Are the old models still working?

By Tom Milner, V3

Market insights

May I ask, how old you are? As the adage goes, subtract your age from 100 and that should be your equity weighting, with the rest of your portfolio being allocated to investment grade fixed income. The thinking being that as you get older you should hold less risk and so be heavier on fixed income. Inversely, when younger, you should be able to withstand greater volatility and accept lower prices/losses during recessionary times, and so hold a larger equity position. Simples.

This approach, whilst extremely simplistic, somehow made sense. Previously bond prices would fall and yields rise during higher growth environments and then prices would rise during the economic contractions. Unfortunately, we have entered this current contraction with already high investment grade prices (after the post financial crisis period), as a result, investors following even basic diversified portfolio mandates have not really been protected.

For some time now, the simplistic equity/bond diversified portfolio era has been replaced by practitioners of mathematical, academically-backed models, which incorporate more asset and sub-asset classes in order to attempt to further diversify portfolios and reduce the risk of big losses.

Unsurprisingly, the method and model used are only as good and as relevant as the data they are based on. Predominantly this is historical data used to establish a correlation between assets classes and volatility. This is incorporated with the outlook for return expectations for asset classes in the coming years based on the outlook for growth and inflation. Fine in a normal period, but during the current one, which contains so many variables (and unique ones at that), it is even harder than ever to decipher how differing regions and the world economy will look in one or two years’ time. As a result, investors should question both the portfolio construction model’s inputs (correlation between asset classes and volatility) and the asset classes’ outlook and expectations. Subsequently, taking higher risk in a portfolio is indeed accepting higher risk of losses if wrong.

For this reason, an investor may be advised to diversify their portfolio to reduce risk, and currently it is here that investors will face a dilemma. With bond markets massively supported by central bank buying, prices are distorted. This, coupled with various government programmes also seeking to stabilise economies, has created massive intervention and talk of potential inflationary outcomes. Typically, inflation causes bond prices to fall, but from much higher levels than we see today, implying that with very low or negative coupons, buyers and holders of these securities could face losses.

Equities normally trade on multiples of future earnings. Trading on low multiples during economic contractions and high multiples during high growth environments. In ‘normal’ market times multi-asset class traders, investors and diversified portfolio managers might use comparisons between investment grade fixed income yields to help gauge at which multiple equity markets might reasonably trade, but here too, with manipulated bond prices, how should an investor use this comparison as a healthy guide?

Globalisation and relatively ‘free trade’ were deemed to be good as it helped prices to go down or to rise slowly. In the current economic contraction unemployment, partial unemployment, furloughed workers etc. have increased sharply and unemployment is likely to remain high in the coming twelve months.

Populism has already seen success and may well increase as the current economic contraction leads to more redundancies in the real economy. Even if some forecasters expect a reasonable rebound in economic activity during the second half of 2020 and into 2021, it may take several years to get back to the level of growth witnessed at the end of 2019. This is important as political populism is not in favour of free market economics and would lead to more turbulence in capital markets.

Many banks and financial advisors prefer to have their investors relatively fully invested. This could be as they are very long-term investments and so accept potential unrealised losses (as over time they believe their portfolio construction models will succeed), or because they simply like to have their investors fully invested as they will generate earnings in custody fees and through clients who create transaction revenue.

Before looking into the future, let’s have a run through of the key numbers from May:

  • Developed market equities continued their strong bounce following terrible first quarter losses, with planned reopening of economies and reduced rates of COVID-19 infections in many countries supporting the positive sentiment. Equity indices still have important losses for the year, however In May they were largely up, with the S&P500 gaining 4.53%, the STOXX Europe 600 gaining 3.04% and in Japan, the Nikkei 225 gaining 8.34%. Globally, the MSCI World Index gained 5.03%.
  • Fixed income markets remained supported, with central bank purchase and support programmes ongoing and better news on the virus and economic front aiding investor nerves. Developed Market Sovereign Bonds held onto their gains for the year. US and Eurozone Sovereign Bonds were 0.22% and 0.31% higher respectively. US Investment Grade Bonds were up 2.07% and the European Investment Grade Bonds were up 0.03%. US High Yield Bonds were 4.40% higher and Emerging Market Bonds up 5.65%.
  • Oil rallied as the previously announced OPEC plus deal to cut production, coupled with better economic sentiment finally led to sustained higher prices.
  • Gold remained steady even as risk assets rallied, with gold rising 1.85% in the month and up 14.11% for 2020. Widening acceptance that gold can be used as a valid diversifier in portfolios, given the lack of alternatives, appears to have contributed to its gains.

Global markets in numbers


Market Outlook and V3´s position

As economies reopen and equity investors push prices up further, it seems that optimism is back in vogue. However too many questions remain unanswered for V3 to be striking a pose à la Madonna, instead believing that investors should take the less sexy route by remaining cautious.

With severe economic contractions and the likely recessionary consumer reaction still to arrive (in the form of reduced discretionary spending), headline growth rates should not distract observers from the fact that it will take a LONG time to reach similar levels of global growth to those that we witnessed at the end of 2019. Yes, equity markets are pricing in higher valuations, despite lower forecast earnings based on low comparative bond yields, but these yields are artificially low due to central bank intervention.

It was popular to buy lower investment grade fixed income positions for their higher yields when economic contractions would normally be expected to create greater financial stress in this segment (as corporate cash flows reduce and default rates increase). Similarly, many investors increased the duration in their portfolios, buying longer dated bonds and central bank buying of shorter dated investment grade bonds has helped prices rally. However, the possibility of inflation picking up in the coming years should caution holding too much of this paper.

The pending US Presidential election should elicit many ‘Trump Tweets’ and although his election team might prefer the backdrop of positive stock market returns, ultimately they thrive on populism and we should expect increased calls to protect US workers and talk of trade tariff threats targeted towards China and Europe, which are not normally taken constructively by markets.

Brexit is scheduled for the end of the year and discussions between the UK and the Eurozone still appear relatively difficult. A hard Brexit remains a real possibility and this too would prove unsettling for the European economy.

Given the current environment, increased cash holdings with shorter dated fixed income positions and the use of precious metals as a diversifier of preferably protected equity positions seems favourable.

For more information, please contact our Chief Investment Officer, Tom Milner, on:

+41 22 715 0910

Cover image: Shutterstock

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