Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
‘We’re all creatures of the present’: Look to history for future of equities
It’s hard to see through the fog of war generated by the chaos of Covid-19 pandemic and the slightly misguided macroeconomic policy that was supposed to fix it, but David Polak – senior vice president and investment director at Capital Group, the US-based asset management giant with $2.6 trillion in FUM – has a few ideas about what will come next.
Rates will eventually settle at a higher level than they were – but nobody wants to be Arthur Burns, the Fed chairman who made the mistake of easing too early and whose mess Volcker was tapped to clean up. That’s why, after the market rally that followed the latest rate rise, Jerome Powell took the opportunity to inform investors that he really was “going to drive the car into the ditch” – albeit carefully. The inflation surprise on Friday (November 11) suggests that the Fed may have begun to accomplish this goal, while Polak is unconvinced by gloomy outlooks that assume the presence of high rates means equity markets will be in the doldrums.
“There’s always a talking head who says that going forward you should expect low single digit returns,” Polak said. “It’s probably worth going back and seeing who said that in March of 2009. It’s the easy button. It happens after every crash – every strategist comes out and says you should expect a far gloomier future than there is today. They might be right, but that’s not why they’re saying it. We’re all creatures of the present; we all extrapolate from our current views. It’s hard not to.”
That doesn’t mean that Polak is a bright-eyed optimist – just that he and Capital Group are more constructive than the prophets of doom. Markets could have a really tough Winter, and probably Spring. They could go lower, or keep bouncing around. Investors don’t yet have a good feel for the car actually entering the ditch, or the earnings adjustments to come.
“Equities tend to compound at seven per cent per annum…If you look at the rate of return of the ACWI index over now 49 years, it compounds at just under eight per cent,” Polak says. “Long-term history tells you that equities compound at that. There’s no reason to believe they won’t go back to that. Will we be at that kind of rate the first year or two coming out? Probably not. It’s not going to be a straight line – that only happens in 2019.”
Opportunities still abound in healthcare, power grid electrification, and short-duration tech. Companies tend to do a pretty good job of adjusting their costs and supply chains, especially after the last two years. The businesses that come out of such disruptions “tend to be battle-hardened” – more efficient and more effective. Polak believes that now is the time to take advantage of everything being comparatively cheap, and Capital Group is in high single digit levels of cash in most of its portfolios.
Which is not to say that risks aren’t waiting in the wings, though Polak is sceptical of anybody who believes they can identify the next black swan (a black swan you can see coming is, after all, a grey swan). The market is “very concerned” about Taiwan and China’s intentions for it, a potential energy crunch in Europe, the war in Ukraine, and rate policy.
“So what could go wrong out of all of that? Political instability is one of those things that can really rattle the market in the short-term,” Polak said. “So what happens if a world leader disappears. There’s been a lot written about what happens if Putin suddenly disappears. It kind of depends on who’s coming (after him). The thing that would worry us the most is some geopolitical action that would add to market uncertainty.”
“They really hate uncertainty and they’re already uncertain at the moment. Something that would add to that could actually paralyse investors, and paralysis is the most difficult part of the market to deal with. We got paralysis during 2008-2009 because we had what looked like a systemic failure in the financial system and people stopped doing things. When people stop doing things you find it very hard to establish a clearing price for assets.”
It’s that last point that is perhaps the most worrying. The recent chaos in the UK gilt market, borne out of the UK government’s misguided “mini-budget” response to a burgeoning cost of living crisis, illustrates how parts of the financial system can quickly lock up as fiscal and monetary policy find apparently competing priorities.
“If you start seeing parts of the financial system seizing up, that rattles markets,” Polak said. “And that could be a bigger risk than geopolitical risk. If you suddenly find there’s a whole sector – like liability-driven investing in the UK – (seizing up), memories go back to 2008-2009.”
