« Long-term investment is about playing with regime shifts, with regimes defined by some kind of equilibrium level, some mean reversion dynamics, and countercyclicality. »

« Long-term investment is about playing with regime shifts, with regimes defined by some kind of equilibrium level, some mean reversion dynamics, and countercyclicality. »

« Long-term investment is about playing with regime shifts, with regimes defined by some kind of equilibrium level, some mean reversion dynamics, and countercyclicality. »

 

Pascal Blanqué concluded the session on asset allocation, laying out three assumptions. The first is that if valuations classically revert to the mean there will be problems, starting with the US and spreading to the rest of the market. The second is that interest rates at equilibrium will stay low, but not immobile. The third is that over the long run earnings have been the main driver of returns. From this standpoint, equities and bonds as asset classes should be more complementary.

Equity prices have risen faster than earnings in the most recent period, which is in line with the general view of diminishing returns. Using a chart based on Fed analysis, he showed that this also happened in 1982, but was corrected by divergence in the other direction. These cycles lasted an average of 14 years. The question is whether the return on physical capital could catch up with the high returns seen in the late 90s. Given the trends in the labour force, in capital stock, in productivity, and in the sharing of added value in favour of profits, it is unlikely without a boom of productivity. However, mean reversion took place by 2012, in about 14 years. So the bet, he posited, is whether it will happen again now.

Responding to the moderator, who indicated that returns have been disappointing to date and whether this is a new trend, Mr. Blanqué agreed. For long-term investors, this sequence is one among others; longterm investment is a path through various segments. In this sequence, he relies on a simple calculation: Take a 50-50 bond portfolio on the equity side, a 2% dividend yield, 5% earnings growth, and a yield to maturity of 2%. Doing the math, 7+2 divided by 2 = 4.5%, nominal before taxes and fees. This is twice less than the average of the last three decades.

In this environment clients want capital preservation, broader management, and priority on total rather than relative risk. They may be doing well against benchmarks, but these were flat to negative in net terms. The second aspect is that in a world of “fatter tails”, you need flexibility, but his has an effect on yield. The third aspect is enlarging the investment universe and building ncontinuums across the fixed income space, beyond liquids and illiquids. If faced with diminishing returns we have to think of the value chain, emphasized Mr. Blanqué. The value will be shifting upstream in the advisory space, and downstream in the value chain to execution and services.

Long-term investment is about inefficiencies, and there are many. “Regime shifts are a territory of uncertainty, not risk, because it’s not predictable, “ he continued. “I have three directions in mind. One is the Goldilocks Great Moderation 2.0. This is the temptation of the market at the moment, with a soft landing of the cycle,” he said. It could lead to the second one – going back to the 1990s, with a disruptive landing of credit and asset price bubbles with eventual deflationary consequences. This, in turn, could lead to the third, which is back to the 1970s, an inflationary type of regime, with severe consequences.

« Goldilocks may be over, but it is probably too soon for the bears. »

 

Asked about ESG, Mr. Blanqué highlighted three approaches. One starts with exclusion but then moves to engagement and active ownership. The second is price-signalling, so not related to risk and return but to pricing and the creation of new markets. This includes green bonds and impact investing. The third that is gaining favour rapidly is the risk approach in which ESG is a pool of risk factors, poorly remunerated, and asymmetrically distributed across corporates. The probability that some of those risks materialise is high enough to “open up a field of options to play with in the portfolio”, he suggested.

This analysis leads to three takeaways, continued Mr. Blanqué. The first is that you have two forces pulling in different directions. One comes from the US and is pulling for the extension of the cycle, while the other is heralding a late cycle or a slowdown outside the US. “You have to combine them because the themes are not necessarily of the same quality on one hand, and value some kind of cyclicality on the other hand.”

The second is that derivatives matter, and there are many second derivatives “turning the corner”. Global growth and its synchronisation is slowing down and volatility, while low, is creeping up. The third takeaway is that the risks to worry about are not necessarily the classic ones. We are too focused on inflation and growth as a big risk, Mr. Blanqué emphasized, while we should be more worried about longer-term risks from geopolitics or trade. They are mispriced and are growing. Moreover, endogenous risks such as liquidity are important.

« Goldilocks may be over, but it is probably too soon for the bears. »

THE BENEFITS OF DIVERSIFICATION AND HOW TO DO IT

There are two reasons to diversify portfolios – the high correlation between traditional assets and increasing volatility.
There are four types of diversification:
• Diversification within traditional asset classes, which is useful but not efficient in times of crises. 
• Diversification through alternative assets, such as real assets, which can hedge against inflation and protect against unexpected drawdowns, with private debt serving as the credit continuum asset.
• Diversification through alternative investment processes such as Smart Beta, factor investing, and Alternative Risk Premia, which allow exits from standard benchmarks (SMART) or from pure asset class investing (factor investing and alternative risk premia). 
• Diversification through betting on megatrends or disrupters, such as demography, technology, digitalisation, climate change, or ESG, focussing on private debt and equity, smalland mid-caps, and thematic or disruption funds. This is a wayto invest in future winners where risk is rewarded, moving from secular stagnation to secular growth, and reducing exposure to cyclical sectors.

THREE SOLUTIONS FOR INVESTORS

He enumerated three solutions for investors. One is the fixed income continuum solution, “basically bringing into one portfolio solution the various portfolio solutions across the liquid and less-liquid spectrum of the fixed income space”. The second is the capital structure approach. The possibility, and Amundi has it in emerging markets, to put together equity and bonds, combining the equity-holder view with the bond-holder view across the spectrum of instruments and segments of the asset class.

The third comes mostly from the equity side, but also from the fixed-income side. “We are seeing an approach putting the equity side in the first bucket for reasons related to some belief in the efficiency of those markets. Most tactical asset allocation is run through this bucket. The second bucket is factor exposure – statistical dynamics. And the third one is idiosyncratic or thematic. This is a promising type of approach.”

Mr. Blanqué concluded with three convictions on what long-term could be. 
 
– The first is a pass through the regimes and sequences, with the capabilities to articulate the short-term and long-term throughout. 
 
– The second is that long-term is about metrics. If you are really a long-term investor you are faced with problems of metrics. What sort of measure for risk, for example. We are measuring risk taking a one-year bar at best, which is not enough, he said. The same holds for returns, where annualised returns are the norm in the industry. “But annualised return does not exist, it’s not observable. It’s an ex-post. If you are really a longterm investor, what should be your best measure for returns?”
 
– The third conviction is governance. Long term is governance, and there are various aspects to it, including engagement, active ownership, and fiduciary duty. “The investment community has been operating with a very simplistic definition of fiduciary duty. Maximisation of returns, full stop,” lamented Mr. Blanqué. 

« If you are really a long-term investor, you must embrace partnership with your asset manager beyond cyclicalities in a win-win game. That is not necessarily what we see most often. »

« If you are really a long-term investor, you must embrace partnership with your asset manager beyond cyclicalities in a win-win game. That is not necessarily what we see most often. »