Last week I had the pleasure of presenting on asset allocation at the Portfolio Construction Forum in Sydney. The session looked at three alternative economic scenarios and how an investors’ asset allocation should be positioned on balance. What was interesting was how the audience of 600 delegates voted for each scenario. At 42 percent, 36 percent and 23 percent respectively for each of the neutral, bear and bull case, fat tail risk seems to be the order of the day. In other words, just about any scenario is likely in the current environment.
No sooner had the ink dried on this conclusion than the surprise escalation in the trade war occurred. Just hours before Federal Reserve Chair Jay Powell was due to take the stage at the Jackson Hole Economic Symposium, China announced its retaliation to the plan by the United States to increase tariffs on more of its imports from China. The Trump twitter tirade that followed was so far out of left-field it sent equity prices immediately down by 2.5 percent.
It really is a fat-tailed world after all. How should investors be positioned?
Markets like normal
What is normal?
Normal is when the likelihood of the base case occurring is around 95 percent and the probability of an extreme bull or bear scenario is assigned around a 2.5 percent probability each. In other words, the tails around a normal distribution are typically thin.
Fat tails occur when the probability of extreme outcomes rises, causing the tails on the curve to be elevated or “fattened” (see Chart 1.)
When we move away from normal, uncertainty rises.
There are a number of possible fat tail events that have the potential to cause significant uncertainty. These include, but are not limited to: the US-China trade dispute, Brexit, the US-Europe trade dispute and geopolitical risk in Italy, Hong Kong, the Middle East, and of course North Korea where its foreign minister recently said “we are ready for both dialogue and confrontation”.
None of these events are considered base case but in a world where Donald Trump can become President of the United States and the UK willingly elects to exit the European Union, their likelihood of occurring should not be understated.
Chart 1. Fat-tailed distributions
Macro liquidity, market illiquidity
Next month will likely see a raft of major central banks cutting interest rates further. The European Central Bank (ECB) meets on September 12 and the US Federal Reserve meets on September 15. Both are expected to ease monetary policy and, in the case of the ECB, reveal its thoughts around unconventional policy options.
The combination of unconventional monetary policies together with the post financial crisis regulations that reduce the market making capacity of investment banks has resulted in what American economist Nouriel Roubini called an environment of “macro liquidity and market illiquidity”.
The major central banks around the world have made it very clear – they will continue to do whatever it takes to support and extend the economic cycle. This creates an environment of macro liquidity that has the effect of suppressing market volatility and compressing risk premiums. The forced crowding of positions that are not necessarily supported by the underlying fundamentals is tantamount to a coiled spring that can unwind quickly. The impact on market pricing is then made worse by the absence on market liquidity.
While macro liquidity has reduced market volatility, market illiquidity makes for an unstable equilibrium. Investors shouldn’t, therefore, confuse lack of volatility with stability.
In this environment, where the probability of the extreme event (positive and negative) has increased to the point of being almost as likely as the neutral scenario, how should investors be positioned?
- Invest in low or minimum volatility strategies. These are funds that take positions in sectors or companies that have a more muted relationship with the overall equity market. An example in our portfolios of this kind of strategy is the Alliance Bernstein Min Vol Fund.
- Maintain portfolio diversity. This means having an allocation to bonds as well as to equities and alternative assets. Bonds have become less attractively valued in recent months but the relationship to equities is such that if equities sell-off, bonds will act as a cushion.
- Stay liquid. This doesn’t necessarily mean increasing your allocation to cash. It does mean making sure your allocation to smaller markets or asset classes that are less widely traded is appropriately sized for your needs.
Risk management as important as return management
To (not quite) paraphrase Milton Friedman, uncertainty is always and everywhere a market reality. The chart below illustrates the history of events that have peppered the last couple of decades. The level of uncertainty has increased over the last few years. Heightened levels of uncertainty that characterise a fat-tailed world weigh on business investment and hence future growth and earnings potential. The equity market is beginning to come around to this realisation. That is, that growth is likely to be weaker in the future than it is today.
Chart 2. Global economic policy uncertainty has reached record highs
Late cycle investing can be volatile, especially when the chance of an extreme event occurring is not insignificant. For this reason, more than at any other time in this cycle, risk management is as important, if not more so, than return management.
It was interesting to watch your panel, which decided on a neutral SAA allocation despite the specific task of responding to the audiences' fat tailed distribution! This highlights the entire problem with an SAA approach and traditional portfolio construction, where the anchoring effect overwhelms everything - despite when it is quite obviously inappropriate. In addition, I'd dispute your assertion that "the relationship to equities is such that if equities sell-off, bonds will act as a cushion". I'm sure you are aware that this hasn't always been the case historically and certainly prospectively, we could well be getting gradually closer to the time when bonds and equities both go down together, destroying the traditional and commonly used SAA portfolio - and most peoples' investment capital with it. This is why it is so important to seek genuine diversification away from traditional allocations. Instead, investors might prefer a genuinely outcome orientated approach with professional investors who are prepared to be different from consensus, and who will genuinely do the work and consider all the alternatives which are available.
There is an unsustainable imbalance where one side does not meet WTO requirements. It's only natural that such imbalances are ameliorated. To denounce Trump as left field ignores this fact.
Dr Lander, you wrote at length on this subject on 5th August. I noted Mathew Smith's comment, "A lot of interesting words however Jerome just what action does all this translate into?", to which you chose not to respond. I now note another three paragraphs, this time disagreeing with Ms McNaughton's approach to portfolio construction, but again offering little of substance. The third paragraph is simply a thinly disguised sales pitch. Using the colloquial, maybe it's about time to put up ........
Thanks for a very interesting read. I note the term 'dispute' being used instead of 'war'. There are quite significant differences e.g. disputes are usually resolved whereas wars produce winners and losers, also often there are reparations. So is the situation between US-China a dispute or a war. Or perhaps somewhere in-between but leaning towards the later.
Graeme, I am an advocate for the need for alternatives to the standard SAA approach - to align with common objectives and risk tolerances (such as reducing the risk of catastrophic losses). These can take many forms. They are often time-consuming and generally require professional implementation and skilled management to deliver results. The way I best "put up" personally is as a portfolio manager delivering outstanding risk-adjusted returns. Note that I am not a financial adviser and can't advise anyone what is appropriate for them personally.