Global Economic Outlook: 101

The monthly OECD composite leading indicators (CLIs) give a good warning of the upswings and downswings of industrial cycles, both regionally and globally. The most recent CLIs point to diverging patterns of economic growth across major economies.

The CLIs show signs of continuing expansion in the United States, Germany, Japan and Russia, while pointing to a moderate downturn in the United Kingdom, France, Italy, Canada, Brazil, China and India.

To understand what is going on with global economic activity, it is also important to monitor the behavior of commodity prices. Commodity prices contain "real time" information and at present their behaviour confirms the expansion of industrial momentum world-wide.

World trade growth is intensely cyclical and has seen substantial fluctuations during the past 20 years. Reflecting globalization, exports and imports account for an ever-increasing share of GDP on a world-wide basis. This process is likely to continue as a more closely inter-linked global economy raises world income by improving competition and encouraging specialization. It also magnifies the economies' exposure to overseas demand fluctuations. Indeed, foreign trade multipliers are a lot more powerful than they were in the past.

The upward move in oil prices and the quantitative easing by developed nation central banks have worsened the inflation outlook. This has led to the upward price spiral in other commodities (including precious metals such as gold, silver and platinum) and increased the volatility in the currency markets.

Futures, Forwards, Options and Exchange-Traded Funds

Investors are using futures, forwards, options and Exchange-Traded Funds (ETFs) in a wide variety of contexts. For example, borrowers are using futures contracts to lock in borrowing costs for anticipated needs. Lenders are using such instruments to lock in lending spreads in anticipation of receiving cash to invest in the future. Fixed income portfolio managers are using financial futures to hedge portfolio holdings and expected cash flows, and/or to facilitate the orderly sale of securities during asset mix changes. Equity portfolio managers are using index futures and ETFs to shift asset allocations in anticipation of buying and/or selling of the physical securities associated with an asset class, an industrial sector or a geographic region.

In addition, for portfolios of large agricultural real estate investments, agricultural commodity futures contracts for corn, cotton, soybeans and wheat are used to sell short the commodity futures contract to protect against a price decline in an agricultural commodity in which the investor has or expects to have an inventory of those particular crops.

In these particular examples, we are talking about 'hedging', and not speculation, because there are risks associated with the underlying investment securities and/physical products. These instruments, when used for hedging, can be used to offset potential declines in the value of portfolio securities. They can also help facilitate large securities transactions and reduce the risks associated with security-specific and market-specific risks as well as exogenous variables such as political, monetary, weather and currency uncertainties.

Risk, But Not as Many Know It

A basic and undeniable fact: Risks exist in many forms.

One of the basic fallacies of modern portfolio theory is the belief that risk can be defined and measured by variability in the price of securities. However, this is only a partial measure of total risk.

I would define risk as the exposure to the possibility of loss.

A taxonomy of risk was outlined by former US Defence Secretary, Donald Rumsfeld, in a press conference in 2002: ‘Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.’

To some, this may seem an unlikely source for insights about market risk as well as general risks. We still do not have precise quantitative knowledge of the feedback between financial and real variables.

Known risks are those that are defined by current knowledge. They can be modelled, estimated and the parameters calibrated. Unknown risks are subject to statistical determination based upon what is already known, but the parameters cannot be calibrated. The unknowable risks cannot be known and cannot be modelled.

We humans seem to attach greater significance to specific events that have already occurred when we try to anticipate the future. That type of mental gymnastic is the reason that something that has never occurred gets a low probability when trying to predict or model risk.

Managing risks really means reducing the cost and likelihood of potential perils for a price. Our own approach incorporates behavioural, liquidity and non-linear dynamic factors.

Lifecycle Pension Funds - The Question

When it comes to retirement, I do not believe that most people want to invest in some type of lifecycle pension fund if that fund is worth an uncertain future value at age 65 or 70. 

Would savers have peace of mind that they have the financial wherewithal to live their retirement years in financial security and comfort if, for example, they have been primarily invested in bonds and cash instruments? Well, it depends on their particular circumstances and the timing of these particular portfolio allocations. 

Stocks, bonds, real estate, private equity, commodities, cash and hedge funds have all generated attractive returns in different time periods.  However, which asset classes will generate attractive returns in which years is a key issue to deal with. The years and the returns (or losses) can vary considerably.  For example, in 2001, real estate and hedge fund returns were a helpful offset to a dismal year for stocks and commodities.  In 2003, stocks and private equity had strong gains in comparison with those of bonds.  However, in 2008, government bonds and cash were the only places to be for positive returns as the financial crisis hit with full force against all the other major asset classes. 

Questions regarding what the future may bring in terms of inflation, market performances, currency movements, personal health circumstances, etc., all have an important impacts on the size of the pension nest egg that will be needed for savers to feel assured that their financial needs will be met in retirement as a result of their decades of personal savings and investments.

We will examine this in more detail in future blogs.

Introduction to AssetAllocation Plus - The Blog Begins

Asset allocation is the first step in any investment process. It is a vital element as it sets the stage for any portfolio's return and risk profile.

Academic studies have shown that more than 90% of variability in investment performance can be attributed to asset allocation.  Decisions concerning asset mix have a greater impact on a portfolio's overall investment results that individual security selection or market timing.

Multi-asset, multi-market and multi-style can be combined to produce portfolios that can be constructed to be strategically actively managed within client-determined risk ranges.

In this blog I will explore a wide range of traditional (stocks, bond and cash instruments) and alternative (hedge funds, private equity, real estate, commodities, currencies, timberland, etc) asset classes, markets, styles and strategies.

I am open and flexible regarding the mix of components that can be used as it depends on client investment objectives, risk tolerances, income requirements and liquidity needs.  I believe that getting market exposure through cheap and efficient building blocks such as ETFs, index funds and futures are valuable tools in the portfolio construction and risk management process, especially when combined with active alpha generators.

Keeping up with economic, market and political factors are important in trying to anticipate what could happen and by developing strategies that reflect those views.  We certainly do have our opinions, views and strategies.

I hope you enjoy reading and interacting with this blog and welcome your feedback.