Today, economic fluctuations are more volatile than they have been throughout the last 20 years, and cycles are shorter and more extreme. This is likely to persist. And the tailwinds of falling inflation, cheap credit and, to a significant extent, the backstop of the Federal Reserve ‘put’ – or lowering of official interest rates to support markets in tough economic times – is largely exhausted. This broad uncertainty is reflected in markets. Bond yields continue to fall, signalling deflation, while inflation-linked bonds remain relatively expensive, flagging inflation. Simultaneously, the Australian dollar is strong, signalling growth, while fear in the markets is conveyed by expensive options protection, and equities vacillate depending on the latest data.
This year’s sideways, range-bound market has been driven by leading growth indicators. In spite of this, the way money is typically managed is, arguably, ill-equipped to respond to the potential range of market eventualities that may unfold. Conventional wisdom locks most superannuation funds into a regime whereby they remain in the market at all times, in essentially the same asset allocation and at the same risk level regardless of the outlook. This is ‘time in’, rather than timing the market. There are good reasons for this. Staying static has worked over most of our careers as asset allocation of any sort has tended to perform well given a 25-year bond bull market and generally stable and positive economic growth. Despite their sound reasoning, static risk guidelines can create constraints and inefficiencies. Many of these are avoidable, but four elements of long-term investment: flexibility in asset allocation, benchmarking, active management and diversification can be improved. Greater cyclical volatility in markets, and more extreme outcomes, underscores the need to enhance these sooner rather than later.
FLEXIBILE ASSET ALLOCATION In a more volatile environment, the ability to change asset allocation to capitalise on opportunities is more important than ever. Current equity valuations should be incorporated into expectations of future returns – particularly when extreme environments are forecast. There is a well-documented relationship between normalised Shiller price/earnings (P/E) ratios and future average returns (see Chart 1). A commonly made observation is that not once in history has a P/E ratio above 30 in the US resulted in a positive return in the succeeding 10 years. The inference is clear: valuation should be taken into account when determining long-term return expectations. In the shorter term, expectations can be adjusted not only on the basis of valuation, but also on other factors, including earnings, momentum and liquidity. This necessitates a more frequent reassessment of the assumptions that underpin portfolio construction, and a licence to alter the asset allocation as conditions change.