Changing demographics throws traditional asset allocation a curveball

Changing demographics throws traditional asset allocation a curveball

Changing demographics throws traditional asset allocation a curveball Bloomberg News

Portfolio managers who adhere to a method of asset allocation that has served them well for more than three decades may be in need of a wake-up call.

The warning comes as a number of prominent economists are arguing that a demographic sea change threatens to foster rising interest rates, reduced inequality, and stronger wage growth around the globe. This could have huge practical implications for people who manage money, potentially upending the long- standing schematic for asset allocation that sees many portfolio managers split their investments between bonds and stocks.

"Most pension funds and endowments around the world have a similar sort of way of sussing out their projected returns from bonds and from equities and then use historical correlations from bond and equities to build efficient frontiers," Toby Nangle, head of multi-asset allocation at Columbia Threadneedle Investments, said in an interview with BloombergTV. "But if that data that that historical correlation matrix is based on is based on this 35-year period of declining real yields and low levels of correlation, with bonds meaningfully outperforming cash, then this is sort of challenged if that starts to go into reverse."

Such a change would upend typical portfolio management, which has seen asset managers look to the past performance of both bonds and stocks as their guide to the future. Managers usually examine historical volatility and returns to construct portfolios that smooth and maximize returns, depending on an investor's risk tolerance.

The key benefit provided by such diversification is a lack of covariance between assets within a portfolio; in other words, there is a tendency for the two holdings to move in opposite directions. In practice, this results in reduced upside during boom periods but more protection during rougher patches in financial markets.

For the past 35 years, holding a mix of stocks and bonds has been a successful strategy in achieving this end, with the low levels of correlation between the two asset classes resulting in more consistent returns than a fully concentrated portfolio.

Nangle, however, sees the potential for the looming scarcity of labor to reshape economic and financial market dynamics in a piece for VoxEU in May. Along with Charles Goodhart, senior economic consultant for Morgan Stanley and a former member of the Bank of England's Monetary Policy Committee, Nangle proffered the thesis that the fall in global real interest rates over the past few decades has been driven by a massive pool of available workers and the ability to access them thanks to globalization.

The increased supply of workers pushed down the cost of labor and encouraged employers to invest in labor-intensive rather than capital-intensive plants. This, in turn, put downward pressure on interest rates in light of the depressed demand for capital equipment.

As an increase in labor bargaining power and a decrease in global savings pushes interest rates, the price of bonds will head in the opposite direction and lose value. Since Nangle expects stocks and bonds to move more in tandem in a rising rate environment, this manner of constructing portfolios to reduce volatility and produce better risk-adjusted returns must be reexamined.

"The relationship between the volatility of a portfolio and asset mix is determined by the correlation between those assets," Nangle said. "If you thought that equity and bond correlations are going to rise, then the bendy blue line in that chart is going to become much more of a straight line."

That's exactly what happened the last time labor's borrowing power enjoyed a sustained increase, which was from the end of World War II to the dawn of the 1980s.

In other words, the old methods of diversification might not be very useful for portfolio managers in the future.

Nangle's view that we're on the cusp of a secular rising rate environment may have implications for other asset classes, too.

George Magnus, senior independent economic adviser to UBS, noted that the same demographics that would support increasing exposure to equities at the expense of bonds—the prospect of rising yields and inflation—are also for reduced returns on capital—a negative for corporate profits.

"Asset allocation would undergo a major change only if we can be confident there will be a rise in relative labor returns that also triggers higher inflation," said Magnus. "For that to happen, demand conditions have to become firmer and stay that way. Otherwise margins get squeezed, and both bonds and equities will falter."

With U.S. corporate profit margins close to all-time highs, downward pressure from structural forces amplifying any cyclical mean reversion would widely be considered a negative for equities, and it's not clear that the typical beneficiaries of rising inflation would be poised to benefit from such a development, either.

"Margins are high, and higher worker share of income would compress them, making current valuations less attractive," said George Pearkes, analyst at Bespoke Investment Group. "Commodities have been a traditional rising inflation hedge, but as we've seen, currently the world is already vastly oversupplied, and holding a commodities position with curves in steep contango is a very expensive proposition."

So what's the new hedge portfolio managers should be looking at?

"Cash is a really horrible asset because it makes you look lazy, really, to take someone's money and not do anything with it and charge a fee for it," said Nangle. "If you want to control the volatility of a portfolio, you need to be using shorter-dated assets in investment-grade credit and Treasuries."

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