Amin Rajan asks what if we are in a prolonged era of fatter tails and frequent bubbles?
Three eye-popping features of the S&P 500 index are bearing heavily on the current deliberations of asset allocation committees at pension plans and asset managers alike:
• Since the start of this decade, price fluctuations of 4% or more in intra-day sessions occurred nearly six times more than they did on average in previous 40 years.
• Ten of the 20 biggest daily upswings and 12 of the largest daily drops since 1980 have occurred in the past three years.
• High frequency traders, using powerful computers to trade at high speeds, now account for 60% of daily turnover.
Outwardly, these numbers explain the concerns felt currently by investors in all segments. The present debt crisis on both sides of the Atlantic is the immediate cause. But concerns had been mounting since early 2009 when it was clear that, having socialised the banking losses, governments in Europe and the US had to walk a fine line between financial solvency and rising unemployment.
As a result, the following questions have come to the fore:
• Will the global economy slip into the dreaded double dip, without quite having recovered from the last one?
• Will globalisation generate ever more unrelated systemic shocks from localised events like earthquake in Japan and asset price bubbles in China?
• Is the West in a 10-year flat line à la Japan, after the political stalemate on both sides of the Atlantic pushed the collective investor psyche to the edge last summer?
• Who will act as back stops for the EU member states as they deal with burgeoning public debt, with no constitutional mechanism to tackle it?
• As deleveraging continues apace, what are the chances of big policy errors in national capitals?
• How can investors cope with markets where as much as 70% of daily volatility is just ‘noise’?
Paradoxically, stocks are now inching towards bear-market territory at a time when business balance sheets are in good health: many firms have hoarded cash, paid down debt or locked into low interest rates. Household liabilities, too, have fallen - by $1.2trn in the US alone, for example.
Clearly, politics, not economics is driving the market. The centre of gravity has moved from financial centres to political capitals. The implications are clear.
First, markets may well be in a prolonged period of frequent bursts of risk-on/risk-off activity that ignore business fundamentals.
Second, investors may well be forced to jack up their risk appetite to bring their funding levels in line with their liabilities that will fast mature in this decade due to ageing populations in the OECD countries.
Third, the asset industry may have to re-anchor itself around new value propositions, if it is to regain investor confidence in the wake of two traumatic meltdowns since the Lehman collapse.
Fourth, active management may well thrive, as continuing volatility will create new buying opportunities for those with strong nerves or rebalancing windows for those who are value investors. The crisis since 2008 has burnt investors badly. But Baron Rothschild’s advice still holds: the best time to buy is when ‘there is blood in the streets’.
Finally, asset managers will need to develop better shock absorbers in their investment approaches and business models. They will have to do old things better alongside new things, if they are to turn the current crisis into an opportunity.
De-risking vs re-risking
Since the 2008 crisis, de-risking has gained traction. In the DB space, liability driven investing has been at the vanguard. Likewise in the DC space, LDI-lite approaches have come into the new generation of target income funds.
However, as the European sovereign debt crisis has unfolded, the use of government bonds in LDI structures has come under sharp scrutiny for two reasons: the prospect of big ‘haircuts’ despite their status as risk-free assets delivering risk-free returns; and the questionable over-emphasis on sovereign bonds in the Solvency II regime. Quite simply, there is hardly anything risk-free in today’s investment landscape.
At a recent conference in London, for example, a prominent pension trustee went even further, after reciting the catalogue of sovereign defaults over the past 100 years.
He believed that today’s capital markets are in for a prolonged period of bumpy rides, at least until substantive deleveraging is over in the West. In the meantime, markets will drift sideways; gains will mainly stem from buying on the dips caused by big price dislocations.
On this argument, re-risking rather than de-risking may be a more ideal option. This sounds counter-intuitive in today’s climate fraught with uncertainty. But old certainties no longer hold in these extraordinary times.
Hence, the 2012 annual CREATE-Research survey will focus on whether it is possible to make a virtue of the necessity and learn to live with volatility. Sponsored by Principal Global Investors, it will address the following questions:
• How will the market dynamics unfold in the face of prolonged financial deleverage and political stalemate in the West?
• How will the balance between de-risking and re-risking pan out?
• What tools and approaches will be used most (see diagram)?
• Where will the new opportunity sets emerge for investors in all segments?
• What specific changes will be required, as a result, in key areas like asset allocation, investment research, portfolio construction, and stock selection?
• How will these changes affect the existing risk models, product stress tests and client engagement?
• What business model changes are essential if asset managers are to learn to live with volatility?
The 2012 survey will also track key changes since our previous surveys in areas as diverse as client behaviours and asset allocation in DB and DC space alike.
In the process, we shall address the big question: namely, is it possible to turn volatility into an investment opportunity for clients in this decade?
This article first appeared in the January issue of IPE magazine. Prof. Rajan is the CEO of CREATE-Research. Previous years’ annual survey reports are available at www.create-reserach.co.uk