Академический Документы
Профессиональный Документы
Культура Документы
FOREWORD
John Maynard Keynes wrote in the preface to his seminal work The General Theory of Employment, Interest, and Money, published in 1936, that the difficulty lies, not in the new ideas, but in escaping from the old ones. The systemic crisis shaking the global financial edifice to its foundations for over four years now has led economic, political and financial policymakers to explore, sometimes against their better judgement, completely new avenues as they look for solutions to problems that have ramifications stretching way beyond any that have had to be coped with since the Great Depression. New approaches to monetary policy, such as quantitative easing or nominal GDP targeting, are still in their early days. As classic Keynesian reflationary strategies have become inoperable as government have run up mountains of debt, chances may have to be taken with new ideas to revitalise flagging economies, boosting competitiveness by focusing more intently on innovation and entrepreneurship. Upheavals on financial markets, coupled with a structural tightening of correlations between asset classes, call for innovative concepts to improve asset allocation. With this purpose in mind, Pictet Wealth Management adopted a pragmatic and realistic approach, striving to pinpoint the most likely ways in which the changed economic and financial world of today will have to innovate to kick-start a fresh cycle of growth. Our approach has been geared to identifying financial tools best suited to delivering the most effective possible combination for generating returns and controlling risk in clients portfolios. As part of our ongoing process of blending the most progressive, state-of-the-art academic research with the best practice of recognised investment practitioners, we held the annual seminar of our Strategy Committee on 8 October on the shores of Lake Geneva. This brought together our in-house investment experts with outside specialists world renowned in their fields of expertise. In this, the second, annual issue of Perspectives Special Edition, we have presented the most relevant findings that emerged from this seminar. The document is divided into two sections. The first outlines how we have strengthened the process we use to allocate assets in portfolios by integrating the pioneering approach of making selections based on risk factors. In this respect, we have focused primarily here on presenting long-term implications for our strategic allocation, i.e. for an investment horizon of ten years. The second part has five articles on the main topics covered by our external contributors. The subjects discussed range from innovation in monetary policy to the latest developments in capturing risk. In addition, we have provided an insight into a topic experiencing rapid development: behavioural finance. We trust this second edition of our annual Perspectives Special Edition will provide much food for thought, maybe even answering some of the questions you might have about financial and macroeconomic conditions that are in such a state of flux at present, demanding ever more advanced and up-to-date know-how. To close, I would just like to take advantage of this opportunity to pass on to you all my best wishes for 2013. Philippe Bertherat Partner, Pictet & Cie
CONTENTS
23 editorial - sECULAR OUTLOOK THE DELEVERAGING CYCLE IS ADVANCING IN DIFFERENt WAYS Yves Bonzon, Chief Investment Ofcer, Pictet & Cie
46 79
central Banks
1416 MONETARY POLICY IS EVOLVING Frederic Mishkin, Former Member of the Board of Governors of the Federal Reserve System Alfred Lerner Professor of Banking and Financial Institutions Graduate School of Business, Columbia University
2022 A JOURNEY INTO THE UNKNOWN Jim Reid, Managing Director Global Head of the Fundamental Credit Strategy Group, Deutsche Bank
2426 PERCEPTIONS, BELIEFS AND ACTIONS Olivier Oullier, Professor of behavioural and brain sciences, Aix-Marseille University Strategic adviser to governments and private institutions
2829 Viewpoints with Antti Ilmanen, Managing Director, AQR Capital Management (Europe) LLP
inVestMent ManaGeMent
3031 Viewpoints with Yves Choueifaty, President and Chief Investment Ofcer, TOBAM
With the decision of the Federal Reserve to continue its policy of asset purchases (QE) as long as US employment remains depressed, we can say that ination targeting as a tool of monetary policy, introduced in the early 80s under Paul Volcker, has nally been buried.
THe deleVeraGinG cYcle is adVancinG in different waYs
Yves Bonzon Chief Investment Ofcer, Pictet & Cie
Four years after the collapse of Lehman Brothers, the likely economic and financial trends that we described for the first time in our Secular Outlook in late 2009 have begun to emerge more clearly. We said then that the bursting of a credit bubble gives rise to the structural risk of deflation in an economy, if excess debt is liquidated in a disorderly manner. Faced with such a possibility, governments respond more or less skilfully by employing one or more of three approaches: 1) transfers from creditors to debtors through financial repression; 2) debt restructuring (by rescheduling and writing off); and 3) printing money (monetisation). The first two approaches are deflationary and the third potentially inflationary. The challenge is to apply these three remedies in the right proportions, so as to offset deflationary forces without tipping into hyperinflation. In all cases, the state transfers wealth from creditors to debtors. A major consequence for investors of transferring wealth by these means is that safe assets are valued at levels implying negative returns after inflation, as Christophe Donay explains on page 13 of this publication. The negative real yield on US Treasury bonds on maturities up to 20 years is a symptom of depression and classic financial repression. Meanwhile, assets perceived as more risky, in most cases real assets, and in particular stocks, are valued at levels implying positive returns after inflation. However, macroeconomic risks will remain very high as long as the deleveraging cycle is incomplete. During this phase, the volatility of real assets will be very high, to the point where few investors are likely to have the resilience to absorb the ups and especially the downs that they encounter.
