Finding opportunity in the global imbalance

Conference presenters painted a complex picture of a global economy that remains highly vulnerable to political and economic risks in the wake of the 2008 global financial crisis. Throughout the event, plan sponsors discussed what the key global risks are today, as well as the emerging tools and strategies being developed to manage them.

In particular, delegates discussed the im­portance of challenging conventional investment wisdom and why plan sponsors need to get used to dealing with long-term geopolitical risks.

The global imbalance
Can developed economies break free of the debt super­cycle that has stunted economic growth since 2008? That was the question posed by this year’s keynote speaker Christian Menegatti, head of global economic research and managing director with Roubini Global Economics.

He argued that policy-makers must understand that the developed world is in a balance sheet recession and more liquidity simply will not solve the problem. “Rather, what is needed is balance sheet repair,” he said, noting that as Europe and the U.S. struggle to find the best way forward, the U.S. has been far more successful in its efforts to fix its problems. American monetary policy has led to a slow but steady economic recovery in the U.S., while austerity-fo­cused Europe has been falling further into recession.

Me­negatti believes that pushing up savings rates in European countries has been the wrong move because it has kept money out of the economy. This, he argued, has been an economic growth killer for the euro zone.

So what’s next for Europe? More huge hurdles, said Me­negatti, not the least of which is Italy, the world’s third-largest bond market. Restructuring that market could po­tentially open up problems that would make the Lehman Brothers collapse look like a “walk in the park.” And while he doesn’t see this happening, Menegatti did warn that political risk is massive in today’s markets and investors should not underestimate the potential for politics to derail fragile financial markets.

Against this backdrop, euro zone banks continue to de­leverage as they seek to recover from the 2008 global finan­cial crisis. In his presentation “Financial Deleveraging: The Global Implications,” Duncan Webster, chief investment officer and head of CIBC Global Asset Management Inc., provided an overview of the state of banking in Europe, ex­plaining that financial deleveraging and liquidity injections on the part of central banks now provide many opportuni­ties for investors. “It’s counter to the consensus view but we are positive on equities,” he said, arguing that increased liquidity is pushing more money into stocks.

At the same time, however, there are some big risks. “Given their sheer size, European banks represent the big­gest threat to the world economy,” Webster said. He noted that the banks’ focus on growing bank deposits as a way of deleveraging will in fact improve conditions over time — if it’s done right.

“Further deleveraging is required over the next two to three years to the tune of two to three trillion euros,” he explained. “How this is done will shape the out­look for the global economy.”

For investors looking to navi­gate the tricky European market, the banking crisis means they must be able to exploit regional differences between countries in Europe and emerging Europe. Therein lie some important opportunities, Webster said, particularly in the area of active currency management.

While both Menegatti and Webster pointed to emerging political risks to the global economy, speaker Bruce Cur­wood, director, investment strategy, Russell Investments Canada, encouraged plan sponsors to focus more closely on their own internal risk management practices. In his presen­tation “Geopolitical Headwinds” are Risk Management Tail­winds,” Curwood argued that uncertain and irrational mar­kets mean that plan sponsors should focus less on return optimization and more on risk management.

“The world is driven more and more by geopolitical forces,” Curwood said. “These are overriding investment fundamentals.”

With in­creased investor uncertainty in the external markets, plan sponsors should take steps to pull their focus away from returns and back to risk within the plan. “Investors need to focus on the two things they can control — governance and risk management processes,” he explained.

Risk-adjusted decision making can help plan sponsors perform better against a backdrop of global uncertainty and market volatility — conditions that are likely to prevail for a long time. “The global economy is a complex and non-linear system that is impossible to predict and very difficult to control,” he concluded. The implications for plan spon­sors? Look inside your own plan and make sure your risk management is focused on this new reality.

Balance in an era of imbalances
If we look closely at the state of the global economy, we’ll see that imbalances are the name of the game, says Samer Habl, managing director—tactical allocation, Franklin Templeton Multi-Asset Strategies. His presentation “Seiz­ing Advantage from Global Imbalances” identified global issues facing investors today, from the debt crisis in de­veloped market countries to a pending slowdown in Chi­na’s economic growth. Such developments challenge in­vestors’ assumptions about the equity risk premium and should prompt them to ask whether or not they are being adequately compensated for the investment risk they’re assuming.

Habl pointed to record-low nominal yields globally and the fact that long-term real rates in the developed world are currently lower than those in Japan. “Together these cre­ate a very high equity risk premium,” he said. “The ques­tion investors need to ask is whether it’s enough reward for the risk.” So what is the opportunity inherent in this advantage? “As diversification becomes harder to come by, plan sponsors can benefit from large return differentials in global equities and fixed income,” Habl said.

