In recent times, it has become increasingly instructive to look at the world through a “VUCA” lens. The term, which was coined by the U.S. military, describes an environment in terms of Volatility, Uncertainty, Complexity and Ambiguity.
In 2017 we have experienced a bull market in global equities, resulting in new highs for many indices, while levels of volatility remain low by historical standards. However, while this may persist in the shorter term, investors probably cannot rely on this benign investment environment continuing indefinitely. So what challenges do investors face in 2018 and beyond?
In 2017, the correlation between assets has fallen, as has volatility. The question is how long volatility might remain low. Risk models are useful tools for gauging the effects of market changes on asset prices, but caution is certainly needed whenever markets shift from a low to high volatility regime. As volatility picks up, asset managers could break their risk budgets and be forced to de-risk at the wrong time. We would emphasize that there is no single and “correct” measure of risk.
Several potential flashpoints could send shockwaves through markets. We see political risk across many parts of the globe, all of which would have an impact on markets. Not all risks that we identify would necessarily have negative market outcomes. In the U.S., for example, reform to fiscal policy could potentially result in an upside market surprise. In Catalonia, meanwhile, there are many ways the uncertainty around independence could play out.
Some geopolitical shocks would be only a short-term disturbance, but others may represent a paradigm shift - a ”new normal” for which we need to carefully examine the effects across investment markets.
Investors are faced with complexity as they strive to meet investment objectives in an environment of compressed returns. Developed market equities and bonds delivered returns during the past 25 years that were well above long-term averages. The forecast for investment markets over the next ten years looks potentially less healthy than it has been in the past 25 years. Asset managers need to help investors select strategies to manage this complexity, and everyone may have to work much harder to generate compelling returns in such an environment. This creates the need to look into alternative return drivers and more complex solutions.
Investment options have increased – solutions range from active to passive, public to private investment, and from single strategies to risk-rated multi-asset portfolios. Smart beta and enhanced index investing have blurred the distinction between active and passive. In an outcome-focused investment approach, the ways in which alpha and beta are obtained may be less important than focusing on how they can be combined innovatively to meet client needs.
Central banks will be confronted with difficult decisions in the coming year. Though growth has strengthened, global inflation remains relatively weak and the desire by the central banks to normalize balance sheets may have unpredictable effects on markets. We believe major economies will take time to recover from past crises and for the erosion of spare labor capacity to be felt. Inflationary pressures therefore seem unlikely to build quickly enough to force central banks into such rapid policy tightening that would threaten economic expansion.
For investors, there is a lot riding on central banks getting things right.
For investors, there is a lot riding on central banks getting things right. The annualized flow of central banks’ asset purchases will decline by US$2 trillion by the end of 2018. While this should put some upward pressure on global interest rates, the impact on yields is unclear, partly because unwinding these policies has not been tried before. This matters because interest rates are a key input to most pricing models for risk assets which discount future cash flows, as well as when valuing liabilities. Moreover, the very composition of the U.S. Federal Reserve itself is ambiguous from 2018, with several positions potentially needing to be filled.
So, Volatility is low but could rise, geopolitics is Uncertain, our clients’ needs are Complex, and monetary policy is Ambiguous.
To deal with this VUCA environment, we as an asset management industry need to build resilient portfolios. We can do this by understanding assets and risks – and by embedding environmental, social and governance (ESG) considerations into our investment process.
As asset managers, we need to offer a broad range of investment capabilities so investors can diversify their portfolios. Our risk management processes need to be robust in all market conditions. This should include pragmatic scenario analysis incorporating qualitative and quantitative skills. To create resilient portfolios, we must thoroughly understand the underlying assets we invest in and the risks inherent in these. This comes through fundamental research.
Finally, we as an industry must adapt and enhance our investment process through the innovative use of data and technology and help build resilience in the assets we invest in through our wider ESG proposition. As the stewards of our clients’ assets and as active managers, we must ensure that the businesses we invest in are properly governed through engaging with company management, and taking up our voting rights at company annual general meetings (AGMs). Incorporating ESG into our investment process improves our level of understanding of the assets we invest in and of unrewarded risk.
Investors will continue to face uncertainties as we move into 2018. The asset management industry needs to build resilient portfolios to deal with a VUCA world. Diversification across the wider range of investment options that we now have will be crucial too. Asset managers need to have their own high-quality capabilities to assess the capabilities of others and to combine all these skills to build better outcomes for clients.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
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