SECULAR TRENDS
1960 Bretton Woods ECONOMIC ENVIRONMENT 1970 Floating FX Oil shock Ination 1980 Disination Plaza Arbitrage 1990 Fall of Berlin Wall Globalisation Internet E-trading 2000 EMU Great global imbalance Chinas rise Structured credit 2010 Managed Western deleveraging Nominal GDP and asset price targeting EM discrimination EUR 2.0
Risk-factor-based TAA and SAA Developed quality blue chips Gold (until 2015) EM debt
De la Grande Modration la Grande DiVerGence: facteur de Volatilit dans les MarcHs financiers
Innovation a word that is frequently bandied about and a phenomenon that is often underestimated and ultimately poorly understood. Mankind has the natural tendency to regard technical or economic hurdles placed in its path as unconquerable. Worse yet, such obstacles are viewed as only capable of leading to an inevitable downturn or even disaster. That is the pessimistic version of the history of mankind. The amazing progress made over the last few centuries should teach us that the boundaries and barriers we are confronted by today will be pushed further back in the future. Innovation plays a crucial role in helping us to reach an understanding of the long-term dynamics driving economies. In recent centuries, economies have expanded thanks to significant breakthroughs on the innovation front. These have forced back the bounds of the unimaginable. This limitation/innovation process generates much greater dynamism when the economic climate encourages risk-taking. Innovation is essential for understanding clearly the trajectories economies in the developed world might take over the next ten years. Innovation also has a magical quality in that it can conjure up growth drivers for economies where they do not appear to exist. This leads us to the conclusion that sustainably strong growth cannot be generated without innovations. The current
sluggish state of economic growth in the developed world could be largely attributable to the absence of any significant innovations at present. Innovation can take two main forms In macroeconomic analysis, innovation can take one of two forms: transient or radical. Transient innovation will tend to benefit one particular sector or its boost to growth will only be short-lived. For instance, the arrival of the iPhone or iPad has benefited Apple and its sub-contractors. By no stretch of the imagination has this particular innovation kick-started growth in the US or significantly brought the countrys jobless rate down. Whenever a new iPhone generation is launched, US retail sales experience a bounce and growth goes up a gear. The impact on economic growth is tangible, but it does not last long. The launch of the iPhone4 added half a percentage point to US GDP growth in one quarter before the effect evaporated in the subsequent quarter. In contrast, a radical innovation will spread through all layers of the economy. Its impact will be both unmistakable and permanent. It will emerge as a growth driver boosting the whole of the economy concerned. Lets take an historical example. The advent of the railways in the 19th century led to huge investment
GrowtH, inflation and fiscal/MonetarY-policY sHocks oVer tHe last four decades
Ination Decade Growth Fiscal Policy Monetary Policy End Beginning End Beginning End Beginning End Beginning
1970s Moderate High High Low Keynesianism Keynesianism Low interest Low interest rates rates 1980s Very Low Low High Keynesianism Supply side Low interest High rates Ination targeting
Endogenous Ination Ination 1990s Low Low Low High Endogenous growth growth targeting targeting 2000s Low Low Low Deep Endogenous Keynesianism Ination Ination Recession growth targeting targeting 2010s Low Moderate? Moderate High? Keynesianism Supply side? Ination targeting
Source: Pictet & Cie, AA&MR
break scenario we favour would see growth quickening rapidly over the next ten years accompanied by a more gentle acceleration in the rate of inflation. Forthcoming shifts in monetary/fiscal policy Since the early 1980s, monetary policies throughout major developed nations had been focusing on inflation, evolving in the early 1990s into specific inflation targeting, but the sub-prime crisis in late 2008 prompted central banks to take pragmatic emergency steps. Inflation targeting gave way to quantitative easing. This particular approach to monetary policy cannot be regarded as a transient phenomenon though: after all, its primary objective has, purely and simply, been to prevent the whole financial edifice from crumbling. We will see a shift away from quantitative easing over the coming years. But what will the new monetary policy look like? The answer to this question is self-evidently unclear. However, the persistence of below-potential economic growth, high unemployment and high debt levels simultaneously in the developed world do seem to point to two possible paths: firstly, a return to virtuous growth would help to mop up unemployment and provide a virtuous route to paying down all the accumulated debt; secondly, quickening inflation, ideally to a limited extent, would also help to lighten the debt burden. Taking those two factors into consideration, monetary-policy stances geared to nominal GDP targeting or nominal income targeting must be regarded as serious candidates. The implications for the major asset classes i.e. accelerating growth and/or inflation to a limited degree, i.e. not exceeding 4%-5% p.a. would be positive for equities, but very negative for sovereign bonds regarded as the safest of havens (Bunds and US Treasuries) and positive for peripheral eurozone government bonds (Spain, Portugal, etc.).
