The Great Recession that continues to rattle global stock markets has fundamentally changed the asset allocation rule book for institutional investors, and those who fail to adapt do so at their clients’ peril, say leading financial experts.
“The dislocations of the financial crisis have a permanent component,” Carmen Reinhart, economics professor at the University of Maryland, tells Institutional Investor. “If you compare the decade after a crisis to the one that preceded it, you find lower GDP growth, higher unemployment and lower real housing prices. Leveraging unwinds.”
Reinhart, best known for her book This Time Is Different, a history of financial crises written with Harvard University economics professor Kenneth Rogoff, has extended her analysis of a crisis to the ten years preceding it and the ten years that follow. The resulting report, “After the Fall,” written with Reinhart’s husband, Vincent Reinhart, resident scholar at the American Enterprise Institute for Public Policy Research in Washington, and unveiled at the Federal Reserve Bank of Kansas City’s economic conference in Jackson Hole, Wyoming, in late August, contends that financial crises have unusual aftereffects that last ten years.
Shrinking household and bank balance sheets, as well as disruptions in credit markets, leave a permanent mark on growth and employment, Reinhart says; economic trajectories change after a financial crisis, and the aftermath doesn’t last a few years but closer to a decade. GDP growth drags significantly, unemployment continues, and median housing prices remain 15 to 20 percent lower during the 11 years after a crisis, Reinhart found. “I know it’s not uplifting, but at Jackson Hole the import of the message was taken home,” she says. “People were not saying we were off our rockers.”
Edward Keon Jr. certainly wasn’t. “The impact of the crisis has changed the way we do things,” says the portfolio manager and head of asset allocation at Prudential’s Quantitative Management Associates. The primary effect has been on investors’ appetite for risk. Keon’s model found there was a regime shift by investors resulting in lower risk tolerance and reducing equity valuation. “We have adjusted our tactical asset allocations as a result,” he says. Keon is neutral or underweight U.S. equities because of investors’ pronounced risk aversion and overweight emerging markets because of their favorable demographics compared with Western economies, which have hefty pension entitlements.
Another way of incorporating this increased risk aversion is to allocate more capital to high-yield bonds. Says Keon, “Investors are favoring fixed income, and high yield has the potential for attractive returns compared to the riskier parts of the stock market.”
But not all investors agree with Reinhart’s thesis that this time things are different. Jeff Applegate, CIO of Morgan Stanley Smith Barney, believes this is just another business cycle. “Our methods for reaching an overweighting of an asset class haven’t changed,” he says. “Though the downturn was unusually severe, the way markets have recovered has been quite normal, cyclically. It is comparable to prior business cycles.”
In 2008, Applegate believed that the economy would start improving by April 2009, so he increased his allocations to small-caps, which tend to strongly reflect economic cycles. This proved to be the correct call. In June of this year, having captured the excess returns in the sector, he reduced his allocation to small-caps and added to emerging equities. “Fundamentally, we don’t have a different assessment today than in April 2009,” says Applegate.
Striking a postcrisis middle ground is ING Asset Management’s Paul Zemsky, who agrees that this time around a few things have changed. “The size of our tactical moves is smaller because the tail risk is higher,” he notes, adding that the dispersion of potential economic outcomes means uncertainty is higher than ever. A double dip is possible but not likely, he says. “In general, we have been overweight equities with the belief that the fundamentals are still improving.”
Not everyone is convinced the stock market will come back. “You had a bubble, and bubbles don’t come back,” says Stanley Kon, director of research for fixed-income manager Smith Breeden Associates, based in Durham, North Carolina. “We have experienced many structural changes in the economy, and because of these structural differences, asset allocation must change as well.” He argues for a greater focus on alpha versus beta risk budgeting.
Reinhart, the most outspoken believer in the new normal, begs off making precise allocation recommendations. “There are sectors that can thrive in low growth,” she says, “and sectors that need a boom.”
