Global Macro Trends

Portfolio Construction at the Dawn of 2012: Challenging Conventional Wisdom

By Henry H. McVey, February 5, 2012

The global macro-environment appears to be undergoing a major sea change as the duel influences of deleveraging in the developed markets and rising consumption in the emerging markets gain momentum. Given the magnitude of these trends, we believe that now is the time for portfolio managers to rethink some common approaches to asset allocation and hedging. Among them, we believe that greater exposure to real assets is now required, but non-traditional approaches to the asset class may warrant investor attention. In addition, we question whether in today’s volatile environment there are more efficient ways to hedge than through the use of short-term put option strategies. Finally, we believe that government bonds are becoming less practical as traditional ‘shock absorbers’ in portfolios.

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What makes investment management so compelling? As any portfolio manager would tell you, it’s the opportunity to express a view of the world through security selection and asset allocation. Yet as with any art form, beauty is in the eye of the beholder—and everyone is entitled to an opinion.

We were recently reminded of this upon receiving ample feedback from Chief Investment Officers (CIOs) and other investment professionals about whether they agree or disagree with our outlook for 2012.1 And since we welcome feedback and dialogue—it often clarifies our thinking—we thought it might make sense to spend a little more time explaining why we favor certain strategies over others—some of which, as we fully realize, simply don’t jibe with the consensus at this time.

In particular, we wanted to highlight three high-conviction beliefs that may depart from common thought about global macro and asset allocation.

1. We believe real assets should be a core holding in any portfolio, but we think many investors may not be optimizing their approach to the asset class. As we detail below, the lesson we learned from trading commodity swaps for some time is that many of today’s products are often highly inefficient as performance enhancers and can be equally unproductive as portfolio diversifiers. For those who have not been keeping score, we would highlight that, on an absolute basis, the total return of the S&P GSCI (formerly the Goldman Sachs Commodity Index) was just 8.5% between 2004 and 2011, whereas spot return was 147.5% during the same period.2 We acknowledge there is no silver bullet in real assets, but for sophisticated institutional investors who have some flexibility in their mandate and the resources to perform detailed due diligence, our suggestion is to consider forgoing some liquidity in order to gain exposure to real assets that could deliver better potential returns, improved cash-flow profiles, and more robust inflation protection—all with the possibility of less downside risk and much lower correlation than what the average investor may be getting.
2. We think the use of equity options for portfolio insurance needs to be evaluated more critically. These days, in our view, many investors appear to favor public-equity options as a form of downside protection. Given ongoing volatility, we can’t blame them. But what we found is that doing so consistently may actually yield minimal returns over time. In fact, for those who want greater market exposure and have a longer time horizon, it could make sense, under certain circumstances, to try to take advantage of the volatility by taking the opposite side of the trade (as we detail in the next few pages).
3. After a 20+ year bull run, we see an inflection point within the developed sovereign fixed-income markets. We believe many government bonds can no longer serve as meaningful shock absorbers within an asset-allocation framework. Eurozone countries like Spain and Italy continue to face funding challenges, and their bonds do not appear to provide compelling value at current yields, whereas yields on U.S. Treasuries, German Bunds and Japanese government bonds (JGBs) are now so low that they appear to be getting near full price3. At the same time, the potential return on corporate credit is compelling at current interest rates, presenting a significant opportunity cost for those who favor government bonds, in our view. See below for details, but our research indicates that that the risk premium on corporate credit appears to be near record levels. That’s why we suggest tilting allocations away from government bonds and toward U.S. corporate credit, with our target portfolio 1,500 basis points underweight the former and 1,000 basis points overweight the latter.

Looking at the big picture, our macro view remains largely unchanged. Our base case reflects a favorable outlook for risk assets in 2012, though nothing of grand proportions. In this type of environment, we still think that the risk/return profile of ‘spicy’ credit is compelling,4 and our target portfolio continues to reflect this as our largest overweight position.

We also believe there’s a strong case to be made for real assets and other alternatives. In addition to our large underweight position in global government bonds, we “pay” for our overweight positions with small underweight allocations to cash and global public equities (Exhibit 1).

Exhibit 1

In our Target Allocations, Overweight Credit
is a Significant Focus

KKR Global Macro & Asset Allocation target allocation as at December 31, 2011. Source: KKR Global Macro and Asset Allocation.

