An interview with Bernhard Langer, CIO, Global Quantitative Equity
and Scott Wolle, CIO, Global Asset Allocation
In Europe, the sovereign debt crisis does not look as severe any more as it did a year ago, but is still far from being over. The US did not fall off the fiscal cliff at the end of 2012, but could still go back into recession. A hard landing in China has not materialized, however the long term GDP growth rate seems to levelling off at a considerably lower rate than in the previous decade.
CIO perspectives talked to Bernhard Langer and Scott Wolle about the economic environment and respective implications for investment strategies.
What is your outlook for the global economy in the months ahead?
Bernhard Langer: I think we live in a world where politicians are doing only the minimum they have to do to keep things in balance. And then, quite quickly, they push the envelope to the central banks. The deal seems to be that politicians do the talking and the central banks have to ensure that there is ample liquidity to help the banks. The banks in turn are buying debt from the governments and then handing it back to the ECB and other central banks as collateral.
It all happens in the money aggregate we call M0 and it won't trigger much inflation as long as the economy is not picking up. This is not the case at the moment, although corporations are doing quite well. They have a lot of excess cash and the balance sheets generally look healthy and don't seem to be leveraged too much. However we see a decrease in corporate earnings growth. Our base scenario is a continued slow, low growth environment with some inflation which is generally favorable for equities. A threat to this scenario would be rising interest rates. But interest rates will only rise if there is a positive shock in GDP, which I think is unlikely in the near future.
Scott Wolle: It is very important to remember the key backdrop: The developed world is going through a very large cycle of debt unwind. Historically, this has led to a great deal of disinflationary or deflationary pressure. A debt deleveraging process is usually accompanied by slow growth and it takes less of a disruption to really push the economies into a bit of stress than would normally be the case.
Given reasonable equity valuations globally and supportive central bank policies, equities should on average provide reasonable returns. As one looks past the intermediate term, the interesting question is: What happens, when the economy starts to normalize? If the monitoring and normalizing of the monetary policy is not done properly, an abrupt reduction of monetary stimulus could damage major economies, or, if the stimulus is withdrawn too slowly, then you have a period where inflation really starts to pick up. A base case of 2% growth for the US and a little less in Europe is reasonable with controlled inflation. It is the fragility that comes along with the growth and the healing of the economy which is a risk for investors.
Different regions of the world are in different stages of the deleveraging process. Asia is in the process of leveraging up. In the US, especially in the private sector there has been considerable progress in working through debt. Europe's progress has been impeded by the austerity measures. How can investors tell whether 2013 will be a risk-on or a risk-off year?
Bernhard Langer: Rising interest rates are really the major risk currently. There will always be other events which move the markets and I therefore expect them to be quite volatile. In February for example, when the minutes of the US Fed meeting came out, people read between the lines that the expansive monetary policy might be reversed sooner rather than later, and the markets reacted negatively. Quite obviously, what the markets pay attention to is a change in monetary policy, a change in interest rates. That raises the question, when will central banks ever be able to stop their ultra-light monetary policy. However, with the current backdrop, I still see opportunities on the equity side; on the other hand investors need to be selective with corporate bonds, and also more selective with government bonds.
Scott Wolle: Taking a step back, I think there is a real danger in taking too rigid a view of how a year is likely to shape up. There are many variables that can affect the course of events and investors need to be prepared to respond.
You have to maintain flexibility both in your portfolio structure as well as in your thinking to adapt to the circumstances and adjust your portfolio accordingly. The question is 'how vulnerable is your portfolio to some of the things that could happen'. What if it comes to a hard landing in China, to fiscal problems in the US, or if the Italian election precipitates a further crisis in Europe? Not just trying to get locked into a certain vision of how you think the world will play out and not be willing to alter those views is probably the most important thing to do.
How do you handle the need for flexibility in your portfolio?
Scott Wolle: We think of that in a few different ways. The first is that you make sure that you start off in a fairly neutral position by considering possible economic outcomes and owning assets that represent the different outcomes. Just owning the assets is not sufficient, however. You need to own enough of each to defend your portfolio if a particular economic environment occurs. At Invesco, we define three possible outcomes: Non-inflationary growth, inflationary growth and recession. Non-inflationary growth is when real growth is decent and inflation is under control, inflationary growth and recession are self-explanatory. By having a strategic allocation that contains assets that should do well in at least one of those environments, you start off with a fairly resilient portfolio.
