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. 

 

 

Leave a comment