Over the past few months I have been exploring how economies and markets might evolve over the next decade with fund managers, CIOs, consultants and pension funds. I believe we, and our clients, need to better understand the forces driving current market volatility and to explore possible future market scenarios in order to regain the confidence to invest for the long term again.
The next few years will likely be as volatile as the last few. We are bombarded with numerous charts of asset prices rising one quarter and falling sharply the next. This uncertain and flip-flopping market has taken its toll on our patience, confidence and risk appetite. It is clear that 5 years since the global financial crisis began we continue to face a crisis of confidence.
What we are looking at is just the tip of the iceberg!
Many investors are still waiting for this storm to pass, in hope that the norm they remember from the past will return. Developed market prosperity in the 90s was far from the norm; it was a leverage-induced party, which will take decades to clean up. We need to get used to this environment for the foreseeable future.
At least this is the consensus view amongst economists and strategists. Europe will remain dogged with problems, central banks will continue to print money to stimulate growth and avoid deflation, the ECB will keep doing just enough to support the Euro, the US and the UK might muddle through with low/no growth, volatility will remain high, investor sentiment will stay fragile and that rates will remain low for the next 5-10 years. If this sounds familiar it’s because this is broadly where we have been for the past 5 years. This “muddle through” view of the future is what is built into most budgets, plans and business strategy.
How long do you think we will continue to muddle-through for? What asset classes and investment portfolios you think will preserve capital, generate income and real growth in this central scenario?
Economists, strategists and market practitioners draw a number of parallels with Japan. Between 2000 and 2010 Japanese investors dramatically reduced their exposure to domestic bonds from 48% to 16%, in favor of foreign bonds from 4% to 24%. In trying to explain the present or predict the future, it is very tempting to draw on historical comparisons – 1930s, 1970s, Japan’s lost decade – however many factors today are different from the past. The future may not follow the consensus view, in fact it rarely does.
In order to explore different futures we need to look beneath the surface of this volatility.
In my experience the key to developing a good forecast of how things might pan out in the future is to understand the unarticulated challenges and frustrations of stakeholders today. We can use this to develop scenarios for the next 5-10 years.
The 5 major forces of change that lie beneath the surface and drive much of the volatility we have observed in markets are as follows:
- Debt addiction: It is no secret that we have excessive debt in the financial system, which is manifesting in many ways, including the Eurozone crisis. Despite a lot of talk of austerity, de-leveraging and belt-tightening, most countries have more debt now than they did in 2007. We have transferred the debt built up over decades from banks to governments, who now owe more than they can repay. This situation is not sustainable.
- Government & Regulation: Since the financial crisis regulators are becoming more intrusive and aggressive. Regulation is hard to anticipate, but its influence can be significant and can affect a wide range of areas. Governments also have the inherent tension of addressing very serious long-term issues within political cycles that are short term.
- Demographics: The developed world has an aging workforce, leading to major changes in the cost of pension and healthcare provision. The growth in size of population also has implications for resources, in particular energy, water and food. The asset management industry has grown exponentially in a pre-retirement world; we are now moving into a post retirement world that needs income, preservation and solutions. Asset managers have to adapt or die.
- Technology: The current pace of change in physical technology and the impact on society in general and markets in particular has been likened to the Industrial Revolution. Developments have created new industries, new investment opportunities and fresh solutions to existing problems.
- Public Trust: The relationships between the public and their government, their media, their banks and their corporates have deteriorated following recent scandals, with deep concerns that institutions are not acting in the public’s best interest.
These are major forces of change on their own, let alone when considered together. We could be entering a period of significant change in world economies, politics and capital markets that could materially affect the decisions facing investors.
Let’s consider some alternative scenarios for the next decade:
There are various future scenarios we could imagine:
Depression – this is the scenario that the bond markets have been pricing in – a deep and protracted trough in economic output, a sharp and prolonged increase in unemployment, fall in consumption, restriction of credit, shrinking output and shrinking investment. We would see significant defaults on corporate bonds, equity markets would fall and bond yields would remain low. We are familiar with this to some extent though we have been teetering on the edge of it. Central banks have thrown the kitchen sink at trying to limit this risk so far. Assets that one might hold to preserve value in depression include global bonds, cash and put options.
Sovereign default – it is very plausible that a major country will default in the next few years. Sovereign default means a country does not pay its owed interest or return its borrowed principal. The longer economic growth remains low and the longer governments do not reduce their spending or cannot increase taxes, the harder it becomes for them to service their debt and access future capital. This would lead to significant losses on government bonds and all risky assets. Diversifying government bonds might be the main store of value in this environment.
Currency crisis – we are seeing a race to the bottom with developed countries trying to devalue their currencies faster than each other to maintain global competitiveness. In this scenario we could see significant devaluation of a major currency that becomes self-fulfilling. The country’s purchasing power and wealth would be diminished leading to a sharp rise in bond yields.
Euro break up – it feels like the risk of this is reduced for now as the ECB has said that it will do whatever it takes to sustain the Euro given the undesired consequences of a Euro break up – defaults on contracts and significant losses. Being overweight core Europe versus the periphery would be a sensible way to invest for this scenario.
