The world has changed yet the
industry- standard balanced fund
configuration, where a move from 70:30
to 65:35 passes for a strategic shift,
remains entrenched.
This will spell
trouble for super funds as the period of
disinflation almost certainly comes to
an end, writes ROB PRUGUE. At the height
of the credit crisis “contagion of
fear”, investors were rightly assessing
the threat of two secular inflationary
environments: deflation/ depression; and
rising inflation. If successful in
averting the credit crisis, the
Keynesian-like fiscal and monetary response
of governments and central banks are
likely to yield to some sort of inflationary
pressures sometime down the road.
If the
response isn’t successful, then the
credit crisis has the potential to
convert itself from an asset deflation into
an economic one. Either way, disinflation
is unlikely to last indefinitely.
If correct, then the risk/return metrics
used in many asset allocation models
may eventually yield some disappointing
results. Secular inflati onary cyc les
Historically speaking, GDP and corporate
profitability cycles generally last for
five years.
There is typically one global
recession every five years, with corporate
profitability correlating with GDP
swings. Underlying this five-year GDP
profit cycle, however, lies an even deeper
and longer lasting capital pricing cycle:
inflation. Inflationary cycles generally
span between fifteen to twenty years;
thereby holding between threeto- four
GDP profit cycles for every one inflationary
cycle. Using simple boating analogy, the
profit cycle would represent the speed
to which the boat moves whilst the more
secular inflation would represent the
tide that lifts the boat up and down.
Economic theorists like Peter Bernstein and Keith Ambachtsheer have long argued the need to assess the influence on capital markets under different secular inflationary cycles. Although perhaps they’ve used different names in identifying these, the dates highlighted have not been too dissimilar. Essentially, there have been four secular inflationary cycles during the twentieth century (five if you include the artificial pricing period during the war years): Depression/ deflation (late 1920s and 30s); Benign inflation (1950s and half of 60s); Rising inflation (1970s and early 80s); and Disinflation (mid 1980s through to late 1990s).
The risk/reward metrics under these different secular inflationary cycles have varied significantly, both in nominal and real terms. Given the current debate as to where the inflationary cycle may be heading, we decided to re-examine Messrs. Bernstein and Ambachtsheer’s posit as to how asset class risk metrics vary over these four different inflationary periods. If they do, then what does this say to our current diversified asset class configuration? Is the standard balanced fund growth/defensive asset allocation of 60/40 a relic of the past?
If members choose from different diversified options off targeted risk/return metrics (expected real return targets, expected volatility, expected negative returns of one in so many years, etc), then would this static growth/defensive asset mix make such risk/return targets vulnerable?
Since inflation cycles are long lasting,
we would need a database spanning
nearly 100 years to make any sort of
comparative analysis or informed remarks
as to how assets could be expected
to perform under a new inflationary
cycle.
The most comprehensive and
lengthy economic and asset database is
supplied by Ibbotson Associates. This
yearbook has detailed US monthly economic and market information starting back around the early 1920s. Rather than reading too much into this data, our preference is to assess the direction, impact, and changes in risk/return metrics, then relate such changes to economic theory. The goal here would be to help ascertain any similar impact were we now in the midst of a secular shift in the inflationary regime.
Disinflati on
If one considers inflation as a tax
on the real value of our assets, then the most enviable inflationary environment would be disinflation. Disinflation refers to a drop in annual inflation figures. Although still positive, the level of
inflation drops year-by-year, thereby
delivering higher real asset values off
a positive economic and profit
environment. For our purposes, we equate
the start of disinflation to the end of
1981, when the then head of the US
Federal Reserve made a determined push against the then prevalent high inflation.
Monetary policy was tightened, with short-term rates pushing above 14 per cent. The impact from this was a temporary hit on economic growth and corporate profits, but a permanent blow against inflation. Whilst secular inflation fell by nearly 75 per cent from previous peaks, all the major asset classes benefited from this new, more manageable secular regime. Aside from having the highest nominal and real long-term returns, these high returns similarly had the lowest volatility. The market corrections that existed during this period were short lived as the asset bull markets eventually returned to their upward trend. Any short-term correction proved to be a buying opportunity for the medium term investor. In addition, the correlations amongst the major asset classes were highly positive, around 0.75 or more.
