2018: an SAA odyssey

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Definition of Strategic Asset Allocation (SAA): A portfolio strategy that involves setting target allocations for various asset classes and rebalancing periodically to the original allocations when they deviate significantly from the initial settings due to differing returns from the various assets.  From Investopedia

April 1968. Fifty years ago. It was perhaps the first mainstream introduction to fictional Artificial Intelligence (AI) when we met ‘HAL 9000’, the supercomputer controlling the spacecraft Discovery in Arthur C Clarke and Stanley Kubrick’s confounding sci-fi epic 2001: A Space Odyssey. HAL was an early exercise in AI over EI (emotional intelligence) and the omnipresent conflict between man and machine, pitting his hard-coded mission priorities over expendable human life, against his onboard human nemesis, scientist Dr. David Bowman.

In their battle, Bowman ultimately prevails by first deactivating HAL’s advanced capabilities, regressing the supercomputer to a juvenile state. Then he permanently shut down his circuitry in emotionally-charged scenes of pathos rarely associated with the deactivation of a machine (a theme revisited again in Spielberg’s A.I.). An eerie future glimpse perhaps, into the evermore humanlike connection we make today with assistants Alexa, Echo, or Siri…?

The risky odyssey continues after the GFC

We have been on something of our own unchartered odyssey in the years since the GFC. Central bank policies have kept bond yields low, allowing all financial assets to perform well against a low volatility backdrop. As a result, many superannuation funds have continued with a pronounced skew towards risk assets, retaining high equity allocations versus fixed income. And it’s worked out very well. Risk asset prices rose and have kept on rising. Generally, the more risk while these interventionist ‘training wheels’ were in place, the more return you made. Not too many spills, given dampened volatility. Very nice.

But will this strategy continue to work in the future? Markets received their first real warning in March 2018, when volatility returned amidst a perception easy money would end sooner than expected. We knew the US Federal Reserve (the Fed) would continue hiking rates – they’ve telegraphed their message well over the past five years – but the combination of rising rates, tapering and budget and current account deficits eventually meant an inevitable resurfacing of volatility. With US Treasuries remaining the global benchmark by which other markets are judged, rising rates will remain a global phenomenon, despite low growth and inflation.

US Fed journey is a balancing act

There has been much conjecture over recent months on the near-term path for US 10-year Treasury yields. Currently hovering around the 3% mark (the highest in eight years) a new consensus suggests a continued climb onwards toward (and perhaps beyond) 3.5%, at which point more widespread rotation from equities to bonds would be likely. Inflation and continued growth are key, but so is new Treasury supply.

It’s a balancing act. If Treasury yields continue to rise, it may choke future growth prospects, particularly with growth and inflation prospects remaining relatively benign. But solid employment gains, albeit with little wage pressure so far, combined with strong economic data point toward further post-GFC recovery. This provides the ammunition the Fed needs to return to a more normal short-term rate. But as we have seen over the past few months, the Fed is not immune from ever-present geopolitical rumbles. Tenuous, to say the least.

The Fed will normalise short-term rates over time, eventually reaching 2.5% or 3.0% over the next two plus years. A tougher question is what becomes of 10-year yields. Should the Fed hike too quickly, we could continue to see the flattening of the yield curve. However, US$1trillion+ budget deficits combined with the Fed’s tapering programme mean unprecedented supply in the coming years. Who will buy these bonds at current levels?

Watch sensitivity to rising rates, higher spreads and volatility

In a similar vein, the resurgence of volatility also left its mark in credit spreads, which remain wider than at the start of the year. However we view wider spreads as temporary in nature, due to short-term increases in corporate supply, rather than any deterioration in credit fundamentals or increase in default risks. Nonetheless, investors need to remain more cautious as market volatility increases, and not forget that we remain in a rising interest rate environment. Leaving your bond allocations sensitive to a change in rates and spreads is riskier today than in the past.

Fortunately, there exist a good number of strategies where that sensitivity can be neutralised. Any allocation to fixed income should exist as yin to the (equity) yang within portfolios, i.e. that it is uncorrelated (or negatively correlated). Investors should ensure it is proven so. Higher risk fixed income sectors can be closely correlated to equities when investors most want them not to be, notably during extreme risk off periods. The GFC is a fine case in point where certain high yield securities fell just as sharply as equities.

There is also no doubt that we still face a complicated set of extraneous geopolitical factors; the precarious relationship between ‘frenemies’ Trump and Kim, China’s opaque economics, tit-for-tat trade warring, and the volatile US/Iran/Israel dialogue to cite some of the current clouds. Their negative impact on equity markets could be severe, though any one has sufficient energy to disrupt the status quo in fixed income markets too. It pays to find fixed income manager delegates that possess inherent and proven dynamic tools to make material defensive adjustments when storm clouds gather, and equally to take risk when opportunities present.

Time for a new course on the odyssey

At least technically, a reasonably compelling argument has emerged for a rebalancing back towards closer equilibrium between equity and bond allocations. Not in a rush, but tailwinds are building, and layering in at increasingly attractive forward yields is starting to appear sensible.

Equally, initial audience reactions suggested 2001 took time to prove itself, though it’s come to be regarded as one of the greatest and most influential movies, dealing with complex themes of evolution, technology and AI. While the then fiction of human space travel has yet to materially progress from the moon landings of the late-sixties and early-seventies – notwithstanding ongoing efforts by the likes of Branson and Musk – 2001 gizmos such as flat screens, tablets, and smartphones abound.

 

James Bloom is Managing Director, Investor Relations at Kapstream Capital, an affiliate of Fidante Partners.

Fidante is a sponsor of Cuffelinks. For more articles and papers from Fidante, please click here.

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