“These are real economic earnings from the Bureau of Economic Analysis, in the United States. You’ll note that, during the dotcom bubble, the NIPA earnings do not show the excesses of that two- or three-year period. It was flat for a long time,” he said. “Even during the most recent period, the NIPA earnings were flat in terms of earnings growth in 2008 and part of 2007. It would have been possible by the fall of 2008 to realize there was a clear difference between what companies said they were doing and what they were [actually earning].”
Opportunities in credit
Sasveld’s seven-year return outlook for credit surpasses his expectations for equities. For some of the most beaten-down sectors like the U.S. residential mortgage-backed securities, expected annualized returns could surpass 10% as the asset class comes off record high default rates being priced in.
The same sort of logic could apply to U.S. high-yield corporate debt. A depression level default rates are priced in, assuming the catastrophic economic lows of the Depression are not repeated, then there is a nice margin to work with as credit yields come off their record highs. If a historical default rate of 15% was attributed to corporate high-yield debt, there could be a significant return.
“From a top down macro perspective, the ultimate expectation is 25% default and 35% recovery for high yield; that’s pretty outrageous compared to history. That’s the highest default rate on record for high-yield bonds,” he said.
Sasveld said that, in the credit environment, investors now have to pay attention to what was previously a small concern—government policy. Trillions have been earmarked by the U.S. to fight the financial crisis in various stimulus packages. Much of this money is being funneled into the credit markets directly.
Sasveld noted that the most effective measure thus far has been the Temporary Liquidity Guarantee Program, which is used to insure the default risk on designated securities. The preference on this has been to backstop residential mortgage-backed securities.
He suggested there could be a wide divergence in performance between residential mortgages and commercial mortgage-backed securities, depending on how government money is deployed.
Lessons from institutional portfolios
Liquidity management should be a key pillar of portfolio management, Sasveld said. Otherwise, well diversified portfolios have been obliterated in this downturn by an inability to sell assets.
When selecting an asset class, Sasveld says portfolio managers now need to cover off the portfolio’s risk by ensuring an even balance between assets that could be sold if there is a need to raise capital, and non-liquid assets that have long-term growth potential.
Even more fundamental is an acknowledgement that managing downside risk is more important than future gains. There is recognition by pension managers that chasing extra basis points of returns on high growth/higher risk assets should be avoided if the fund already has its future liabilities funded.
This means setting up an asset allocation that is designed to meet specific and targeted goals. Reaching those goals is more important than adding risk to the portfolio to chase returns.
For “those in our business who say ‘expect the unexpected,’ sometimes the unexpected is a reversion to some sort of equilibrium. I think HNW individuals [still] have to be careful not to get too aggressive in their asset allocation policy,” he said. “For pension funds that are fully funded, there is no reason for them not to lock down [their strategy] and become a liability-driven investor. [In the U.S.,] the excise tax on corporate pension plans removes the incentive of generating returns above your liability.”
To comment on this story, contact us.