Therefore, the disinflation period has by far been the most rewarding to asset owners, be it in nominal or in real terms. Not too surprising, therefore, that asset owners sought to increase their wealth through leveraged exposures, where borrowing rates were below actual returns delivered. Whereas Disinflation benefits asset owners, inflation uncertainty has the opposite effect. The two worst inflationary regimes are “Deflation” and “Rising Inflation”. Deflation refers to negative inflation, where one buys assets cheaper tomorrow than they can today.
On the flip side, Rising Inflation brings an equal uncertainty towards real asset pricing, with a hypothetical tax-like impact on real assets. Although opposite within this inflationary spectrum, its impact on real values differs greatly across asset classes. Most pension plans in the days of Disinflation held generic balanced fund exposure of 60 per cent equities, 30 per cent bonds, and 10 per cent cash. Exotic investing was considered going offshore, and those that did held a home country bias. Very few pension plans held any meaningful exposure to private equity or hedge funds.
Diversification was typically holding two to four balanced fund products, where the funds manager was responsible for managing both the security selection and asset allocation. Ri sing inflati on This question has a personal relevance for me. Amongst his many accomplishments at the Inter-American Development Bank (IDB), my father was instrumental in developing the IDB pension scheme in the early 1970s. At the time, the US was just entering one of the worst economic environments, one that would last until 1982 – rising inflation.
Regardless of the asset allocation mix, real returns fell way short of the intended pension immunisation target of CPI plus 4 per cent. As previously mentioned, however, all asset returns struggled during this period. At first glimpse the return numbers don’t look too bad, but once you deduct the tax-like impact of inflation, real returns look remarkably poor. All assets had underperformed GDP growth. Of the major assets, only equities delivered some positive real returns, albeit by a miserly 29 basis points. Much of this positive result stemmed from the inflation pass through provided by dividends/profit payout. Conversely, cash delivered a negative real return of 9 basis points, with long government bonds delivering a negative real return of 1.33 per cent. CIOs targeting immunised results of CPI plus 4 per cent fell well short.
The second worst period for allocating between asset classes was during the depression period of the 1920s and 30s. Unlike the inflationary period in the 1970s where nominal GDP was positive, under the deflationary 1920s and 1930s nominal GDP and profit growth were flat. During this deflationary period, inflation averaged around negative 2 per cent. Interestingly, real GDP growth varied little through these four secular inflationary cycles. In the rising inflation period equities outperformed bonds.
However, under the weak nominal GDP scenario, investors sought refuge in defensive assets with their fixed coupons and income. Intuitively, much of this stems from accessing a fixed coupon payment during a period of contracting GDP and corporate profitability. This scenario, where bonds outperform equities when nominal GDP is weak, is observed more recently in Japan where bonds have delivered a handsome outperformance when compared to the broad equity market.
Optimi sing a ba lanced portf olio
While profit cycles play an obvious
role on asset class pricing and returns,
secular inflationary cycles have a much
more profound impact on the real values
of all asset classes. As the pension
manager’s objective is to immunize assets against inflation, any discussion on the direction or move into a new secular inflation regime would not be complete unless risk/return metrics were analyzed. However, using the last 20 years of data as a guide to the future would be flawed and would open the pension scheme up to the risk of missing their stated CPI+ target. For nearly 30 years, asset class returns have been attractive from a reward and a risk perspective.
As previously mentioned, under deflation investors sought refuge in the guaranteed income from defensive assets. Conversely, under rising inflation, long dated government bonds noticeably lagged equities. From a risk budgeting perspective, deflation favours bonds, rising inflation favours equities. All this becomes meaningful when CIOs attempt to build their diversified portfolios.
Although today many plans include a more diverse asset class
configuration, real capital asset
pricing will still have a significant
impact on how asset classes perform in
the medium to long term, and will
therefore play a significant role on how
a diversified portfolio is configured.
Although the expected return inputs may
be more in line with the current
economic environment, if the risk
metrics are not commensurate with the
new inflationary regime envisaged, the
GIGO (garbage in – garbage out) rule
will inevitably impact final returns.
The jury is still out as to the direction the economy is headed. We’ve gone from systemic risk to fears of an economic recession. The month of October 2008 was one of the worst on record, and it is therefore difficult to find any asset manager who is not claiming that their asset class is oversold. Although these tactical oversold readings may be true, how much to allocate within the diversified fund configuration will depend on the inputs utilised within the portfolio optimization process. Beware of GIGO.
