That many stakeholders in the global financial markets anticipate a return to the pre-global financial crisis yield environment is understandable, taking the cue from an impending policy rate hike by the U.S. Federal Reserve. The new normal, epitomized by a prolonged period of low interest rates, has had one of the longest runs in the history of the business cycle. Never has the world experienced a protracted period of low policy rates as it did between August 2008 and now.
However, a few perspectives should be considered thoroughly by investors to temper their expectations of an impending normalization in the near-term.
1. The idea that the economies of the developing and developed world, excluding the U.S. and Western Europe, would support global consumption post-crisis has not eventuated. China’s 2 percent devaluation of the renminbi is indicative of its ‘old school, export competitive’ standpoint, though its other compelling motivation, as elucidated by some, is to make the RMB attractive for consideration by International Monetary Fund (IMF) in its Special Drawing Rights (SDR) review, i.e., to align the RMB’s central parity rate closer to the spot rate. Elsewhere in the Pacific, the onset of Abenomics since December 2012 has not led to significant change in Japan’s domestic private consumption.
2. Colossal debt in the form of personal and household debt is a major impediment to world growth through its effects on disposable income and consumption. Other than some of the major developed economies, household debt-to-GDP has increased in many nations (Scandinavian and emerging economies in particular) since the financial crisis, vis-a-vis income growth which has evidently not kept pace.
3. Thus, central banks other than the Fed, are not expected to raise their policy rates given the medium term outlook on many economies. It is likely that the Fed too may not raise the Fed Funds Rate in successive FOMC sittings, though it is widely expected that an inaugural rate hike would eventuate before 2015 ends.
In light of the above scenarios, taking decisive portfolio management action is crucial in these volatile times.
Traditional interclass asset fundamentals
In the 10 years prior to the crisis, the eurozone showcased some novel attributes for the cash asset class, which was not observable in other developed financial markets in the same period, in that it had a strong positive correlation with the Euro Stoxx 50 Index and a fairly significant Sharpe ratio (returns above risk free rate per unit of risk). The latter was not evident in the other four developed financial centers, though all those markets experienced average positive correlations between their blue-chip stock indices and the cash asset class return, contrary to established belief that high cash rates/interest rates lead to declining stock valuations. From a risk-adjusted standpoint, not surprisingly, gold was the best performing asset class in that period. Cash was the best performing asset in the eurozone and Japan, whereas quoted equities saw great returns in the U.S., UK and Singapore.
The onset of the crisis
The cash asset class saw unanimity across markets in that it became the worst performing asset between August 2008 and August 2011. All major asset classes saw poor performance in that period. Empirically, the correlation between sovereign securities (Treasuries/government bonds) and cash rates in all markets remained strong-positive with the exception of the U.S. Gold retained its record of performing the best amongst the major asset classes, however, across markets its correlation with cash indicated a strong negative bias.
The four years following August 2011 saw quoted equities outperforming other major asset classes ostensibly in the search for yield. Some interesting asset correlations have emerged in this period, such as the gradual decline in the performance of gold with its correlation showing strong positive movement with cash across markets. In the U.S., treasuries have strong-negative correlations with cash generating positive excess returns, unlike Treasuries. Likewise, in Singapore, cash has showcased strong returns, though government bonds and cash have maintained a positive correlation. The experience in the eurozone suggests continued poor performance in the cash asset class though correlations have remained positive.
Positioning the portfolio and key takeaways
There have been assertions of late that cash is a less volatile asset class and that fund managers should move into cash, pending rate normalization. The experience in the U.S. and Singapore is indicative of long-term sub-performance of cash though at the current moment it offers greater excess returns vis-a-vis other asset classes. On the other hand, the eurozone evidently has stable cash performance in normal periods and has showcased poor performance throughout the crisis. With the onset of Abenomics, Japan has experienced greater volatility in its cash and government bond returns. Except in the first three years of the crisis, equities have been the best performing asset class across all markets over the long term.
In light of these observations, asset allocation across markets should consider the following broad processes:
1. Determine the ideal level of cash to hold in the portfolio.
2. Staying invested in equities, noting however, that equity has been performing well in search of yield in the post-crisis environment. Thus, rebalancing the equity portfolio would be in order.
3. Evidently, gold retains its ‘safe haven’ quality. However, gold is currently experiencing sub-par performance tracking the cash asset class due to investor expectation of a return to normalization. The advent of normalization would see gold trend lower until inflation rebounds to long term normalcy. Hence, there is ample time for those not already in gold to consider investing in it.
4. Consider the novelties of investing in real property; in the eurozone and the U.S., property currently has strong negative correlation with cash and generates amongst the best returns. However, timing of entry and selection are crucial as the low interest rate environment would have fed into property valuations.
5. Structured product investments should make up 5 to 10 percent of the asset allocation to provide yield enhancement and replicate dynamic asset allocation without engaging in active trading.
Amar Ramachandran is Head of Investment at Asia Capital Reinsurance Malaysia Sdn Bhd / ACR Re Takaful Berhad.