Thinking About Allocations to Real Assets

As we detailed in our Phase III paper5 last October, our base view is that investors face a greater risk of disinflation or deflation—rather than inflation—in the near future. This view is founded on historical patterns showing that credit withdrawal through deleveraging can serve as a disinflationary force in developed-market economies; there have been four such periods in the U.S. since the 1800s (Exhibit 2). After a peak in the debt-to-GDP ratio, the average inflation rate over the following ten years was -0.6%, with the exception of one period after World War II, which actually exhibited positive implied inflation (Exhibit 3).

Exhibit 2

Since 1800, There Have Been Four periods
of Deleveraging in the U.S.

We also found that non-wartime deleveraging is generally disinflationary throughout all developed markets—not just in the U.S.—as shown in Exhibit 4, which traces data back to the early 1800s using Carmen Reinhart’s and Kenneth Rogoff’s analysis of debt and defaults, and illustrates that inflation has averaged around zero, with a peak of 4.1% and a low of -1.4%.

So if we consider disinflation to be the greater near-term risk, why do we propose being overweight real assets? We believe there are three reasons—the first being the unprecedented magnitude of monetary and fiscal stimulus now in the financial system. Though we are still in uncharted territory, we think some form of mean reversion in the inflation cycle is likely in the future. All told, the amount of money spent on monetary and fiscal stimulus in the U.S. since 2008 is now nearly 38% of GDP—four times what the government spent during the Great Depression (Exhibits 5 and 6). Put another way, the stimulus currently at work is so big that there is no historical playbook for investors to truly understand how a liquidity injection of this magnitude will eventually manifest itself in the economy and/or the financial markets, in our view.

Second, thinking about inflation requires a more global perspective these days. We believe that urbanization among emerging markets will exert upward pressure on commodity prices—particularly those of oil, corn, and iron ore. Just consider that China is now only about 45% urbanized, compared to 87% in Brazil and 78% in Mexico6.

And finally, we believe continuing political uncertainty in the Middle East—including tensions surrounding Iran’s alleged nuclear program—is creating heightened geopolitical anxiety, which we do not expect will subside in the near term.

As macro investors and asset allocators have increased their exposure to real assets, many have invested in popular commodity notes and swaps that unfortunately have not helped them to achieve their financial aspirations, including solid performance and low correlation. Indeed, the total-return feature of many commodity indexes in recent years has been disappointing at best (Exhibit 7). The S&P GSCI has actually not delivered much total return since its public launch in 2004: on an absolute basis, it was just 8.5% between 2004 and 2011, while spot return was 147.5% during the same period. In our view, negative roll costs and outsized volatility have all played a part in such significant relative underperformance. No doubt, volatility could fall and out-year prices could collapse, which would make futures and forwards more appealing, but that is not our central view.

This trend of underperformance has had significant implications for almost any investor who has traded in real assets. For example, just consider today’s highly popular multi-asset-class mutual funds, which in many instances allocate at least 5–7% to commodity notes and swaps. Total assets in this fund category alone grew from $60.5 billion in 2004 to $298 billion in 2011—a 392% increase.7 While the multi-asset class fund is just one fund category, we think that there are numerous other examples of similar growth in retail and institutional investment vehicles that have increased their exposure to the real asset category, often through the futures-linked products we eschew.

Exhibit 7

Actual Total Return from the GSCI Has Been Far Less Than the Movement in Spot Commodity

The Goldman Sachs Commodity Index (GSCI) total return index measures the returns accrued from investing in fully-collateralized nearby commodity futures, the excess return index measures the returns accrued from investing in uncollateralized nearby commodity futures, and the GSCI spot index measures the level of nearby commodity prices. Data as at December 31, 2011. Source: Goldman Sachs, Bloomberg.

Exhibit 8

GSCI Correlation Now at Extraordinarily High Levels

Data as at December 31, 2011. Emerging market equities = MSCI Emerging Markets Gross Local Index; Emerging market debt = JPMorgan GBI-EM Global Composite Unhedged USD. Source: Bloomberg.

As Exhibit 8 shows, in addition to lackluster returns, many of the popular commodity indexes have lately been highly correlated with the public markets. The GSCI’s 24-month correlation with the S&P 500 is now +85%, up from -17% as recently as 2003. A similar story holds true for emerging-market equity correlations, which surged to 75% in 2011 from 6% in 2003.

