Five-Year Capital Market Outlook — 2019 Australia

Key actions from a macro viewpoint also make sense through other portfolio construction lenses

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At Willis Towers Watson, we believe no single approach to portfolio construction can yield “the answer.” Therefore, we consider the problem through multiple "lenses," four of which are displayed opposite — our delegated/"outsource-CIO" portfolios capture more but we simplify for illustration. Doing so shows that ideas make sense based on our macro views will tend to make sense anyway.

Five portfolio priorities for a surprise-free 2019

We think the chances of nasty surprises has gn. How can we deliver needed returns, whilst reducing the risk of unexpected events?

1. Diversify

Why? Diversification is always a good idea and is an especially good idea now. Relative to equity-heavy peer groups, it is not always painless, but we remain firmly of the view it will prove correct.

How? Ideas that are consistent with our macro outlook are discussed below.

Many funds could still benefit from diversifying equity risk. Simple ways of doing so include investing in:

• Alternative credit: Many institutions have added credit to their return-seeking portfolio through relatively vanilla loans, high-yield or multi-strategy alternative credit mandates. We strongly believe success in alternative credit is driven by a consistent and persistent focus on manager and strategy selection. Over the past few years, new and better strategies are available in niche, undercapitalised areas of the market. Private debt (bridge financing) and parts of securitised markets are key examples.
• Alternative beta: Some hedge fund strategies are just expensive, but novel, forms of beta. Over the years we have sought to strip away the complexity and fees and provide these betas to investors cheaply. These strategies include reinsurance and momentum, which have the benefit of being much less macro-sensitive than equities. Selectivity, innovation and clout – if it doesn’t exist, create it through networks – are required.
• Low beta hedge funds: (See priority #4, Alpha).
• Ironically, an internationally diversified equity portfolio is also likely to be US-heavy. US equities remain richly priced relative to economic prospects and other equity markets. Diversity may be as simple as temporarily reducing US equity exposure in favour of non-US markets, although this is governance-and price-dependent (see priority #3, Dynamism).

2. Reduce unrewarded risks

Why? Because risk should only be taken if it is required and rewarded.

How? Australian investors are typically good at focusing capital where it is rewarded. But, an implication of our longer-term outlook is that some of the forces that are pushing long-run expected returns lower are also pushing the returns that are required to meet savers’ objectives lower. Might you be targeting a level of return and risk that is high relative to what savers actually need? The communication and commercial challenges surrounding adjusting return targets are high, but we still believe revisiting required return targets is a useful exercise.

We also encourage investors to integrate scenario analysis into risk management. This has two dimensions:

• Macro scenarios: We believe we are approaching an inflection point in the business cycle and have passed it in the capital cycle. This creates additional uncertainty that traditional risk management approaches will struggle with. Considering the impact of, for example, a Japan-style deflationary equilibrium emerging in the developed world through deterministic scenario analysis will provide an intuitive understanding of macro risks.
• Climate change scenarios: Climate change is, in our view, an important form of systemic uncertainty that long-term investors face. Grappling with its impact on a portfolio is daunting, but we strongly believe scenario analysis is the answer. Even an approximate understanding of portfolio exposures to climate risk factors can help indicate the easy wins to reducing financial exposures and, for those inclined, to improving the extra-financial impacts that are likely to become more important.

Finally, all these and other risk metrics can be combined to form a Portfolio Quality Scorecard. This embeds beliefs about expected returns and risk under different scenarios, dynamism, diversity requirements, illiquidity, fee tolerance, peer risk and sustainability factors (amongst others) and quantifies the current portfolio’s standing relative to them. The result is a holistic view of risk and portfolio resilience that importantly can be used to assess future portfolio changes.

3. Macro and dynamism

Why? Understanding the range of outcomes is an important way to reduce uncertainty. That understanding can be used to dynamically manage risk or to create value. The latter is hard and should only be undertaken by those with the governance budgets and beliefs required. But using dynamism to manage risk is more widely accessible.

How? In most cases, effective dynamic risk management means focusing on downside risk and introducing intelligent protection. Diversity is the first answer, but there are others:

• Levered high-quality bonds as a return-seeking asset: Return-seeking assets tend to do well when GDP gth does well. The flipside is they don’t when gth is weak. Adding a levered exposure to domestic and/or US bonds is capital efficient, positive returning in ‘normal’ times and does well in the downside economic outcomes we expect.
• Controlled unhedged FX exposure: FX exposure adds risk but this is not unrewarded: It can be an attractive source of diversity. For investors with pro-cyclical base currencies like the Australian dollar, unhedged exposure to currencies like the US dollar and Japanese yen can add downside protection.