Since 2008, several, if not all, developed countries have been pursuing a Keynesian fiscal policy mix. This has betrayed its limitations. To start with, governments financing capabilities are close to being exhausted. Secondly, the spending spree by governments has failed to deliver virtuous economic growth, as stubbornly high jobless rates show. Worse still, once government spending is reined back, growth immediately slows and drops permanently below potential. In conclusion, innovation shocks are frequent enough to be a prospect when the forecasting time-frame is long. The time-frame chosen for estimating expected returns from asset classes is ten years. We have demonstrated the chances of a shock equating to a shift in the style of monetary and/or fiscal policy, or a shift in the growth and/or inflation regime, are high. We believe that, among all the errors and approximations that forecasting over the long run involves, one particular one must be avoided: the mistake of assuming that the environment of tomorrow along with its underlying economic mechanisms will be the same as those of today. This has informed our efforts to integrate the notion of a trend-break and regime change into our approach to allocating assets. *A Kondratiev Cycle, also known as the long-wave cycle, is a cycle lasting 40 to 60 years. A purely nancial explanation is given for this: during the upcycle when the economy is expanding, surplus investment pushes interest rates up; the increased cost of borrowing, in turn, triggers an economic downswing, eventually leading to the cycle being rebooted and starting all over again.
Gold price
1,800 QE 1 QE 2 QE 3
1,600
1,400
Gold (USD/oz)
1,200
1,000
800
10
THree Main reGiMes for inflation and tHree reGiMes for econoMic GrowtH
Sluggish growth Standard growth Innovation shock Gr=1% Gr= 2.5% Gr= 4% Disination = 0.5% Standard ination = 2% Deationary Unlikely environment Unrealistic
New normal
Goldilocks
Golden growth
11
US US Germany
US 2.8% 2.8% 2.8% EU 2.2% 2.8% 2.7% US 7.0% 7.7% 7.5% EU 7.3% 8.0% 7.8%
Private Equity Real Estate (Monte Rosa) Private Equity (Monte Rosa) *
* Monte Rosa 2011 expected annualised net IRR 15%
12
EXpected returns froM asset classes witH a return to standard GrowtH (Scenario II)
Central scenario with Starting regime Ending regime Annualised Expected Return innovation shock on growth 2013 2015 2016 2022 2013 2022 Cash US 0.0% 3.8% 2.6% Government Bonds Corporate Bonds IG Corporate Bonds HY Equities US 2.7% 8.1% 6.5% EU 3.3% 9.2% 7.4% Asia ex-Japan 3.0% 7.4% 6.1% - - 8.0% - - 15.0%
Sources: Pictet & Cie, AA&MR
US Germany
US 2.8% 2.8% 2.8% EU 2.2% 2.6% 2.5% US 7.0% 7.4% 7.3% EU 7.3% 7.7% 7.6%
Private Equity Real Estate (Monte Rosa) Private Equity (Monte Rosa) *
* Monte Rosa 2011 expected annualised net IRR 15%
Scenario II: no shock, but a process of normalisation Under this scenario, we have worked on the assumption that, gradually, US economic growth would revert to its potential rate. Such a scenario is very close to the mean-reversion scenario cited in the introduction to this article. We have not gone into detail about how our estimates of expected returns have been calculated as this is not our aim here. We have adopted the premise that the trajectory of expected returns on asset classes takes on the shape of the economic cycle. We have summarised the findings in the tables. Returns on asset classes: risk assets hold the better hand We can summarise the main conclusions concerning our estimated expected returns on asset classes in four points: In both the scenarios, risk-based assets look to offer the best return prospects. Expected returns from equities in developed markets would be above their historical average if an innovation shock occurs: 10% on average vs. 7%. If there were an innovation shock, equities in the developed world would clearly outperform emergingmarket equities even though growth in the emerging world would be faster. There are two reasons for this. Firstly, the conversion of economic growth into
corporate earnings is still less efficient for companies in the emerging world than in developed nations: nominal GDP growth/earnings growth elasticity is 1.4X for businesses in the developed world compared to 0.8X for those in emerging countries. Secondly, companies in the developed world tend to have increasingly broad international exposure this allows them to lock on not just to economic growth being generated in their own backyards, but also to global economic growth to boost turnover and profitability. Sovereign bonds issued by countries perceived as being safe havens since 2008 (Germany and the US) today offer investors pitifully low interest rates. After generating an annualised total return of 8.2% since 1974, annual returns on US Treasury bonds would work out at between just 0.8% and 1.0% depending on the regime. Sovereign bonds would be likely to underperform equities. The same goes for corporate bonds. We, therefore, see a likely relative reversal of fortunes for asset classes. Corporate bonds on developed markets would struggle on account of both very low interest rates and historically narrow credit spreads. Expected annualised returns from investment-grade corporates are estimated at 2.8% for both the innovation shock and normalisation scenarios.