Not surprisingly, given how poorly the GSCI index has performed in recent years, we have become increasingly open to new investment ideas in real assets, including direct private energy. Supporting our viewpoint is some thought provoking research by researchers Peng Chen and Joseph Pinsky of Ibbotson Associates. They produced a persuasive paper in 2002 entitled “Invest in Direct Energy,” which outlines a thoughtful case for our approach. The paper examines the period of 1970–2000, and concludes that investments in direct private energy perform extremely well in inflationary periods (1970s) and delivered modest but positive real returns in disinflationary periods. Though correlations have increased in recent years, Chen’s and Pinsky’s work shows a correlation of direct energy investments of -0.35 with large U.S. stocks and -0.42 with international stocks.

Another feature we like in many of today’s private oil and gas investments is that they can be structured to provide investors with a current income stream, which is consistent with our Brave New World thesis.8 Given the significant capital expenditures required by energy companies for new shale development in the U.S., there is a solid opportunity for investors in real assets to acquire mature fields not involved in shale exploration at reasonable prices with good cash-flow characteristics, in our view. We believe that, while exposure to these types of investments may not be as immediately lucrative as certain new discoveries, they do generate healthy yields, serve as effective inflation hedges, and could be less subject to some of the vagaries and shortcomings of traditional commodity exposures.

We also believe that these investments may act as a natural hedge in any portfolio with substantial assets in the corporate sector, including traditional corporate buyout vehicles. For example, if oil prices rise significantly, then the underlying assets of our real-asset portfolio may deliver improved earnings results at a time when some corporate investments—particularly those heavily dependent on oil as an input—are likely to suffer from margin degradation.

We also think there are some interesting opportunities in public and private real estate markets for investors interested in hedging inflation—and our research suggests that real estate tends to correlate more highly with inflation in a low-rate environment (Exhibit 9). This makes sense to us as the ability for real estate owners to raise rents amid low-financing costs is an attractive combination.

Exhibit 9

Inflation Hedging Power of Real Estate is Strong

Data from 1Q1978 to 3Q2011. Correlation of US Consumer Price Index quarter-over-quarter change against NCREIF Total Rate of Return on Real Estate9 and NAREIT Equity REITs quarterly total returns. Source: Bureau of Labor Statistics, National Council of Real Estate Investment Fiduciaries, Federal Reserve Board, Bloomberg.

The bottom line is this: we believe the universe of real assets is large and complex, requiring thoughtful due diligence and research to achieve investment objectives. Our experience trading and investing in real assets for several years has led us to conclude that it increasingly requires non-traditional approaches—including forgoing some near-term liquidity, on occasion, in order to gain exposure to vehicles that could possibly serve as good total-return investments and inflation hedges.

Thinking About Equity Protection

Many macro investors and asset allocators tell us they make sure to buy downside protection against tail risks. We tend to subscribe to that philosophy, but, like in real assets, it depends on the approach. When portfolio managers promise net returns of 10% to investors but with lower volatility metrics, our view is that one has to think long and hard about how to spend premiums in order to gain efficient downside protection.

Everyone has a different opinion on the topic, but our experience in the markets leads us to believe that there are often better ways to hedge downside risk than the common practice of buying put options outright. Exhibits 10 and 11 illustrate why we generally dislike using put options to hedge equity risk. Specifically, these exhibits show that the S&P 500 underperformed the CBOE S&P 500 Put-Write Index during 2007–2009. In other words, an investor could have actually lost money hedging equity positions via put options during the last bear market because even as the market fell, volatility spiked so high that “insurance premiums” became prohibitively expensive.

Exhibit 10

The S&P 500 Underperformed the CBOE S&P 500
Put-Write Index During 2007-2009

Exhibit 11

Despite the Financial Crisis, Writing Puts Since June 2007 has been a Better Strategy Than Holding Equities

Data as at January 17, 2012. The CBOE S&P 500 Put-Write Index measures the performance of a hypothetical portfolio that sells S&P 500 Index (SPX) put options against collateralized cash reserves held in a money market account. Source: CBOE, Bloomberg.