Ideas to dynamically create value, which we consider for the portfolios we manage, include:

• Reduce macro risk temporarily: Our outlook suggests taking less risk now in order to take more later. The difficulty of this decision is not to be underestimated, nor is the complexity of managing it. But underweighting equities in favour of less macro-sensitive assets, e.g., alternative credit, alternative beta, and low beta hedge funds, or temporary derisking through options should be considered.
• Reduce exposure to tighter liquidity: US corporate debt is a key area of concern. For example, in our view, vanilla leveraged loans face a set of medium-term fundamental pressures.
• Reduce exposure to ‘great expectations’: At the time of writing, earnings gth expectations in the US remain excessive. Consequently, forward-looking returns for US equities in particular are weak. We remain underweight versus the rest of the world. While less so than the US, discounted conditions in Australian equities also look optimistic relative to our outlook.
• Look to the next cycle: Risk premia will not remain unattractive forever, creating an opportunity to redeploy capital when they are reasonable. While the near-term pathway for some emerging markets is risky, medium-and long-term prospects are strong. Understanding and managing the macro, in particular, FX exposure, is critical.
• Selectivity in private markets: Many Australian investors have, appropriately, allocated significant capital to private markets, e.g., infrastructure and real estate. This makes sense from a diversity perspective, and we encourage those who haven’t to consider an allocation. However, private market assets are subject to the same liquidity-driven compression in risk premia that all risky listed assets have suffered from and are relatively richly priced (Australian infrastructure especially). For those who can benefit from the diversity an additional allocation provides, we recommend selectivity. For those with full private markets weights, now might be an attractive time to take profits and build optionality through liquidity.

4. Innovate through alpha

Why? The reality investors face is, in our view, one of generally low returns – due to low cash rates and low starting risk premia – and elevated volatility as the business and capital cycles move through their late phases. In this environment, the value of genuinely skilled active management is outsized.

How? Finding skilled managers is not easy and requires a relentless focus on achieving truly ‘best in class’ skill. However, with best-in-class alpha in your toolkit you can consider the following:

• Reduce beta risk by replacing foregone return with alpha.
• Better, more concentrated equity portfolios: Diversifying exposure to specific risk premia or the economic cycle is one thing, but stock diversification is another and often goes too far within active equity portfolios. Provided you can find a number of truly skilled equity investors with complementary styles to run your portfolio, concentrating your holdings in their 10 to 20 best ideas and combining those portfolios together captures their alpha, moves the dial, controls costs and, we believe, delivers superior equity returns in most environments.
• Differentiated, low beta hedge funds: In general, hedge fund performance disappointed during and after the global financial crisis. However, we remain committed to our approach to hedge fund investment, which prioritises differentiation, low beta and value for money as well as all-out skill. In our view, many portfolio would benefit from exposure to these managers.
• Skilled fixed-income managers can help you navigate the late stages of the business and debt cycles in bond markets. Our approach is to own assets we like, provide capital where it is scarce and deploy it through skilled managers.

Finally, we are acutely aware of the tension between alpha and fees. Our focus as advisors may be value for money, but inevitably investors will face increased scrutiny and pressure on outright fee levels. This means prioritising the fee spend to focus on maximising alpha per unit of fee and capital invested. The four ideas on this page are presented in the priority order we would suggest.

5. Innovate to find diversity: China

Why? The world economy can increasingly be simplified to three centers of gravity:

1. The US: a $20 trillion economy, ging at c.4% nominal
2. The Eurozone: a $14 trillion economy, ging at c.3% nominal
3. China: a $14 trillion economy, ging at c.8 — 9% nominal

These centers of gravity operate in economic terms (quantified above), political terms and, more recently, investment terms. Until now, locally listed Chinese assets have been hard for foreign investors to access. But China’s gradual financial liberalization means this is no longer true. This third opportunity set is now open to investors and, in our view, cannot be ignored.

How? From an opportunity set perspective, it makes sense to access this large and ging set of cash flows. But, the attraction of China’s markets is not about stellar returns but stellar diversity. Because its economy and capital markets are still relatively closed, its economy and its assets will operate on a different (albeit not entirely decoupled) cycle to the rest of the developed world economies and capital markets. Assets that behave differently mean diversity – which is what makes China’s local capital markets attractive to investors.

However, capturing that diversity is not that straightforward:

• China’s economy will continue to liberalize and manage its reliance on debt gth, which creates a manageable but challenging economic outlook.
• That, and the wish to capture economic diversity and a broad range of asset risk premiums, means we want to own exposure to both positive Chinese economic outcomes and negative ones.
• Moreover, there are a variety of issues with existing equity and fixed-income benchmarks – concentration, patchy accounting disclosure, volatile prices – which means being highly selective when investing passively.

Therefore, we want exposure to both risky assets, (e.g., equities and private markets) and bonds. These assets also need some form of cost-effective active or smart beta management. This is possible to create separately, but is time-consuming and resource-intensive. Cost-effective ‘one stop shops’ combining well-structured equity portfolios plus bond exposure are rare but available. Investors will need to be somewhat brave and innovative to capture the early diversification benefits on offer. 

The contents of this article are for general interest. No action should be taken on the basis of this article without seeking specific advice.