Hyperinflation – we’ve already seen prices rise by around 5%pa over the past 3 years, but hyperinflation is when it rises above 10%pa and gets out of control. Prices increase rapidly as money loses value, wiping out purchasing power. Investors hoard assets and we could even find people rioting on the streets. Index linked bonds and Gold might prove to be a good store of value in this scenario.
Climate change & resource scarcity – this relates to the growing concern that climate change is for real and our ability to create new renewable energy /resources/ technology is slower than our demand for resources globally. This is plausible if emerging economies keep growing at the current rate and demanding their share of water, oil and other resources. Governments have to divert capital from productive uses to accelerate the development of new technologies; ultimately this could lead to conflict between nations. Agriculture, soft commodities, environmental technology could be interesting investments for this scenario.
Major War – would lead to destruction of physical and human capital leaving a depleted workforce and dampening economic output and consumption for many years. War is negative for all risky assets, with only Swiss francs or maybe put options preserving capital.
Which of these scenarios worry you the most? Which do you think is most likely? What kind of portfolio with you hold to weather this storm?
We must remember that these risks are inter-related and also none of these scenarios need to play out fully for asset prices to change and start reflecting these fears.
We could summarize these as 2 competing scenarios – inflationary and deflationary:
The Deflationists have been worrying policy makers and driving bond market pricing in recent years. They believe that the world will take years to work out the excess debt cycle we have created in the past 60 years. They are clear that low growth and low inflation combined with systematically high unemployment is here to stay with interest rates staying low for a generation. Government bonds, cash and gold tend to be the best stores of value in this scenario.
The Inflationists are starting to be heard more now. They say Central banks have already made money too easy and that they will continue to print money across the globe. This systematic monetary debasement since the gold standard will ultimately lead to inflation that will tear through investment values. Cash will lose money in real terms and many investments will not even meet cash. In this kind of scenario index linked bonds, gold, agriculture and real assets might be the best stores of value.
We should also consider a Bullish Scenario. What if market fears are overdone?
Those that found the courage to more bullish in 2012 and coming into 2013 would have performed well. There are positive developments around the world and maybe these fears are overdone and already priced in. We would enter a more bullish environment if the Eurozone stabilizes better than markets are pricing in, US recovery continues, China recovers, inflation picks up gradually but central banks in control. We should have some allocation to these bullish scenarios in our portfolios. Some of the following assets maybe more appropriate investments for a bullish economic backdrop – European equities, global growth equities, EM equities, long-short equities, real estate and private equity
Do you think markets are pricing in too much doom and gloom? How likely you think a more bullish scenario is? What assets you would you hold for a more bullish market scenario? How much you think you should allocate to a more bullish scenario?
Synthesis – So what do we do with all this information?
We have considered various forces of change working beneath the surface driving current market volatility. We have begun to explore various future market scenarios and started to think about the kind of assets that might perform in each of these scenarios. This does not have to be a one off static exercise but can be developed further over the next few quarters/years and can be refined by getting input from various stakeholders including your fund managers.
We could build a broad portfolio of investments across portfolios designed for a muddle through, bullish, inflationary and deflationary scenarios:
- Muddle through portfolio including assets like global equity income, global high yield, EM equity/debt, multi asset funds, loans, ABS and real estate.
- Inflationary portfolio including assets like index linked bonds, gold, agriculture, real estate and other real assets.
- Deflationary portfolio including assets like global bonds, cash and put options
- Bullish portfolio including assets like European equities, global growth equities, EM equities, long-short equities, real estate and private equity.
Given market uncertainty, there would be benefits in dynamically changing these allocations between scenarios ourselves or having our fund managers be more dynamic in their allocations for us. This could be a sensible way to allocate medium to longer-term investments.
Most of us take an incremental approach to change, through a series of short annual or quarterly steps. Managing long term money, portfolios or businesses with a series of one year horizons, will not prepare us for shocks and surprises that lie ahead; and will not perform as well as a longer term strategy grounded in proper long term scenario analysis.
Further reading & useful references:
• Morgan Stanley Research Europe: Global Asset Managers – How asset managers grow in a low return world? – 10th November 2011
• HSBC Global Research – Multi Asset: “The 10 key trends changing investment management and how they will affect asset prices” – Garry Evans September 2012
• Goldman Sachs Global Investment Research: US Asset Management at a Crossroads – Introducing five possible pathways to the future 5th October 2012
• Peter Schwartz: Winning in an uncertain future through scenario planning – 27th Feb 2012
• Harvard Business Review: Adaptability The new competitive advantage – July-August 2011
• McKinsey & Co. Financial Services Practice: Growth in a time of Uncertainty – The Asset Management Industry in 2012
• McKinsey & Co. Financial Services Practice: The Mainstreaming of Alternative Investments – Fuelling the Next Wave of Growth in Asset Management
• Towers Watson: We need a bigger boat – sustainability in investment
• Create-Research: Innovation in the age of volatility
• Outsights: 21 drivers for the 21st Century