Conventional Asset Allocation Techniques Are Redundant
Asset Allocation is an investment strategy that looks to balance risk and reward by apportioning a portfolio’s assets to meet an investor’s specific investment goals/return expectations, in line with their risk tolerance and investment horizon. The three main asset classes: cash; fixed interest; and, equities, each have different risk/return profiles, with cash historically considered the lowest risk asset class, and equities, the highest. As risk increases, the expected returns across these asset classes increases commensurately, to reward the investor for accepting higher risk.
Cash (or proxy) is considered to deliver a risk free rate of return, which is calculated by subtracting the inflation rate from the yield of the government bond best matching the investment horizon. In theory, the risk-free rate is traditionally a “shelter” for investors not willing to accept additional risk, and accordingly, opting to earn a lower (minimum) return for the relative safety of their investment’s exposure to this asset class.
However, the impact of sustained quantitative easing (QE) by ALL major central banks around the world – negative (real) interest rates – has broken (or complicated) this relationship to the point that conventional asset allocation techniques have been rendered redundant.
In a negative interest rate world cash, historically believed to be the safest asset class, is by definition guaranteed to lose the investor money (and their purchasing power), as the interest rate is either negative or, if notionally positive, does not cover the prevailing rate of inflation.
The mechanics are similar for bonds. If a bond is sold with a negative yield then, at maturity, the buyer does not receive back the total amount invested. Investors buy at a price above par; but, over the term period, the price reverts to par when it reaches maturity. In other words, the negative interest rate erodes the value of the security with the negative interest built into the price paid for the bond when it is purchased, as it is basically not possible to collect negative coupons.
The theory behind the policy for negative interest rates is that commercial banks will be dissuaded from maintaining large balances with their central bank and will instead opt to lend money to businesses and consumers who will, in turn, spend the money. The increase in lending and spending is likely to boost economic activity, leading to growth and inflation. In this way, negative interest rate policy is considered by many to simply be an extension of traditional monetary policy.
This is generally positive for supporting and bolstering corporate earnings; and, for growth of well-managed, quality proven and profitable businesses which are capital-light and produce significant surplus cash flows from which higher dividends (supporting income yields greater than those from bonds) and/or share repurchases can be funded. These are the types of companies Adansonia invests in.
So equities, the asset class historically considered to have the highest risk, is the asset class most likely to generate a positive real (total) return for the investor, in a negative interest rate environment. The allocation to equities in an asset allocation sense is also an assessment of the additional risk taken, for excess return above that for cash, delivering a risk free rate. As we discussed above, in a negative rate environment, cash is guaranteed to generate a negative real return for the investor, so the relative arguments of risk and return between cash and equities is broken, as cash is the riskiest asset. This is why equity markets will support higher price earnings’ multiples (valuations), as the opportunity cost of investing in cash and fixed interest in a negative rate environment is low to non-existent, until yield curves steepen considerably, heralding higher future real interest rates in response to growing growth and inflation expectations.
Notwithstanding all of the above, tactically – on a 3-6 month view – Our portfolio’s allocation to cash may increase to preserve capital when:
Our view of risk versus expected return from the equity component of the Portfolio does not support the level of market exposure; and/or,
We are unable to find investment opportunities that we deem to be fundamentally undervalued; and/or,
Our confidence in the near-term macroeconomic outlook deteriorates (and which prospectively impacts our earnings’ expectations).