Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Thursday, 2 February 2012

Comments on the Reuters asset allocation poll

Interesting results from the Reuters poll of investment managers. In light of the January rally, the headline "Investors kick off 2012 with defensive stance" seems to justify the old adage of "Buy when everyone is selling".

However, what is a "defensive stance"? The dogma preached by astute pundits of finance is that stocks are riskier than bonds. There is truth in this (how much truth is based on how "risk" is defined but that is another post). However, as will all pithy sayings, the nuance is lost. Just ask a Greek bondholder about low risk bonds and riskless sovereign bonds.

To me, "defensive stance" connotes an unwillingness to invest in general. Therefore reading the headline, I would think that investors have pulled back from investing in both stocks and bonds and increased their cash balances. Also there might have been a shift from stocks to bonds in their portfolios.

The poll shows that only the latter is true. Surprisingly asset managers have decreased their cash holdings from 6.6% to 6%. In aggregate, equity accounted for 50.5% of the portfolios, bonds 36.2% and cash 6%. Equity allocation is the lowest in 3 months and bond allocation highest in a year.

There are regional variations but the decrease in cash holdings is consistent across regions bar the US. But US asset managers still have the lowest cash holdings of only 2.3% compared to 9% in continental Europe, 6.5% in Japan, 8.9% in UK and 6.9% in China.

Is this really a "defensive stance"? The allocation indicates a consensus view of low growth and hence low policy interest rates. But if current and expected rates are low then this should also reduce the cost of holding cash. And the low bond yields on offer provide a slim margin of error on the asset allocation call. Therefore decreasing cash and increasing bond holdings indicates a certainty (ignore desperation to beat benchmark) that the current low growth, low rate muddle will continue without the situation getting worse or better. It would be interesting to know whether the average portfolio duration has also gone down. I suspect it has and that would indicate that investors are confident that central banks will continue to debauch fiat currencies in the medium-term to prevent a correction. But they are gloomy about the long-term. Hence the reduction in equity holding.
This behaviour is similar to Friday night revellers making the last order before the bar closes. They imbibe despite being aware of the mayhem on the streets which they will have to negotiate in order to get home.

If this is the consensus view, what is the contrarian play? The short answer is overweight equity, underweight bonds with above average cash holding. At some stage, the ability of central banks to sustain the current low growth, low rate muddle will break down. The benign scenario is that growth picks up and conventional policy is restored. Returns from fixed interest rate bonds are not going to be pretty. Equity will surge. This scenario has a higher probability of playing out in the US than Europe or Japan.

The malignant scenario is political upheaval due to low growth which may be coupled with high inflation due to money printing (sorry, "unconventional policy"). Just to be clear, this is not an armageddon, end of civilisation scenario. It would be more like the 1930s in terms of suffering and economic cost. Bonds again are not going to do too well as defaults and inflation destroy return. In contrast, equity of judiciously selected companies should provide reasonable capital protection and return. And again, US is likely to outperform.

The reason for a higher than average cash holding is because of heightened economic uncertainty and increased volatility. This environment throws up bargains which can be snapped up if one has cash to deploy. Moreover, with interest rates this low, the opportunity cost of holding cash has never been lower.

Broadly, a personal portfolio should have a North American equity bias, hold short-maturity (max 3 years) bonds and have a reasonable (~10%) cash buffer.

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