13
CENTRAL BANKS
The basic paradigm of central banking has been that, in the words of Milton Friedman, inflation is a monetary phenomenon and that central bankers could control inflation. While they worried about fiscal issues, they always felt that those would be taken care of by governments in advanced economies and it was really only a problem in emerging markets where governments could not get their act together. The role of central banks was to focus on controlling inflation and not to worry about unsustainable debtto-GDP levels what is called fiscal dominance. A second central banking tenet was that monetary policy did not have to think about financial stability issues. It was concerned about financial stability, because if things blew up, that could be costly in terms of government bailouts or a big hit to the economy. But financial stability was the responsibility of the regulators. The objective of central bankers was to use monetary policy to control inflation, only secondarily worrying about business cycles and output.
These two ways of thinking led to the framework of flexible inflation targeting used by central bankers in advanced countries. The key is to ground inflation expectations over the long run with numbers say, 2% per annum. Then flexibility may be applied in the short run to deal with business cycles, being careful not to undermine low inflation expectations. However, the financial crisis has shown that these underlying assumptions of central banking practice are no longer valid, requiring a rethink to address new challenges. The first challenge is the issue of what we call the zero lower band. It is clear that nominal interest rates cannot fall much below zero, because people can just stuff their cash under their mattresses or in safe-deposit boxes. When the floor of zero nominal interest rates is reached, central banks must turn to non-conventional policy measures. The second challenge is that financial crises impose very high costs of cleaning up after them and restoring
14
financial stability can undermine what central bankers are trying to do with monetary policy. Furthermore, central banks may contribute to financial crises by creating an environment of price and output stability, as in the Great Moderation before the financial crisis. The stability at the time led to risk-taking because people underestimated the degree of risk. Worse, when interest rates are very low, people take excessive risks in the search for yield. And the third challenge is that monetary policy may end up being inflationary when central banks find themselves operating in a framework of fiscal dominance. If the fiscal authorities fail to reduce debt levels to a sustainable level, the central bank faces only two policy options, neither of which is palatable: They can bail out the government by monetising (purchasing) the debt which creates a highly inflationary environment. They can stand tough and refuse to monetise the debt. However, that would increase the likeli hood of default which could push up interest rates to fund the debt making it harder to reduce the deficit. So what does all this mean for central banking? The first issue is to deal with the zero lower bound, which means that the only way to pursue expansionary monetary policy now is through non-conventional policy measures. These can involve lending programmes providing credit in chosen markets as was done during the crisis. Or it can involve purchases of assets, frequently called quantitative easing (QE). Or there is management of expectations making a commitment to keep interest rates low for a very long time.
In the US, for example, inflation expectations have been very solidly grounded by the Federal Reserve, but core inflation is actually below the targeted 2% level because there is so much slack in the economy. So while inflation is low, the other element of the so-called dual mandate unemployment is not. Unemployment is very high and notwithstanding the recent drop, the labour markets do not look very strong. The Fed needed to do something more expansionary, hence three episodes of QE. The first was during the crisis, which was effectively fire-fighting rightly doing whatever it took to put out the fire. Once the crisis started to dissipate, the second episode of QE was still fire-fighting by purchasing long-term bonds, but there was no long-term strategy behind it. The Federal Reserve has also been managing expectations by saying it expected to keep the Federal Funds rate at zero until a specified date which has now been extended to mid-2015. The problem with that promise is that it depends on the state of the economy if it recovers more strongly than expected, rates may have to rise earlier. So the latest round of QE is open-ended: the Fed said it would keep buying assets until labour markets improved. The Fed may be moving towards nominal GDP targeting. This means committing to keep interest rates low until nominal GDP is growing adequately, even if for a short period of time inflation rises above 2%. The problem is, of course, to avoid undermining long-term inflation expectations and there will be a lot of discussion at the Fed about how to articulate this. The second issue for central banking is financial stability. Since a good monetary environment and potentially low interest rates can stimulate credit booms and credit bubbles, central bankers now recognise their re-
Central banks may contribute to nancial crises by creating an environment of price and output stability, as in the Great Moderation before the nancial crisis. The stability at the time led to risk-taking because people underestimated the degree of risk. Worse, when interest rates are very low, people take excessive risks in the search for yield.