The Put-Write Index above shows the return of writing one-month, at-the-money S&P 500 put options against cash reserves held in a money market account fully collateralizing the position. Buying longer-duration put options at the beginning of 2007 could have offered far more effective protection, but would have also required great foresight. Under normal conditions, the volatility curve is in steep contango, so buying longer-term put options can often be an even more expensive proposition than monthly protection.

We believe hedging is an essential part of any strategy in a Phase IIII environment for a variety of reasons. Of all the things we worry about these days, we view Europe as our greatest source of concern and an area that merits special attention. In addition to short-selling the euro, one protection mechanism we favorably view is the 2013 Euribor curve, whose rising interest rate path suggests the pricing in of a growth rebound in Europe (Exhibit 12). We think this scenario is too optimistic, since the austerity measures taken by European governments are significant and budget targets will have to be revised substantially downward in 2013. We measure this by looking at the relationship between nominal GDP less interest expense. When nominal GDP is above interest cost (assuming debt-to-GDP is around 100%), our research shows a country can begin to reduce its debt load. But as Exhibit 13 shows, many European countries are nowhere near their target levels of growth relative to borrowing costs. Moreover, given that the EU treaty proposal laid out in December 2011 is so fiscally conservative, we believe there is little chance of surprising growth levels this year—particularly as growth upside next year remains very limited.

Exhibit 12

Euribor Futures Imply ECB Returns to Tightening
Mode in 2013. We Disagree

Data as at January 4, 2012. Source: Bloomberg.

Exhibit 13

Ultimately, Countries Need Growth to Overcome
Debt Loads

Data as at January 17, 2012. e=IMF estimate. GDP = Gross Domestic Product. Source: IMFWEO Sep 2011, Bloomberg.

Can Sovereign Bonds Still Be Shock Absorbers?

I am not sure who coined the adage that “laughter is the shock absorber that eases the blows of life.” But in the portfolio management profession, it was Nobel Laureate Dr. Harry Markowitz, the father of Modern Portfolio Theory, who proposed adding “shock absorbers” (i.e., diversifiers) to a portfolio, particularly in the case of assets whose values move inversely to one another10.

Our note thus far has shown that the counter-cyclical nature of government bonds has served as an important diversifier in many portfolios; that deflation remains a greater near-term risk than inflation; and that Treasuries, Bunds, and Japanese government bonds have been important shock absorbers of late as the number of tail risks over the past three years has been on the rise, including those emanating from geopolitical tensions, as well as banking and sovereign-debt crises. But what has made government bonds even more durable these days is that they have generated attractive returns in both ‘risk-off’ and ‘risk-on’ environments—and that they have served as an important hedge in both good and bad markets in recent years (Exhibit 14).

Exhibit 14

U.S. Government Bonds Have Been a Meaningful Shock Absorber in Good Markets And Bad…

Data as at December 31, 2011. Source: Bloomberg.

Exhibit 15

But We Are Now at a Much Different Starting Place

Data as at January 13, 2012. Source: “Irrational Exuberance” Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005 by Robert J. Shiller.

However, after the Fed explicitly laid out its dovish playbook, which includes a virtual promise—as of January 25—of no interest-rate hikes at least until 2014 and of low inflation, there are several reasons to suggest that we are at a major inflection point in terms of the role of global government bonds in the overall asset-allocation process. For starters, we wonder what’s left from a performance standpoint. After hitting 15.84% in 1981, bond yields fell 1,400 basis points to a low of 1.72% near the end of 2011 (Exhibit 15). From a historical perspective, according to data from Robert Shiller, it’s worth noting that nominal 10-year Treasury yields in 2011 were at their lowest official levels since recordkeeping began in 1871; the previous record low was set in January 1941 at 1.95%. Following that reading, the subsequent 10-year real return of long-term U.S. government bonds was -3.1% on an annualized basis, according to our calculations. Further, the theoretical upside of government bonds is truncated by today’s low yields. For example, even if 10-year U.S. yields fell immediately to parity with Japanese government bonds (which bear the world’s lowest yield of just 1%), the price upside would range in the neighborhood of just 8%.11

Exhibit 16

Credit Spreads are Still Way Above Average

Data as at January 13, 2012. Source: Corporate yield from Bloomberg, Treasury yield 1962 to current from Bloomberg, 1925 to 1961 from the U.S. Treasury, 1921 to 1924 from the National Bureau of Economic Research, 1919 to 1920 “Irrational Exuberance” Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005 by Robert J. Shiller. Moody’s BAA Corporate Bond Index reflects the average yield of constituent corporate bonds that have been given Moody’s BAA credit rating. Corporate bonds can receive ratings that range from a high of AAA to a low of C. Bonds given the BAA rating are considered as medium-grade obligations, meaning they are neither highly protected nor poorly secured. Bonds rated BAA and above are considered investment grade. Z-score is a measure of the distance in standard deviations of a sample from the mean.

