Economic uncertainty has accelerated in the past decade, reflecting major demographic shifts, such as the increasing number of baby boomers retiring and soaring fiscal deficits.
It is set to increase again from 6 January, when president-elect Donald Trump officially takes office, according to attendees at the recent Professional Planner Researcher Forum.
Callidum Investment Research principal consultant Rob Prugue said heightened uncertainty, alongside regulatory pressure to outperform, had important implications for allocators.
“You’re being judged on your performance and your active calls, such as where inflation is going to go, what will happen in the Ukraine, and will tariffs be introduced, and those calls could go either way,” he said.
“There is no mathematical formula. You can’t even apply logic because it’s out of the realm of logic now. It’s not like CPI and GDP growth, which can be statistically measured and forecasted. The political uncertainty that comes from Trump’s presidency is too great to quantify and [his decisions] too irrational to assess logically.”
Yet, it is in this highly uncertain, highly unpredictable environment that investment professionals must make asset allocation decisions.
T. Rowe Price Australia international equity portfolio specialist Sam Ruiz said there had been a “distinct change” in the factors driving equity markets and all asset class returns.
Ruiz cited research that showed that, back in 1994, investors needed around 15 per cent of their portfolio in risk assets to generate an annual total return of 7 per cent. By 2022, that had soared to 96 per cent in risk assets.
“A lot of people say, ‘when yields are low, you’ve got to take more risk’, but when that happens for such a long period of time, there’s a lot of ingrained muscle memory, and with that comes certain behaviours,” he said.
“Since 2021-22, one of the biggest challenges we’ve had is looking at how to untangle some of that internal bias you develop when it comes to valuation, and the parts of the market where you think the best opportunities are.”
According to Ruiz, the 2022 UK pension crisis, the 2023 collapse of Silicon Valley Bank, and the Japanese Yen carry trade unwind in August, illustrated the potential perils of muscle memory.
“In each of these cases, the system was designed to lever up and chase yield because there was an obligation to drive returns or no option but to invest in low-yielding risk-free assets or, in some cases, negative yielding risk assets,” he said.
“All of these things came to an end. We can manage portfolios a certain way or out of obligation, and I’d say muscle memory [played a role] in those instances.”
Looking ahead, fiscal challenges – particularly the alarming US fiscal deficit – will underpin a difficult yield environment, said Franklin Templeton fixed income Australia managing director Chris Siniakov.
He added that today’s uncertain economic outlook was being fuelled by many factors including an “abnormal” economic cycle, geopolitics and the three Is; inflation, inequality and immigration.
There’s also the potential for “policy accidents” although Siniakov said, in such situations, “guardrails” were likely pop up to contain the impact and “bring it back into place”.
He described the situation as “constrained chaos”.
“I’m not trying to be alarmist but if you think about US politics, for example, we just had the election result, but there’s also the mid-term election cycle, and governors at the state level trying to influence policy, so it’s not just one individual at the top,” Siniakov said.
But he conceded that any extreme ideas that risk shaking up geopolitics and global markets will likely be countered by guardrails that come into place.
“If there’s a situation where a central bank goes rouge and tightens a few more times and causes an accident, then central banks will step in and either start to ease policy and put a floor under the economy, or go back to some old QE [quantitative easing] tricks, which I hope we don’t see again,” Siniakov said.
As a result, the “sign curve of a cycle” that used to illustrate peaks and troughs that were “nice and even” will be replaced by a lot more “stop, starts and sideways behaviours” into the near future, Siniakov said.
“What we have seen in the last couple of years is probably how we should expect yield environments to behave in the next three to four years,” he said.
To do well in this type of environment, investors need to be more dynamic and tactical, Siniakov said.
“Strategic asset allocation [that leans] towards traditional benchmark indices may be problematic because you’re leaving too much [return] on the table,” he said.
According Prugue, the strategic asset allocation of many balanced superannuation options, over the past 20 years, have largely maintained a 60/40 split between growth and defensive assets, despite significant changes to the expected rate of return of underlying assets.
‘If funds are to deliver CPI plus 3 per cent, their approach may need to change,” he said. “They may need to rethink what constitutes growth and value, and make allocation decisions accordingly.”
“If you’re targeting CPI plus 3 per cent, why invest 40 per cent in bonds when you’re getting CPI minus 3 per cent? To truly get CPI plus 3 per cent, you’re going to have to reallocate the growth end of your portfolio to basically anything that moves.”
Active management is the key, Siniakov said.
“You need to be active and obviously have skill. If you can’t back your skill then you’re passive and that’s unfortunately what’s happening in the industry.”
