Risk Assets: Don’t let your intuition lead you astray

The first quarter of 2019 certainly ended with a brighter outlook than could be seen when it began. The resolution of several uncertainties and clear signals of support for the economy coming from central banks are reviving attraction to and appetite for risk assets. Does that mean it’s time to start changing portfolio allocations? If the answer is to be yes, then any increase in exposure to equities must take into the account the notion of total portfolio risk.

For this year, we have identified five pivotal issues likely to influence financial markets. For each of these, the outlook was relatively unpromising at the end of last year and beginning of 2019, prompting a strengthening of portfolio protections. While this remains relevant, Q1 2019 marked an inflexion point, alleviating uncertainties regarding several of these pivotal issues. The most notable expressions of this shift are new injections of liquidity that should strengthen risk assets, and stocks in particular. Nonetheless, any increase in exposure to risk assets must be approached from the perspective of managing portfolio risks and maintaining a suitable risk level.

CENTRAL BANKS: SUPPORTIVE SIGNAL FOR RISK ASSETS

While just last February, the ECB held that it had no plans for the long -term refinancing of banks, it ultimately announced the opposite in March. This about-face has multiple repercussions. The injection of liquidity is, first and foremost, intended to boost the economy, primarily financed by banks in Europe. However, the mere fact of the announcement resulted in an easing of the market.

A similar phenomenon can be seen in the US, where, despite short-term setbacks, growth is supported by the Fed’s pronouncements. On both sides of the Atlantic, inflation remains subdued. In the eurozone, core inflation hovers around 1%, whereas in the US it remains checked at about 2%. These are low inflation levels that encourage domestic consumption.

The accommodating policies of central banks, justified by the absence of runaway inflation and a maintenance of long-term rates at low levels tend to push up the valuation of stocks.

THE OTHER PIVOT POINTS: DÉTENTE AND SURVEILLANCE

Several factors identified as having significant repercussions on the value of assets have developed favorably over the quarter. First among these is the stabilization of oil prices at a price in line with our ideal scenario of 70 dollars a barrel. This stabilization promotes consumer spending by limiting inflationary pressures. In Western economies with low inflation, fluctuations in the price of oil are, in fact, the primary source of variance in inflation. Emerging countries that are not producers also stand to gain from this stabilization, as a sharp rise in oil can quickly damage their external balances and trigger inflation.

In Europe, political tensions have eased off. The departure of the UK from the EU has not yet begun, but the capacity of Brexit to produce a major shock appears to be lessening. As for the European elections, these will in all likelihood bring an array of surprises, however, the end result is unlikely to threaten the current political equilibrium.

Another notable détente concerns the USChina trade war. While it is by no means over, and the outcome is yet to be determined, the start of negotiations presents a significant step forward compared to the tensions of 2018.

The last of our pivotal issues rests on the resistance of China’s economy. Government measures to support growth are beginning to bear fruit. Credit shows signs of recovery; investment spending is picking up, particularly for infrastructure. While China cannot play its exchange rate card without annoying the US, it is certainly leveraging monetary and budgetary policy to prop up growth. The country may benefit from another round of measures in the second half of the year, with a positive impact on global growth.

SPOTLIGHT ON STOCKS

At the beginning of the year, we opted for a balanced profile in our portfolios. The lifting of certain areas of uncertainty on the world scene leads us now to look at increasing our positioning on higher-risk assets, particularly equities. Although we are seeing a short-term slowdown of activity, we are confident in our core scenario and believe we can identify risk assets with a favorable risk-adjusted return over 6 - 12 months.

We see the risk of overvaluation in the equities markets as no longer an issue. Valuation on the basis of expected profits is currently in line with 10-year averages. While much higher just a year ago, it has been forced downward by lower stock prices, even as companies’ profits continued to rise.