The second piece is to really think about your tactical process in terms of various assets relative to cash. Rather than saying 'do I think stocks will do better than bonds' I think the better question to ask is 'do I think stocks will do better than cash' and really calibrate your positions in that way. And by having a disciplined process where you are considering what kinds of situations would cause stocks, bonds and commodities to do particularly well or particularly poorly, pick up that information on a frequent basis and alter the portfolio structure accordingly. In summary, start off in a very neutral framework that will be resilient to economic shocks and then have a disciplined process for evaluating the current situation and adjusting each asset individually as the situation would suggest.
The core competency of the GQE investment team is a quantitative model-driven investment process. What is the investment philosophy and what are the advantages for investors?
Bernhard Langer: At the end of the day, the functions and the advantages of quantitative investment are fairly simple. Quant managers use computers, not as a decision maker, but as a tool to process huge amounts of data. Our investment philosophy is based on fundamental data and behavioral insights. So instead of being driven by the day-to-day noise, such as political turmoil, our quantitative model is based on profound concepts which make market prices move. We systematically apply these concepts in a disciplined way. The investment approach therefore is very transparent and consistent, and with all the quantitative information you collect, I would almost call it a learning organization. Moreover, you avoid the pitfalls of emotions and other things. For example, after the financial crisis nobody would have thought that interest rate levels will ever be so low, e.g. Bund yields under 2%, simply because that has never been the case before.
The same is true for volatility. We all learned that one should be rewarded with higher returns if one takes more risk. However, research shows that the opposite is true for equities, which seems to be counter-intuitive at the first glance. However the fact that low volatility equities perform better than high volatility equities in the long term holds true for every region in the world. In our portfolios, we exploit this 'anomaly' and combine it with our stock selection approach. This results in lower volatility portfolios without compromising on the return potential.
Many investors can't afford a repetition of what happened during the financial crisis. They are looking for a new approach that protects on the downside, but still participates in prosperous times. How does Invesco's Global Asset Allocation Team cater to these new requirements?
Scott Wolle: The way you framed the question is exactly the right way investors should think about the world, because one of the overriding factors in investment is the math around compound returns. If one can preserve value in the difficult periods, then one does not need to do nearly as well as some risky strategies when times are good. Because you tend to loose more in the downs than you gain in the ups. If you have a 20% loss of your assets than you need a 25% gain just to get back to neutral, so by limiting how much you loose on the downside, you can end up in a better place even without full upside participation.
The way we try to accomplish that is consistent with what I described before. We first think about what kinds of economic outcomes there are and pair each of those outcomes with a different asset class. After finding assets which are appropriate for each of the three economic outcomes, we balance the amount of risk exposed to each of these asset classes. We are not paying attention to the main benchmarks. Our approach is to think what the role of each asset in the portfolio is and build up from there. So in effect we should be defended against each of the different economic outcomes.
Why is now the right time for this kind of strategy?
Scott Wolle: Our strategy is not terribly new. We actually have been managing this strategy for institutional clients since the fall of 2008 so it is not something we did in response to the financial crisis but actually something we developed in advance of it and had some large clients benefit from it throughout the financial crisis. We just happened to be able to introduce a vehicle to the retail market after the financial crisis.
One of the characteristics of this strategy is that we do two things that are often thought of as very risky, which is we use derivates and there is also a moderate amount of leverage. We usually have about 1.35 dollars invested for every dollar in assets, that's our strategic allocation. Because investors usually think of derivatives as risky, it's funny to find those in a strategy that is designed to be risk-aware and somewhat risk-averse relative to more equity oriented strategies. You have to understand the reason why we use derivatives and leverage. It is to target a particular level of risk, which allows us to balance the portfolio across the different economic environments. And the instruments we use to get exposure to various assets are primarily exchange traded futures. These are very straight forward instruments, very flexible, very liquid, and very transparent.
Bernhard Langer: The most dangerous thing one can do these days is not to be invested or to stay in cash. So I would argue: Be aware of what Scott described, have a flexible portfolio which fits your risk budget and be aware about what happens to your portfolio when certain events occur. One should not invest outright in a global equity fund and hope for the best, these times are gone. Many of our actively managed strategies can be tailored to individual risk budgets and the embedded proven stock selection process results in a unique return pattern which is beneficial for diversification. Other strategies balance risk across different asset classes and therefore offer protection on the downside. Staying on the side-lines is by all means not appropriate these days.