The following is a portion of the most recent research bulletin of the Morgan Stanley Smith Barney Global Investment Committee. To read the full version of the bulletin, released yesterday, click here.
Portfolio diversification can improve and smooth out performance across investment environments and, given ongoing policy disarray and the likelihood of recession in both the US and Europe, it's a concept worth revisiting.
Since the Global Investment Committee (GIC)
moved to a more cautious tactical asset allocation on Oct. 6, the US equity market has gained 6%. However, in that relatively short period were sharp swings that included a gain of more than 10%, then a loss of nearly 10%, followed by a gain of 6%. During the same period, 10- year US Treasury yields went up 40 basis points and then down 40 basis points.
Much of the recent volatility in risk-asset prices comes from market reaction to Europe's efforts to contain and resolve its sovereign debt crisis. Portfolio diversification, however, is an ongoing objective—and is not an antidote for any particular event. The GIC may change tactical allocations as economic or market conditions dictate, but its portfolios are always diversified by asset class and geography.
EUROPEAN ROUNDUP. Our latest portfolio changes further reduced our allocation to European equities because of deteriorating economic conditions there. Since we made those changes, policymakers have moved quicker than we expected toward a more fiscally integrated Europe, providing coordinated liquidity to European banks and twice lowering the European Central Bank's (ECB) policy interest rate. We expect the ECB to further reduce rates in 2012. A saner fiscal policy framework should also enable the ECB to step up its sovereign bond purchases; we even expect the ECB to embark on Quantitative Ease (QE) in 2012.
However, the ECB can only go so far. Unlike the Federal Reserve or the Bank of England, the ECB does not have the authority to act as lender of last resort. Increasing the firepower of the European Financial Stability Facility and establish-ing the European Stability Mechanism in 2012 can make up some of the shortfall, but, even if policymakers cobble together a debt plan that quells investor concerns, the data suggest that a recession has al-ready begun. Morgan Stanley and Citi economists are both now forecasting a European recession. Throwing another wrench in the works, Standard & Poor's has warned that it will be reviewing the credit ratings for European sovereign debt and the region's banks.
US RECESSION LIKELY. Meanwhile, the US economy has been growing at stall speed and credit conditions are tighten-ing as a result of the distress in Europe. A dose of fiscal stimulus would help the US economy, but that doesn't appear to be in the offing. As US growth remains subpar, we think the Fed will eventually embrace a third round of QE, but we doubt that QE3 will significantly boost the economy. Rather, we expect a US recession to begin within the next year. For now, neither Morgan Stanley nor Citi economists are forecasting a US recession, though both have recently lowered their US growth estimates and acknowledge recession risks.
BETTER IN EMERGING MARKETS. We nevertheless anticipate continued growth in emerging market (EM) economies, driven primarily by domestic demand. EM fundamentals are generally superior to those in DM countries, and EM policymakers have a more robust toolset to deploy if needed as compared with DM policymakers. The People's Bank of China started to ease monetary policy last month, joining the recent actions of Russia, Turkey and Brazil. Because of the incremental growth being generated by the EM economies, we still expect positive GDP growth at the global level in 2012.
THE CASE FOR DIVERSIFICATION. Can diversification add value for investors in such an unsettled economic environment? The last market cycle reminds us that this is indeed the case. During the October-2007-to-February-2009 down- turn, most equity asset classes ranked near the bottom of the performance ranking (see Table 1). By contrast, most of the fixed income and alternative/ absolute return asset classes performed significantly better. Not surprisingly, those relative asset-class rankings were largely reversed during the February- 2009-to-April-2011 bull cycle.
It stands to reason that the performances of our recommended diversified portfolios appear near the center of the return rankings in the two radically different periods. They do so because they are blends of most of the discrete asset classes in the table. The GIC maintains three sets of model portfolios: Level 1 (L1) for portfolios under $1 million, Level 2 (L2) for portfolios between $1 million and $20 million, and Level 3 (L3) for portfolios in excess of $20 million. Within each level, there are eight models, with Model 1 (M1) being the least risky with no equities and Model 8 (M8) being the most risky and an all equities and alternative/absolute return investments portfolio.
