Adjusting Global Portfolio

Summary

This comprehensive discussion on adjusting a global investment portfolio based on macroeconomic factors offers a structured framework for financial analysts. It emphasizes the importance of incremental changes to a portfolio containing equities and bonds, guided by macroeconomic considerations. Here are the key ideas summarized:

1. Macro-Based Recommendations: Focus on adjusting allocations between equities and bonds, reallocating assets between countries, modifying bond credit quality, adjusting duration and yield curve positioning, and managing currency exposures.

2. Systematic Approach: Begin with a checklist of macroeconomic questions covering trend growth, global integration, business cycle phases, monetary and fiscal policies, current account balances, and currency pressures.

3. Trend Growth: An increase in trend growth favors equities due to potential for higher earnings growth, while negatively impacting bonds through higher real interest rates. Adjust allocations towards markets or countries experiencing unpriced growth shocks.

4. Global Integration: Markets becoming more globally integrated should see a decrease in required returns, justifying a reallocation towards these markets from ones already highly integrated.

5. Business Cycle Phases: Allocate more to equities when economies approach the business cycle trough, and reduce bond allocations, adjusting for term and credit premium considerations. Adjust portfolios based on the synchronization of business cycles across markets.

6. Monetary and Fiscal Policies: Significant policy changes or unexpected policy outcomes provide opportunities for portfolio reallocation based on their implications for economic growth and the business cycle.

7. Current Account Balances: Reallocation should consider shifts in current account balances, favoring countries with improving or surplus current accounts.

8. Capital Accounts and Currencies: Assess the impact of capital flows on currencies, avoiding allocations in currencies that have overshot their sustainable levels unless assets remain attractive post-hedging.

9. Valuation Considerations: Always consider what is already priced into asset valuations, as this impacts the attractiveness of any investment.

10. Quantifying Views: Utilize various models and frameworks, such as the Singer–Terhaar model for equilibrium returns, the Grinold–Kroner model for equity market returns, and the Black–Litterman framework to integrate these expected returns with equilibrium returns, to systematically quantify recommendations.

This approach requires analysts to deeply understand and integrate macroeconomic trends and policy shifts with sophisticated financial models, aiming for incremental portfolio improvements that capitalize on these insights.

Learning Outcome

• recommend and justify changes in the component weights of a global investment portfolio based on trends and expected changes in macroeconomic factors

The coverage of capital market expectations has provided an intensive examination of topics with which analysts need to be familiar in order to establish capital market expectations for client portfolios. This section brings some of this material together to illustrate how analysts can develop and justify recommendations for adjusting a portfolio. The discussion that follows is selective in the range of assets and scenarios it considers. It focuses on connecting expectations to the portfolio and is about “direction of change” rather than the details of specific forecasts.

Macro-Based Recommendations

Suppose we start with a fairly generic portfolio of global equities and bonds (we assume no other asset classes are included or considered) and we are asked to recommend changes based primarily on macroeconomic considerations. Further assume that the portfolio reflects a reasonable strategic allocation for our clients. Hence, we do not need to make any wholesale changes and can focus on incremental improvements based on assessment of current opportunities. To be specific, we limit our potential recommendations to the following:

• Change the overall allocations to equities and bonds.

• Reallocate equities/bonds between countries.

• Adjust the average credit quality of our bond portfolios.

• Adjust duration and positioning on the yield curves.

• Adjust our exposures to currencies.

To approach the task systematically, we begin with a checklist of questions.

1. Have there been significant changes in the drivers of trend growth, globally or in particular countries?

2. Are any of the markets becoming more/less globally integrated?

3. Where does each country stand within its business cycle? Are they synchronized?

4. Are monetary and fiscal policies consistent with long-term stability and the phases of the business cycle?

5. Are current account balances trending and sustainable?

6. Are any currencies under pressure to adjust or trending? Have capital flows driven any currencies to extended levels? Have any of the economies become uncompetitive/super-competitive because of currency movements?

There are certainly many more questions we could ask. In practice, the analyst will need to look into the details. But these questions suffice for our illustration. We will examine each in turn. It must be noted, however, that they are inherently interrelated.

Trend Growth

All else the same, an increase in trend growth favors equities because it implies more rapid long-run earnings growth. Faster growth due to productivity is especially beneficial. In contrast, higher trend growth generally results in somewhat higher real interest rates, a negative for currently outstanding bonds. Identifiable changes in trend growth that have not already been fully factored into asset prices are most likely to have arisen from a shock (e.g., new technology). A global change would provide a basis for adjusting the overall equity/bond allocation. Country-specific or regional changes provide a basis for reallocation within equities toward the markets experiencing enhanced growth prospects that have not already been reflected in market prices.

Global Integration

All else the same, the Singer–Terhaar model implies that when a market becomes more globally integrated, its required return should decline. As prices adjust to a lower required return, the market should deliver an even higher return than was previously expected or required by the market. Therefore, expected increases in integration provide a rationale for adjusting allocations toward those markets and reductions in markets that are already highly integrated. Doing so will typically entail a shift from developed markets to emerging markets.