In an era of slowing economic growth and intense mar­ket volatility, liquidity is scarce and economies are faced with high barriers to private capital at a time when they need it most. Unlocking value in an era of deleveraging means looking at the best balance sheets available to in­vestors right now — select multinational corporations, according to Rudy Pimentel, executive vice-president and product manager, PIMCO. “Corporations started with better initial conditions and have been better managed through the present crisis,” he said. But while there is significant in­vestor interest in the high-yield space, bank loans are more attractive today simply because, in volatile economic times, “loans are senior in the capital structure and have a prior­ity claim to those cash flows,” he explained. “Today, loans offer better volatility and loss-adjusted returns in this ‘new normal’ world.”

To access these opportunities, Pimentel recommended an opportunistic and relative value approach to credit. Above all, he stressed the importance of removing tradi­tional benchmark constraints and other guideline limita­tions that force investors into less attractive opportunities. However, he also added that this approach means inves­tors must constantly assess macro-economic and policy developments and understand the complex interconnec­tions between different financial markets.

As investors seek opportunities for growth beyond flag­ging developed markets, emerging markets continue to be a major focus for plan sponsors. However, too many inves­tors continue to look at the asset class solely from an equi­ty perspective, while ignoring the rich set of opportunities in bonds and currencies, according to Morgan Harting, se­nior portfolio manager, AllianceBernstein Investments, Inc. In his presentation “An Integrated Approach to Emerging Markets Investing,” he argued that it’s time for investors to take an integrated approach to emerging markets through multi-asset portfolios that strategically combine equities, bonds and currencies. This approach performs better from a risk and return perspective because it recognizes that emerging markets have matured and become key in the global fixed-income market. As he noted, “roughly 55% of the J.P. Morgan Emerging Market Bond Index [EMBI] is now rated investment grade, whereas a decade ago, most bonds were rated at the lower end of speculative grade.” However, emerging markets bonds are also highly correlated with emerging markets stocks, meaning investors should com­bine them strategically.

Currency exposure is another major driver of emerging markets returns and should impact both stock and bond selection. Considering each in a separate portfolio fails to truly capture emerging markets performance and could lead to added risks. Harting argued that a multi-asset port­folio is the best way to balance all the opportunities in these regions.

As emerging markets rise and global markets become more correlated, investors are seeking opportunities for uncorrelated returns. This is why more plan sponsors are looking at global small-cap equities, according to speaker Chris Steward, institutional portfolio manager, Pyramis Global Advisors, who gave the presentation “Small-Cap Investing Opportunities Outside of North America.” With more than 4,500 stocks in the small-cap universe versus only 1,900 in the large- and mid-cap space, the opportunity set is twice the size, Steward explained. “Global small-cap stocks also offer important diversification benefits in an era when correlations between national stock markets are at all-time highs,” he said. Small-cap stocks are less affected by global investment trends and performance tends to be driven more by idiosyncratic local market factors.

Steward also pointed out that, although global small-cap stocks are riskier than large-cap stocks, they are less risky than emerging markets equities and have historically pro­vided higher risk-adjusted returns when added to a devel­oped global large-cap portfolio. “Global small-cap investing, which has been on the rise in the institutional marketplace, is likely to accelerate, given the renewed focus on the asset class,” Steward explained.

While the global financial crisis has shifted investment opportunities into new and emerging areas, it has also changed how investors view bonds, according to Kenneth Barker, a partner with Baillie Gifford. In his presentation “Rates and Currencies: The Long View,” he discussed how short-term thinking in the fixed income space has reduced the average holding period for a U.S. treasury bond to a mere 12 days. Said Barker, “This is perverse, because aca­demic research suggests that our predictive ability for in­terest rate and currency movements is extremely poor over short periods.” He also noted that investors should instead be investing on the basis of sustainable trends in econom­ics, politics or other social factors. In today’s volatile geo­political space, bond investors should be looking long term and focusing on whether a country’s politics will allow it to develop economically without problems like high inflation.

So where are the opportunities? Right now, according to Barker, global economic imbalances may be a source of bond and currency movements that persist for a considerable pe­riod, opening up potential investment possibilities. For ex­ample, developed economies must achieve competitiveness and this may drive exchange-rate appreciation in emerging markets currencies. “However, there is a lingering tendency towards inflation in emerging markets despite reforms,” he said. “This suggests that inflation-linked bonds may have merit, particularly since real yields are relatively high.”

Challenging conventional wisdom
While the financial crisis has meant investors need to fo­cus on the long term, it may also be a good time to chal­lenge conventional investment wisdom. Raymond Mills, portfolio manager, international core equity strategy with T. Rowe Price, presented “Profiting in Global Equity Markets by Avoiding Conventional Wisdom.” As investors cast a wider net in search of returns in this fragile glob­al economy, Mills believes they must push beyond some commonly held misperceptions. For example, he noted that although conventional wisdom argues diversification is dead, highly correlated markets don’t all produce equal returns. Investors should instead look beyond market cor­relations when making the diversification decision. At the same time, while many investors avoid equity markets during times of stress, Mills pointed to data showing that crisis points have offered some of the best opportunities to buy stocks. “Investors must have the courage to buy stocks even when it might feel wrong,” he said.

