By Colin Moore, Global Chief Investment Officer
Markets were driven down and then back up by responses to the U.K. referendum. Global Chief Investment Officer Colin Moore urges investors to balance return goals with caution for consistent performance ahead.
Q: The second quarter was marked by more volatility and mixed results around the world. But U.S. stocks and bonds both reached record or near-record levels. What was driving those markets?
A: There were two big effects during the quarter. When the U.K. referendum vote occurred, the first reaction was fear. It tends to happen very quickly and very violently, because people are uncertain about the future. Then the next morning, or maybe it's the next week, they realize that the world has not fallen apart, and the markets correct again in a positive way. The second effect occurs when people begin to think about the longer-term implications of a change. But it's not clear that people fully understand the long-term effect of the U.K. referendum. So I'm a bit nervous that the markets have come back so far so fast. The markets seem to be saying that there's no threat to global growth, but there certainly is a threat.
Q: How are you analyzing the impact of the U.K. referendum's effect on the global banking system?
A: The bulk of our research focus will be within the European Union, particularly in areas like Italy. First, we are looking to identify the weakest banks. We don't want to expose our investors to them, either through our investments or the use of those banks as counterparties. A second consideration is the potential for contagion. If one of those banks goes down, even though we don't have direct exposure, it may influence or damage other banks that we do deal with in Europe. We recently received the results of the European bank stress tests, and my initial response is that the results are encouraging, but need a lot more scrutiny. We're pretty comfortable about the situation in the U.K. and the U.S. The regulators in both countries have insisted that both banking systems recapitalize, and they are at levels that can absorb any stress that will be put on them by the U.K. referendum itself.
Q: Central banks continue to be a big influence on the market. What can they accomplish now?
A: Central banks can help ease the market's fear factor. For example, right after the U.K. referendum, the Bank of England and the European Central Bank stepped up and essentially said, "We will maintain adequate liquidity in the marketplace. You don't need to worry." That had an immediate effect, and I praise them for it. But when we talk about these additional stimulus tactics, I have believed for years that they are relatively ineffective in creating growth. Think of it this way: You're saying to someone, "I'm creating these extraordinary measures, creating negative interest rates in some countries, but you should feel confident about going out and building a new factory or hiring new people. I want you to invest in the future even though I'm telling you that I'm creating extraordinary measures to combat a potential crisis." Those two are just not behaviorally consistent.
Q: You mentioned negative interest rates. Even positive rates are at or near record lows. In some cases, markets appear a bit distorted. As an investor, how should I think about that?
A: Understanding the risk-free rate is essential to evaluating any investment. Whether it's a bond or an equity or a new house, you have to have some sense of what your risk-free return is and the additional return you require to warrant the risk of your investment. If that risk-free rate is being distorted in some way, then how do you evaluate investments? Zero or negative interest rates also undermine banks' profitability and their willingness to lend, and are a challenge for people who depend on "normal" levels of interest income. I'm very concerned, because we're getting to the point where we're dependent on extraordinary policies. It is an addiction.
Q: With all that in mind, how do you evaluate markets now?
A: The equity market is pretty richly valued. U.S. equities are probably more attractive than others around the world because we have relative stability. But our expected return from U.S. equities is modest at 5% or 6%, and you're picking up 12-18% volatility when you invest. That's not a particularly attractive risk/return trade-off. So, yes, U.S. equities look attractive compared with other asset classes, particularly U.S. Treasuries, but they're not necessarily that attractive on their own merits.
Q: In that kind of environment, how should investors balance risks and rewards to meet their long-term goals?
A: People tend to get too optimistic about the broad level of economic growth. Then they don't adjust enough when actual growth turns out to be lower. If you think economic growth is going to be very high, you would invest in broad-based market indices. But we don't expect high growth. Instead, we expect medium-term economic growth to continue to be in the 1.5-2.5% range, on average. Not all businesses and assets will grow at the average rate, so you have to look for pockets of higher growth that will emerge. Then we think about volatility. When we're experiencing low growth, our sensitivity to shocks increases - the U.K. referendum being the latest example. So, we have to think about the consistency of the returns that we get. How we allocate risk within a portfolio should not just be based on the highest expected return, which is probably equities, but the best combination of risk and return that we can get. Most of our work shows that investors can handle 8-10% volatility. Much more than that and they start to behave the wrong way, selling low and buying high. So, we try to create portfolios that are much more stable and that have the correct balance between risk and reward so clients will stay with their investments for the long term.
Q: Brazil, a struggling emerging market country, is in the global spotlight this year as host of the summer Olympics. How do you view that market?
A: I think what's happening in Brazil is quite positive. Remember, this is a country rich in many resources, including its people. With the proper stewardship, there can be a tremendous future for the country. A country may have a rich store of human capital, but you have to find ways to help the people become healthy and well-educated. Beyond fiscal discipline, it's going to be important for Brazil to spread wealth in its economy through the development of its people, infrastructure and private sector businesses. With better government, we should now be thinking much more brightly about Brazil than we were just one or two years ago.
Q: What about emerging markets more broadly?
A: Given the concern about low, slow growth structurally in the world, you have to look at where there are pockets of growth. One way to do that is to look at themes where there is growth around the world, such as the development of healthcare or infrastructure. Emerging markets are going to be at the center of both these developments.
It's a mistake just to think about emerging markets geographically. We all got obsessed about BRICs (Brazil, Russia, India and China). When you create these acronyms or names like "emerging markets," you're assuming a level of homogeneity about how they will act, and that's clearly not the case. So, the trick will be to move beyond the country definition of emerging markets and take a more thematic approach.
Q: You've written about the trend of unbundling asset management products, separately offering the elements of beta, strategic beta and alpha to clients at different price points. What's going on?
A: Consider the analogy of the cable TV industry. People don't necessarily buy the full package anymore. Perhaps my generation still does, but other people are now buying internet service and downloading the entertainment they want, instead of paying for a standard TV package. Similarly, in the investment marketplace, we will increasingly see investment products that are unbundled. You may want to buy the beta on its own, and that's already a fast-growing area - which investors may know as passive investing, and which they should be able to buy at very, very low cost. Strategic or smart beta factors are harder to analyze and reproduce, particularly if you combine them together. They require more experience and more knowledge, and they're also slightly less common. Hence, while they are increasingly available unbundled from other sources of return, they will be priced higher than basic beta. Alpha is much rarer, but also more valuable because it has idiosyncratic return - meaning it is not explainable by reference to anything else, thereby offering better diversification benefits.
Q: Why is this trend of unbundling asset management products happening?
A: There are three reasons. First, technology makes it easier. There are instruments and tools that allow you to individually create and analyze beta, strategic beta and alpha, and offer them separately. That just wasn't available 10 years ago, and the technology has improved even in the last few years to really do this efficiently. Second, traditional, fully "bundled" investment products have disappointed some investors after accounting for costs and the return they forgo when their behavioral reaction leads them to buy high and sell low. Lastly, investor demand is changing, and some of that is generational. We see younger people wanting to buy the services that they specifically want.
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