Phases of the Business Cycle

The best time to buy equities is generally when the economy is approaching the trough of the business cycle. Valuation multiples and expected earnings growth rates are low and set to rise. The Grinold–Kroner model could be used to formalize a recommendation to buy equities. At this stage of the cycle, the term premium is high (the yield curve is steep) and the credit premium is high (credit spreads are wide). However, (short-term) interest rates are likely to start rising soon and the yield curve can be expected to flatten again as the economy gains strength. All else the same, the overall allocation to bonds will need to be reduced to facilitate the increased allocation to equities. Within the bond portfolio, overall duration should be reduced, positions with intermediate maturities should be reduced in favor of shorter maturities (and perhaps a small amount of longer maturities) to establish a “barbell” posture with the desired duration, and exposure to credit should be increased (a “down in quality” trade). The opposite recommendations would apply when the analyst judges that the economy is at or near the peak of the cycle.

To the extent that business cycles are synchronized across markets, this same prescription would apply to the overall portfolio. It is likely, however, that some markets will be out of phase—leading or lagging other markets—by enough to warrant reallocations between markets. In this case, the recommendation would be to reallocate equities from (to) markets nearest the peak (trough) of their respective cycles and to do the opposite within the bond portfolio with corresponding adjustments to duration, yield curve positioning, and credit exposure within each market.

Monetary and Fiscal Policies

Investors devote substantial energy dissecting every nuance of monetary and fiscal policy. If policymakers are doing what we would expect them to be doing at any particular stage of the business cycle—for example, moderate countercyclical actions and attending to longer-term objectives, such as controlling inflation and maintaining fiscal discipline—their activities may already be reflected in asset prices. In addition, the analyst should have factored expected policy actions into the assessment of trend growth and business cycles.

Significant opportunities to add value by reallocating the portfolio are more likely to arise from structural policy changes (e.g., a shift from interest rate targeting to money growth targeting, quantitative easing, and restructuring of the tax code) or evidence that the response to policy measures is not within the range of outcomes that policymakers would have expected (e.g., if massive quantitative easing induced little inflation response). Structural policy changes are clearly intentional and the impact on the economy and the markets is likely to be consistent with standard macroeconomic analysis, so the investment recommendations will follow from the implications for growth trends and business cycles. Almost by definition, standard modes of analysis may be ineffective if policy measures have not induced the expected responses. In this case, the analyst’s challenge is to determine what, why, and how underlying linkages have changed and identify the value-added opportunities.

Current Account Balances

Current account balances ultimately reflect national saving and investment decisions, including the fiscal budget. Current accounts must, of course, net out across countries. In the short run, this is brought about in large measure by the fact that household saving and corporate profits (business saving) are effectively residuals whereas consumption and capital expenditures are more explicitly planned. Hence, purely cyclical fluctuations in the current account are just part of the business cycle. Longer-term trends in the current account require adjustments to induce deliberate changes in saving/investment decisions. A rising current account deficit will tend to put upward pressure on real required returns (downward pressure on asset prices) in order to induce a higher saving rate in the deficit country (to mitigate the widening deficit) and to attract the increased flow of capital from abroad required to fund the deficit. An expanding current account surplus will, in general, require the opposite in order to reduce “excess” saving. This suggests that the analyst should consider reallocation of portfolio assets from countries with secularly rising current account deficits to those with secularly rising current account surpluses (or narrowing deficits).

Capital Accounts and Currencies

Setting aside very high inflation situations in which purchasing power parity may be important even in the short term, currencies are primarily influenced by capital flows. When investors perceive that the portfolio of assets denominated in a particular currency offers a higher risk-adjusted expected return than is available in other currencies, the initial surge of capital tends to drive the exchange rate higher, often to a level from which it is more likely to depreciate rather than continue to appreciate. At that point, the underlying assets may remain attractive in their native currency but not in conjunction with the currency exposure. An analyst recommending reallocation of a portfolio toward assets denominated in a particular currency must, therefore, assess whether the attractiveness of the assets has already caused an “overshoot” in the currency or whether a case can be made that there is meaningful appreciation yet to come. In the former case, the analyst needs to consider whether the assets remain attractive after taking account of the cost of currency hedging.

There is one final question that needs to be addressed for all asset classes and currencies. The previous discussion alluded to it, but it is important enough to be asked directly: What is already reflected in asset prices? There is no avoiding the fact that valuations matter.

Quantifying the Views

Although the analyst may not be required to quantify the views underlying his or her recommendations, we can very briefly sketch a process that may be used for doing so using some of the tools discussed in earlier sections.

Step 1	Use appropriate techniques to estimate the VCV matrix for all asset classes.
Step 2	Use the Singer–Terhaar model and the estimated VCV matrix to determine equilibrium expected returns for all asset classes.
Step 3	Use the Grinold–Kroner model to estimate returns for equity markets based on assessments of economic growth, earnings growth, valuation multiples, dividends, and net share repurchases.
Step 4	Use the building block approach to estimate expected returns for bond classes based primarily on cyclical and policy considerations.
Step 5	Establish directional views on currencies relative to the portfolio’s base currency based on the perceived attractiveness of assets and the likelihood of having overshot sustainable levels. Set modest rates of expected appreciation/depreciation.
Step 6	Incorporate a currency component into expected returns for equities and bonds.
Step 7	Use the Black–Litterman framework (described in a later reading) to combine equilibrium expected returns from Step 2 with the expected returns determined in Steps 3–6.