At this year’s Global Investment Forum, the discussion among Pioneer investment professionals was generally positive. Of course, everyone was conscious of the current market reality: that the major force behind recent positive, though benign, market trends is the unprecedented creation of liquidity and extremely loose stance of monetary policies around the world. Monetary policy alone cannot be the only conduit to a new economic model of income growth and job creation. We believe the best investment strategy may be based on a broad diversification of asset classes, keeping equities over-benchmark.* However, diversification alone is not enough to face volatile markets and we must consider other ways to manage risks.
- The Federal Reserve’s indecision about when to start “tapering” underscores its difficulties in implementing an exit strategy. They have discovered that their current approach is increasingly ineffective; regardless of the number of Quantitative Easing (QE) programs, any signals of changing this policy can unintentionally create an excessive and premature tightening of financial conditions.
- The role of fiscal policy to address the long-term impediments to growth is still hampered by a dysfunctional relationship between the Obama Administration and Congress. The deal that ended the recent U.S. federal government shutdown left most of the structural issues pending and only postponed the debate. If this persists, we could expect a permanent repricing of U.S Treasuries.
- We believe developed countries appear to be in a better cyclical position for the next 12-18 months than in the past five years. However, the growth trend is notably lower than before the crisis and the structural drags on future growth, stemming from the transition process, remain significant. Some developed countries, especially the U.S., still command huge competitive advantages in advanced manufacturing, new energy technologies and in the quality of their institutions, which could boost the long-term growth trajectory.
Asset allocation and asset returns, under some of the more complex and persistent global circumstances (political and financial instability, rising local inflation, new financial crises and violent shifts in capital flows) are difficult to define with confidence. Expected returns based on current valuations and past experience are low for equities and credit, and negative for core government bonds. At the same time, given the liquidity-driven nature of current market trends and the uncertainties of these global economic transitions, volatility will tend to rise. We feel the best strategic positioning may come froma highly diversified portfolio,with an overweight of the equity component, an underweight in core government bonds (especially U.S.) and a significant position (at least 20 to 25%) in alternative assets.
Is diversification the only way to proactively manage risk in a low return, high volatility world? Peter Bernstein, a well-known economist and financial historian, proposes this simplified approach to improving the risk/return characteristics of a portfolio:
- Make decisions in areas where you have control over the outcomes.
- Seek situations that are reversible.
It is virtually impossible to control macroeconomic outcomes but the choice of asset classes is controllable.
As a proxy for market efficiency, consider the dispersion of returns in a certain asset class, which allows us to focus on asset classes where dispersion is high (less efficient) – alternative asset classes. Although in the early stages of development, liquid alternatives have promising prospects. They are designed to offer returns that are less correlated with traditional asset classes. Another advantage is they may offer returns that are more “dispersed” than traditional ones, i.e. they may offer more opportunities for selection within the asset class. And, because of their lower liquidity, decisions made in alternative asset classes are less “reversible” than traditional ones. Therefore, there is a trade-off between “control” and “reversibility,” which must be managed with a careful calibration of alternative asset classes in a diversified portfolio.
*Diversification does not assure a profit or protect against loss in a declining market.
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