Please note that the figures mentioned in this article are no longer available.
Markets have reacted negatively to the Federal Reserve (the Fed) announcement, as we signalled last week , with the Standard and Poor’s 500 now off roughly 3% from the announcement by the Fed. What the Fed was trying to do is suggest that economic growth is now of sufficient strength to begin the reduction of quantitative easing, from about September this year, assuming the US economy performs the way that the Fed expects between now and then. However, the all financial markets have been distorted by Fed actions, and the reversal of those actions will see all markets impacted; the higher risk more than the lower risk. In the context of heightened volatility the following three sections will be explored, with a view to defining a “true” balanced portfolio.
- historical performance of various active and static portfolio allocation strategies,
- the historical relationship between GDP and equity performance, and
- consideration of what a “true” balanced portfolio might resemble.
As we showed last week, it is possible to switch between the bond (75% bond and 25% equity, or the light blue line in Figure 1) portfolio and the equity (75% equity and 25% bonds, or the grey line in Figure 1) portfolio on a dynamic basis, and the performance of that dynamic approach is shown as the dark blue line in the below time series. From this time series in Figure 1, one can see that the dynamic and static equity (75% equities and 25% bond) does not tend to stay above 20% for many time periods, and that a high level of return has recently been achieved.
Now, in order to achieve portfolio returns higher than 20%, for the static equity portfolio (75% equity and 25% bonds, or the grey line in Figure 1) then one would need to be expecting high GDP levels, as equities effectively provide a leveraged exposure to economic growth. This relationship, between economic growth and equity returns, is explored in the next section.
GDP and equity returns
As Figure 2 indicates, annual equity returns (the light blue line on the left hand axis) tend to anticipate changes in economic growth (the dark blue line on the right hand axis). For example, equity returns weakened dramatically over 2008, in anticipation of the fall in annual gross domestic product (GDP), recorded slightly later. Also, notice how the higher levels of annual GDP tend to be associated with higher equity returns.
In order for equity returns to continue higher than they currently are, one would need to expect that economic growth would be on the high side of the historical range as provided on the right hand axis of and the dark blue line in Figure 2; say over 3.50%. However, most economic forecasters, including the RBA, expect GDP growth to be in the 2.5%-3% range for the next few years. Such modest estimates reflect, among other things, a decline in the fortunes of the mining sector and a sluggish non-mining sector that is being challenged by a persistently high Australian currency. While growth might be higher than 3.50%, a sober and realist assessment suggests that it will not be, which means that the recent equity market performance has, already, reflected a somewhat optimistic view of growth.
While such optimism can persist, the main point is that most of the good news is already reflected in equity market pricing, leaving equity market participants in a quandary about the forward outlook in the context of a withdrawal for quantitative easing (QE) by the Fed. If all financial markets have been upwardly distorted by the Fed, and by QE, then without QE the markets will adjust. In particular, the recent rise in the risk free rate should inspire institutional investors to asset allocate from equities to bonds, as the bond yield effectively provides what yield investors can achieve in equities, without the default risk of equities. In other words, current concerns are only just the beginning, and much more equity volatility is ahead of us, as pricing concerns intensify.
Towards a “true” balanced portfolio
If we have only just entered a new period of equity volatility, then it may be helpful to consider how much a typical portfolio is dominated by equity risk. While many planners and others have lulled the average investor to accept that 75% equities and 25% bonds is a “balanced” portfolio, the problem is that equities dominate the risk of the investment portfolio. As we have argued before, this is anything but “balanced”, as investors are heavily leveraged to the fortunes of the economy; portfolios do well in growth situations, and do badly when growth is low, or negative. We argue that investors need greater diversification, in order to move away from a situation that leverages the portfolio to movements in GDP, or the overall growth in the economy.
In the Figure 3, we show a time series of how much portfolio risk can be attributed to equities, for two portfolio weighting. Specifically, we see that the typical “balanced” portfolio, as shown by the dark blue line on Figure 3, effectively “swamps” the portfolio risk with equity risk, where equity risk is accounts for over 80%, or more, of the total risk on the portfolio. In contrast, a portfolio with less equities and more bonds (75% bonds and 25% equities), has much less exposure to equity risk at all times.
Such an allocation is much closer to a “true” balanced portfolio, as equity risk varies, yet tends to be about 50% of total portfolio risk. If the idea of a “balanced” portfolio is catered around achieving a greater diversity of risk factors, then having equity risk comprise roughly 50% of total portfolio risk seems closer to a truly “balanced” portfolio, when compared to the portfolio that holds 75% equities and 25% bonds.
While we foreshadowed increased equity volatility last week, as the world adjusts to reality of low growth, the problem of asset allocation remains central to dealing with a state of elevated equity volatility; a situation we have only just begun, and situation that will be with us for some time. While Australian equity markets have already built in the optimistic case for growth, this piece suggests that there is a limit to growth in the short term; a limit that is strengthened by the withdrawal of QE by the Fed. In this context, better portfolio design is urgently required; a design that balances out equity risk, with bond risk. A design that is more truly balanced is available, yet it involves more bond risk in the portfolio. Changing the portfolio, towards this more conservative risk makes a lot of sense in the period of volatility that has only just begun.