Making economic forecasts and asset allocations must be a very a very difficult job at the moment for asset managers.
We have very low bond yields in certain key economies, yields that provide little margin for error with respect to either inflation or a weakening ability to finance interest payments and ultimately capital repayment. Yet, these sovereigns are also accumulating debt at a time of slow economic growth. Many sovereigns in this camp may be years away, and a significant deterioration in global economies, from this risk, but the potential for default does exist.
Furthermore, while bond yields have fallen in many areas, many management charges have not: low bond yields and static strategic allocations are squeezing many an asset manager`s value proposition.
In other countries, the risk of default is more pressing and immediate: high and volatile bond yields in certain European economies do imply significant default risk, especially in the context of deteriorating economic conditions – growth prospects are continuously being revised down and the risks to growth revised up.
Equity markets, on the one hand, are at “relatively low P/E ratios”, have yields that exceed many bond markets, and, with central bank commitment to low interest rates and quantitative easing, there could be “an argument” for a full equity allocation. Low growth, low bond and cash yields, and markets providing minimal capital returns but yielding good dividend flow, are in many cases assumed to continue for a while. But this scenario depends on stability, and minimal downside risk to economic growth.
On other measures markets are highly valued, and with weaker capital investment by companies, part of current higher dividend yields could well end up being a return of capital and not a return on capital.
If asset managers truly believed that equities offered higher risk adjusted returns than bonds, then we should be seeing a significant shift from bonds to equities from active managers, but many of the strategic allocations that I have seen do not reflect this.
In an out of equilibrium world with low bond yields, for a given liability profile, investors will need to increase consumption of capital. A higher allocation to equities could provide a higher portfolio yield that would reduce capital consumption risks. But, it would appear from asset allocation structures that managers are comfortable with the short term (many are holding close to full benchmark weights) but not the longer term profile of equities.
Longer term the impact of low growth, low levels of capital investment and high dividend yields are likely to impact the longer term return of equities. In other words, many asset managers are behaving as if the yield differential between bonds and equities is in fact a trade off, not for volatility, but for longer term risks to capital, and not sufficient a trade off to significantly lower bond allocations even when bonds offer minimal returns.
Another underlying issue is central bank manipulation of money supply and low risk asset supply. Keeping bond yields low and equity prices high risk improperly pricing the current and future risk and returns of asset classes. It may also increase the aversion to holding risky assets leading to higher portfolio cash balances. This has led many to diversify into alternative asset classes.
Unfortunately, low economic growth environments are especially sensitive to high debt levels and demand shocks of any kind. Some institutions are probably being too sanguine about the risks.
Indeed, the more government debt grows, and the slower economic growth, the more economic growth becomes dependent on and destabilised by a) fiscal policy, b) the crowding out of private sector risk taking and c) the return on debt financed economic activity.
Government debt expansion represents its own bubble in that it is a temporary and significant source of demand that cannot be replicated by the underlying economy in its absence. In this context markets and managers would appear to be anticipating a global austerity led demand shock. Indeed, while many corporations are holding record cash levels and have lower debt burdens than consumers and governments, they are unlikely to step in with financial stimulus if they see a risk of a demand shock: replacing current capacity, upgrading capital stock to reduce costs and increase efficiency, perhaps, but the type of investment needed to lay a stronger growth trajectory is less likely to be on the cards.
One area where I feel managers are being too sanguine is Europe: while many acknowledge the problems they feel that ultimately Europe will pull together, that fiscal integration and ECB support will stay default and ultimately economic growth will recover. But growth has been much weaker and austerity has more greatly impacted the region than expected. The longer Europe is stuck in the current low growth/marginal recession rut it is in, the more likely the debt loads of more important economies like France will roll over, and France itself has already set off on the road to austerity. What if the overall debt load of Europe now exceeds the ability of its economies to grow its way out of trouble in the present environment?
The other area that I feel managers are being too sanguine about is China. China has been overly dependent on capital investment to drive GDP growth and with these high levels of investment, it has accumulated increasing amounts of debt.
It is difficult really to get an exact figure on the amount of debt the economy has accumulated given all the different off balance sheet funding vehicles available, but there is increasing concern over not just the amount of debt but the economic efficiency of that debt. Michael Pettis discusses these issues intelligently in his blog China Financial Markets as does Patrick Chovanec in his blog An American Perspective from China.
Capital investment should go more or less go hand in hand with current growth in supply and demand, so that new roads that are built are likely to be used to improve productivity in the economy and buildings and other infrastructure used to house services and production. Such investment will have a high return that will either help fund further investment in an area or investment elsewhere. The lower the return, the less likely the capital invested (borrowed) can be used to fund growth. The further out the capital investment is in terms of the ability of economic activity to generate a viable return the less it will drive immediate growth in productivity and further capital investment. Excess investment relative to the ability to generate a viable return on that investment increases the risk of default on the underlying loans and limits the amount of free capital within the system that can be used to fund growth.
It is not that China will not continue to need quite significant future levels of investment, but that this investment is so far off into the future that the economy is unable to finance and use it in the present. In an economy with significant future growth potential, the rate of growth of capital investment will at times slow significantly to allow investment booms to be incorporated into a natural balance in the economy. The need to increase consumption as a % of GDP is part of this necessary rebalancing.
Many commentators argue that China needs more and not less investment and that current concerns over excess investment are unfounded. In February HSBC brought out a report, China Inside Out- What over-investment?, which argued that China’s per capita capital stock was well below the US and other advanced economies, but it also noted that relative to GDP it appeared to be comparable – and note with much of GDP being comprised of investment, the actual capital to GDP less capital investment is much higher than other economies.
We have uncomfortable scenario of a sovereign debt boom coming hard on the heels of a consumer and financial sector debt boom accompanied by a Chinese capital investment boom. The denouement of all these economic forces happening at the same time should be of concern to those who manage investors money. Unfortunately the European debt crisis and the China capital investment risk are rarely looked at within the same compound framework.
Additionally, we also appear to have built up significant a collateralised debt risk within the Chinese economy through the so called wealth management products that could destabilise the consumer side of the economy if we see a financial crisis in China – Zero hedge, China Daily.com, UBS report Nov 2011.
The global risks are very real and building. While many of the indicators that have come out of the US appear to indicate improvement, much of this improvement is ambiguous and not of sufficient quality to offset the bigger forces building towards a demand shock.