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The first quarter of 2019 certainly ended with a brighter outlook than could be seen when it began. The resolution of several uncertainties and clear signals of support for the economy coming from central banks are reviving attraction to and appetite for risk assets. Does that mean it’s time to start changing portfolio allocations? If the answer is to be yes, then any increase in exposure to equities must take into the account the notion of total portfolio risk.
For this year, we have identified five pivotal issues likely to influence financial markets.
For each of these, the outlook was relatively unpromising at the end of last year and
beginning of 2019, prompting a strengthening of portfolio protections. While this remains
relevant, Q1 2019 marked an inflexion point, alleviating uncertainties regarding several
of these pivotal issues. The most notable expressions of this shift are new injections
of liquidity that should strengthen risk assets, and stocks in particular. Nonetheless,
any increase in exposure to risk assets must be approached from the perspective of
managing portfolio risks and maintaining a suitable risk level.
CENTRAL BANKS: SUPPORTIVE SIGNAL FOR
RISK ASSETS
While just last February, the ECB held that it had
no plans for the long -term refinancing of banks,
it ultimately announced the opposite in March.
This about-face has multiple repercussions.
The injection of liquidity is, first and foremost,
intended to boost the economy, primarily
financed by banks in Europe. However, the mere
fact of the announcement resulted in an easing of
the market.
A similar phenomenon can be seen in the US, where,
despite short-term setbacks, growth is supported
by the Fed’s pronouncements. On both sides of the
Atlantic, inflation remains subdued. In the eurozone,
core inflation hovers around 1%, whereas in the US it
remains checked at about 2%. These are low inflation
levels that encourage domestic consumption.
The accommodating policies of central banks,
justified by the absence of runaway inflation and
a maintenance of long-term rates at low levels
tend to push up the valuation of stocks.
THE OTHER PIVOT POINTS: DÉTENTE AND SURVEILLANCE
Several factors identified as having significant
repercussions on the value of assets have
developed favorably over the quarter. First
among these is the stabilization of oil prices
at a price in line with our ideal scenario of 70
dollars a barrel. This stabilization promotes
consumer spending by limiting inflationary
pressures. In Western economies with low
inflation, fluctuations in the price of oil are, in
fact, the primary source of variance in inflation.
Emerging countries that are not producers also
stand to gain from this stabilization, as a sharp
rise in oil can quickly damage their external
balances and trigger inflation.
In Europe, political tensions have eased off.
The departure of the UK from the EU has not
yet begun, but the capacity of Brexit to produce
a major shock appears to be lessening. As
for the European elections, these will in all
likelihood bring an array of surprises, however,
the end result is unlikely to threaten the current
political equilibrium.
Another notable détente concerns the USChina trade war. While it is by no means over,
and the outcome is yet to be determined, the
start of negotiations presents a significant step
forward compared to the tensions of 2018.
The last of our pivotal issues rests on the
resistance of China’s economy. Government
measures to support growth are beginning
to bear fruit. Credit shows signs of recovery;
investment spending is picking up, particularly
for infrastructure. While China cannot play its
exchange rate card without annoying the US, it
is certainly leveraging monetary and budgetary
policy to prop up growth. The country may
benefit from another round of measures in the
second half of the year, with a positive impact
on global growth.
SPOTLIGHT ON STOCKS
At the beginning of the year, we opted for a
balanced profile in our portfolios. The lifting
of certain areas of uncertainty on the world
scene leads us now to look at increasing our
positioning on higher-risk assets, particularly
equities. Although we are seeing a short-term
slowdown of activity, we are confident in our
core scenario and believe we can identify risk
assets with a favorable risk-adjusted return over
6 – 12 months.
We see the risk of overvaluation in the equities
markets as no longer an issue. Valuation on the
basis of expected profits is currently in line with
10-year averages. While much higher just a year
ago, it has been forced downward by lower stock
prices, even as companies’ profits continued to rise.
