“In the particular circumstances the world economy finds itself in, we clearly cannot exclude the possibility of either deflation or high inflation. One of the greatest bond bull markets ever has left conventional bonds extremely vulnerable to both risks. 

Governments may not be able to prevent the forced liquidation of excessive levels of debt, causing a vicious cycle of falling prices and incomes that mean debts cannot be serviced or repaid in full. Ten-year gilt yields of around 2% have almost never been this low. They imply a high probability of this ‘debt deflation’ but the additional 2-3% yield on the small population of high-grade, sterling-denominated corporate bonds is not enough to guard against its consequences. To the extent that monetary policies aimed at averting debt deflation eventually lead to high inflation and currency collapse, we might even experience both, in sequence.’

Bonds without guaranteed inflation protection cannot hold out these possibilities of high nominal and real loss and at the same time act as ’risk reducers’ in a portfolio.  Yet this is how bonds and bond funds are being used across the industry and by self-directed investors.

Related posts

Money Marketing Magazine : The bond illusion November 2011

New Position Paper: Bonds: a false market October 2011

To read the full article click here (you may need to register for ft.com). I summarise the arguments below.

Target date funds are the basis of the default fund in the government-sponsored NEST auto-enrolled pension scheme, which is an important boost to their credibility. The next step in putting them on the retail investment map will be product launches from private providers. We expect Vanguard, a target date fund market leader in the US, to be amongst the first. This will allow anyone with a personal pension to match their capital and contributions to a specific retirement date or, if they plan to draw down in retirement, to a sequence of dates.

Target date funds make the risks taken by an investor and the expected payoffs specific to age, stage and the manner in which they expect to take pension benefits, whether as an annuity (with or without inflation protection) or drawdown. It can also make risk-taking activity specific to ‘utility’ or the way in which they value different attributes of the payoffs from risk taking. In personal retirement planning, utility or welfare is significantly defined by the adequacy of real purchasing-power outcomes at distant horizons and the consequences for spending of shortfalls in adequacy. Volatility does not explain utility well in pensions saving. Correctly defining utility, and allocating capital to maximise expected utility at the right time, represent important gains relative to the failed ‘balanced management’ paradigm that dominates investment management today.

In the article I examine whether these benefits can be delivered without the time-intensive personal financial planning or segregation of portfolios that we can achieve, working with very wealthy clients.  I believe this is exactly what is enabled by our adoption of the technique or ‘portfolio separation’: the separation of portfolios into a risky segment and a risk-free segment – risk free in terms of the nature of the outcome (real or nominal) and its date (or duration) supports. It will require, as it does for us, very high orders of systematic  decision processes. It is scalable to the mass market and target date funds supply the basic chassis if not the engine.

‘Wealth management firm No Monkey Business (NMB) believes the National Employment Savings Trust (NEST) should follow its lead and adopt the principles of Liability Driven Investment (LDI). According to NMB, NEST’s newly-published Statement of Investment Principles (SIP) makes ill-advised trade-offs in its target date funds between short-term, nominal volatility and long-term real outcome risk. The impact is that younger members will be irrationally conservative, middle-aged members will exchange equity risk with inflation risk and older members approaching retirement will be matched to the wrong kind of pension.’

Read the whole article here.

WealthAdviser is published by GFM, ’the largest online news publisher serving institutional investors/wealth managers and their investment managers/advisers across all asset classes’.

Our Defined Outcome portfolios are managed to individually-customised applications of a quantitative model, designed at the asset allocation level to deliver goal-specific outcomes within explicit tolerance ranges at defined future dates. The allocation decisions follow from monthly computer runs of a unique model for every goal-based portfolio for every client. For the first time since the collapse of Lehman Brothers, we reran models midmonth, using Tuesday’s Tokyo close and Monday’s close for all other markets.

Several recent posts have focused on the attraction of Japanese equities. In this one, we focus on changes in exposure, rather than the allocations themselves, in the belief any investor, whatever their views, should change their exposures in response to such large price changes. As an explanation, we show below in full what we sent to clients on Monday, in advance of the changes. Though specific to our process, we think it is of interest to investors with different approaches.