From the perspective of strict fundamentals, however, sovereign bonds remain far too expensive. The rates on 10 - year bonds are generally pegged in the long term to a slidingaverage GDP growth. The latter comprises real growth, which is in Europe around 1.5 %, plus inflation, also around 1.5 %. That means the 10 - year Bund should pay around 3 %, when what we see is that it has sunk back into negative territory. Absent a deflationary scenario, we are therefore headed for a rise in long-term interest rates, and consider bonds to be expensive currently. From our perspective, bond holdings offer relatively low levels of natural protection to equity risk, within the eurozone at least.

TO INCREASE THE PROPORTION OF RISK ASSETS, TRIM THE BONDS

These market forecasts, geared toward an appetite for risk, should translate into portfolios. However, a response consisting entirely of favoring stocks over bonds would be biased, as it fails to take into account a key aspect: the overall risk of the investment portfolio.

Before undertaking any change to allocation, a first step consists of assessing the amount of risk desired for the portfolio. This level of acceptable losses will play a part in determining the weight given to various asset classes. Reasoning from a strict arbitrage standpoint between asset classes can have significant—and sometimes poorly grasped—consequences in terms of risk.

To understand this, let’s consider the simplified hypothesis of a balanced portfolio comprising 50 % stocks and 50 % bonds, for which one seeks to increase exposure to risk. For this portfolio, assume potential losses in the equities component to be 30 %, and that of the bonds segment to be 10 %, or three times less. The weighted average of potential losses would thus stand at 20 %. This can be reduced to 15 % thanks to the additional protective effects of inverse correlation between asset classes, as stocks and bonds mutually protect each other.

If we stick to a strict move toward risk assets and increase the stock component to 70 %, versus 30 % bonds, the potential losses also shift, becoming 24 % on average, or 19 % if we factor in the protection afforded by decorrelation. Granted, the new allocation does increase the proportion of risk assets held in the portfolio. However, the portfolio’s overall risk budget is also significantly increased.

It is, however, possible to increase the portfolio’s sensitivity to stocks, while maintaining risk levels similar to that of a balanced portfolio, if such is the asset manager’s goal.

In a limited risk management scenario, exposure to equities should be increased to 55 % only. However, bonds should be reduced to 23 % and the remaining capital (22 %) should be reallocated to monetary instruments. The increased exposure to risk assets thus entails just a 5 % increase in the equities component. Meanwhile, the percentage of bonds is halved.

This demonstration is merely an example, but it nonetheless illustrates our core focus when it comes to allocation: determining the correct risk level assigned to a portfolio, in order to preserve or, on the contrary, adjust it if need be.

If we choose to keep the budgeted risk level constant, then cutting the bond portion and integrating a risk free asset — cash — makes it possible to ride the curve of market efficiency. In doing so, we confirm our positive view of stocks, but are able to keep overall risk flat if we make that our strategy.

DETERMINING ACCEPTABLE LOSSES

The art of asset management, however, consists of adjusting risk levels over the life of the portfolio. Indeed, risk budgeting is the cornerstone on which allocation rests. Naturally, this begs the question, which is crucial, of how to determine the risk budget for a portfolio. There is no easy answer for this, but rather a combination of factors to be weighed:

• The strength of convictions, particularly with respect to medium-term market outlook and the views for particular asset classes;
• The overall level of risk in the markets, as well as their skittishness (volatility);
• The management track record. The risk budget assigned may vary according to whether the portfolio is emerging from a period of losses or gains.

These elements make it possible to assess the overall appetite for risk. Conviction on an asset class alone is not enough and cannot be meaningfully applied without considering the risk budget. When the outlook brightens, it is necessary to know what direction you wish to take and how fast to move towards your goal. This is why our enthusiasm for risk assets does not express itself as mere reallocation. Consideration must be given to the portfolio’s total risk, something which goes well beyond directional views on the assets it contains.

By no means a mere arbitrage among asset classes, allocation is the combined result of expertise in many areas. Our fund managers bring together their convictions as to market trends with the development of a suitable risk budget, while steering the portfolio in terms of its specific history, and not only the markets. No one of these elements, in isolation, offers an adequate basis for effective management.