From the perspective of strict fundamentals,
however, sovereign bonds remain far too
expensive. The rates on 10 – year bonds are
generally pegged in the long term to a slidingaverage GDP growth. The latter comprises real
growth, which is in Europe around 1.5 %, plus
inflation, also around 1.5 %. That means the
10 – year Bund should pay around 3 %, when
what we see is that it has sunk back into negative
territory. Absent a deflationary scenario, we are
therefore headed for a rise in long-term interest
rates, and consider bonds to be expensive
currently. From our perspective, bond holdings
offer relatively low levels of natural protection to
equity risk, within the eurozone at least.
TO INCREASE THE PROPORTION OF RISK ASSETS, TRIM THE BONDS
These market forecasts, geared toward an
appetite for risk, should translate into portfolios.
However, a response consisting entirely of
favoring stocks over bonds would be biased,
as it fails to take into account a key aspect: the
overall risk of the investment portfolio.
Before undertaking any change to allocation, a
first step consists of assessing the amount of risk
desired for the portfolio. This level of acceptable
losses will play a part in determining the weight
given to various asset classes. Reasoning from a
strict arbitrage standpoint between asset classes
can have significant—and sometimes poorly
grasped—consequences in terms of risk.
To understand this, let’s consider the simplified
hypothesis of a balanced portfolio comprising
50 % stocks and 50 % bonds, for which one
seeks to increase exposure to risk. For this
portfolio, assume potential losses in the
equities component to be 30 %, and that of
the bonds segment to be 10 %, or three times
less. The weighted average of potential losses
would thus stand at 20 %. This can be reduced
to 15 % thanks to the additional protective
effects of inverse correlation between asset
classes, as stocks and bonds mutually protect
each other.
If we stick to a strict move toward risk assets
and increase the stock component to 70 %,
versus 30 % bonds, the potential losses also
shift, becoming 24 % on average, or 19 %
if we factor in the protection afforded by
decorrelation. Granted, the new allocation
does increase the proportion of risk assets held
in the portfolio. However, the portfolio’s overall
risk budget is also significantly increased.
It is, however, possible to increase the portfolio’s
sensitivity to stocks, while maintaining risk
levels similar to that of a balanced portfolio,
if such is the asset manager’s goal.
In a limited risk management scenario,
exposure to equities should be increased
to 55 % only. However, bonds should be
reduced to 23 % and the remaining capital
(22 %) should be reallocated to monetary
instruments. The increased exposure to
risk assets thus entails just a 5 % increase
in the equities component. Meanwhile, the
percentage of bonds is halved.
This demonstration is merely an example,
but it nonetheless illustrates our core focus
when it comes to allocation: determining the
correct risk level assigned to a portfolio, in
order to preserve or, on the contrary, adjust
it if need be.
If we choose to keep the budgeted risk level
constant, then cutting the bond portion and
integrating a risk free asset — cash — makes it
possible to ride the curve of market efficiency.
In doing so, we confirm our positive view of
stocks, but are able to keep overall risk flat if
we make that our strategy.
DETERMINING ACCEPTABLE LOSSES
The art of asset management, however,
consists of adjusting risk levels over the life
of the portfolio. Indeed, risk budgeting is the
cornerstone on which allocation rests. Naturally,
this begs the question, which is crucial, of how
to determine the risk budget for a portfolio.
There is no easy answer for this, but rather a
combination of factors to be weighed:
- The strength of convictions, particularly with
respect to medium-term market outlook and
the views for particular asset classes; - The overall level of risk in the markets, as well
as their skittishness (volatility); - The management track record. The risk
budget assigned may vary according to
whether the portfolio is emerging from a
period of losses or gains.
These elements make it possible to assess
the overall appetite for risk. Conviction on an
asset class alone is not enough and cannot be
meaningfully applied without considering the
risk budget. When the outlook brightens, it is
necessary to know what direction you wish to
take and how fast to move towards your goal.
This is why our enthusiasm for risk assets
does not express itself as mere reallocation.
Consideration must be given to the portfolio’s
total risk, something which goes well beyond
directional views on the assets it contains.
By no means a mere arbitrage among asset
classes, allocation is the combined result of
expertise in many areas. Our fund managers
bring together their convictions as to market
trends with the development of a suitable risk
budget, while steering the portfolio in terms of
its specific history, and not only the markets.
No one of these elements, in isolation, offers an
adequate basis for effective management.
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