15
CENTRAL BANKS
sponsibility for stability. Indeed, some people are now saying that the Feds interest rates are too low and will lead to a bubble. In practice, there is no expansion in credit at the moment because the economy is still deleveraging, but the Fed needs to monitor this while it is keeping interest rates at zero. That is another seachange in the way central banks have to operate and what they have to think about in terms of policy. The third issue is fiscal dominance. In the US, the politicians have yet to come to grips with the debt-to-GDP level, and that could lead to a rise in bond rates. Since the Fed recognises that a sharp rise could create a deep recession, it might decide to buy bonds to hold rates down. That would pose a very serious inflationary risk for the US if the fiscal authorities do not get their act together. Despite these fears, I am a typical American optimist. In previous periods of acute fiscal deficits, the Congress has eventually decided to carry out fundamental tax reforms and fix the problem. Despite the political divisions now, the problem is still solvable and I believe that the US political process will fix it. How long that takes is another issue, but I do not think fiscal dominance is likely to be a problem in the US. But turning to the eurozone and Europe, the fiscal dominance issue is much more scary. Everyone knows that one of the major flaws in the creation of the eurozone was the failure to think hard enough about the fiscal union and what to do about member states overspending. The no bailout rule is dead, but new fiscal rules are not going to solve the problem because it is easy to get around them, as with the old Growth and Stability Pact. But a second flaw in creating the euro was the absence of a banking union unlike in the US where states are involved in regulation but bailouts are done by the centre. When Greece goes down, there is no way that it can repay its debt and it will have to default. The issue then is how to stop the contagion spreading in Europe. The key is to make sure that the banks are healthy, that there is a resolution authority when banks collapse, that there is deposit insurance and that the governance problems are sorted out. The classic procedure for dealing with banking crises is to recapitalise the banks after establishing the true state of their balance sheets. That was done in the US, but the European stress tests were inadequate and the authorities avoided dealing with the issues. Instead, they focused on boosting capital ratios, but that deals with individual banks rather than the systemic problems. And since it is costly to raise capital, the banks will shrink their balance sheets by selling assets, making things worse for other banks and reducing lending which hits economic growth. It has been remarkable to watch this slow-motion train wreck for the past couple of years, and the contagion problem could be a nightmare if Greece goes under. In practice, I think that Europe will muddle through because the European Central Bank will do whatever it takes to deal with the crisis. The ECB has said it is willing to buy sovereign debt in countries facing debt problems through what are called Outright Monetary Transactions (OMT). The pressure on the ECB to monetise the debt will continue, with consequences for inflation. There is one hope, however, which is that they actually get their act together and create a proper fiscal union something that Brazil achieved when it reined in the spending of the states. But we have not seen a lot of progress along these lines yet in Europe, so I cannot say that there is a very high probability of this happening.
The Fed may be moving towards nominal GDP targeting. This means committing to keep interest rates low until nominal GDP is growing adequately, even if for a short period of time ination rises above 2%. The problem is, of course, to avoid undermining long-term ination expectations.
16
17
18
19
Jim Reid Managing Director Global Head of the Fundamental Credit Strategy Group Deutsche Bank
In this presentation, I want to discuss the latest edition of a report that I write every year which looks back at the history of financial markets in an attempt to understand what we can learn about them and asset price performance that will help us in the future. This years report was called A Journey into the Unknown, reflecting the fact that while economic history has been invaluable in this crisis, several of the key economic and financial variables are at levels never seen before. This is a giant experiment, effectively: we are all lab rats in todays global economy. First, interest rates. The longest time series of shortterm interest rates I can find is for UK base rate, which goes back to 1694 when the Bank of England was created. The UK has been through a lot in that 318-year history, with the industrial revolution, manias, panics, bubbles, depressions and wars. Yet base rate had never fallen below 2% until the recent financial crisis, and it has now been at 0.5% for more than three years.
