Changing demographics throws traditional asset allocation a curveball

Portfolio managers using traditional stock/bond asset allocation for last three decades get wake-up call

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."


Guillermo Roditi Dominguez, portfolio manager at New River Investments and author of related works on the interplay between demographics and real wages, indicated that he had been increasing his holdings of Treasury inflation-protected securities and breakevens in anticipation of the lack of diversification benefits that government bonds are poised to provide.

"If you look at TIPS yields and nominal yields, you see two different pictures: One is trending down still and one is breaking out," he said.

The discrepancy between the two can be primarily attributed to the disinflationary effects of lower oil and cheaper imports, according to Dominguez.

"With yields clearly in an uptrend, I would say the bond market could see yields rise significantly on a change in inflation expectations," he added. "More generally, the market hasn't really had to deal with truly rising inflation expectations in decades."

Nangle also suggested a more fundamental shift in the approach to portfolio construction would be warranted given the scale of the demographic changes.

Many funds have mandates to have a certain degree of exposure to certain asset classes—for instance, 40 percent to U.S. stocks, 20 percent to international equities, and 40 percent to sovereign debt. This traditional method of portfolio construction, according to Nangle, affords portfolio managers limited flexibility to switch between asset classes.

By contrast, dynamic asset allocation consists of taking the fund's mandate—for example, to generate a real return of 4 percent with less volatility than a given benchmark—and grants a portfolio manager more discretion in selecting asset classes to achieve this goal. Nangle noted that one of the funds he manages had no holdings of European high-yield bonds at the end of last year, but now it has a 10 percent weighting, "because it just looks like a nice big risk premium that's opening up that's there for new money to take advantage of."

But for the interest rate backdrop investors have to deal with—and in turn, the asset allocation process—cyclical factors are likely to play the dominant role in the near term.

"I do think the rolling deleveraging the world is going through should keep a lid on global inflation for a while as well," said Mark Dow, founder of Dow Global Advisors. "I expect both those looking for wage inflation and those looking for [the fourth round of quantitative easing or deflation] will end up disappointed."

Nangle's thesis "is, however, a valid concept to file away, so that if you do see signs of it, you might recognize it earlier on," he added.