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Special Report

ESG: The metrics jigsaw

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Enter international bonds stage right

The 1990s will be remembered as the heyday for equities. That heyday saw a number of plan sponsors make a large allocation to non-Euro-zone (‘international’) equities to capture what they thought would be attractive investment returns and also to derive diversification benefits for their investment plans. However, international equity has generally had disappointing results in both these areas, while international fixed income has actually provided higher returns, lower volatility and better diversification benefits during the past several market cycles. International equity’s disappointing portfolio characteristics cast doubt on the typical method of achieving non-domestic investment exposure primarily through an allocation to international equities. The investment experience of the past 15 years, as well as the outlook for these markets going forward, provide a compelling argument that investment plans would be better served by holding a higher portion of their international exposure in fixed income rather than equities.

Performance and volatility of international fixed income and equity
The superiority of international fixed income over international equities in terms of both investment performance and volatility (standard deviation) over the past 15 years has been quite impressive (Table 1). From a performance perspective, the longest time period (15 years) is probably the most impressive during which international fixed income outperformed international equities by 220 basis points a year through a variety of market cycles. Looking at the volatility figures, the magnitude of the difference is dramatic. Also note that the volatility of international fixed income has generally been declining in recent years while that of international equities has generally been rising.
The case for using emerging market debt in place of emerging market equities parallels that among the developed markets and is even more compelling. During the five-, 10- and 12-year annualised periods ending 31 December 2002 emerging debt has outperformed emerging equities by more than 10% a year and had much lower volatility.

Diversification benefits
International equities have also performed poorly in terms of providing diversification benefits to Eurozone investment plans. During the past 10 years the correlation of international equities to Euro-zone equities has been very high at 0.87. This correlation is far higher than that of any two other major asset classes. To make matters worse, the correlation between these two asset classes has been increasing recently and rose to 0.90 for the five years ending 31 December 2002. On the other hand, international fixed income has been a much better diversifier to Euro-zone securities with correlations of 0.11 and 0.38 versus Euro-zone bonds and equities, respectively, during the past 10 years.
The true measure of international portfolio diversification comes during periods when domestic securities perform poorly. Since 1990 there have been 17 quarters when the MSCI EMU Equity Index has generated a negative return. International equities have performed positively in only one of those down quarters and were highly correlated to Euro-zone equities (+0.82). In contrast, international bonds performed positively in six of those down quarters and were essentially uncorrelated to Eurozone equities (+0.07).

Impact on overall investment plan returns
Given the more attractive characteristics (higher returns, lower correlations and lower volatility) of international fixed income versus international equity, it is interesting to see how much value would have been added by substituting international fixed income in place of international equity in a typical plan sponsor’s portfolio. Three model portfolios all having exactly the same domestic asset allocations (18.7% equity, 42.4% fixed, 6.0% real estate, 10.1% cash/other) but with differing international exposures were created. Replacing international equity with international fixed income generally would have improved returns and significantly lowered volatility during the past five-, 10- and 15-year periods.

International equities will continue to struggle in the post-equity bubble environment
Do these facts simply indicate that fixed income has performed relatively well recently and that now is the time to rebalance and/or increase allocation to developed and emerging market equity? The simple answer is no. A number of factors such as lingering issues of corporate governance, a critical lack of corporate pricing power, as well as geopolitical uncertainties will continue to weigh on the equity market in the foreseeable future.
In addition, the current economic downturn has left a large number of international companies (particularly in the US) burdened with excessive levels of debt, and US corporate debt as a percent of GDP has reached record levels. According to Moody’s, 2001 saw the highest rate of global bond defaults in a decade as 212 rated companies defaulted on $135.1bn of debt. Last year was even worse as 115 issuers defaulted on $138.8bn of debt during the first nine months of the year alone.
The financial situation of many large corporations has also been seriously impaired by the negative equity environment of the past few years. Companies whose bottom lines had previously benefited from positive equity returns in their pension plans are now seeing their credit ratings downgraded due to the substantial burden of shoring up their seriously underfunded pensions plans.
In an attempt to drastically remedy the situation and in light of dangerously low credit ratings, companies in many sectors are now being forced to implement new balance sheet strategies. Paradoxically, this will be to the benefit of bondholders following years of capital excesses that had previously benefited shareholders. Not surprisingly, it is those companies (and sectors) that were the best examples of the aforementioned debt excess, corporate governance failures, pension underfunding and price-taking environments that have had to resort to the hard core restructuring of balance sheets and business models. Those that take the necessary measures will survive and doubtless improve. Those that don’t will find themselves on the infamous list of corporate failures that has typified the consequences of a reckless drive for shareholder value.
Economic theory would suggest that in a world of falling bond yields, the cost of borrowing declines, which stimulates economic growth and in time results in higher interest rates and rising bond yields. Worryingly, at this stage of the global recovery, this is not what has been seen, which raises question marks about the kind of economic environment that now exists. The future may well be one of low inflation, low interest rates, low government bond yields and low equity returns. To some extent, such developments should not be surprising given the disinflationary forces that are at work across the globe.
Increasingly, the ability of governments to create inflation is declining in a world of mobile capital. Capital markets are now so quick to punish any lapse in policy that it is unlikely to be worthwhile for a government to allow anything but a temporary rise in inflation.
Central banks around the world have made a commitment to reduce inflation, and they have enjoyed significant progress over the past decade.
In Europe, one of the cornerstones of Economic and Monetary Union (EMU) is the control of inflation. Since the introduction of the single currency in January 1999, the ECB has steadfastly sought to maintain inflation close to its 2% target (to some extent even to the detriment of economic growth).
In Asia, Japan continues to grapple with deflation and China is also exporting disinflation as it uses its huge capacity to produce low-cost goods.
In the US, the corporate and private sectors are both burdened with relatively high levels of debt which will impede spending and by implication economic growth.
Technological improvements and growing competition in an increasingly integrated global economy make it more difficult for producers to push up prices.

Conclusion
It is difficult to argue with the conclusion that international equity has been a disappointing asset class for investors during the past 15 years when compared to the higher returns, lower volatility and better diversification characteristics of international fixed income. The critical question for Euro-zone plan sponsors is whether international fixed income will continue to outperform. Many of the key economic elements that helped supported international fixed income (a global disinflationary environment, lack of corporate pricing power, record corporate debt levels and geopolitical uncertainties) remain in place. The painful memory of a three-year-old bear market will also have a restraining influence on equities going forward. Given these factors, there is little indication of a near-term change in the current low interest rate and poor equity environment. As such, plan sponsors would be better served by reducing a portion of their international equity allocation in favour of a larger allocation to international fixed income.
John Makowske is a partner in Rogge in Conneticut

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