A scenario-based approach to preparing for all outcomes in an uncertain world
This article appeared in Glacier Research’s Funds on Friday on 25 June 2021.
The values of assets in South Africa are largely determined by global forces, such as the prospects for economic growth and the risks of inflation. These are uncertain. Surprises – both good and bad – will affect asset values. There are several successful approaches followed by investment managers to managing the impact of these surprises and finding a balance between generating returns while mitigating risk. A scenario-based approach, which we’ll discuss in this article, has a long illustrious and proven career in corporate boardrooms all over the world. It enables executives to think about uncertainty and plan for outcomes they cannot control. We believe that this approach to risk management belongs at the core of clients’ investment portfolios, to add some form of stability in an uncertain world.
Investment managers exist to help investors meet their objectives.
For a pre-retirement investor, their objective is to generate sufficient returns on their savings to justify their decision to forego what they could have bought (and enjoyed consuming) today. For the post-retirement investor, their objective is to ensure that the capital accumulated through a lifetime of sacrifice will sustain their income requirements for as long as possible. In other words, the goal is to grow and protect savings.
Predictions are hard, especially about macroeconomic events and outcomes.
A potential source of return for an investment manager in the short run could well be correctly forecasting macroeconomic events. As one example, an investment manager correctly predicting the impact of a global pandemic on markets at the start of 2020 and the widespread disruption and decline in asset values that would follow. As another, an investment manager correctly predicting at the start of 2021 that the rand would appreciate. If they had acted on this view and tilted their portfolios accordingly, investors would have earned especially good returns. However, if the rand had depreciated these investors would have lost out on performance.
The challenge with focusing on predicting outcomes like this, albeit tempting when you see in hindsight just how good the returns can be, is that it is unlikely to be sustainable. We are just as likely to be wrong as often as we are right because the world is uncertain, and many futures are possible. An unexpected future can therefore potentially derail an investors’ outcome.
If we accept that the future is made up of many potential scenarios, we must then focus on how to avoid adverse outcomes for client portfolios.
Clem Sunter, South Africa’s pre-eminent futurologist always maps out potential outcomes by focusing on the main uncertainties that will affect outcomes. Having identified global growth and inflation as two of the principal variables affecting asset values, we’ve followed Sunter’s approach and constructed a matrix, as shown in Figure 1 below. Each one of the four squares represents a potential future that corresponds to an inflation/growth outcome.
Figure 1: Risk matrix
Source: Denker Capital
The black circle in the middle of the matrix represents market expectations that correspond with current asset values. Growth can either be surprisingly strong or surprisingly weak while inflation can also surprise us and markets, either positively or negatively. The purpose of this exercise is not to predict whether growth/inflation is likely to be higher/lower than expected, but to understand the risks to asset values should this world – one with inflation/growth better/worse than expected – turn out to be the actual future. Understanding the risks in the different scenarios helps us to construct a portfolio of assets that will help investors achieve their financial objectives regardless of the growth/inflation outcome.
To make this practical with an example:
At the end of March, US bond option markets priced in a roughly 30% chance that US inflation would, over the next five years, exceed 3%. The market’s base case for US inflation is still relatively benign, but inflation concerns are mounting – the market is nervous that less benign outcomes are becoming more likely (even though the central estimates remain moderate). What happens to a South African portfolio if this risk comes to pass? As an investment manager in the SA -Multi-asset – Low equity space, I am asking myself if I (and our investors) will be able to sleep at night if the unexpected happens.
The US economy last experienced sustained high inflation in the 1970s and early 1980s. The rest of the world, with their pegged exchange rates, imported this inflation to domestic markets. Asset valuations reflected the economic uncertainty – interest rates were high and market valuations were low. The unexpected rise in inflation substantially destroyed the real value of fixed interest securities. The subsequent taming of inflation resulted in a 30-year bull market for developed market fixed interest securities.
Fast forward to today and we must ask ourselves a few questions about inflation.
How will a future in which US inflation turns out much higher than 3% affect US asset values (including the US dollar) and how will South African growth, inflation and asset values be affected? Will our previous experience be a relevant and useful guide to the future? Or does the flexible exchange rate regime, a central bank that targets domestic inflation and potential for economic reform, result in a different trajectory? Can the South African economy and asset markets decouple from the global forces that would cause such an inflation shock? Would the US dollar remain a reliable safe-haven asset? Or, would a highly inflationary US economy rob a South African investor of a valuable diversification asset? If so, what is the appropriate response for an investment manager?
What of a world where the US economy enters secular stagnation – slower growth and lower inflation than is widely expected, which is what US economist Larry Summers often warns us about?
What happens if US growth disappoints for an extended length of time? Would asset values, commodity prices, the rand exchange rate and domestic growth weather such a storm? What would be the impact of this on our efforts to achieve structural reform? Can an investment manager be confident that investors who are reliant on stable capital would be protected in this scenario?
Can anyone know which of these inflation/stagflation scenarios is more likely than the other?
There is no easy way for investors to assess if their investment manager is managing their money with these risks in mind. It is impossible to know (or plan for) all potential futures. We also will not know what could have been and what returns were sacrificed to protect against the unknown, or which returns were earned through careful risk management. We can only observe after the fact, what returns a portfolio earned from a particular set of outcomes.
The past provides a glimpse into investment manager philosophies.
Investment managers that take careful account of this uncertainty and the risks of potential macroeconomic outcomes should have less variable returns because of their inherent diversification. The ‘box and whiskers’ chart below illustrates this point. Using some of the funds in the SA – Multi-asset – Low equity category to illustrate different outcomes, the top and bottom of the extended lines (whiskers) represent the single best and worst monthly fund returns. The box represents the range of second and third quartile monthly returns delivered by the different funds. The ideal would be very short bottom whisker (limited large losses), a tall top whisker (a number of very good months) and a box that is slightly higher than competitors – i.e. compounding better than peer returns consistently. This is tough to achieve. As a first approximation of good risk management practices – a short bottom whisker and a relatively higher bottom end of the box is a good outcome to observe.
Figure 2: Returns of selected funds in the SA – Multi-asset – Low equity category over four years.
Source: ThomsonReuters, Lipper, 30 May 2021
Thinking about and planning for uncertainty is a proven and worthwhile approach in business, and a cornerstone of investing to help investors achieve their objectives.
When managing a portfolio to alleviate the impact of uncertainty, an investment manager may well forego potential returns, but they will also be limiting the impact of potential negative outcomes. We believe there are benefits to proactively applying the scenario-based approach when we manage investors’ money in the multi-asset category.
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