PensionsJul 22 2016

Through the looking glass

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Through the looking glass

Let’s admit it, Brexit was a bit of a surprise. Both sterling and the UK stock market rose in the days running up to the referendum, indicating that investors were strongly expecting the British public to vote to remain. The bookies thought so too and were offering odds as high as 6-1 for an ‘out’ vote.

Most of the professional predictors also got it wrong. But the polls of voters were close – running close to 50:50 for much of the month before the vote. Most professional investment managers took steps to protect their portfolios from an ‘out’ vote – even if they did not think it was likely to happen.

Given that a sterling devaluation was the most likely investment fallout, increasing exposure to foreign currency assets offered a simple protection if the unlikely happened.

All of that seems obvious in hindsight, but the moral of the story is clear: portfolios should not be positioned to take advantage of your base-case scenario – the set of events you believe are most likely to happen.

Portfolios should also reflect the range of other possible outcomes. Trying to model all of the possible outcomes would be beyond the scope of a typical private client. There is a genuine application to retirement planning of a client’s investments – do not just plan for the most likely future, plan for some less likely ones as well.

The difficulty with designing investment portfolios for a very long time period – such as the 15 to 30 years most pension savers invest for – is that the range of possible scenarios quickly becomes unmanageably large.

That is one reason why hiring a professional portfolio manager can help. But at the very least, clients and their advisers should consider bad as well as good economic outcomes. So what are these scenarios and what investments would do well?

The good, the bad and the ugly

One good economic scenario is as follows:

• Over the next few decades, global economic growth picks up, led by the US (which will shrug off its sluggish performance of the past few years) and China (which successfully deals with its unwieldly banking system and transition to free-market economy).

• Japan manages to generate some modest inflation and all of the developed and emerging markets are lifted by the tide.

• Quantitative easing becomes a quirk of the past as central banks gradually wind down their asset purchase programmes and inflation creeps into a sustainable positive territory.

This is most investment managers’ central good scenario. It is a scenario in which equities and property go up and bond prices come down. Price rises are gradual – no booms and busts – while interest rates gradually increase in line with more typical inflation levels that are signals of a healthy global economy.

Most investment managers will tend to favour this scenario, with portfolios holding fixed income assets in order to moderate risk and not because they are expected to offer much in the way of returns.

Alice Through the Looking Glass is a bad version of this world:

• China fails to tackle either its political or economic problems as the authorities lose control of what has historically been a region rife with internal conflict. US leaders take the world’s only superpower on an isolationist course, leading to a decline in world trade and heightened political instability.

• The eurozone disintegrates following the loss of the UK and Japan remains in the middle of its zero growth quagmire. Central banks take increasingly drastic measures to inject first stability and then inflation into the system, aggressively cutting rates and buying up debt.

• Interest rates are negative pretty much everywhere – as is inflation. Equities fall globally down to multi-decade lows, a property crash follows and credit spreads spiral out of control.

• All risk assets and corporate bonds lose money. Only high-rated government debt performs well.

But look again at the mirror and a dysfunctional version of the good scenario appears – without the chaos of the bad:

• Brexit causes years of uncertainty for the eurozone, but the status quo is ultimately restored, with the UK remaining a major trading partner and the euro remaining intact.

• The US struggles to get back to the economic growth levels enjoyed before 2008, but muddles through, as do China and Japan who find partial solutions to their troubles – enough at least to create economic stability.

• Some equity markets do well, but others do not. UK interest rates pick up slightly, but remain historically low.

• Property appreciates modestly, fuelled by growing population demands rather than the business sector. Corporate bonds as a whole perform better than government debt, but unforeseen credit defaults continue to hamper the sector.

• Recoveries come in fits and starts, and then evaporate again, leaving successful market timing the only real winner.

Cover all bases

So which is most likely – and what level of probability would you ascribe to each? And what are the other possible scenarios that should be considered?

Such questions are commonplace to professional investors who routinely consider and debate the changing economic environment around them.

Private investors planning a long-term asset allocation have a tough challenge. Their portfolio reflects their expectation for future scenarios whether intentionally or not. Rather than express a world view by accident, much better to do so intentionally. Then at least when the portfolio is reviewed periodically there is a context and structure that should encourage sensible decision-making.

This is a much-simplified version of what can become very complex models that investment managers use to help to position their portfolios. The more sophisticated the model, the more care that should be taken over the inputs, and the more regularly it should be reviewed.

Without the time or tools of professional investors, private clients might find it more practical to work on just a handful of scenarios – and ascribe relative rankings to each one. This will help to map out a sensible starting portfolio.

Regular monitoring is something that most private investors struggle with. Without a strong governance process, the initial portfolio is really under pressure to stand the test of time. In some cases this may be no bad thing; reactive tinkering can do more harm than good.

But as long as there is a clear process and rationale, the portfolio can be then reviewed against the changing economic backdrop in a structured and logical fashion, however frequently it is revisited.

Bob Campion is head of institutional business at Charles Stanley Pan Asset