Exhibit 17

History Suggests that the BAA-10 Year Spread
is Too High

(%)	Moody’s Corporate BAA Yield	Risk Free Rate (US 10 Year Treasury Yield)	Risk Premium (BAA-10 Year Yield)	Risk Premium % BAA Yield
Current	5.13	1.86	3.27	64%
Average	7.09	5.08	2.00	30%
Stdev	2.87	2.69	1.01	13%
Max	17.18	15.84	7.24	74%
Min	2.94	1.86	0.10	2%
Z-score	-0.7	-1.2	1.3	2.5

Data as at January 13, 2012. Source: Corporate yield from Bloomberg, Treasury yield 1962 to current from Bloomberg, 1925 to 1961 from the U.S. Treasury, 1921 to 1924 from the National Bureau of Economic Research, 1919 to 1920 “Irrational Exuberance” Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005 by Robert J. Shiller. See Exhibit 16 source for Moody’s BAA details.

Even more noteworthy is that there is an opportunity cost to holding government bonds at current levels, as opposed to moving up the risk spectrum, in our view. Using the Moody’s Corporate BAA as a proxy, credit spreads as measured against 10-year Treasury yields now stand at 1.3 standard deviations above their historical average (Exhibit 17).

Exhibit 18 also highlights another important point: the percentage of the overall yield attributable to the credit risk premium is now 64% of the total, versus a historical average of just 30%. Put another way, as nominal yields have fallen, most of the decline—to date—has been linked to a decline in the risk free rate, not necessarily spread compression. Our research shows this outcome has two implications. First, it appears that any meaningful upside beyond the coupon payment in today’s low rate environment is primarily linked to just spread compression, not a further reduction in the risk free rate. More importantly, though, if we do eventually get some mean reversion and bond yields do go back up, then there appears to be much more risk in the risk free rate moving higher than credit spreads widening substantially from current levels.

Exhibit 18

Credit Risk Premium Appears Outsized

Data as at January 13, 2012. Source: Corporate yield from Bloomberg, Treasury yield 1962 to current from Bloomberg, 1925 to 1961 from the U.S. Treasury, 1921 to 1924 from the National Bureau of Economic Research, 1919 to 1920 “Irrational Exuberance” Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005 by Robert J. Shiller.

A clear risk to our strategy is a significant global economic contraction, in which corporations’ robust balance sheets would come under siege. But we think this outcome is unlikely for several reasons. Inflation in China is falling—which should allow the Chinese government to become more accommodative in 2012—and we expect China to account for nearly one third of total global GDP growth in 201212. Second, we believe that the market does not fully appreciate how significant the European Central Bank’s recent refinancing program is for reducing contagion risks in Europe. Finally, home prices in the U.S. appear to be bottoming, and as such, our work suggests that the potential for a severe recession is low.

Summary

It’s hard work to construct and maintain a portfolio that actually achieves one’s investment objectives—especially in today’s environment. As we look towards 2012 and beyond, we believe that finding strategies that take advantage of outsized liquidity is the most sensible thing to do. At a time of low real rates—a time when central banks appear to have snuffed out many of the major tail risks—we suggest considering meaningful overweight positions in the “spicier” parts of the credit market. We propose increased allocations to real assets, though approach matters, and given the surge in demand for such assets, we believe, investors need to be judicious about identifying opportunities that actually deliver on their promise. Finally, while we are proponents of hedging strategies, our research and experience in using shorter-term equity put options leads us to eschew this strategy unless volatility appears understated and/or there is an under-appreciated event risk. Otherwise, we believe there may be more efficient ways to manage downside risks, including duration exposure, adhering to established trading ranges in the equity markets, and arbitrage of variant risk perceptions across asset classes.