The essential In a market environment characterised by disruptive trends and possible regime shifts, asset managers need to evolve and to enhance their capabilities to understand, measure and factor these new trends into investment processes. Potential lower returns and higher risks expected in the future will require investors to move towards a high conviction approach to find the value left in the markets and potential winners in a changing environment. This will also require the further embracing of factor investing to gain exposure to well rewarded risks while avoiding unrewarding ones. Portfolio construction will also need to adapt to this new environment and to consider multiple scenarios. In doing this, it will be paramount to embrace a flexible approach that goes beyond the traditional boundaries (active vs passive, liquid vs illiquid, benchmark constrained allocations). In this regard, an ongoing dialogue with investors will be key in order to understand and address their evolving needs. The ability to provide greater transparency, effective tools and services will also be increasingly relevant in order to pursue the best opportunities while mitigating risk.
As structural trends take place, different long term economic scenarios emerge that will require investors to rethink their investment strategies. In this new world, equities could be less risky than previously thought, Emerging Markets should gain a relevant role in the core allocation, while bond investing will need to be flexible in the search for opportunities across the liquidity continuum. |
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An aging population will be a headwind for developed market economies and for China, where the issue of debt will also need to be addressed in the near future. |
Implication for investments: while most risk assets should benefit in a boom phase, a bubble burst will cause extreme disruption in financial markets, a deep economic recession, and will end up being deflationary. Depending on the level of rates when the bubble bursts, government bonds and other perceived safe assets, such as gold, could benefit and could provide some protection to the downside. The probability of occurrence of any of these three scenarios will change over time depending on how the prevailing trends will evolve and therefore it will be key to monitor the evolution of the major macro variables to recognise the inflection points that could trigger a regime shift. |
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The implications for financial markets could be meaningful, as they are already vulnerable due to the many consensus trades in the market.
In fact, credit spread compression has been impressive across the entire global fixed income universe. Government bond yields remain close to historical lows, with an increasing disconnect with the real economy, which is finally showing signs of more robust and widespread recovery, but with weak inflation pressure. All the aforementioned conditions expose investors to an asymmetric distribution of returns with limited gains (due to the lower expected returns) and greater potential losses (due to high valuations and the increased risk of tail events). The ETF-isation of the market (with a high concentration of risk in an index and in big/giant names, and the possibility of fast outflows in case of changes in market sentiment), combined with reduced market liquidity and more restrictive regulation, could further exacerbate the asymmetry of returns. This complacent environment could further strengthen negative biases such as herding into crowded trades, overconfidence and confirmation. As a consequence, we believe investors should rethink their investment strategies. From a tactical perspective, while it is not yet time to aggressively scale back risk (financial conditions continue to be easy and the economic cycle is still strong and synchronized overall), it’s time to recalibrate risk (focusing on areas which retain valuation gaps, such as European, Japanese and some EM equities) and increase the focus on selection. On a longer-term perspective, the regime shifts will require a redesign of investment strategies towards a multiscenario approach. This requires seeking out investment ideas that could perform well in the most likely scenario, while not eroding much of the performance in the others, and hedging against losses that could occur in case of negative scenarios. Portfolio construction based on different aspects of these scenarios, depending on investor time horizon, and required liability and liquidity profiles, will become key. This approach would in fact represent a more resilient way to navigating regime shifts while not missing opportunities, should the great moderation continue |
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Portfolio construction based on the different scenarios, considering investors’ liability and liquidity profiles, will be key in an era of regime shifts |
