less, bond yields can be expected to remain low as well — 3 to 4 percent. Economic growth is likely to clock in at a real rate of 2 percent. As a result, Canadian stocks can be expected to return 6 to 7 percent and a balanced portfolio just 4 to 5 percent.

The biggest asset in household balance sheets tends to be real estate. Historically, housing prices increase at an average of 1 to 2 percent in real terms. Since today’s housing market is far from normal, Canadians should expect very modest gains in housing prices (if at all).

Will Baby Boomers dump assets en masse?

Mr. Drummond said that it is a fallacy that Baby Boomers nearing retirement will dump their stock holdings. Firstly, there is little historical basis in the claim because it is only since the 1980s that stock ownership has become widespread. Today, the alternative to stocks offer very low yields. The low yields were one reason why so many seniors were invested in income trusts. Also, the current tax regime discourages holding safer investments in taxable accounts.

On Inflation

Different groups of investors looking at the same set of economic data are reaching different conclusions. The bond market sees low inflation but the gold market expects high levels of inflation. Mr. Drummond thinks it is the bond market that is right because the Bank of Canada has an explicit inflation target of 2 percent and the central bank will do everything it can to keep inflation at that level. It is true that there is extraordinary monetary stimulus in place. Inflation is still low because the velocity of money is low. When economic growth returns to normal levels, it will be quite easy for the Bank of Canada to withdraw the stimulus.

Other media coverage of Mr. Drummond’s talk:
Canada not immune to global economic challenges – The Gazette
Canadians need to save more as portfolios yield less – Canoe Money

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  4. Given Mr. Drummond’s take on the value of global investing, would you change your asset allocation to reduce US and developed market allocations and increase emerging markets as a longterm investor? Or are the synchronous conditions likely to change?

    Just on the basis of sector diversification, I also have questions.

    All of the international indexes (both developed and emerging) seem to be 22-28% in financials. That doesn’t seem so good! And then I see another possible overlap: 18-23% in “industrial materials” which is very similar to XIC at 24%.

    Am I really getting enough sector diversification by investing globally? The only thing I seem to be getting away from is energy (10% or less, vs. 25% in Canada). I guess you could say that the other 40%ish of the international indexes is that diversification. But maybe a three way equal split Can/US/Global is no longer a good plan. If not, what percentages would you think might be?

    To achieve maximum sector diversification for US investing, I am thinking of focusing on companies that operate internationally (to spread out currency risk) and that represent sectors not found in
    Canada. How to do that with indexing? I’m thinking of buying a mix of mostly VIG (US dividend fund) and a bit of VGT (information technology). Here is the sector breakdown for VIG according to
    Vanguard’s site:

    Portfolio composition
    Equity sector diversification
    Dividend Apprec ETF Dividend Achievers Select Index
    as of 09/30/2010 as of 09/30/2009 as of 09/30/2010
    Consumer Discretionary 12.00% 11.20% 12.00%
    Consumer Staples 25.10% 24.40% 25.10%
    Energy 10.30% 6.60% 10.30%
    Financials 6.50% 15.60% 6.50%
    Health Care 13.20% 11.80% 13.20%
    Industrials 19.60% 16.50% 19.60%
    Information Technology 6.00% 6.40% 6.00%
    Materials 5.70% 4.90% 5.70%
    Telecommunication Services 0.20% 0.00% 0.20%
    Utilities 1.40% 2.60% 1.40%

    So…. low in financials, low in materials, not too high in energy and lots of the things we don’t have. The only thing that seems too low when you compare with VTI is Information tech, so I was thinking of adding that bit of VTG.

    VTI, from a sector diversification point of view, has too much energy, too much financials and not enough consumer staples.

    Portfolio composition
    Equity sector diversification
    Total Stock Market ETF MSCI US Broad Market Index
    as of 09/30/2010 as of 09/30/2009 as of 09/30/2010
    Consumer Discretionary 11.30% 10.10% 11.20%
    Consumer Staples 9.70% 9.90% 9.70%
    Energy 10.40% 11.10% 10.40%
    Financials 15.80% 16.00% 15.90%
    Health Care 11.90% 12.90% 11.90%
    Industrials 11.30% 10.90% 11.30%
    Information Technology 18.90% 18.60% 18.90%
    Materials 4.00% 3.80% 4.00%
    Telecommunication Services 3.00% 2.90% 3.00%
    Utilities 3.70% 3.80% 3.70%

    What do you think of that in light of Mr. Drummond’s talk and the search for sector diversification in general?

    • @Flagen: Many great questions here. I’ll try my best to answer but keep in mind that this is my take and you could hold a reasonably different opinion:

      1. The proportion of emerging markets in global stock markets is about 17%. That would roughly be the allocation I would make to emerging markets in the foreign equity component of my portfolio. I think it is likely that Emerging Markets will continue to show strong economic growth. But economic growth doesn’t always translate into stock market returns. Therefore, I think the current share of emerging markets in global equities is appropriate.

      2. Mr. Drummond also made the point that global markets are getting synchronized and investors should look for sector diversification. I’m not entirely sold on this idea. For one thing, it doesn’t matter which equities you own — if the stock market swoons, there likely will be no place in stocks where you can find refuge. The same is true for global diversification — in times of stress, stock market correlations go to 1. This is not unprecedented. It’s happened before and will happen again. But diversification still offers benefits at other times. You only have to look at US, EAFE and Emerging market performance in the past 10 years to see how divergent returns can be.

      I prefer VTI for two reasons: (1) Low cost and (2) Low turnover. I don’t follow VIG closely, so I can’t comment knowledgeably on how it fares on these two counts. VIG plus VTG might be reasonable. Of course, other investors would prefer to slice and dice into value and small cap. I prefer to keep it simple. I think it is far more important for investors to stick to a well thought out strategy.

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