The Economist April 30th 2022 Finance & economics 67I
n 1988 steveguttenberg,a comic
actor, appeared on a British talk show.
At one point he was asked why he had
not appeared in “Police Academy 5”,
having starred in the earlier films. He
replied that, in his view, all the impor
tant philosophical questions had been
addressed in the first four movies.
This brings us to the more serious
business of investing, and a sequel of a
very different kind. Ten years ago Antti
Ilmanen, a finance whizz, published
“Expected Returns”, a brilliant distilla
tion of investment theory, practice and
wisdom. His latest book, “Investing
Amid Low Expected Returns”, is an up
date, taking in a decade’s worth of addi
tional research and data. Mr Ilmanen has
read all the books and papers, sorting the
good stuff from the junk. He has a gift for
explaining clearly and concisely the
lessons of this research for investors. The
new book is as invaluable a resource as
the old one. If it has a fault, it is that it
does not quite address all the important
philosophical questions. A sequel may
be necessary.
Start, though, with a recap of the
expectedreturns framework. There are
two sources of return on an investment:
income and capital gain. The income on,
for instance, a government bond is the
interest (or “coupon”) paid once or twice
a year. Bond prices and yields move
inversely. So when interest rates fall, as
they did for much of the past four de
cades, bond investors enjoy a capital
gain. In essence a capital gain of this
kind brings forward future returns. You
get the income now you were going to get
later. But as yields fall ever lower the
scope for further capital gains becomes
more limited. So low yields imply low
expected returns. This bondlike logic
holds for other assets—equities, property, private equity and so on. Dividend and
rental yields have fallen in response to the
secular fall in interest rates. Owners of all
kinds of assets have experienced windfall
gains. But today’s low yields imply low
expected returns in the future.
What now? As Mr Ilmanen sees it, low
expected returns can materialise through
either “slow” or “fast” pain. In the slow
pain scenario, assets remain expensive
and investors receive desultory bond
coupons, equity dividends and rental
receipts for years on end. In the fastpain
scenario yields revert to their higher his
torical averages. This implies a spell of
brutal capital losses followed by fairer
returns thereafter. The choice is between
wellheeled stagnation and a crash.
Mr Ilmanen is too much of an episte
mological sceptic to put all his chips on
one scenario. He is also too careful an
analyst to miss that low inflation made
the highassetprice, lowyield 2010s what
they were. Many of the factors that kept a
lid on inflation in that decade—global
isation, efficient supplychain manage
ment, tight fiscal policy, an expandingglobal workforce—are now attenuating
or unwinding. Mr Ilmanen’s hunch is
that the 2020s will see something of a
reversal of the investment trends of the
preceding decade. But he generally es
chews investing on hunches.
Faced with lower expected returns,
investors have three courses of action:
they can take more risk to reach for
higher returns; they can save more; or
they can accept reality and play the hand
they have been dealt as well as they can.
The first approach may increase returns
but also makes them more uncertain.
Saving more means sacrificing today for
the sake of tomorrow, a highly personal
choice. Understandably, Mr Ilmanen’s
focus is on the third approach. He sets
out a chapterbychapter analysis of
various investment assets and styles. He
advises how to put them together in a
truly diversified portfolio. Along the way,
he explains why market timing is a snare
(you end up taking too little risk); what
the true appeal of private equity is (not
superior returns); and why portfolio
insurance will not save you (it is too
expensive in the long run).
There are shortcomings. A quarter of
the 500+ references are from authors
affiliated with aqrCapital Management,
Mr Ilmanen’s employer. This weighting
gives the book a less independent air
than “Expected Returns”. Readers would
have benefited greatly from a chapter on
the implications of low expected returns
for different sorts of savers. The fastpain
scenario, for instance, is surely prefer
able for young savers, to whom the book
is dedicated. Perhaps this and other gaps
will be filled in “Expected Returns III”.
Even Mr Guttenberg has been teasing
fans with the prospect of “Police Aca
demy 8”. The big philosophical questions
are never truly settled. ButtonwoodExpectations management
An important new book considers how to deal with low prospective returnsagainst the dollar, which was itself strong.
Now China’s fight against the pandemic
is instead contributing to the currency’s
sudden weakness. Lockdowns stringent
enough to hamper manufacturing have
been imposed on Shanghai and other cities
accounting for over 9% of gdp, according
to Gavekal Dragonomics, a consultancy.
China’s economic figures for April will
“certainly be disastrous”, it says. The war in
Ukraine has contributed to outflows from
China’s bond and equity markets, as for
eigners reassess the risks of investing in
countries at geopolitical loggerheads with
the West. And as America has lost its fear of
the virus, its economy has overheated,
forcing the Federal Reserve to raise interest
rates. In April the nominal yield on ten
year Treasuries briefly exceeded that on
Chinese bonds for the first time since 2010.
(Real yields remain much higher in China,
where consumerprice inflation is only
1.5%, compared with 8.5% in America’s
larger, more “mature” economy.)
A weaker yuan is both a reflection of
these challenges and one way to cope with
them. It will in particular help to shore up
China’s exports. But the central bank is notprepared to let the currency be dominated
by market forces. It bears the scars of past
falls in the yuan, which took on a momen
tum of their own. On April 25th it said it
would cut the amount of reserves banks
are required to hold from 9% of their for
eignexchange deposits to 8%. That will re
lease some dollars to the market, alleviat
ing pressure on the yuan. The move also
signals the central bank’s displeasure at the
speed of its currency’s descent.
China’s currency worries may deter the
central bank from cutting interest rates to
revive growth. That will leave its economy