Over the next decade, we believe that returns from traditional asset classes will change dramatically compared to the past. The return for a global balanced portfolio (50% invested in global aggregate bond and 50% in global equity) could drop from the annualised 8%8 recorded after the GFC to an estimated 4.5%, assuming an average 2% dividend yield, 5% earnings growth and 2% of bond yield to maturity, and keeping Price to Earnings ratio (P/E) unchanged. So, unless good exogenous news on growth or additional monetary stimulus materialises, which could further drive P/E expansion (and we think this is unlikely at this stage), it becomes relevant to rethink how to increase returns both on the equity and the bond components. To do that, we believe that investors can enjoy multiple sources of potential extra performance, such as: access to opportunities across all the liquidity spectrum, factor investing, alpha9 generation, in particular in markets that are still inefficient (such as EM, Japan or small-mid cap companies), and by exploiting the potential of long-term growth themes as well. The inclusion of ESG as a risk factor will also be paramount, in our view. ESG investing could allow investors to both reduce risks that are not negligible, such as carbon risk11, and identify long-term opportunities that could best address the challenges raised by new regulations, and consumer and investor habits. |
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In addition to searching for new sources of returns, investors should also consider how best to optimise portfolio construction to manage future changes in the risk environment. Alongside the lower expected returns, we also see increasing sources of risk that could potentially lead to higher volatility (see volatility fertilizers box) and losses that at some point could trigger strong negative reactions from loss-averse investors. |
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Consequently, investors should assess each portfolio component on the basis of its potential gain or loss profile in each of the three possible scenarios. In order to do this, we think it is key to analyse each investment exposure to different risk factors (i.e., growth, inflation, interest rates). For example, currencies could be played to gain exposure to certain interest rate dynamics or as a hedge against phases of market turmoil. All in, this means looking beyond traditional asset class boundaries and benchmark-constrained allocation and moving towards a new type of investment thinking, designed around four main paradigms: |
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Lower expected returns, possible volatility fertilizers and tight valuations are among the challenges that will require investors to rethink their investment strategies. |
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The traditional risk/return framework of asset classes will change as a consequence of paradigm shifts. |
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Based on their different priorities, investors can embrace different approaches to exploit market opportunities that the regime shift will offer while also mitigating possible phases of downside. |
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The bond component has to be redesigned in order to meet new investor demands, to mitigate interest rate risk, and to enhance the low expected returns from government and high-grade corporate bonds. |
In our view, these trends will drive a structural catch-up of EM investing vs DM, but some areas of risk will remain. A key area to watch on a structural basis will be the resilience of the Chinese backdrop and the ability to manage the economic transition, the currency credibility and the management of the debt issue without major disruption.
All the previous developments clearly point to the need to remap the EM universe, going beyond geographical frontiers and focusing on macro drivers and vulnerabilities for each country. In fact, countries are at different stages in the transformation process, with different stability conditions (i.e., reserves, current account) as well as varying levels of room for manoeuvre in terms of fiscal and monetary policies, electoral cycles and reform impulses. |
Approaching EM investing in an integrated manner (bond and equity) is an important factor, as it helps to understand the full capital structure of companies. |
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1-Source: BIS Working Papers, “Demographics will reverse three multi-decade global trends”, by C. Goodhart and M. Pradhan, August 2017. 2-Source: IMF Global Financial Stability Report, October 2017. 3-Source: Amundi calculation on data from McKinsey & Co at April 2016. According to McKinsey, “91% of global consumption growth will be generated by people living in cities from 2015-30”. 4-Federal Reserve Bank of Kansas City, April 2017, Waiting for a Pickup: GDP and SharingEconomy. 5-The Nielsen Global Survey of Corporate Social Responsibility and Sustainability, 2015. 6Global Sustainable Investment Review, 2016. 7-World Trade Organization (WTO), as at October 2016. 8-Amundi analysis on the annualized return over the period from 31 March 2009 to 31 October 2017 of a 50% MSCI AC World Net Total Return Index and 50% Bloomberg Barclays Global-Aggregate Total Return Index. Nominal returns before fees and taxes. 9-Alpha measures risk-adjusted performance, representing excess return relative to the return of the benchmark. A positive alpha suggests risk-adjusted value added by the manager versus the index. 10-Source: Amundi analysis on Bloomberg data and Amundi forecasts. EMU Core Govt = JPMorgan GBI Germany; US Govt = JPMorgan US; EU Corp, US Corp, EU HY and US HY are BofA Merrill Lynch indexes, all equity indexes are MSCI. All indexes are TR. Nominal returns before fees and taxes. Past performance is no guarantee of future results. 11-Financial risk related to the companies carbon footprint and carbon exposure.
12-Mercer European Asset Allocation Survey on European pension funds industry, 2017. |