Something similar is true of other advanced economies: over the last 150 years, base rates for the G7 countries, Switzerland and Spain have not been much below 3% until recently. Now, rates across those nine big economies have been hovering at around 0.5% for the last three years or so. Never before in history have so many countries had base rates so low for so many years with no sign that they are going to rise soon. Moving further up the yield curve, something similar has happened with Dutch 10-year government bonds. With nearly 500 years of data available, we can see that yields reached an all-time low last summer. The same is true for US 10-year Treasuries, which have reached record lows in the 220-year history that I have data for. Yet government debt is pushing to levels where history tells us that sovereign crises often occur. Carmen Reinhart and Kenneth Rogoffs seminal study three years ago suggested that, once a governments debt
20
1'000
100
10
1 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010
Source: Deutsche Bank, GFD
rises above 90% of gross domestic product, the economy tends not to grow out of it without financial repression, inflation, devaluation or default. Today, although many developed economies have debt levels above the 90% of GDP which history says often creates a problem, their bond yields are mostly at all-time lows. Second, fiscal deficits. Throughout US history, balanced budgets were the normal peacetime phenomenon until around 40 years ago. While big deficits accumulated during wars, fiscal balances very quickly moved back into surplus when peace returned. There is also evidence from other countries indicating that balanced budgets were the fundamental cornerstone of economic policy until the last 40 years. Since then, however, deficits have become the cornerstone of most countries economic policy. In the last 44 years, there have been only four surplus years in the US, which all occurred around 2000 when the Internet boom produced artificially high tax revenues. Apart from those four years, the US has been in deficit every year since 1968. Something similar has been true for other leading economies surpluses have been extraordinarily rare over the last 40 years. Now the sovereign debt crisis has hit and many countries are under pressure to cut their deficits. But most of their economies have been based on running deficits, and they will find it very difficult to restore balanced budgets. Every country that has cut its deficit so far has seen disappointing growth. Why did we move from balanced budgets to deficits? The turning point for me was in 1971 when the ties that bound currency systems to precious metals were broken. All through modern history, most currencies were backed by precious metals through a gold standard or, later, the Bretton Woods system. Before 1971, if
you had run a deficit for more than a couple of years, the likelihood was that the economy would be hit by outflows of gold reserves. Countries were disciplined into running cautious budgetary stances by the gold standard. When President Nixon suspended dollar convertibility to gold in 1971, we entered an era of freer currencies with nothing backing money. In a paper money system, running a budget deficit might hit the currency, but there is no loss of reserves. And that started a slow growth of beggar-thy-neighbour deficit accumulation, and beggar-thy-neighbour increases in the money supply. One interesting consequence was that the price of gold, more or less fixed until the 20th century, began to explode (see above chart). The biggest impact of this on financial markets was higher inflation. In the 700 years before the start of the 20th century, global prices rose very gradually, with as many down years for inflation as up years. Although there was a small upward long-term trend of inflation, deflation was as commonplace as inflation. But in the 20th century, there has not been a single negative year for global inflation since 1933. Again, I think that this is down to the gradual weakening of ties to precious metals to the point where they were completely abandoned in 1971. It is the conventional wisdom that inflation has been well controlled over the last 20 or 30 years, and that central banks have done a good job. But an analysis of 40 developed and emerging economies around the globe shows that very few countries have kept their average annual inflation rate below 5% since 1971. When most countries have had to deal with a problem such as a currency crisis, debt crisis or growth problem, invariably the inflation rate has been pushed higher in a freer currency world. So my realistic, pragmatic conclusion
Over the last 150 years, base rates for the G7 countries, Switzerland and Spain have not been much below 3% until recently. Now, rates across those nine big economies have been hovering at around 0.5% for the last three years or so. Never before in history have so many countries had base rates so low for so many years.
21
With a currency crisis, debt crisis or growth problem, invariably the ination rate has been pushed higher in a freer currency world. So my realistic, pragmatic conclusion is that in a world facing huge fundamental problems, it is inevitable that countries will print money until politics gets in the way or, more likely, ination surges.
22
23
Olivier Oullier Professor of behavioural and brain sciences, Aix-Marseille University Strategic adviser to governments and private institutions
At first sight, my profile may seem a bit unusual with respect to finance: I have a background in complex systems and then moved into psychology and neuroscience, with a particular emphasis on how we make decisions and what is going on in our brains. I work as an academic professor/researcher and I advise public and private institutions on how to develop prospective or crisis management strategies based on what we know about the human brain and behaviour dynamics. Many of the decisions we make every day in our jobs are related to things that we are used to dealing with. But even if we have no idea about something, no background or training on a topic, we are very likely to have an opinion about it and sometimes to share it. As human beings, we always make calls. These decisions are biased for most of them and, at times, not appropriate for the context in which we are evolving. The investors chief problem and his worst enemy is likely to be himself, yet we have a strong tendency to blame our mistakes on information or others. A strong belief, rooted in standard economics and its models of rational decision-making, is that a person will use information to make the right choices after making an informed judgement, balancing rights and wrongs, pros and cons, costs and benefits, etc. But people do not behave in this way. Real human beings behave very differently from the artificial economic agent that is still at the heart of most decision-making models today. Behavioural finance draws on cognitive and social psychology to analyse dozens of psychological biases that influence how we process and use information to make choices. But we can now go further by using neuroscience to analyse how our brains function in the decision-making process. I am not here to sell you the perfect solution; anyone who would claim that brain sciences alone can provide the perfect strategy, regardless of the field (economics, finance, marketing, management), would be at best misinformed, if not lying. The main advantage of learning about what we know about behaviour and the brain in finance is to avoid mistakes, to avoid repeating mistakes and perhaps to develop insights that complement and, sometimes, supplement traditional financial theories and tools in understanding what is at play when making decisions. For example, we are all overconfident. Many of the decisions we make every day in our jobs are related to things that we are used to dealing with. But even if we have no idea about something, no background or train-
ing on a topic, we are very likely to have an opinion about it and sometimes to share it. As human beings, we always make calls. These decisions are biased for most of them and, at times, not appropriate for the context in which we are evolving. For instance, we have a powerful aversion to loss: if you ask people whether it is more painful to lose money or to earn money, of course people prefer to earn money and yet loss-aversion can make them reluctant to cut their losses when it would otherwise make sense to do so. When we look at brain data, it appears there are two distinct dynamics that are employed when we compute what we can gain and what we can lose. Besides, when people are in loss-aversion mode they rely more on the brain networks that deal with fear. There is also herding, our tendency to mimic or follow what other people do. If you want your employees to do something, telling them that almost everyone they know does it is much more effective than telling them it is the right thing to do. In the UK, Her Majestys Revenues & Customs (HMR&C) did an experiment with letters sent to citizens informing them of the percentage of people who pay their taxes on time compared to traditional reminders. This strategy increased significantly the number of people who paid their taxes on time. Our tendency to herd might come from our strong tendency to mirror others. We have brain cells called mirror neurons that fire whether one is performing an action or seeing someone else perform the same action. And if someone is performing an action that you are thinking about, you somehow start to resonate with the person and might even mimic that action spontaneously; this is what is at the heart of herding behaviour. Some of the most common biases are listed on page 26. There are many others. Any or all of them may distort how we process information and reach decisions; we are living in a jungle of biases that we have to navigate and endure.
