Purpose and role of the SAA
The purpose of the strategic asset allocation (SAA) is to be the foundation upon which the portfolio sits. The foundation needs to be stable, balanced and capable of withstanding market headwinds. Each part of the foundation should interact with other parts of the foundation to reinforce the structural integrity of the whole portfolio.
The role of the SAA is to do the heavy lifting inside the portfolio. It should generate most (in excess of 90%) of the risk and return outcomes for the entire portfolio leaving tactical tilts and manager selection with relatively minor (but no less important) roles to play.
A remodelling is needed post-pan
It has been mentioned often about the number of trends that were in play prior to the pandemic that were accelerated because of it – e-commerce, online learning and green technology to name a few. In financial circles, one of the big trends that was significantly accelerated because of covid is the amount of debt in the economy. In the US alone, total household, corporate and government debt rose from 226% of GDP pre-pan to 258.4% of GDP post-pan. In dollar terms, that is equivalent to $5.5 trillion. What took eight years in the early 2000s took just one year in 2020.
Chart 1: Total US Household, Corporate and Government Debt (%GDP)
Zombie, zombie, zombie-ie-ie
The intention of the policy makers during the pandemic was to support the economy. Get as many businesses and households over the gorge left in the economy by the forced shutdown as possible.
They were successful in this task. At the peak of the pandemic, the expectation was that around 12% of corporates in the US would default on their borrowings. In reality just 3.5% did. This compares with a 12% default rate following the global financial crisis (GFC) in 2008. The workload of business restructuring experts has never been lighter.
In Australia, while the Reserve Bank has said business insolvencies started to rise towards the end of last year they were still well under half the rate of the pre-COVID years despite the pandemic.
It is not just a US or Australian phenomenon. Corporate insolvencies in Germany fell by 21.8% in the year to February, continuing a downtrend that saw them hit their lowest level since 1999 last year thanks to a waiver provided by the government during the pandemic. In Japan, bankruptcies fell to the lowest in 31 years.
The issue with policy makers stepping so far into the marketplace to provide support is it impairs the free functioning of the economy. If so many trends have been accelerated as a result of the pandemic, then it is even more imperative for the old trends to make way for the new. Resources in the economy such as land, labour and capital are finite. A freely functioning economy will ensure these resources are put to the highest and best use. When policymakers stand in the way of the free market operation, resources are inefficiently allocated and productivity suffers.
The introduction of quantitative easing (central banks printing money to buy government and corporate bonds) was made large by the pandemic. It is the clearest example yet of policy makers interfering in the free operation of the market. In this environment, price signals get distorted and resources are misallocated.
We have evidence of this. Ahead of the pandemic the Bank of International Settlements (BIS) estimated that the proportion of zombie companies in developed economy listed markets was about 15%, up from only 4% in the pre-financial crisis era. In Australia, Canada and the US (with a relatively higher population of listed companies than Europe or Japan) the proportion was significantly higher at about 25%.
Zombie companies invest and employ less than their healthier peers. They are less productive and, given their relative significance within western economies, have an impact on the ability of capitalism’s “creative destruction” to recycle financial and human capital into more productive activities. These companies subsist on cheap and freely available government and central bank support.
Other evidence can be seen in the proportion of US businesses less than one year old – now close to a record low. New businesses spend more than old ones. They hire more, invest more and are generally more productive.
Much higher debt in the system today than ever before means the potential for bankruptcies and severe economic harm if rates were to rise materially, or the flow of credit were to slow, is even greater.
The consequence is the reaction function of central banks and governments will be constrained for years, if not decades, to come. Quantitative easing will remain and markets will become even more administered than freely functioning. All the while, the scale of debt, deficits and zombies will like increase further.
The bottom line from all of this is lower for longer – lower economic growth, lower interest rates and lower inflation.
What are the implications?
A number of implications stem from this environment both in terms of risk management and return management. From a risk management perspective, greater support from policymakers means lower risk. Policymakers will increasingly underwrite the market to prevent a widespread wave of defaults.
If risk is lower in public markets, then returns are necessarily also lower. One follows the other. Lower risk attracts additional, non-native, investors into public markets. This suppresses the return premium for all public market investors. So we should expect to see lower expected returns in public markets over the next five years or so.
Second, lower interest rates means income investors need to think more in total return terms. The charts below analyses the income/capital growth split from two of our preferred, long running Australian equity funds.
Chart 2: The shrinking income share of total returns
In December 2006 the income from Alphinity was 17.9% out of a total return of 26.6%. The income from Wavestone was 13.5% out of a total return of 21.9%. In both cases, the income component was around two-thirds of the total return.
Fast forward to April 2021, the income from Alphinity was 2.2% out of a total return of 36.2% and the income from Wavestone was 1.0% out of a total return of 30.2%. In both cases, the income component fell to around 5% of the total return.
This illustration of how income returns have declined is not fund specific. It illustrates, however, that total returns can still be attractive in a low income environment, indeed more attractive in this example. It also highlights how income investors need to adapt their thinking. Income, at least in part, will need to come out of capital.
Unlike public markets, where risk is lower thanks to the support of policy makers, income seeking and non-native investors are less likely to seek returns in private markets. The illiquidity risk associated with these markets is unchanged in the post-pandemic environment. Relative to public markets then, private markets offer attractive risk-adjusted returns.
Our new assumptions
The table below shows how our 5-year expected return assumptions compare with the 5-year historical average of actual returns. These are the returns on the asset classes only. They do not include value added from active management or manager selection.
The international equities asset class has a higher return and risk than Australian equities because it includes emerging markets.
Our new SAA models
Given this outlook, we have made a few changes to the strategic asset allocation underpinning our three model portfolios – capital preservation, capital balanced and capital growth.
The main changes we have made are to decrease the allocation to fixed income. This reflects the concerns we have with the low starting yields for bonds and the expected increase in government issuance.
We reduced the weight in Australian equities in favour of international equities. This reflects the view that international equities offer greater potential for return given the larger universe of opportunities. The greater diversity offered by international equities also means lower risk.
Finally, we increased the allocation to alternatives. This reflects our view that this asset class offers greater risk-adjusted return potential providing investors can accommodate the illiquidity risk that this comes with.