Why we should follow the model

Our model is by design ‘contrarian’ but it is also blind to emotional influences on how it allocates capital (other than those emotions captured in the risk preferences for each portfolio goal). It is hard headed and also hard hearted.

The assumptions the model has been given about extreme short-term volatility in absolute and relative returns, from whatever source, allow for the kind of shock experienced in Japanese stocks. These assumptions are what keeps us out of equities for short-term liabilities.

The assumptions the model has been given about uncertainty in the long-term trend of real returns from any equity markets are also extremely prudent. In Japan’s case, the shortage of history (we only use data since the initial post-war reconstruction phase which we think ended in the mid-1950s) means that our trend projections allow for greater uncertainty than either the UK or US, which have over a century of data. But in fact there is widespread agreement amongst expert professionals that we ought not to expect any impact on the long-term trend of real returns from investing in Japan as a result of these tragic events.

The near-term impact on markets is likely to be explained by three factors:

1. The effects on measured activity – output, GDP, exports etc
2. Perceptions about the underlying valuation of Japanese equities
3. The effects on the mood of Japanese investors.

We should comment briefly on all three influences on the impact.

Counting the cost

While the destruction of national resources is always a loss, in economics the replacement of scrapped assets is counted as a gain. We can also anticipate that economic output will be temporarily lost due to power shortages. We do not yet know how public capital will be applied to making good personal loss, so that the neutral effects of reinvestment we should expect in the national accounts are not prevented by financial incapacity at the individual household level. Overall, however, the profile of activity will definitely change but not , over a decent interval, its eventual level. Temporary effects should not greatly alter the price investors are willing to pay for long-term profit and dividend streams for Japan’s businesses.

Market valuation

The market’s capacity to absorb such a shock ought therefore to be partly dependent on whether the valuation of share prices is thought to be particularly high or low at the time of the shock. Valuations are generally much less demanding than at the time of the Kobe earthquake in 1995, thanks to the combination of modest returns and gradual improvement in both profitability and profits in absolute. If we examine all incidents of major earthquake activity in industrial Japan since the start of the 20th century it is arguably the health of the banking system and the state of the property market (its main collateral) that has explained best the market impact. Both are infinitely healthier than in 1995.

You will read or hear that the Japanese public sector could not be in a worse shape to deal with a disaster. This misses the point that governments never have money; only the private sector and foreign sector have money. Governments merely attach some of it, through taxation or borrowing. Japan is fortunate as an immensely wealthy and highly successful trading nation that it is not dependent on foreign creditors. In an era of low personal incomes growth and high risk aversion, the government’s financial deficit necessarily follows from the personal sector’s preference for high, liquid and low-risk holdings of financial assets and so has not made borrowing difficult.

Mood

If the economic impact of the tsunami is temporary and the valuation context is supportive, the market impact may mainly reflect its unpredictable effect on the mood of Japanese households and their instincts for how to manage their own balance sheets better in response to this sort of risk. We will see some national characteristics come to the fore in this crisis involving fortitude and discipline but we cannot assume either will extend to their risk tolerance.  They are likely to be glad they have been so risk averse to date but we cannot be sure they will not decide to be even more risk averse. If they are, the job of markets is to lower prices to tempt them back to risk taking.

Unlike 1995, markets look much more attractive to foreign investors and so their reaction could prove an important factor in determining the subsequent price action in Tokyo. Several major investment houses had said before the earthquake that they were bullish of Japan at current valuations and had been increasing exposure.  Amongst conventional valuation measures, yields are now higher than in the US and price to book values lower than either the US or UK. Earnings and cash flow multiples will be less useful for comparative purposes because of the short-term dislocations to sales.

Awakening the Zombie

The headline writer obviously makes the same assumption most investors do that Japan has been a zombie for a long time. As the article points out, Japan has actually been fully competitive in sterling terms with other markets in the last decade and particularly useful in the credit-crisis bear market. What counts is valuation, not economics.

At today’s low valuation Japan should be as useful as other major markets, but has the potential to be the best.