“Investors should also be wary of buying growth stocks in the hopes that companies will be able to grow earnings consistently over several years,” said Mills. Most investors tend to be overly optimistic about growth potential. Similarly, investors tend to put too much faith in economic growth as a driver of market per­formance. On the contrary, there is little relationship between economic growth and market performance over the long term. “Investors should al­locate capital considering fundamen­tals, not just forecasting economic growth,” he concluded.

Investors are also challenging con­ventional approaches in another key area: passive investing. Daniel Leveau, head of quantitative equity strategies with 1741 Asset Management, sought to reframe the active versus passive debate as the “wrong battlefield” in his presentation “(R)evolution of Indexing Methods.” Rather, he said, the debate should be about what investors are getting out of the strategy and how well it suits their individual needs. He encouraged plan sponsors to look very closely at the kinds of indexing methods avail­able to them. “Right now, the dominant indexing method available is based on market capitalization,” he explained. “The problem with this approach is that it imposes a pro-cyclical investment behaviour on investors” because a mar­ket-cap weighted approach overweights overvalued stocks and underweights undervalued stocks.

A series of new indexing methods presents a clear chal­lenge to the market-cap approach by breaking down beta sources in different ways. Methods employed by this new generation of indexes include optimization procedures, as well as processes that focus exclusively on return or risk. These newer approaches can lead to more attrac­tive allocations and help investors better achieve their investment objectives. “This new spectrum of approaches opens up the field to diversification within a passive port­folio,” said Leveau.

Another area of portfolio construction being chal­lenged in the wake of the 2008 financial crisis is asset allocation. In her presentation “Redrawing Asset Alloca­tion: Think Function, Not Form,” Wendy Cromwell, direc­tor of strategic asset allocation, Wellington Management, described the “lopsided risk distribution” inherent in a traditional balanced portfolio comprised of 60% equities and 40% bonds. A 60/40 approach ignores the fact that al­though equities thrive in economic environments marked by growth and falling inflation, they do much less well in other regimes. This asset allocation approach can also lead to ill-timed asset shifts on the part of investors.

What is the alternative? Cromwell argued that investors should adopt a “functional framework” whereby asset allo­cation is defined by the role or function of the asset class in the portfolio, not just by long-term returns, risk and corre­lations. Such an approach, said Cromwell, helps to balance a portfolio’s risk distribution, and mitigate investors’ nega­tive behavioural tendencies. “If you buy an asset class with an understanding of its expected behaviour across different market and economic environments, you’re more likely to hold onto it, as long as the asset class performs consistently with that expectation,” she added.

One emerging research area with truly global implica­tions is behavioural finance. This topic was addressed in a presentation called “Brains, Bourses and Borders: Behav­ioural Finance With a Global Perspective” by two speakers, Murray Carlson, associate professor, and Dale Griffin, professor, marketing division, both from the Sauder School of Business, University of British Columbia. Carlson and Grif­fin presented their insights on behavioural finance and its role in driving global market performance. “Behavioural finance tells us a lot about investing because it describes systematic ways in which people think irrationally about financial decisions,” Griffin explained. “So rather than start­ing, as traditional finance does, from an economic model of how to optimize your financial investments, it starts with a psychological model of how people actually think about money and the future.” From a global standpoint, Carlson and Griffin pointed out that one investor bias that is found across all markets is the preference for the familiar, which leads to the home equity bias — the tendency for investors to overinvest in their local markets and miss the opportu­nity for a truly diversified portfolio. This is clearly one area of finance that could benefit from further exploration as investors seek better ways to challenge their own assump­tions about local versus global markets.

Global risks were also front and centre during our final session — a panel featuring Canada’s leading plan spon­sors discussing opportunities and challenges in the global marketplace. Moderated by Zev Frishman, senior vice-president, investment management, Open Access Limited, the panel included James Davis, vice-president, strategy & asset mix, Ontario Teachers’ Pension Plan; Bob Kamp, vice-president, investment management, Telus Corporation; Dave Lawson, chief investment officer, Workers’ Compen­sation Board — Alberta; and Colleen Sidford, chief invest­ment officer, Ontario Power Generation Inc. While the pan­el discussed how their plans are dealing with the changing global investment landscape, a good portion of the discussion fo­cused on tail risk. With geopolitical risk looming large and the effects of the 2008 global financial crisis fresh in everyone’s minds, plan spon­sors discussed the pros and cons of strategies that seek to hedge all aspects of market risk. While some plan sponsors have benefited from stress-testing scenari­os, others admitted that extensive stress testing can be a costly and time-consuming endeavour for smaller plans. Some panelists leave it up to their managers to make such decisions about which risks to hedge.

In the end, according to Lawson, hedging can pull the fo­cus away from a plan sponsor’s main responsibility: ensur­ing money is there to pay benefits for the future. “If hedging every possible tail risk means we can’t earn the real returns we need to pay our pensions, we have a very serious prob­lem,” he explained. “Yes, hedging and minimizing risk in certain scenarios is important, but it’s not our total goal.”