The Model 5 (M5) portfolios are particularly instructive because, at the $20 million-plus level, they represent the lowest risk portfolio that strategically allocates to every one of the global asset classes in our models. Therefore, for similar levels of risk, we can compare the hypothetical and prospective benefits of diversification derived by adding different degrees of liquid and illiquid alternative/absolute return investments to portfolios also comprising traditional asset classes. The strategic allocations to alternative investments in the M5 portfolios run from 9% in L1 to 24% in L2 and 28% in L3.
In the 2007-to-2009 bearish period, the L3 M5 portfolio, which contains the most alternatives and smallest allocation to global equities, performed best among the three M5 GIC portfolios. In the 2009-to-2011 bullish period, the L1 M5 portfolio, which includes the most equities and the fewest alternatives, performed best. Over the combined 2007-to-2011 period, the L3 M5 portfolio fared best, demonstrating the value of including alternative assets in an investment portfolio. Taking this hypothetical exercise back to 1997, the three GIC strategic portfolios each returned about 7% per annum—a result higher than that of US or global equities, global fixed income or cash during the same period (see Chart 1). As for the downside, the L3 M5 portfolio's worst one-year period, at -23.2%, was better than the worst one-year returns of the L1 or L2 portfolios, which have lesser allocations to alternative/absolute return investments (see Table 2). Looking at all eight models, in most instances the worst-one-year period improved as the allocation to alternative/ absolute return asset classes increased from L1 to L2 to L3.
Now that we have reviewed our strategic asset allocation advice, let's turn to our tactical positioning.
SAFER POSITIONING In aggregate, we are underweight in our allocation to risk assets—equities, real estate investment trusts, commodities, high yield bonds and emerging market debt. Conversely, we are overweight in safe havens—cash, short-duration debt and investment-grade bonds—as well as managed futures.
We continue to overweight EM equities, for which valuations and relative-growth prospects remain favorable and where there is more policy flexibility. EM equities also offer relatively high dividends (chart). Within DM equities, we favor the US over Europe and Japan, both of which have structural and cyclical headwinds. Within US equities, we continue to favor large-cap stocks. Large-cap stocks typically outperform during adverse market conditions and still offer a relative-valuation advantage as compared with history. At the style level, we prefer growth stocks over value stocks. During the periods of decelerating corporate earnings that ac-company recessionary episodes, growth stocks—companies that have the ability to deliver relatively stable earnings growth regardless of the economic backdrop or those expected to post above-average earnings growth—typically hold up better. In addition, value stocks continue to appear to be somewhat expensive relative to growth stocks on a historical basis.
ALTERNATIVE INVESTMENTS. Among the alternative/absolute return investments that we use in our model portfolios, we are maintaining a slight underweight tactical allocation to commodities. We believe it is prudent to limit exposure to this economically sensitive asset class in light of the increased risk of recession. Another asset class with close ties to the economic cycle is real estate investment trusts. Given coming GDP growth challenges, we believe it is judicious to maintain a reduced exposure there as well. As for managed futures, we have a tactical overweight position. This asset class has low historical correlations to other asset classes, thereby providing a considerable degree of portfolio diversification. In addition to that, managed futures have historically performed well during adverse equity markets.
CASH AND FIXED INCOME. It remains hard to make a compelling valuation case for cash, short-duration fixed income and DM sovereign debt when most of those yields fall short of inflation and appear expensive relative to equities and other risk assets. However, given the cyclical risk we foresee, the defensive properties of these asset classes should provide welcome ballast to a diversified portfolio during a turbulent period; we are overweight in cash and short-duration debt and market weight in bonds. Within bonds, we remain moderately underweight to DM sovereign debt. Prioritizing safety and quality over wide spreads, we are limiting our exposure to high yield corporate bonds and emerging market debt, while favoring exposure to investment-grade corporate bonds.
IN CONCLUSION. As new challenges and opportunities appear, we continue to evaluate our risk exposure and tactical positioning. Our analyses suggest many safe havens would have less vulnerability in the likely challenging economic period ahead. As a result, at a high level, our asset allocation models overweight global cash, market weight global bonds and alternative/absolute return investments and underweight global equities.
The MSSB Global Investment Committee includes: Jeff Applegate, Chief Investment Officer; David M. Darst, Chief Investment Strategist; Kevin Flanagan, Chief Fixed Income Strategist; Jonathan Mackay, Senior Fixed Income Strategist; Charles Reinhard, Deputy Chief Investment Officer, Douglas Schindewolf, Director of Asset Allocation.