24
25
we know people, the more activity in these areas of the brain peaks. Thanks to neuroimaging there is evidence that when people first interact, the evaluation of the decision to invest money occurs after another individual invested. As people interact with each other, the brain switches from reactive mode to anticipation mode, as we can see the brain network supporting the decision is active before knowing how much the other one invests. This casts light on how people have a tendency to trust the market too much and make decisions even before they have all the information. Anticipation can be a great asset, but it can be a disaster as well. So what are the challenges for researchers and people in finance? We understand a lot more about human behaviour, our biases, how our beliefs can mess up our judgement and how this judgement can influence decisions. But the true dynamics between the individual and the collective level remain very hard to evaluate, and we do not yet have efficient models to connect them. Yet, brain sciences have provided unprecedented insights into how judgement and decision-making can be processed differently in the brain. Such findings hint at the reasons why people very often make poor decisions in spite of having a clear judgment of a situation. On top of that, the intrinsic dynamics and emerging self-organised technical patterns of a market can disturb or stabilise behaviour as much as external information can, contrary to efficient market theory. Another challenge is that most of the experiments are conducted in labs, on Western-educated students on campuses in democratic, industrialised countries. As a result, they are not universally representative, and the context is not very realistic. The insights could be totally wrong if applied to a global population. This is why I do a lot of work with subjects who work in financial institutions rather than students on my campus. We have also developed new techniques of data mining and crowd sourcing for large-scale analyses and new portable neuroscientific devices that can be
used in workplaces unobtrusively so we can establish more sound general insights. Thanks to our growing knowledge of cognitive biases and how the brain works, we know that we will not deliver perfect solutions. But if we can train people to identify their biases, they could identify very complicated days when the stakes are really high and they could assess whether or not they are ready to deal with them. People will have to learn how to say that, for example, someone is dying in a persons family and the people in charge will have to learn to accept that such occasions can totally flip that persons ability to deal with major crises. Anchoring: We rely too much on previous information, regardless of its accuracy. The effect can be multiplied if we hear the information from someone we respect a lot or someone we totally despise. Negativity bias: When weighing options we put more weight on nega- tive factors that are painful, not only financially but in terms of ego. Illusion of control: We overestimate our ability to influence events. If we miss a day at work and some stocks dive, we tell ourselves that, if we had been at work, it would have been different. Priming:The way that we process and use information depends on who gives it to us. Observer expectancy effects: If we are convinced that something is right, that will influence the way we process information. In the models we use, the way we interpret information and the people we rely upon, our choices reflect our strong beliefs. Endowment: Because we bought something, we value it more. We will be less reluctant to sell something that we did not buy. Backfire effects: We evaluate people according to whether they say what we want to hear. We downplay them if they go against our views and it may even strengthen those views. Gamblers fallacy: We believe that previous events have a strong influence on what is going to happen, even if they are totally unrelated. Hyperbolic discounting: We prefer a gain that arrives sooner rather than later.
26
27
Our answer to a low-return environment in which most portfolios are highly correlated with equities is cost-effectively investing in many return sources to reduce equityrisk concentration without sacricing expected returns
Investment perspectives from Antti Ilmanen Managing Director, AQR Capital Management (Europe) LLP
28
Illiq s uid
Alpha
Carry: overweight assets with high income Momentum/trend: overweight assets with high recent returns Defensive: overweight assets with low beta or high quality.
