Changes in Global Investment Portfolio

Going from capital market expectations to asset allocation requires analysis and interpretation. In order to improve performance and client-advisor relationships, it is essential to translate and identify the fundamental factors affecting portfolios and asset allocations.

Macro-based Recommendations

Macro recommendations involve the ‘high level’ aspects or the broadest view possible of a portfolio. Looking at what is driving global economic growth can help inform the process. In addition, analysts should consider the countries that are becoming more or less competitive and question the causes of such shifts. Lastly, they should interrogate the stages of the business cycle various countries are in. These questions can help analysts make adjustments to:

• Equity vs. fixed income.
• Specific country investments.
• Credit ratings within the fixed-income portfolio.
• Currency exposure.
• Positioning on the yield curve.

Trend Growth

Higher trend growth rates would favor increasing equity and real estate portfolio weightings. Conversely, outstanding bonds would be under downward pricing pressure as more fixed-income instruments with more competitive rates are issued.

Global Integration

The Singer-Terhaar model states that the required return should decline when a market becomes more globally integrated. A decline in required return should come with a shift away from markets that have already undergone much of their integration (developed markets) towards markets that are still making a global transition (emerging or developing markets).

Phases of the Business Cycle

It is desirable to increase allocations to equity before an economic expansion begins. This typically correlates with the ‘trough’ of the business cycle. It is also desirable to decrease fixed-income exposures as inflation and interest rates may be ready to rise.

The opposite would be confirmed when the economy has peaked, and a contraction is imminent. Equities should be sold in favor of fixed-income instruments, likely to benefit from falling inflation and interest rates.

While descriptive of general trends, it is essential to remember that business cycles may vary from country to country in terms of length and intensity. An analyst should always perform due diligence to understand the unique situation.

Monetary and Fiscal Policies

According to the efficient market hypothesis, asset prices may be inclusive of monetary and fiscal policy decisions. An opportune moment to analyze these policy changes for maximum impact would be during structural policy changes (i.e., an overhaul of the tax code). Alternatively, these analyses can be run when extreme policy decisions are made or have not had their intended effect (i.e., stimulus sent to a business, but they continue suffering).

Current Account Balances

An expanding current account deficit will often put upward pressure on actual required returns to entice more savings in the deficit country and attract the increased flow of capital from abroad required to fund the deficit.

An expanding current account surplus will, in general, require the opposite to reduce excess savings. Analysts should consider reallocating from countries with rising current account deficits to those with rising account surpluses.

Capital Accounts and Currencies

Capital accounts tend to be the primary catalyst for relative currency valuations. When investors perceive a higher risk-adjusted return on the portfolio of assets in one country, they will inevitably want to switch over. The analyst needs to separate the returns from the currency appreciation and the returns from the underlying assets. When parsed out and treated separately, an analyst may correctly decipher the cause of the returns and ensure that they come from the underlying quality of the investment itself, not just the demand for the currency in which the underlying investment was denominated.

Quantifying the Views

While not always explicitly mandated in the governing documents of a portfolio, a general approach to quantifying views based on macro analyses should follow the following steps:

• Step 1: Estimate the VCV matrix for all asset classes.
• Step 2: Use the Singer–Terhaar model with VCV matrixes. Determine equilibrium expected returns for all asset classes.
• Step 3: Use the Grinold–Kroner model to estimate returns for equity markets.
• Step 4: Use the building block approach to estimate expected bond returns.
• Step 5: Establish directional views on currencies relative to the portfolio’s base currency.
• Step 6: Incorporate a currency component into expected returns for equities and bonds.
• Step 7: Use the Black–Litterman framework to combine equilibrium expected returns from Step 2 with the expected returns determined in Steps 3–6.

Question

Higher rates of trend growth are least likely to favor increasing portfolio weightings in:

1. Equity.
2. Real estate.
3. Fixed income.

Solution

The correct answer is C:

A higher trend growth rate means that the economy will likely be on an upswing. This underlies growth in corporate profits, hiring, rental incomes, interest rates, and inflation.

A and B are incorrect. Bonds are more negatively correlated with the first two factors than either stocks and/or real estate investments, meaning they will likely experience capital losses in times of trend growth rate. In contrast, equity and real estate will receive a boost.

Reading 2: Capital Market Expectations – Part 2 (Forecasting Asset Class Returns)

Los 2 (h) Recommend and justify changes in the component weights of a global investment portfolio based on trends and expected changes in macroeconomic factors