Illiq ui d s
uid Illiq
These styles travel well: value-investing, for example, was pioneered in the 1930s by Benjamin Graham in equities and has been found to work in other asset classes. The same is true for carry, momentum/trend and defensive styles. In stock selection or in more macro trading, all these styles have done well over the last 35 years. Risk-reducing styles such as trend-following and defensive equities can be especially interesting portfolio allocation strategies on their own, but I believe there are advantages in multi-strategy portfolios. One is obviously that they give better diversification, potentially reducing costs through netting. But perhaps more important, a multi-strategy approach induces less return-chasing. Investors like to do some market-timing and style-timing but the right amount is pretty small you need to be very humble about any timing you try to do. The most important thing is to avoid the common mistake of chasing strategies that have performed well in the past two or three years. This is usually a trap in momentum/trend-following. Even people who know that they make this mistake find it difficult to avoid, so a multi-strategy portfolio ties you to the mast and makes you more likely to behave like a long-term investor. An example of the success that can be achieved in this way is provided by Warren Buffett, an investor with an extraordinary track record. Everybody is interested in knowing the secret of his success, and although he is Mr Value Investor, there is much about his record that cannot be explained by looking at value signals. But you can explain virtually everything by putting in factors such as high quality and low beta. He has always said that he buys value and quality, but he also levers up low-beta opportunities.
risk premia such as equity premia and duration premia. At the top are alpha investments, which we think should be a small part because they are elusive and costly. We believe investors can capture some of the returns that are categorised as alpha better by looking at alternative-beta premia.
Source: AQR
29
INVESTMENT MANAGEMENT
We believe that we are the only portfolio manager in the world which can say to its clients that we will never bet with their money.
Yves Choueifaty President and Chief Investment Ofcer, TOBAM
30
patented very soon in Canada, Japan and some European countries. With this tool we can build a portfolio that maximises its diversification.
Risk (Volatility)
We believe the higher returns result from better capturing of the risk premia
Source: TOBAM
The second intuitive reason why diversification will increase the return can be seen in the weighting of the sectors of the S&P 500. As stocks appreciate, the greater their weighting becomes in the index, and vice versa. So, for example, after the first oil shock, energy stocks rose and if you were following a market-cap weighted index, you would increase your allocation to energy stocks until the peak was reached when the oil counter-shock happened, which was the worst day to be holding them. A market-cap weighted benchmark is not a neutral risk allocator; it is a biased risk allocator. And not only is it biased, those biases change over time it is a dynamic risk allocator.
the Anti-Benchmark outperformed or underperformed. They start asking whether the benchmark outperformed the Anti-Benchmark or underperformed it, because they realise that we do not make bets. Ours is a diversified portfolio, the most boring portfolio. The nonboring portfolios simply make enormous bets.
31
contriButors
EDITORIAL TEAM PICTET & CIE Kalina Moore Wilhelm Sissener DesiGn and editorial consultancY Stphane Bob Production Multimedia Winkreative REPORTER John Willman ENGLISH TRANSLATION/REVISION Stephen Barber Daniel Steffen Keith Watson pHotoGrapHY Mara Truog
32
Disclaimer This report is issued and distributed by Pictet Group. It is not aimed at or intended for distribution to or use by any person or entity who is a citizen or resident of, or located in, any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation. The information and material presented in this report are provided for information purposes only and are not to be used or considered as an offer or invitation to buy, sell or subscribe to any securities or other financial instruments. Furthermore, the information, opinions and estimates expressed herein reflect a judgment as at the original date of publication and are subject to change without notice. The value and income of any of the securities or financial instruments mentioned in this document can go up as well as down. The market value may be affected by changes in economic, financial or political factors, time to maturity, market conditions and volatility, or the credit quality of any issuer or reference issuer. Moreover, currency exchange rates may have a positive or adverse effect on the value, price or income of any security or related investment mentioned in this report. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied, is made by Pictet Group regarding future performance. Instructions stipulated by the client as regards trading, transactions and investment constraints shall take precedence over, and may diverge from, the Banks overall investment strategy and recommendations. Portfolio managers are granted a degree of flexibility so as to accommodate the individual wishes and particular circumstances of clients. As such, the asset allocations specified in this report do not have to be strictly adhered to. Actual allocations to alternative, non-traditional investments (e.g. hedge funds) may exceed those mentioned in the grids herein provided that positions in traditional equities are adjusted accordingly. This publication and its contents may be quoted provided that the source is indicated. All rights reserved. Copyright 2012 Pictet Group
AG
Are you on Facebook? Add Pictet to your daily flow of information by liking our page. Search for Pictet Wealth Management on Facebook and join the conversation.
Follow us on twitter for fast-paced and opinionated updates from our investment specialists and analysts.
facebook.com/pictetwealthmanagement
twitter.com/pictetwm
Subscribe to our YouTube channel to receive the latest interviews with Pictets specialists discussing investment strategies and macroeconomics.
Our video interviews are also available as a podcast on iTunes. Subscribe free of charge, and take Pictets videos with you on your iPad or iPod.
youtube.com/pictetwm
bitly.com/pictet-itunes
perspectives.pictet.com